Be Aware of the Roth Five-Year Holding Requirement

Are you pondering the question of whether or not to convert your traditional IRA funds to a Roth IRA? While your decision involves many factors, one wrinkle to consider is the five-year holding period for converted assets.

The time limit has nothing to do with distributions of regular contributions from your Roth. As you know, you can withdraw regular contributions at any time, tax- and penalty-free, no matter your age. That’s because you deposit those amounts into your Roth using money on which you’ve already paid income tax.

Rather, the five-year holding period comes into play when you’re under age 59½ at the time you make a Roth conversion. In that case, you’ll generally have to wait five years (or until you turn 59½, whichever comes first) before you can pull the “conversion assets” out penalty-free.

When you fail to meet the five-year rule, the penalty is the same 10% you’d pay if you took an early withdrawal from your traditional IRA. That’s the purpose of the five-year rule – to discourage premature distributions from retirement accounts.

Once you reach age 59½, the 10% penalty disappears, though the five-year holding period for converted assets may still apply. For example, say you use the conversion to fund an initial Roth. During the first five years your new account exists, you’ll pay ordinary income tax on withdrawals of the income earned from the converted amounts.

The five-year holding period can also affect your beneficiaries. For instance, if you had no prior Roth account before making a conversion, your beneficiaries will pay ordinary income tax on distributions of earnings. However, they can withdraw converted amounts with no federal income tax or penalty.

Give us a call to discuss this and other Roth conversion rules. Don’t let unawareness of the rules lead to an unpleasant tax surprise.