Two Five-Year Roth Distribution Rules

Take-Away: Just to keep us on our toes, there are two different Roth IRA 5-year seasoning rules with regard to the taxation of distributions from a Roth IRA account which we need to keep straight. The difference results if the Roth IRA was created through contributions or if the Roth IRA was created via a conversion of a traditional IRA.

Roth Conversion Rule: This 5-year rule pertains to a traditional IRA that is converted to a Roth IRA. This 5-year rule applies only if the Roth IRA owner is under age 59 ½. A distribution prior to the owner’s age 59 ½  from a converted Roth IRA will attract a penalty if the distribution is within 5 years of the Roth conversion. This 5-year holding period will restart with every conversion of a traditional IRA to a Roth IRA. Therefore, if multiple traditional IRAs are converted to Roth IRAs, each converted Roth IRA will have its own 5-year holding period, so that distributions from any of them within 5 years of the conversion will trigger a tax if the IRA owner is under age 59 ½.

Roth Contribution Rule: This 5-year rule is used to determine if a Roth IRA distribution of earnings is a qualified distribution. If so, the distribution is income-tax free. The 5-year holding, or seasoning, period starts when the owner’s initial Roth IRA account is established. Unlike the Roth conversion rule explained above, the Roth contribution rule does not restart for each Roth IRA contribution. No matter how many Roth IRAs are created and contributed to by their owner, the income tax on distributions can be avoided if one of those Roth IRAs has been in existence for at least 5 years.

Planning Suggestion: In light of the 5-year rule for Roth contributions, it would be wise to create and contribute to a Roth IRA a nominal amount. Years later, when larger Roth IRA contributions are made, accessing the tax-free income generated by those later Roth contributions will exist since the initial contributed Roth IRA was created more than 5 years earlier in time.

Conclusion: It is easy to confuse Roth contributions and Roth conversions. How the Roth IRA came into existence leads to entirely different rules when it comes to taking a tax-free distribution from a Roth IRA.