A conversion to a Roth IRA can be a smart tax move but there are several rules one must know to take full advantage.
Q.: My wife and I had traditional IRAs for years, then two years ago she switched hers over to a Roth and paid the penalties. Last year, I rolled mine over and paid the penalties. Can we draw both of these out without penalty since the initial IRA was over five years ago?
— Thanks, Charles A.
A.: Charles, There is usually some taxable income but there are no penalties upon a conversion.
Many get confused about the so-called “five-year rule” that applies to Roth IRAs because there is more than one five-year rule.
One applies to “conversions”. The five-year rule on conversions says if you withdraw any of the taxed converted amounts within 5 tax years of the conversion and you are under 59 ½ at the time of the withdrawal, a 10% penalty applies. How long you have had IRAs or Roth IRAs is not a factor.
This rule is needed because otherwise people under 59 ½ would have a way around the 10% penalty that applies to most early distributions out of a traditional IRA. Without the rule, young people could convert and just pay the regular taxes then immediately withdraw the converted amounts from the Roth, thus avoiding the 10% penalty.
A second five-year rule states that if you distribute earnings from a Roth IRA within five tax years of the funding of your first Roth IRA, those earnings are taxable regardless of age and if you are under 59 ½, the 10% penalty applies.
I italicized “converted amounts” and “earnings” because the taxes or penalties I described apply to those items only. There is a set order of withdrawal for Roth IRAs. Those rules are a bit lengthy but it is possible to get money out of a Roth IRA without tax or penalty prior to age 59 ½.
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Dan Moisand’s comments are for informational purposes only and are not a substitute for personalized advice. Consult your advisor about what is best for you. Some questions are edited for brevity.