The pros and cons of Roth IRAs, which were introduced 20 years ago, are well understood. All money flowing into Roth IRAs is after-tax, so there is no upfront tax benefit. As a tradeoff, all qualified Roth IRA distributions can be tax-free, including the parts of the distributions that are payouts of investment earnings.
To be a qualified distribution, the distribution must meet two basic requirements. First, the distribution must be made on or after the date the account owner reaches age 59½, be made because the account owner is disabled, be made to a beneficiary or to the account owner’s estate after his or her death, or be used to buy or rebuild a first home.
Second, the distribution must be made after the five-year period beginning with the first tax year for which a contribution was made to a Roth IRA set up for the owner’s benefit.
Note that the calculation of a Roth IRA’s five-year period is very generous. It always begins on January 1 of the calendar year. For example, suppose you open your first Roth IRA at age 58 and make a contribution to it on March 29, 2018. Further suppose that you designate this contribution as a contribution for 2017, which can be made until April 17, 2018. Under the five-year rule, your five-year period would start on January 1, 2017. Under this scenario, your Roth IRA distributions would be tax-free, qualified distributions as of January 1, 2022 because they would have been made after you turned 59½ and after the five-year period has ended. The five-year period is determined based on the first contribution to the Roth IRA; the starting date of the five-year period is not reset for the subsequent contributions.
Other than making regular contributions, Roth IRAs may be funded by converting a traditional IRA to a Roth IRA and paying tax on any pre-tax dollars moved to the Roth side. For such conversions, a separate five-year rule applies. There generally is a five-year waiting period before a Roth IRA owner who is under age 59½ can withdraw the dollars contributed to the Roth IRA in the conversion that were includible in income in the conversion, without owing a 10% early withdrawal penalty.
Similar to the five-year rule for qualified distributions, the five-year period for conversions begins on the first day of the year of the conversion. However, unlike the five-year rule for qualified distributions, the five-year rule for conversions applies separately to each Roth IRA conversion because the IRS doesn’t want people to avoid the early withdrawal penalty on traditional IRA distributions by making a Roth conversion.
Note that various exceptions may allow the owner of a Roth IRA to avoid the 10% penalty before the end of the five-year period that follows a conversion. Altogether, the taxation of any Roth IRA distributions made before five years have passed and before age 59½ can be complex. If you have a Roth IRA, our office can explain the likely tax consequences of any distribution you are considering. Generally, it is better to wait until the age 59½ and five-year tests are passed before making Roth IRA withdrawals, to avoid taxes.