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Roth Conversion question

Technical topics regarding tax preparation.
#1
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I am reading that for each Traditional IRA you convert to a ROTH IRA, you must endure the 5-year waiting period before the earnings can be withdrawn tax-free. So every year you make a conversion, you have to start a new 5-year period for that new conversion.

And the fact that you have contributed to a "regular" ROTH IRA more than five years ago has no bearing on the new 5-year rule for a conversion.

So my client is 66. He converts a traditional IRA to a ROTH IRA. He treats the amount as taxable income. So if he withdraws ALL of the converted amount and earnings before he meets the 5-year rule, he will have to pay income tax and a 10% penalty on the withdrawn earnings?

Can anyone confirm that I am seeing this correctly? Thanks in advance.
 

#2
HowardS  
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Tax on the earnings, no penalty.
I suffer from depreciation.
 

#3
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Thank you. So I take it that since he is over 59, there would be no penalty on early withdrawal of earnings, just taxability, in case he withdraws before the 5-year timeline.

But do you think I am understanding correctly that each time a taxpayer converts traditional IRA funds into a ROTH, a new 5-year holding period begins? And if so, can he convert to the same ROTH each year, just has to maintain complex records as to the timing of each conversion? Or should he open a new converted ROTH account each time he converts?

The minutiae of these questions is the challenge of tax law. For me anyway. I too suffer from depreciation. Unfortunately it is accelerated depreciation.
 

#4
HowardS  
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New 5 year period for each conversion. I have a client who has been converting part of his significant IRA for the last 5 years. He has 10 separate Roth conversion accounts, his wife has 12. I think you should keep them separate.
I suffer from depreciation.
 

#5
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Thank you. This really helps.
 

#6
jon  
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Are not withdrawals from Roths always considered from non earnings first no matter when they happen??
 

#7
Doug M  
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https://www.law.cornell.edu/cfr/text/26/1.408A-6

This Roth Distribution Reg (Q&A format) is quite helpful. There are two 5 year Roth rules. One for contributions, another for conversions.

The 5 year rule for Roth contributions is really about the earnings. You can always withdraw your contributions in full at any time. If you want your earnings to be tax free, cannot take any earnings out for the first 5 years.

The second 5 year rule has to do with conversion funds that were put into a Roth. This is subject to a 5 year withdrawal rule.

If there are both contributions and conversions to the same IRA, contributions are deemed withdrawn first, then conversion funds, lastly earnings.
 

#8
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So if you're young and convert a traditional IRA to a ROTH, if you withdraw all of it before the 5-year rule is met (and before you're 59 1/2), then you pay a 10% penalty ON THE ENTIRE AMOUNT INCLUDING PRINCIPAL. At least, this is how it reads to me.

But if you are over 59 1/2, this does not apply. Correct?

Taxpayer is 65. He converts $35000 into a ROTH. When he is 67 he withdraws the $35000 plus $2000 of earnings. There are NO penalties. He merely has to pay tax on the $2000 of earnings. Correct?
 

#9
Doug M  
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When did he convert the $35,000? 2019?

Then, in 2021 he withdraws all of the conversion amount plus $2,000 in earnings?

Also, look at pub 590-B on page 28. There - qualified distributions discussed.

https://www.irs.gov/pub/irs-pdf/p590b.pdf

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. 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). A separate 5-year period applies to each conversion and rollover.
Last edited by Doug M on 14-Oct-2019 6:08pm, edited 1 time in total.
 

#10
HowardS  
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Correct. (responding to post #8)
I suffer from depreciation.
 

#11
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Thanks HowardS.

Doug M. I hope I understand this correctly. For example, a 50 year-old converts $50000 from a regular IRA into a ROTH, and recognizes $50000 of taxable income. 3 years later, he withdraws the $50000 plus $3000 of earnings. He is then taxed on the $3000 of earnings, and incurs a 10% penalty on the entire $53000.

The same scenario, but the taxpayer is 60 upon conversion, and withdraws the $53000 in 3 years. In this case he is only taxed on the $3000 of earnings. No penalties.

Hmm. I wonder if he was to make the conversion when 57, and then withdraw it when 60, after he exceeds 59 1/2, would he avoid penalties, and just have taxation on the earnings? I would have to assume that 59 1/2 is the deciding factor regarding the 10%. But not sure.
 

#12
Doug M  
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I agree with both of your scenarios.

As to the "straddle" age 59.5, I would be guessing, but the distribution was made after age 59.5, so yes.
 

#13
jon  
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Remember conversions, traditional to Roth, after RMDs are required do not qualify as RMDs.
 

#14
dsocpa  
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Are the rules different for 401(k) ROTH conversions?
 

#15
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Kendrick wrote:Thanks HowardS.

Doug M. I hope I understand this correctly. For example, a 50 year-old converts $50000 from a regular IRA into a ROTH, and recognizes $50000 of taxable income. 3 years later, he withdraws the $50000 plus $3000 of earnings. He is then taxed on the $3000 of earnings, and incurs a 10% penalty on the entire $53000.

The same scenario, but the taxpayer is 60 upon conversion, and withdraws the $53000 in 3 years. In this case he is only taxed on the $3000 of earnings. No penalties.

Hmm. I wonder if he was to make the conversion when 57, and then withdraw it when 60, after he exceeds 59 1/2, would he avoid penalties, and just have taxation on the earnings? I would have to assume that 59 1/2 is the deciding factor regarding the 10%. But not sure.


FYI - Roth basis is always drawn free of tax & penalty - it's the earnings only that are subject to the 10% penalty. In your example, only $3,000 is ordinary income and the only amount subject to penalty is $3,000. That is if they are under 59 1/2, over 59 1/2 the earnings would be taxable but no penalty. Also, it's important to note that the 5 year rule does NOT apply to conversions, only direct contribution Roth accounts.
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#16
mariaku  
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The OP is correct. I disagree with some of the posters above stating that earnings on Roth conversions are not subject to penalties if withdrawn within 5 yrs of conversion.

Earnings on Roth conversions that you withdraw within 5 yrs of conversion are handled differently from the conversion principal. You are subject to both income tax and the 10% penalty if the withdrawal occurs before the end of a 5-year holding period OR before age 59 ½.

Here is the answer from Ed Slott, a reputable source:


________________________________________
Retirement Account Rollovers: Today's Slott Report Mailbag
Posted: 18 Jul 2019 06:39 AM PDT
By Ian Berger, JD
IRA Analyst
Follow Us on Twitter: @theslottreport

Question:

Thank you for the opportunity to submit questions concerning our traditional IRA’s.

When we retired my wife and I had a traditional IRA and a 401(k) at our employer. A couple of years after we retired, we rolled our respective 401(k)’s over into our respective traditional IRA’s. Now we are considering rolling over annual amounts into newly created Roth IRAs for each of us at our brokerage house where our traditional IRA’s are administered.

We are somewhat confused concerning the 5 year holding period before funds can be withdrawn without penalty from the Roth Rollover. We have been told that the five year period applies to each annual rollover to our Roth and others have told us that there is only one five year holding period which applies only to the first rollover and not subsequent rollovers. Which is true? Furthermore, as we are both over 59 ½ years old, must we wait the 5 year period before being able to withdraw Roth IRA funds without penalty.

Thank you for considering our questions.

Chandler and Cheryl


Answer:

Hi Chandler and Cheryl,

There’s lots of confusion about the 5-year Roth IRA rules, so we’re not surprised you’re getting different answers.

What’s really confusing is that there are actually two 5-year rules. The good news is that you only have to worry about one.

The one you don’t have to worry about (Rule #1) determines whether amounts converted to Roth IRAs can be hit with the 10% early distribution penalty. The one you may have to worry about (Rule #2) determines whether earnings in a Roth IRA can be hit with taxes and the 10% penalty.

You can withdraw amounts you convert from your traditional IRA to a Roth IRA at any time without paying income tax. You’re stuck with the 10% early distribution penalty only if the withdrawal occurs before the end of a 5-year holding period (Rule #1) AND before age 59 ½.

Not that it matters to you, but the Rule #1 holding period applies separately to each Roth conversion and begins on the first day of the year of each conversion.

Since you’re both over 59 ½, you don’t have to worry about violating the Rule #1 holding period, and you can take your converted amounts at any time free from tax or penalty.

Earnings that you withdraw are handled differently. You are subject to both income tax and the 10% penalty if the withdrawal occurs before the end of a 5-year holding period (Rule #2) OR before age 59 ½. (There are special rules if a withdrawal of earnings is made on account of death, disability or first-time home purchase.)

The Rule #2 holding period starts when you do your first Roth IRA conversion. Unlike the Rule #1 holding period, it doesn’t re-start with each conversion. And, the 5-year period begins on January 1 of the year of your first conversion – no matter when the conversion actually occurs.

IRS rules allow you to withdraw all of your converted amounts (first in, first out) before touching your earnings. Since you’re over age 59 ½, any earnings you withdraw won’t be subject to tax or penalty -- as long as you wait until the end of the 5-year period that starts on January 1 of the year of your first Roth IRA conversion.

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#17
HowardS  
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Ed Slott is an author at investmentnews.com and here is an example from an article at that site (Bloomberg), apparently in disagreement:

Example
Sally established her first Roth IRA with a conversion in 2019, when she was 57. She must wait until the five-year holding period ends on Jan. 1, 2024, and until she is 59½ for the distribution of her earnings to be tax-free (a qualified distribution). Both qualifications must be met.

At age 59½, Sally could withdraw the entire account penalty-free. However, any earnings would be taxable as she has not met the five-year holding period.

Since she was 57 when she established her first Roth IRA, she must wait the five years to earn the benefit of tax-free earnings. However, there would be no 10% penalty on the earnings because Sally was 59½ when the funds were withdrawn.


https://www.investmentnews.com/article/20191008/FREE/191009934
I suffer from depreciation.
 

#18
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Howard is correct. I misspoke. The 5 year does apply to conversions. But whoever said the full distribution is subject to penalty, that is 100% wrong. Only earnings.

Remember too, if you convert and do not pay the tax from an external source, the amount that got withheld for tax that didn’t get reinvested in the conversion is hit with ordinary income and 10% penalty if under 59 1/2.
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#19
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I find entry #16 confusing. It seems like it is saying the 5-year holding period starts with the first rollover, and this period takes care of all future rollovers? I thought each rollover of Trad IRA to Roth IRA needed its own 5-year holding period.

So say I rollover $1000 from my Trad IRA to a Roth IRA. Then once the 5-year period holding period is met, I could then rollover $100.000 from my Trad IRA to a Roth IRA, then if I doubled my money in a year I could take out the entire $200,000 ($100,000 rollover principal and $100,000 earnings) without penalty, since I had met the 5-year rule on my first $1000 rollover.

Help. Does each rollover need a 5-year holding period or not?
 

#20
Jake  
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Maybe this is the confusion. I think if you open a ROTH IRA, that initial contribution, and all subsequent contributions (excluding rollovers) , can be withdrawn without penalty 5 years after the initial contribution.. The earnings on those would be subject to both income tax and the 10% early withdrawal penalty if under 59.5. (Subject to a few exclusions - first home etc.). Am I correct?
 

#21
HowardS  
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Go to Q-5 in the following link:
https://www.law.cornell.edu/cfr/text/26/1.408A-6

For purposes of qualified distributions, the first contribution/conversion starts the 5 year clock. There isn't a separate clock for each conversion.

The 5-taxable-year period described in A-1 of this section begins on the first day of the individual's taxable year for which the first regular contribution is made to any Roth IRA of the individual or, if earlier, the first day of the individual's taxable year in which the first conversion contribution is made to any Roth IRA of the individual.

Thus, each Roth IRA owner has only one 5-taxable-year period described in A-1 of this section for all the Roth IRAs of which he or she is the owner.


For purposes of 72(t), 10% early withdrawal penalty, there is a separate 5 year clock for each conversion.

The 5-taxable-year period described in this A-5 for purposes of determining whether section 72(t) applies to a distribution allocable to a conversion contribution is separately determined for each conversion contribution, and need not be the same as the 5-taxable-year period used for purposes of determining whether a distribution is a qualified distribution under A-1(b) of this section.


Q-5 steers you to section 72(t). 72(t)(2)(A)(1) is relevant regarding the 10% penalty. No penalty after 59.5.

It is very confusing and I think I've got it right. :?
Maybe read this first:
https://www.kitces.com/blog/understanding-the-two-5-year-rules-for-roth-ira-contributions-and-conversions/
I suffer from depreciation.
 

#22
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I just read the last link posted in #21. I almost went cross-eyed. So each conversion DOES require a separate 5-year holding period. From the link:

Unlike the 5-year rule for contributions, in the case of conversions, each conversion amount has its own 5-year time period (Treasury Regulation 1.408A-6, Q&A-5(c)), and thus with multiple conversions there may be multiple different 5-year periods underway at once. When withdrawals occur from conversion amounts, they are deemed to be withdrawal on a first-in, first-out basis under IRC Section 408A(d)(4)(B)(ii)(II), which effectively means the oldest conversions (most likely to have finished their 5-year requirement) are withdrawn first, and the most recent conversions are withdrawn last. (Overall, the ordering rules from Roth IRAs stipulate that withdrawals are after-tax contributions first, conversions second, and earnings third.)

So say a TP in his 70's converts $10,000 from his Trad IRA to a Roth. His first conversion. Then the next week he withdraws all of it. What gets penalized? And what gets taxed?
 

#23
HowardS  
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Earnings taxed, no penalty.
(Full circle, back to posts #1 and #2)
I suffer from depreciation.
 

#24
dsocpa  
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S Corp has a 401(k). The 401(k) has a ROTH option. Shareholder has just started contributing to the ROTH account. Now he is thinking it would be a good idea to convert $200k of the deferred contributions to the ROTH. Tax payer is 54 and in the 24% tax bracket. I understand I need to read the plan document to determine if the conversion within the 401(k) plan is even possible. Assuming that it is wouldn't it make more sense to wait until he's retired to convert when his income is lower. Although, that would create taxable social security income for sure. Anyone else ever run into a ROTH conversion in a 401(k)?
 


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