Know the 5 Year Rule To Avoid Tax On Your Roth IRA Distributions

Converting from a traditional IRA to a Roth IRA gives you an investment account that grows tax free, allows tax free withdrawals and hasn’t any minimum distribution requirements after you turn 70 1/2. But you have to abide by the 5 year rule; otherwise you may trigger tax consequences on your withdrawals. Retirees who find themselves making large Roth withdrawals should take note.

The Roth IRA is an ideal investment account for its attributes described above. But money that goes into a Roth IRA comes from ‘after-income tax’ contributions; so it’s all been taxed. The catch, though, is that you must fulfill the ‘waiting’ time before you make any withdrawals from your Roth IRA so as not to incur any penalty or taxation on them. If you’ve waited the 5 years since your contributions and you’re over 591/2, you’re distributions – from those contributions and their earnings – are free and clear.

Such qualified withdrawals have fulfilled all requirements and are free of taxation and penalties. Otherwise you’ve triggered a nonqualified withdrawal.

*How are nonqualified distributions taxed?

If you’re over 591/2 but haven’t waited the required time, just what will be taxed? Since you’ve already been taxed on whatever you’ve directly contributed to your Roth or whatever you converted from a traditional IRA to your Roth, you won’t be taxed on it again! What you will be taxed on is the ‘earnings’ in your Roth IRA which is the amount in your Roth account above what you’ve directly contributed or converted.

But those earnings are not subject to tax until you’ve first withdrawn your contributions and conversions. Specifically, the order of distributions that any withdrawal implies is considered as taking:

1) First, your regular (i.e. direct) contributions, and

2) Secondly, conversion contributions on a first-in-first-out basis (if you’ve made more than one conversion), and

3) Lastly, earning on contributions

You can see that you’ll probably have to withdraw a good fraction of your Roth account before you get to the ‘taxable earnings’ for those nonqualified withdrawals. You also need to keep track of all your contributions and conversions and their dates, so you know when the relevant earnings are coming out. This means a little book-keeping for you.

*Different 5 year rules for direct contributions and conversions!

There are slightly different rules for withdrawing direct contributions as opposed to conversion (i.e. from a regular IRA to a Roth IRA) contributions. For direct contributions, the 5 year duration starts on January 1 of the year for which that contribution was designated. Realize that you can make a contribution for a given year not only anytime during that year but as late as April 15th of the following year. So the 5 year duration can be as little as a few months short of 4 years!

For conversions, though, the 5 year duration starts from the date of the conversion. So, you’ll have to wait at least 5 years beyond your date of conversion to achieve a qualified distribution for that conversion and its earnings.

So there you have it. Keep track of your contribution dates so you know when you can freely take out everything you want.

Shane Flait helps you with your financial legal, tax, and retirement goals.
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