How to Calculate Earnings in Roth IRA account?

[Liangtwn]

Scenario: 1 share of ETF was purchased for $100 in traditional IRA on 2/1/2019 and rolled over to Roth on 2/2/2020 when the market value at the closing was $110. 1/1/2025 market value is $120. The appreciation $10 ($120-110) of the share is treated as the earnings, correct? If so, $10 can be distributed tax free and penalty free on 1/1/2025 because that share has been in the Roth for more than 5 years from year 2020 to 2024.  Correct?  

Thanks!!

[Deepp · Accepted solution]

Hello Liangtwn:

Let's review:

*The appreciation $10 ($120-110) of the share is treated as the earnings, correct?

The $10 gain is classified as earnings in the Roth IRA

* Can the the$10 be distributed tax-free and penalty-free on 1/1/2025 because it has been in the Roth for more than 5 years?

In order for earnings tax-free and penalty-free, the distribution must be a Qualified Distribution, which requires two separate conditions to be met:

First condition, 5 year Rule:

• In your case: If the 2/2/2020 conversion was your very first Roth funding event, the 5-year clock started on January 1, 2020.

• The 5-year period ends on December 31, 2024.

• Therefore, as of January 1, 2025, the Earnings 5-Year Rule is met.

Second condition, Qualified Reason:

• You must meet one of the following: Age 59 1/2or older,
• Qualified first-time home purchase (up to $10,000$ lifetime limit),
• Disability, or
• Distribution made to a beneficiary after your death.

Assuming you are at least 59 1/2 years old (or meet another qualified reason), your conclusion is correct: The $10 of earnings can be withdrawn Tax-Free and Penalty-Free starting January 1, 2025.

[Liangtwn]

Thank you VERY MUCH  for the quick turnaround...

For 5-year rule, is there a different rule to start the 5-yer clock if the conversions are not the very first funding event to Roth?  In the same Roth account, I also have regular after-tax contributions made years ago though.  When you say "very first funding event", does that include regular after-tax contributions made years ago?  Or, you were referring to first Roth conversion only?  

Second condition to be met:  If it is 
Distribution made to a beneficiary after your death,
does that mean the earnings distribution to my beneficiaries can start from 1/1/2025 for my scenario mentioned?  

An additional question about the principle $110 at the conversion.  The withdraw is tax free and penalty free for the principle $110 when either the same age rule or 5-year rule is met.  Correct? 

Thanks again!!

[Deepp]

Thank you for the follow up questions:

Yes, there are two different distinct 5 year rules for a Roth IRA. The Earnings 5-Year Clock (The "Forever Rule"): The earliest funding event—whether it was a $5,000 contribution 10 years ago, or a $1 conversion 5 years ago—starts the clock for all your Roth IRAs. It is a one-time, lifetime clock for the owner.

While, the Conversion 5-Year Rule (The "Penalty-Free" Clock): It Starts: January 1 of the calendar year in which the conversion occurs. This clock is specific to each conversion. If you make 10 conversions over 10 years, you have 10 separate 5-year clocks. Met after five full tax years and a qualified event. 

Earnings Distribution to Beneficiaries: Since your Roth IRA's 5-year clock for earnings is met as of 1/1/2025, your beneficiaries (subject to the 10-year withdrawal rule under the SECURE Act) would receive the entire balance—contributions, conversions, and Earnings—Tax-Free and Penalty-Free on any withdrawals starting 1/1/2025. No Age Requirement: The death of the original owner satisfies the "qualified reason" requirement for the distribution to be tax-free, regardless of your age at death.

Lastly, converted Principal Withdrawals: The converted amount is always tax-free when withdrawn because you paid the tax in the year of conversion (2020). In your scenario: Since the 5-year conversion period (2020 to 2024) is met, the $110 is penalty-free regardless of your current age. If you are also over 59 1/2, the penalty waiver is double-satisfied.

[Liangtwn]

Very last question if you don't mind....

"(The "Forever Rule"): The earliest funding event—whether it was a $5,000 contribution 10 years ago, or a $1 conversion 5 years ago—starts the clock for all your Roth IRAs. It is a one-time, lifetime clock for the owner."

I have only one Roth IRA.  In this Roth IRA, I have mix of after-tax contributions I made starting 20 years ago and Roth conversions I started this year.  Does "Forever Rule" mean earnings 5-year clock started 20 years ago when I made my very first contribution for all my after-tax contributions, both the contributions made 20 and 15 years ago?  

Much appreciated!!  

[Deepp · Accepted solution]

Let's further clarify:

Forever Rule (Tax Free Clock) applies to earnings, which determines if earnings withdrawals are tax free. Your contributions from 20 years long been satisfied. 

Conversion Clock (Penalty-Free Clock) applies to your converted principal. Determines if converted funds can be withdrawn without 10% penalty. It would govern whether the converted funds can be pulled out penalty free, not whether earnings are tax-free. Those are covered by your original Forever Rule that began 20 years ago. This rule exists solely to prevent someone under 59 1/2 from converting funds and immediately withdrawing without a early withdrawal penalty. If someone has already reached 59 1/2 or meets an qualified exception the penalty restriction no longer applies. 

Hope this helps.