The pros and cons of Roth IRAs, which were introduced 20 years ago, are well understood. All money flowing into Roth IRAs is after-tax, so there is no upfront tax benefit. As a tradeoff, all qualified Roth IRA distributions can be tax-free, including the parts of the distributions that are payouts of investment earnings.
To be a qualified distribution, the distribution must meet two basic requirements. First, the distribution must be made on or after the date the account owner reaches age 59½, be made because the account owner is disabled, be made to a beneficiary or to the account owner’s estate after his or her death, or be used to buy or rebuild a first home.
Second, the distribution must be made after the five-year period beginning with the first tax year for which a contribution was made to a Roth IRA set up for the owner’s benefit.
Note that the calculation of a Roth IRA’s five-year period is very generous. It always begins on January 1 of the calendar year. For example, suppose you open your first Roth IRA at age 58 and make a contribution to it on March 29, 2018. Further suppose that you designate this contribution as a contribution for 2017, which can be made until April 17, 2018. Under the five-year rule, your five-year period would start on January 1, 2017. Under this scenario, your Roth IRA distributions would be tax-free, qualified distributions as of January 1, 2022 because they would have been made after you turned 59½ and after the five-year period has ended. The five-year period is determined based on the first contribution to the Roth IRA; the starting date of the five-year period is not reset for the subsequent contributions.
Other than making regular contributions, Roth IRAs may be funded by converting a traditional IRA to a Roth IRA and paying tax on any pre-tax dollars moved to the Roth side. For such conversions, a separate five-year rule applies. There generally is a five-year waiting period before a Roth IRA owner who is under age 59½ can withdraw the dollars contributed to the Roth IRA in the conversion that were includible in income in the conversion, without owing a 10% early withdrawal penalty.
Similar to the five-year rule for qualified distributions, the five-year period for conversions begins on the first day of the year of the conversion. However, unlike the five-year rule for qualified distributions, the five-year rule for conversions applies separately to each Roth IRA conversion because the IRS doesn’t want people to avoid the early withdrawal penalty on traditional IRA distributions by making a Roth conversion.
Note that various exceptions may allow the owner of a Roth IRA to avoid the 10% penalty before the end of the five-year period that follows a conversion. Altogether, the taxation of any Roth IRA distributions made before five years have passed and before age 59½ can be complex. If you have a Roth IRA, our office can explain the likely tax consequences of any distribution you are considering. Generally, it is better to wait until the age 59½ and five-year tests are passed before making Roth IRA withdrawals, to avoid taxes.
This article carries no official authority, and its contents should not be acted upon without professional advice. For more information about this topic, please contact our office.