By Sarah Brenner, JD
Director of Retirement Education
If you recently converted your traditional IRA to a Roth IRA and you under 59 ½, you will want to know about the five-year rule for penalty-free distributions of converted funds from your Roth IRA. Many people are not aware of it. Not understanding how the rule works can result in heavy penalties when you withdraw your Roth IRA funds.
How the Rule Works
If you make annual contributions to your Roth IRA, you can always access those funds penalty-free. It’s that easy. However, when it comes to converted funds, it gets a little more complicated. If you are under age 59 1/2, you can always access your converted funds themselves tax-free. That makes sense because you already paid the tax bill when you did the conversion.
It’s a different story when it comes to the 10% early distribution penalty. If you are under age 59 ½, you must satisfy a five-year holding period on funds that were taxable when converted before you can access those funds penalty-free.
The five-year holding period will restart for each conversion. If the conversion was done at any time in 2022, the holding period for this five-year rule begins on January 1, 2022.
How can you avoid confusion about the five-year rule for converted funds? First, remember that the five-year rule for distributions of converted funds is different from the other five-year rule that applies to Roth IRAs. That is the five-year rule for tax-free distributions of earnings from Roth IRAs. That rule works differently.
A good way to understand the five-year rule for penalty-free distributions of converted funds is to know exactly what it is set up to prevent. When you take a distribution from your traditional IRA and convert it to a Roth IRA, that distribution is taxable but not subject to the 10% early distribution penalty. This fact meant that soon after Roth IRAs became law, those looking for tax loopholes started telling younger IRA owners that they could get out of the 10% penalty by doing a conversion. IRA owners could just convert their IRA to a Roth IRA and then, the next day, withdraw funds from the Roth IRA tax and penalty free.
In response, Congress acted fast. Now we have this five-year rule that says if the converted funds are not held for at least five years or until age 59 ½, any withdrawal before that time would be subject to the 10% penalty the account owner would have paid if she withdrew from her traditional IRA.
There is a sure fire way to avoid having to worry about the five-year rule for converted funds. Don’t take early Roth distributions. If you invest long term and keep your Roth IRA investments intact for years until retirement, the rules are very easy. Everything is distributed tax and penalty free.