Hi Kentyou,
There are different rules for ROTH IRAs depending on whether they are created by Inheritance, Conversion, or Regular Contributions. Below I explain just the differences regarding the 5-year rule:
- Regular, the 5-year rule on Roth IRAs says you cannot withdraw earnings tax-free until it's been at least five years since you first contributed to a Roth IRA account. This five-year rule applies to everyone who contributes to a Roth IRA, whether they're 59 ½ or 105 years old. This relates to the earnings only, you can always withdraw ROTH IRA contributions tax-free at anytime. The five-year period starts on the first day of the tax year for which you made a contribution to any Roth IRA, not necessarily the one you're withdrawing from.
- Conversion, the 5-year rule on Roth conversions requires you to wait five years before withdrawing any converted balances — contributions or earnings — regardless of your age. If you withdraw money from a converted Roth IRA within the first five years after the conversion, you'll have to pay the 10% penalty on any withdrawals. That includes withdrawals of the amount you initially converted -- even though you've already paid taxes on that amount. You're still allowed to use other exceptions to the 10% penalty rules in a Roth conversion situation, however, in particular, if you're over age 59 1/2, then the age exception applies, and you can immediately take withdrawals without worrying about the penalty. Each new conversion starts its own five-year clock, and you'll need to account for multiple conversions to make sure you don't take out too much money too soon.
- Inheritance, if you fail to withdraw 100% of funds from an inherited IRA by the end of the fifth year following the owner's death, the remaining balance is subject to a 50% penalty. Things are different depending on whether you are a spouse or just a non-spouse beneficiary.
Regarding taxation of ROTH IRAs, subject to the 5 year rule penalties above and any exceptions:
- tax is paid on conversion from the traditional IRA to the ROTH IRA (unless back-door ROTH)
- withdrawals of contributions are never taxable (see 5-year rules)
- withdrawals of earnings are tax-free (if taken after age 59 1/2 and subject to 5 year rules)
Here are some helpful links that can provide more information:
ROTH Conversions
Backdoor Roth IRA
