Understanding the 5-Year Holding Period, Roth Conversions, and Exceptions

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To avoid the 10% penalty, do I have to satisfy the 5-year holding period for my Roth conversions if I’m over age 59 1/2?

To avoid the 10% penalty, do my beneficiaries have to satisfy the 5-year holding period for my Roth conversions?

The IRS is not very clear when it comes to when you need to pay penalties on Roth IRA withdrawals, but I think I know the answer.

I would answer these questions: No, you do not have to satisfy the 5-year holding period on Roth conversions in order to avoid the 10% penalty if you meet an exception such as being over age 59 1/2 or being an IRA beneficiary. However, the earnings portion of your distribution may be includible in income if you have not had a Roth IRA open for five years.

Below is my interpretation of their Publication 590 instructions justifying this. I am not a tax preparer. This is just my best understanding. You should consult a qualified CPA or enrolled agent with your specific case.

 

Qualified Distributions from Roth IRA Contributions

To withdraw from your Roth IRA it needs to be a qualified distribution as defined, as follows, by the IRS:

What Are Qualified Distributions?

A qualified distribution is any payment or distribution from your Roth IRA that meets the following requirements.

  1. It is made after the 5-year period beginning with the first taxable year for which a contribution was made to a Roth IRA set up for your benefit, and
  2. The payment or distribution is:
    1. Made on or after the date you reach age 59½,
    2. Made because you are disabled (defined earlier),
    3. Made to a beneficiary or to your estate after your death, or
    4. One that meets the requirements listed under First home under Exceptions in chapter 1 (up to a $10,000 lifetime limit).

The above text is also represented in the IRS-provided flow chart, reprinted at right.

Number one is the basis of the “5-Years” in the 5-Year Roth Rule. Number two is the qualified reasons you can withdraw from your Roth IRA. You need to have satisfied both one and two in order to withdraw the earnings portion of your Roth IRA contributions without penalty.

The IRS says, “You do not include in your gross income qualified distributions or distributions that are a return of your regular contributions from your Roth IRA(s).” In plain English, this means that money you contributed to your Roth IRA according to regular IRA contribution rules (ie. $5,500 or $6,500 each year) is never taxed. I repeat, the basis of your contributions are always tax-free distributions.

You contribute $5,500 to your Roth IRA. It grows to $5,600. In IRS speak, this is $5,500 of contributions and $100 of earnings. The earnings must satisfy both part one and two of the qualified distribution requirements in order to be distributed tax-free.

If your Roth IRA has not been open for five years, then you cannot qualify for tax-free distributions from your contributions’ earnings portion, even if you are older than age 59 1/2, because to have a qualified distribution you have to meet part one (5-year-old Roth) and part two (where the age 59 1/2 exception is).

Qualified Distributions from Roth Conversions or IRA Rollovers

There are different rules provided for Roth conversions or IRA rollovers. Here are those annotated rules:

Distributions of conversion and certain rollover contributions within 5-year period.

If, within the 5-year period starting with the first day of your tax year in which you convert an amount from a traditional IRA or rollover an amount from a qualified retirement plan to a Roth IRA, you take a distribution from a Roth IRA, you may have to pay the 10% additional tax on early distributions.

So far all we’ve learned is that five years after you convert or rollover funds, you can take the conversion or rollover balance out tax-free. Otherwise, you may have to pay the 10% additional tax. The “may” here is really important.

You generally must pay the 10% additional tax on any amount attributable to the part of the amount converted or rolled over (the conversion or rollover contribution) that you had to include in income (recapture amount).

Another way of saying that sentence is: you don’t have to pay a 10% tax on any nondeductible basis (backdoor Roth) that you may have had in your Traditional IRA. If you have to pay a 10% tax because of a distribution from a conversion, it would only be on the portion which you received a deduction for in the past, i.e. normal Traditional IRA balance which here they are calling the “recapture amount.”

A separate 5-year period applies to each conversion and rollover. See Ordering Rules for Distributions , later, to determine the recapture amount, if any.

The 5-year period used for determining whether the 10% early distribution tax applies to a distribution from a conversion or rollover contribution is separately determined for each conversion and rollover, and is not necessarily the same as the 5-year period used for determining whether a distribution is a qualified distribution. See What Are Qualified Distributions? , earlier.

For example, if a calendar-year taxpayer makes a conversion contribution on February 25, 2016, and makes a regular contribution for 2015 on the same date, the 5-year period for the conversion begins January 1, 2016, while the 5-year period for the regular contribution begins on January 1, 2015.

The above section is not very interesting. It just says: each conversion or rollover must have its own 5-year clock. (What an accounting job!)

Unless one of the exceptions listed later applies, you must pay the additional tax on the portion of the distribution attributable to the part of the conversion or rollover contribution that you had to include in income because of the conversion or rollover.

This does not say, “If you meet an exception, then you do not have to pay the additional tax,” like we would prefer it say, but it implies that really heavily. It says, “If you do not meet an exception, then you have to pay the additional tax.”

The phrase “the portion of the distribution attributable to the part of the conversion or rollover contribution that you had to include in income because of the conversion or rollover” is the same as the aforementioned “recapture amount” (defined earlier as “that you had to include in income”).

So to put it all together, “If you do not meet an exception, then you have to pay the 10% tax on the distribution from your deductible basis.”

You must pay the 10% additional tax in the year of the distribution, even if you had included the conversion or rollover contribution in an earlier year.

In other words, you have to pay the 10% tax on the conversion even if you converted (reported it as income) and withdrew (incurring the 10% tax)  all in the same year.

You also must pay the additional tax on any portion of the distribution attributable to earnings on contributions.

In other words, if you also withdrew any earnings (money not represented in your conversion or contribution basis) then you would have to follow the additional tax rules for those (report the earnings on income and maybe also pay the 10% tax).

Other early distributions.

Unless one of the exceptions listed below applies, you must pay the 10% additional tax on the taxable part of any distributions that are not qualified distributions.

Again: If you do not meet an exception, then you must pay the additional tax. This time, the IRS is talking about the earnings portion of a not qualified distribution.

So we learned that: If you do not meet an exception, then you have to pay the 10% tax on conversions and/or the earnings portion. Now the nagging question, What are the exceptions?

Exceptions.

You may not have to pay the 10% additional tax in the following situations.

  • You have reached age 59½.
  • You are totally and permanently disabled.
  • You are the beneficiary of a deceased IRA owner.
  • You use the distribution to buy, build, or rebuild a first home.
  • The distributions are part of a series of substantially equal payments.
  • You have unreimbursed medical expenses that are more than 10% (or 7.5% if you or your spouse was born before January 2, 1952) of your adjusted gross income (defined earlier) for the year.
  • You are paying medical insurance premiums during a period of unemployment.
  • The distributions are not more than your qualified higher education expenses.
  • The distribution is due to an IRS levy of the qualified plan.
  • The distribution is a qualified reservist distribution.

That’s a lot of exceptions, including age 59 1/2 and the beneficiary of a deceased IRA owner.

Now, we come to our real question:

The Question

Do I have to satisfy the 5-year holding period for my Roth conversions if I’m over age 59 1/2?
Do my beneficiaries have to satisfy the 5-year holding period for my Roth conversions?

The reason why this is even a question is because the conversion rules say (paraphrased), “If you do not meet an exception, then you have to pay the additional tax.”

They do not say (paraphrased),”If you meet an exception, then you do not have to pay the additional tax.”

This is logically consistent: If you do not meet an exception, then you have to pay the additional tax, and if you do meet an exception, then you may have to pay the additional tax. Which is why we are stuck.

We know there are the two factors involved in evaluating Roth conversions for their 10% penalty. The two factors are:

  1. Your distribution is made after the 5-year period beginning after the conversion.
  2. You meet an exception.

But it is unclear whether the Roth conversion or rollover rules for a qualified distribution are you must meet one AND two or you must meet one OR two.

In other words, if you meet an exception but it has been less than five years since the conversion, do you need to pay the 10% tax?

There is an IRS example which helps us, found under the “Distributions After Owner’s Death” section of Publication 590.

Here’s the IRS Example:

When Ms. Hibbard died in 2016, her Roth IRA contained regular contributions of $4,000, a conversion contribution of $10,000 that was made in 2012, and earnings of $2,000. No distributions had been made from her IRA. She had no basis in the conversion contribution in 2012.

When she established this Roth IRA (her first) in 2012, she named each of her four children as equal beneficiaries. Each child will receive one-fourth of each type of contribution and one-fourth of the earnings. An immediate distribution of $4,000 to each child will be treated as $1,000 from regular contributions, $2,500 from conversion contributions, and $500 from earnings.

In this case, because the distributions are made before the end of the applicable 5-year period for a qualified distribution, each beneficiary includes $500 in income for 2016. The 10% additional tax on early distributions does not apply because the distribution was made to the beneficiaries as a result of the death of the IRA owner.

Let’s unpack that.

First off, her Roth IRA was established in 2012 and her heirs distribute in 2016. 2016 – 2012 = 4. Her Roth IRA and their conversions were only 4-years old when her heirs distributed, so her Roth IRA most definitely did not meet the “Your distribution is made after the 5-year period beginning after the conversion” requirement.

Here’s a table showing my understanding of the example:

Regular Contributions Conversion Contributions Earnings
2012 Roth IRA doesn’t matter when she contributed, so long as 2012 or after $10,000 doesn’t matter if these are earnings on the conversion or contribution
2016 Roth IRA $4,000 $10,000 $2,000
Divided among 4 Heirs / 4 =

$1,000

/ 4 =

$2,500

/ 4 =

$500

10% Tax Owed? NO NO NO
Taxable Portion
for One Heir
$0 $0 $500

 

The IRS concludes (emphasis added), “In this case, because the distributions are made before the end of the applicable 5-year period for a qualified distribution, each beneficiary includes $500 in income for 2016. The 10% additional tax on early distributions does not apply because the distribution was made to the beneficiaries as a result of the death of the IRA owner.”

In other words, none of them owe the 10% tax, but the earnings portion needs to be included in their taxable income.

None of them owe the 10% tax because they meet an exception (they are beneficiaries of a deceased IRA owner). They don’t meet the 5-Year Roth Conversion Holding Period.

From the fact that none of them owe the 10% tax, we can conclude that for conversions the rule is that either “Your distribution is made after the 5-year period beginning after the conversion” OR “You meet an exception.”

And from this, I think that the correct way to parse Publication 590 is that the list of exceptions quoted above are exceptions to the 10% penalty (whether you incur that penalty from a young conversion or from an earnings distribution from not qualified distribution).

The Qualified Distributions from Roth IRA Contributions definition and associated five-year Roth rule is how you know whether to include the earnings portions in income.

The earnings portion is any portion of the IRA value not represented in the Roth conversion basis or the regular contribution total. As a result, the earnings could have come from either source in reality, but the IRS does not care which it came from.

This means that after 59 1/2 you will not owe a 10% penalty and your heirs will not owe a 10% penalty because both of those are included in the list of exceptions to the 10% penalty.

The 5-year conversion rule is just a rule that after five years you don’t need a reason to withdraw the conversion basis. In other words, the conversion basis is treated like your regular contribution basis after it has been in the account for five years.

After any funded Roth IRA has been open five years and you are older than 59 1/2, then you can get your earnings out without including it in income regardless of the source of your earnings. So, you should open and fund your Roth IRA right now.

Photo by Jennifer Pallian on Unsplash
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Megan Russell has worked with Marotta Wealth Management since 2005. She loves to find ways to make the complexities of financial planning accessible to everyone. Her most popular post: The Complete Guide to Your Washing Machine