February 14, 2017 in Taxes

Dear Tax Talk,



I converted my traditional IRA into a Roth IRA, paying all of the taxes at that time, after I retired and was no longer earning an income. I have had the Roth IRA only one year. Am I still under the five-year rule because I have not fulfilled the five-year holding period even though I paid the taxes and am over 59 1/2? Must I wait the full five years before being eligible to take tax-free IRA withdrawals and tax-free earnings? If I am still under the rule, when will I be able to take tax-free withdrawals with tax-free earnings?



— Jennifer

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Dear Jennifer,



You are subject to the five-year rule on earnings, but you can take tax-free withdrawals of the amount you converted, plus you will not be subject to the additional 10 percent tax.

Uncle Sam wanted to help taxpayers save for retirement and one of the options is opening up an Individual Retirement Account, or IRA. There are different types of IRAs but we will only address traditional IRAs and Roth IRAs here.

The most important aspect to remember on a traditional IRA is that you may be able to deduct your contribution depending on your income, filing status, whether you receive Social Security benefits and if you are covered by a workplace retirement plan. The Roth IRA is different in that contributions are never deductible.

Both types of accounts grow tax free. However the big difference is whether or not you have to pay tax when distributions are made to you from the accounts. Traditional IRA distributions are generally taxable in the year you receive them. I say generally, because if you happened to have made nondeductible contributions to a traditional IRA, there are different rules.

Roth IRA distributions are not taxable if they are qualified distributions or distributions that are a return of your regular contributions. The five-year rule has to do with qualified distributions of earnings, which is not the case here. However, all is not lost.

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With a Roth IRA conversion, the five-year clock begins on January 1 of the year you converted. So if you converted to a Roth in December of 2015, for example, your Roth IRA by early 2017 would be two years into the five-year wait before earnings can be withdrawn tax free. However, you can withdraw the amount you converted at any time without penalty.

Remember also that the point of these accounts is to save for retirement, so Uncle Sam came up with an additional 10 percent tax that would be owed if funds were taken out before age 59 1/2. This is known as an early distribution, and it applies to earnings on Roth IRAs or to any withdrawals made from a traditional IRA except under certain circumstances. Since you are older than 59 1/2, the additional 10 percent tax does not apply to you.

Thanks for the great question and all the best to you.

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