Converting from a traditional IRA to a Roth IRA creates an investment account that grows tax-free, gives tax-free Roth IRA withdrawals, and hasn't any minimum distribution requirements. But you have to abide by the 5 year rule and age requirements; otherwise you may trigger tax consequences and Roth IRA penalties on your Roth IRA withdrawals. Retirees who find themselves making large Roth withdrawals should take note.
The Roth IRA is an ideal investment account for its attributes described above. The contributions go into the account after tax, however, your money comes out tax free. The catch, though, is that you must fulfill the 'waiting' time so as not to incur any Roth IRA penalties or taxation on your withdrawals. If you've waited the 5 years since your conversion and you're over 59½, all of you're Roth IRA withdrawals are free and clear from tax and no Roth IRA penalty.
Such qualified Roth IRA distributions have fulfilled all requirements and are free of taxation and Roth IRA penalties. On the contrary, you could end up with Roth distributions which are non-qualified. To check whether your withdrawal has met the criteria, refer to the diagram.
How are non-qualified Roth IRA Withdrawals taxed ?
If you're over 59½ but haven't waited the required time, just what will be taxed? Tax won't be imposed on a Roth IRA principal (the amount rolled over) which was taxed at the time of rollover. What you will be taxed on is the 'earnings' in your Roth IRA – which is the amount in your Roth account above what you've directly contributed or converted. But unless you are withdrawing your entire Roth IRA balance, it is unlikely that any of you withdrawal will count as earnings. This is due to the manner in which IRS classifies withdrawals from Roth IRA as per the enumerated list in the paragraph below.
IRS considers money to come out of your Roth IRA in the following order:
1) Regular (i.e. direct) contributions
2) If you convert more than one conventional IRA into a Roth IRA, or have done multiple conversions, each has its own 5 year requirement
3) Earning on contributions
You can see that you'll probably have to withdraw a good fraction of your Roth account before you get to the 'taxable earnings' for those non-qualified Roth IRA withdrawals.
Please note that this post is focused on money that gets into a Roth IRA by way of a conversion from a traditional IRA. The rules on withdrawals from a Roth IRA that were original contributions to the Roth IRA are slightly different regarding income tax and Roth IRA penalties. The rules which apply to Roth IRA contributions, rather than conversions, are as follows:
The waiting time for the five-year rule begins on the first of January of the year for which the Roth IRA payment was contributed. As an example, the 2005 Roth IRA contribution could have been made as late as April 15 of 2006. The five years for that contribution starts running on January 1, 2005.
Note that the Roth IRA penalties only apply to those not yet age 59 1/2 who also do not qualify for one of the penalty exemptions which we cover in another post.
Lose a Fortune on Your 401k Rollover
If you do not do any of these correctly:
- Opt for a distribution rather than direct transfer
- Rollover company stock to an IRA
- Choose to rollover to a Roth IRA
- Rollover to your new employer’s 401k
- Rollover post-tax contributions