Roth IRA: Two Clocks
Roth IRAs are extremely popular, and why wouldn’t they be? Tax-free earnings over a lifetime can add up to a serious chunk of change. Although, in order to receive those tax-free earnings, rules must be followed and time frames must be met. Despite the ubiquity of Roth IRAs, there is confusion around what those rules and time frames are. In order to maximize your Roth IRA, it is vital to understand the central guidelines. In fact, there are two primary Roth IRA clocks to consider.
Clock #1 - Penalty-Free Distributions from Roth Conversions
The first 5-year clock only applies to Roth IRA conversions and if the account owner is under age 59 ½. If the account owner is already over 59 ½ (or as soon as they reach 59 ½), this rule can be ignored. When a traditional IRA is converted to a Roth, the under-age-59 ½ account owner must wait 5 years before they can take penalty-free distributions (assuming no exception to the 10% penalty applies). We are not talking about earnings yet – only avoiding the 10% penalty on distributions of converted dollars. This 5-year clock will restart for each conversion that is done.
For example, John was 35 in 2015. He converted his SIMPLE IRA to a Roth in October of that year. The IRS recognizes the conversion as happening on the first day of the year, so John’s holding period for the conversion began on January 1, 2015. He must wait five years until January 1, 2020 before he can take penalty-free distributions of the converted assets. Even though John will only be 40 in 2020, he will have access to his converted assets tax and penalty-free. If John does take a distribution, ordering rules are as follows: contributed dollars come out first, then converted dollars, then earnings.
Clock #2 - Tax-Free Distributions of Roth Earnings
The second 5-year Roth clock deals with the fundamental purpose of establishing a Roth IRA – tax-free earnings. This holding period starts when the first Roth IRA account is established and doesn’t re-start for each Roth IRA contribution or conversion. The holding period begins on January 1 of the tax year for which the first dollar of Roth IRA money is contributed, even if that first contribution was only $1.
For example, Jane established her first Roth IRA with a contribution last year, January 1, 2018, when she was 56. She must wait the full five years until January 1, 2023 for the distribution of her earnings to be tax-free. At age 59 ½, Jane could withdraw the entire account penalty free. However, any earnings would be taxable as she has not met the 5-year holding period. She must wait the five years to earn the benefit of tax-free earnings.
Keys to remember:
There are two clocks: Clock #1 - Penalty-Free Distributions from Roth Conversions (which can be disregarded at age 59 ½), and Clock #2 - Tax-Free Distributions of Roth Earnings.
1. Contributions: Can always be withdrawn tax and penalty-free. No age restrictions.
2. Conversions: Can always be withdrawn tax free. No penalty if withdrawn after 5 years OR after age 59 ½.
3. Earnings: No tax or penalty if distributed after 5 years AND age 59 ½, deceased, disabled or first time home buyer.
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