Take-Away: Roth IRAs are becoming are bigger part of an individual’s estate. In order to maximize the tax benefits of a Roth IRA it is important to follow two primary deadlines that govern Roth IRAs as well as the ordering rules for how a Roth distribution is classified.

Background: I have spent time the past few weeks watching NBA basketball on TV, and thus I am growing accustomed to dealing with the announcer’s fixation on the ‘shot-clock.’ If the team with the ball does not shoot the basketball within 20 seconds, that team loses the ball to its opponents- and you cannot score a basket if you do not have the ball. Rather than hurrying to take the shot due to a deadline, with a Roth IRA the opposite is true – the Roth IRA owner must wait a specific period before the full benefits of a Roth IRA can be assured.  Two separate timelines need to be navigated in order to achieve the maximum tax benefits provided by a Roth IRA.

Timeline #1- Penalty-Free Distributions from a Roth IRA Conversion: This timeline deals with the conversion of a traditional IRA to a Roth IRA when the IRA owner is under age 59 ½. If the IRA owner is over age 59 ½, this timeline can be disregarded. If a traditional IRA is converted to a Roth IRA, and the owner is under age 59 ½, then the Roth IRA owner must wait five (5) years before he/she can take a distribution from the Roth IRA penalty-free. (This statement assumes that there is no other exception to the 10% premature withdrawal penalty then available under the Tax Code.) This 5-year rule does not apply to earnings on the Roth IRA after its conversion; the 10% penalty (excise tax) is imposed on the converted IRA amount that is distributed. Each time a traditional IRA is converted to a Roth IRA, a new 5-year ‘wait’ is required to access that converted amount.

  • Example #1: Kevin is age 44 years old. On March 15, 2017, Kevin converted his traditional IRA to a Roth IRA. Kevin’s Roth conversion is treated as if it occurred on the first day of the calendar year, or January 1, 2017. Consequently, Kevin’s 5-year holding period starts on January 1, 2017. Kevin must now wait until January 1, 2022 before he can take a penalty-free distribution from his converted IRA. Kevin will be 49 years old when he can start to take penalty-free distributions from his converted Roth IRA, but he will have waited the full 5 years, so his patience will be rewarded.

Timeline #2- Distributions of Roth Earnings: A second 5-year rule applies to the why individuals establish Roth IRAs- income tax-free earnings. This 5-year holding period commences when the first Roth IRA is established by the owner. Unlike the first timeline just described, this second timeline does not re-start for each Roth contribution or conversion. This 5-year holding period starts on January 1 of the tax year for which the first dollar of Roth IRA money is contributed to any Roth, even if it only a nominal amount, e.g. $1.00. Thus, the sooner a Roth IRA is established, even with a small sum, the better to start this second 5-year holding period.

  • Example #2:  Tom opens his first Roth IRA on February 15, 2019. Tom is 57 years old. Tom must wait a full 5 years, until January 1, 2024 in order to take any distributions of earnings income tax-free (qualified) from his Roth IRA. At 59 ½ Tom could withdraw the entire Roth IRA balance penalty-free. However, any earnings on the Roth IRA would be taxable to Tom if they are withdrawn by him at age 59 ½ since Tom has not met the 5-year holding period. Tom must wait the full 5 years before he can take distributions of earnings from his Roth IRA income tax-free.

Roth IRA Ordering Rules for Distributions: The two timelines are a reminder that there are also regimented ordering rules associated with distributions from a Roth IRA. If the Roth IRA owner takes a distribution from his/her Roth IRA, the order of how that distribution is treated is: first distributed are contributed dollars to the Roth IRA; second distributed are converted dollars to the Roth IRA from a traditional IRA; and third distributed are the earnings on the Roth IRA. To summarize these ordering rules:

  • Contributions can always be withdrawn from the Roth IRA tax and penalty-free, with no age restrictions [those dollars were previously taxed];
  • Conversions can always be withdrawn from the Roth IRA income tax-free and there will be no penalty, but only if the funds are withdrawn from the Roth IRA after 5 years, or after the owner is age 59 ½; and
  • Earnings will neither be taxed, nor penalized, if the distribution of earnings from the Roth IRA occurs after 5 years and the owner is either age 59 ½, has died, becomes disabled, or is a first time homebuyer.

Conclusion: The two 5-year rules need to be kept in mind when funding a Roth IRA and preserving its tax attributes. Distributions from the Roth IRA will first be the Roth owner’s contributed dollars, then any converted traditional IRA dollars, and finally earnings on the Roth account.