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Understanding The Two 5-Year Rules For Roth IRA Contributions And Conversions

Posted by Michael Kitces on Wednesday, January 1st, 7:01 am, 2014 in Taxes

While Roth IRAs are very popular as a retirement savings vehicle due to their tax-free growth treatment, they also have several unique rules associated with them to ensure that their favorable tax status is not abused. In particular, there are two different 5-year rules associated with Roth accounts to prevent them from being taken advantage of; the first 5-year rule applies to Roth contributions and determines whether earnings will be tax-freewhile the second 5-year rule applies to Roth conversions and determines whether conversion principal will be penalty-free.

Each of the 5-year rules are measured from the beginning of the tax year for which they apply, which means in reality tax-free earnings or penalty-free conversion principal may be accessible in less than 5 years in certain circumstances. And because the Roth rules aggregate all accounts together for the purposes of determining the tax treatment of various distributions, it's necessary to track the various 5-year rules and the amounts they're associated with, regardless of whether they are held separately or mingled together into a single account.

Ultimately, being able to effectively navigate the various Roth 5-year rules creates several planning opportunities as well. For some, taking advantage of the Roth conversion 5-year rule is a way for those well under age 59 1/2 to tap their IRA funds "early" without an early withdrawal penalty. For others, the reality is that the Roth conversion 5-year rule is a moot point anyway, because they already meet another exception to the early withdrawal penalty (e.g., already being over age 59 1/2). However, in all cases, the 5-year rule for contributions must be met before any Roth earnings can actually be tapped tax-free; fortunately, though, because any first-time contribution or conversion can start the clock, clients who are concerned about the 5-year rule can make a contribution to a Roth (or to a traditional IRA and then convert it) to start the time window now, and ensure they'll never need to worry about it in the future!

5-Year Rule For Roth Contributions

The 5-year rule for Roth contributions is used to determine whether a withdrawal of growth will be tax-free as a "qualified distribution" from a Roth IRA. In order to be a qualified distribution, two requirements must be satisfied. First, under IRC Section 408A(d)(2)(A), the distribution must be made either: on/after the date the IRA owner turns 59 1/2;  after death of the IRA owner (i.e., to the estate or a beneficiary); after becoming totally disabled (under the Social Security definition of "total disability"); or for qualified first-time homebuyer expenses (up to a $10,000 limit and subject to other limitations). The second requirement, in addition to meeting one of the preceding tests, is that the distribution must meet the Roth contribution 5-year rule (also known as the "nonexclusion period" under IRC Section 408A(d)(2)(B)).

The 5-year rule essentially states that five tax years must pass from when the first contribution is made to (any) Roth IRA, until a qualified distribution can be made. Because the measurement is based on tax years, this means that a contribution to a Roth IRA as late as April 15 of 2014 will still count as a contribution for the 2013 tax year (in essence, it counts as though the contribution was made January 1st of 2013), which means the first year of a potential qualified distribution would be 2018 (because the five years that passed would have been 2013, 2014, 2015, 2016, and 2017). Notably, this means that a "5-year" qualified distribution could actually be made after less than 3 years and 8 months, as a contribution on April 14 of 2014 (made in 2014 but for 2013) would allow for tax-free distributions as early as January 1st of 2018.

Notably, under Treasury Regulation 1.408A-6, Q&A-2, for the purposes of this 5-year rule the clock starts the first time any money is funded into any Roth IRA, whether by contribution or conversion. There is not a new 5-year clock for each Roth contribution, nor for each Roth account that is held. All Roth IRAs (but not Roth 401(k)s) are aggregated together to determine whether the 5-year rule is met for any/all of them (which indirectly means that rollovers from one Roth IRA to another do not change or reset the 5-year requirement). In the case of rollovers from a Roth 401(k), any years in the Roth 401(k) are not added to the years for the Roth IRA; thus, if the individual did not otherwise have a Roth IRA already, the rollover from a Roth 401(k) begins a new 5-year period, even if the Roth 401(k) itself had already satisfied the 5-year requirement (per Treasury Regulation 1.408A-10, Q&A-4(a)).

The fact that the 5-year requirements are aggregated across IRAs effectively means that once the 5-year rule has been satisfied once for a taxpayer (i.e., if you've already had a Roth for at least 5 tax years), it's been satisfied for good; in turn, this means that recent contributions may actually be eligible for withdrawal as a qualified distribution even if they've been in the account for less than 5 years, as long as the taxpayer overall has met the 5-year requirement with respect to any Roth IRA.

Bear in mind, though, that regardless of whether the 5-year rule is met, for the distribution to be qualified, it must still also satisfy the first part of the test (a distribution made after 59 1/2, death, disability, or under the first-time homebuyer rules).

5-Year Rule For Roth Conversions

As the name implies, the second 5-year rule applies not to (new) Roth contributions, but to Roth conversions from traditional pre-tax retirement accounts, and determines whether Roth conversion principal will be penalty-free.

To meet the 5-year rule for Roth conversions, again the measuring period is five tax years, which essentially means any Roth conversion is deemed to have occurred as of January 1st of that year (Treasury Regulation 1.408A-6, Q&A-5(b)). Notably, since since conversions must occur by December 31st in a given year, their 5-year period will always start in the calendar year in which the conversion occurs; for instance, any conversion between January 1st and December 31st of 2013 will count as a 2013 conversion, but anything in 2014 will count as a 2014 conversion (by contrast, a new contribution as late as April 15th of 2014 could still be counted towards the 2013 tax year).

Unlike the 5-year rule for contributions, in the case of conversions, each conversion amount has its own 5-year time period (Treasury Regulation 1.408A-6, Q&A-5(c)), and thus with multiple conversions there may be multiple different 5-year periods underway at once. When withdrawals occur from conversion amounts, they are deemed to be withdrawal on a first-in, first-out basis under IRC Section 408A(d)(4)(B)(ii)(II), which effectively means the oldest conversions (most likely to have finished their 5-year requirement) are withdrawn first, and the most recent conversions are withdrawn last. (Overall, the ordering rules from Roth IRAs stipulate that withdrawals are after-tax contributions first, conversions second, and earnings third.)

Intention Of The 5-Year Rules

The purpose of the 5-year rule on Roth contributions is relatively straightforward - to require that tax-free growth for retirement purposes be done for the long-term, which means the account must be maintained for at least 5 years (in addition to meeting one of the other requirements).

To understand the purpose of the 5-year rule for Roth conversions, an example of what would occur if it wasn't there might help.

Example 1. Jeremy is 40 years old and would like to tap the $50,000 of funds in his traditional IRA. If he takes a withdrawal now, he will be subject to ordinary income, and a 10% early withdrawal penalty. If Jeremy converts his IRA to a Roth IRA, he will also be required to report the amount as ordinary income; however, he can now take a withdrawal of his "after-tax" principal from his Roth IRA (the conversion amount) without an early withdrawal penalty. The end result: Jeremy could entirely circumvent the IRA early withdrawal penalty by simply doing a Roth conversion first and taking the money thereafter, so the 5-year conversion rule is designed to prevent this!

Example 2. Continuing the prior example, if Jeremy completes his conversion and waits 5 years, he will be eligible to withdraw his Roth conversion principal without any early withdrawal penalty; this is true because he has met the 5-year requirement for conversions, even though he would only be age 45 at the time. Thus, while the 5-year conversion rule prevents individuals from outright dodging the early withdrawal penalty from their IRAs, it does allow them to potentially gain access to their IRAs prior to age 59 1/2, albeit with a 5-year waiting period! (Though notably, any gains on Jeremy's conversion would still be taxable, as even if he has met the 5-year requirement for conversions and contributions, he has not met the 59 1/2, deceased, or disabled requirement to receive tax-free qualified distributions from his Roth IRA.)

Accordingly, it's also worth noting that because the 5-year rule for Roth conversions merely leaves the withdrawal of conversion principal potentially subject to the early withdrawal penalty, any other exceptions to the early withdrawal penalty can still shelter the Roth conversion amount from the penalty. Thus, withdrawals within 5 years of conversion by someone who is already over age 59 1/2 are not subject to the early withdrawal penalty, regardless of the 5-year conversion rule, simply because being over age 59 1/2 itself is an exception to the penalty!

Managing The 5-Year Rules

Because of the different purposes of the 5-year rules, effective techniques for managing and planning around them are different as well.

In the case of the 5-year rule on Roth contributions, the easiest way to manage the rule is simply to start the clock as early as possible, since any first amounts placed into a Roth IRA start the clock. For many, they have already started (or entirely satisfied) their 5-year requirement with prior Roth contributions. For those who have never chosen to make a Roth contribution - or perhaps couldn't, due to the income limitations - an alternative is to do a conversion from a traditional IRA to start the clock; even just a modest $100 conversion is enough to open the time window. For those who have no IRA funds to convert, they can even create an IRA just for the purposes of doing a conversion, as there are no income limits on traditional IRA contributions (the income limits only determine whether the contribution will be deductible or not). However, those looking to do a (nondeductible) traditional IRA contribution and subsequent Roth conversion may wish to wait a year to avoid the risk of the step transaction doctrine.

In addition, it's notable that because distributions are deemed to come from principal first and earnings second, even withdrawals from a Roth contribution within the 5-year time window will not necessarily trigger any income taxation, unless the total distributions exceed all prior contributions. However, it's also important to bear in mind that even if the withdrawal is principal and not subject to ordinary income taxation, if it is a conversion amount within the 5-year time window, the withdrawal may be subject to early withdrawal penalties even if it is not otherwise taxable. On the other hand, as noted earlier, if the individual is otherwise exempt from the early withdrawal penalty (e.g., by being over age 59 1/2), the withdrawal of conversion principal is penalty-free  (over 59 1/2) and tax-free (as it was already taxed at conversion). Thus, for those who are already over age 59 1/2 (or totally disabled), the Roth conversion 5-year rule is essentially a moot point, and only the 5-year rule for contributions remains relevant.

Another notable situation where the rules may overlap is after the death of a Roth IRA owner. As death is an exception to the early withdrawal penalty, any beneficiaries taking distributions from a Roth IRA will always enjoy penalty-free treatment (regardless of whether it's principal or earnings, and regardless of whether the 5-year rule for conversions has been met or not). On the other hand, death does not eliminate the 5-year contribution rule for earnings to be tax-free! Thus, beneficiaries taking withdrawals from a recently opened Roth IRA (if there were no other Roth accounts to start the 5-year clock) may find that the earnings are still taxable until the 5-year time window has passed from when the original Roth owner established the account; on the other hand, because of the favorable ordering rules, beneficiaries taking RMDs will be tapping tax-free and penalty-free principal anyway, so this issue would generally only apply if the beneficiaries were liquidating most/all of the Roth IRA shortly after inheriting it (and before the original 5-year contribution time window had been satisfied).

For convenience purposes, because the Roth rules aggregate together all Roth accounts under IRC Section 408A(d)(4)(A), there is no need to keep Roth contributions and conversions in separate accounts, or to otherwise try to separate out multiple types of contributions. The aforementioned ordering rules (principal first, then conversions on a FIFO basis, then earnings) apply in the aggregate across all accounts. So at the most, accounts should only be kept separate if it is necessary/helpful for tracking and accounting (though notably, conversions should be kept separate if there is an expectation they might be recharacterized and there is a desire to just recharacterize the specific gains/losses and assets associated with that particular conversion).

The bottom line, though, is simply this: it's important to remember that there are two separate 5-year rules, each with their own requirements and stipulations. The Roth conversion 5-year rule is about accessing penalty-free conversion principal (and is irrelevant if the individual already meets one of the other exceptions to the early withdrawal penalty), while the Roth contribution 5-year rule is about accessing tax-free Roth earnings (which are assumed to be extracted last, anyway).

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