What is the 5 year rule for a roth conversion

[jefals]

I'm 75 years old, and did my first traditional IRA to Roth IRA conversion on 12/31/2021.  I know there is a 5 year rule regarding when I can access the funds I converted -- but I think, since I'm over 59 1/2, that 5 year rule does not apply to me -- and I need to verify that.  Is it true, I could access that Roth money penalty-free tomorrow if I wanted to, since I did the conversion when I was well over 59 1/2?

[Critter-3]

The 5 year conversion  rule affects the earnings only and not your original contributions.  You are exempt from the penalty on the distributions however the earnings can be subject to federal taxes.  Just don't invade the earnings until 1/1/25 and all is good.

[jefals]

Thanks Critter-3.   Not sure we're exactly on the same page here.  I'm talking about a ROTH conversion.  Not a contribution of any kind -- whether to a tradional IRA or a ROTH.

As you mentioned Federal taxes might be due on the earnings, I kind of think you are thinking about a traditional IRA.   Once in the Roth, there should be no taxes due on anything  -- as long as I follow the rules...

All that said:  I'm trying to find out if I'm exempt from the 5 year rule related to Roth conversions, namely that each time I make my first Roth conversion of a year I start the clock on a new 5 year waiting period.  Ex:

  I convert 100 shares of McDonalds to a Roth in 2021.

  I convert 100 shares of AT&T to a Roth in 2022.

According to my understanding of the 5 year rule for conversions,  if I don't want a 10% penalty, I must wait till 2026 to get to the McDonalds (stock or earnings), and 2027 to get to the AT&T (stock or earnings).

HOWEVER --  I believe -- since I am 75 (i.e. over 59 1/2),  and just making my first Roth conversion -- that I am exempt from any of these 5 year rules, meaning I can take anything out of my Roth the day after I put it in if I want to, (stock or earnings), penalty free.  THIS is what I'm trying to verify.

[Opus 17]

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@Critter-3 wrote:

The 5 year conversion  rule affects the earnings only and not your original contributions.  You are exempt from the penalty on the distributions however the earnings can be subject to federal taxes.  Just don't invade the earnings until 1/1/25 and all is good.

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Not quite.  There are two 5 year rules.  The 5 year rule about conversions only applies if the account owner is under age 59-1/2.  The general 5 year rule applies to everyone.

[Opus 17]

[Edited, see below.]

[Opus 17 · Accepted solution]

There are two 5 year rules for Roth IRAs.  It's all in here.

https://www.irs.gov/publications/p590b#en_US_2020_publink1000231065

1. To be a "qualified" distribution, the payment must be made after you reach age 59-1/2 (or certain other reasons), AND after the fifth tax year in which you first opened a Roth IRA.

If this is your first ever Roth IRA account, opened 12/31/2021, then the 5 tax-year period runs from 2021 through 2025.  Your withdrawals will not be qualified until 1/1/2026.

This 5 year rule is satisfied by any Roth IRA, so if you had opened a previous Roth IRA in the past, you may have already satisfied this 5 year rule and your withdrawals would be qualified even if you withdrew them tomorrow.

2.  There is a second 5 year rule for conversions.  Each conversion has its own 5 year waiting period, separate from the overall 5 year waiting period for owning a Roth IRA.  Again, you can withdraw your basis but not your earnings.  However, if the withdrawal is otherwise qualified, the penalty for withdrawing earnings from a conversion is only the 10% penalty for early withdrawal, and that does not apply if you are over age 59-1/2. 

The bottom line is that 

1. there is an extra tax on early withdrawals of conversions,
2. each conversion has a separate 5 year clock,
3. the 10% tax for early conversions does not apply if you are over age 59-1/2,
4. the general 5 year rule for qualified distributions applies at any age.

Using your suggestion, let’s convert 100 shares of McDonald stock worth $26,800 on 12/31/2021, and convert 100 shares of AT&T worth $2600 on 7/1/2022.  Your conversion basis is $29,400.

Let's look at 2 scenarios.

On June 30, 2025, the balance is $34,000 (assuming 5% per year) and you need to withdraw $30,000.  Using the ordering rules:

• The first $26,800 is your 2021 conversion. It's within the general 5 year rule, and it's within its own 5 year conversion clock, but it's non-taxable as a withdrawal of your conversion basis and you are exempt from the 10% penalty by your age.  This part is non-taxable. 
• The next $2,600 is your 2022 conversion. It's within it's 5 year conversion clock and is non-qualified, but since it is your conversion basis and you are over age 59-1/2, it's not taxable and not subject to a penalty.
• The last $600 is earnings, and since the withdrawal is not qualified by the general 5 year rule, this portion is subject to regular income tax, but not the 10% penalty.

Or, suppose you want to withdraw the entire account balance on January 2, 2026, and the balance is about $35,000.  Now, the entire withdrawal is qualified because you are over age 59-1/2, and you meet the general 5 year rule.  Using the ordering rules:

• The first $26,800 is your 2021 conversion, and is non-taxable because it is past it's 5 year clock for conversions.
• The next $2,600 is your 2022 conversion.  This is an early conversion subject to a 10% penalty, except this penalty does not apply if you are over age 59-1/2.
• The last $5,600 is earnings, and is non-taxable because the distribution is qualified.

[jefals]

(Boy, I had a hard time getting back into here!  All kinds of problems trying to log-in...Not sure how I finally made it, but anyway, here I am)...

Thanks, Opus 17...

This is a wealth of info, and I appreciate it.  I'm mainly focused right now on just this part of your reply:

The bottom line is that 

1. there is an extra tax on early withdrawals of conversions,
2. each conversion has a separate 5 year clock,
3. the 10% tax for early conversions does not apply if you are over age 59-1/2,
4. the general 5 year rule for qualified distributions applies at any age.

Number 3 is what I'm interested in.  And I think you meant to say"the 10% penalty for early distributions..." rather than 10% tax for early conversions"...  did you not?

(As I am converting from a traditional IRA to a Roth, I pay the tax when it leaves the traditional IRA.  Once in the Roth, there should be no more tax, ever.  It's a 10% penalty on breaking this 5 year rule, that I'm concerned with).

Am I interpreting correctly that, since I made my first Roth conversion at age 75  (well past 59 1/2), that I can take any (or all) of the money out of that Roth at any time (even the very next day after I did the conversion, if I wanted to), with no penalty?

[jefals]

Another way to ask this, taking this from your reply...

"If this is your first ever Roth IRA account, opened 12/31/2021, then the 5 tax-year period runs from 2021 through 2025.  Your withdrawals will not be qualified until 1/1/2026".

Does this 5 year period still apply if I am over 59 1/2 when I do this first conversion?

[Opus 17]

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@jefals wrote:

Am I interpreting correctly that, since I made my first Roth conversion at age 75  (well past 59 1/2), that I can take any (or all) of the money out of that Roth at any time (even the very next day after I did the conversion, if I wanted to), with no penalty?

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Mostly.  However, if you withdraw earnings in less than 5 years, it will not be "qualified" and you will pay regular income tax on the earnings, even though you don't pay income tax on the converted principal.  And that's where the ordering rules come into play.

Early and qualified are two different things, even though they are very similar and it's easy to get confused.  

Any withdrawal you make before 1/1/2026 will be both early and non-qualified.  The "price" for making a non-qualified withdrawal is paying regular income tax on the earnings but not the principal.  There is no penalty for you for making an early withdrawal because you are over 59-1/2.   Any withdrawal you make after 1/1/2026 will be qualified, so withdrawals of earnings will be tax-free.  And even if your withdrawals are considered "early" due to the separate clock that runs for each conversion, there is no penalty at your age. 

Basically, this relates to the difference between an IRA and a Roth IRA.  Suppose I'm 50, and I want to withdraw from my regular IRA.  I pay income tax plus a penalty.  If there was not a separate 5 year clock on each conversion, then I could convert my IRA to a Roth, pay the income tax, then withdraw from the Roth tax-free and save 10%.  That's why the 10% penalty is applied to conversions less than 5 years old, and it's also why that penalty is not applied if you are over 59-1/2, because you would not pay a penalty if you simply withdrew the money from the regular IRA instead. 

[jefals]

Got it.  Thanks Opus.

Ok, then, so as long as I don't take anything out till 1/1/2026, I'm "home-free".  (Even tho it's a "5 year rule, it's more like a 4 year rule for me, since I did the conversion 12/31/21)!

I converted dividend paying stocks -- not cash, which is what I plan to do with my future conversions.  And, since I do now want to wait till 1/1/2026 to avoid the penalty, it would seem to make sense for me to try and convert my least productive stocks -- the ones that pay the lowest dividends -- for the time being, so that I'll still have access to more cash while I'm waiting for that 5 year clock....

[Opus 17]

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@jefals wrote:

Got it.  Thanks Opus.

Ok, then, so as long as I don't take anything out till 1/1/2026, I'm "home-free".  (Even tho it's a "5 year rule, it's more like a 4 year rule for me, since I did the conversion 12/31/21)!

I converted dividend paying stocks -- not cash, which is what I plan to do with my future conversions.  And, since I do now want to wait till 1/1/2026 to avoid the penalty, it would seem to make sense for me to try and convert my least productive stocks -- the ones that pay the lowest dividends -- for the time being, so that I'll still have access to more cash while I'm waiting for that 5 year clock....

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Again, even before 1/1/26, you only pay tax on earnings, if you withdraw earnings. Using the ordering rules, your conversion basis is withdrawn first, so would not pay income tax on withdrawals before 1/1/26 unless you tapped out your conversion basis and dipped into the value that your stocks have earned since the conversion. 

[jefals]

Just "chewing over" this part a little....

Any withdrawal you make before 1/1/2026 will be both early and non-qualified.  The "price" for making a non-qualified withdrawal is paying regular income tax on the earnings but not the principal.  There is no penalty for you for making an early withdrawal because you are over 59-1/2.   Any withdrawal you make after 1/1/2026 will be qualified, so withdrawals of earnings will be tax-free.  And even if your withdrawals are considered "early" due to the separate clock that runs for each conversion, there is no penalty at your age. 

So, then, let's see if I got this:

The 10% penalty is related to the separate clocks.  ( A separate clock for each year I do a conversion).  And I avoid this penalty since I'm over 59 1/2.

The "tax on earnings" is based only on the first clock.    No matter when I do conversions, as long as I don't touch the earnings till 2026, I'm tax free from then on out.   

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Correct?

[Opus 17]

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@jefals wrote:

So, then, let's see if I got this:

The 10% penalty is related to the separate clocks.  ( A separate clock for each year I do a conversion).  And I avoid this penalty since I'm over 59 1/2.

The "tax on earnings" is based only on the first clock.    No matter when I do conversions, as long as I don't touch the earnings till 2026, I'm tax free from then on out.   

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Correct?

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Yes.

[jefals]

Great!

Thanks much for clearing that up!

[fanfare]

a) If you invest the Roth as intended, for growth, Why would you want to take earnings out ??

b) it's unlikely the IRS is going to audit you whatever you do..