Conversion Distributions - Tax Free?

Conversion means that money was converted to a Roth IRA from a Traditional IRA. The act of converting funds from Traditional to Roth results in tax consequences for the owner, as the converted amounts are added to income and taxed at ordinary rates on the owner's tax return. Conversions were first allowed in 1998 subject to certain income restrictions. Most people who did the conversion in 1998 elected to spread the tax consequences over a 4-year period, which Congress allowed to reduce the tax shock for early adopters.

For example, let's say that Jake Brown had $100,000 in his Traditional IRA that he converted to a Roth IRA in 1998, and elected to spread the tax consequences over a 4-year period. Therefore, Jake reported an extra $25,000 income on his tax returns in 1998, 1999, 2000, and 2002 and paid taxes on his total income at ordinary rates each year. Meanwhile, the entire $100,000 was converted in 1998 and began growing as a Roth IRA at that time.

OK, Jake has paid taxes on his converted amounts. Can he withdraw the $100,000 without suffering further tax consequences? If so, when?

The answer is "yes" with one condition: Jake must satisfy a 5-year holding period before he may take a distribution on the converted money without suffering a penalty. The 5-year count began in 1998 on the entire $100,000 although he only reported $25,000 on his tax return that year. The 5-year holding period is fully satisfied the first day of 2003, which means that Jake may withdraw the entire $100,000 tax and penalty free on or after January 1, 2003. A distribution taken before 2003 is subject to a 10% penalty.

If Jake had a separate IRA that he converted to a Roth in 2000, he must wait until 2005 to withdraw funds from that conversion to avoid tax consequences. The idea is that each conversion is treated separately. Furthermore, note that converted amounts may be withdrawn tax and penalty free. Withdrawal of earnings is treated differently.

Earnings Distributions - The First Condition

Withdrawal of Earnings Tax & Penalty Free: An individual must meet two separate tests to avoid taxes and penalties when taking a distribution of earnings from a Roth IRA. With penalties at 10% and ordinary tax rates up to 36% it is certainly worth the effort to understand this concept.

Tax Forms: Taxpayers file forms 8606 (basis) and 5329 (purpose) to identify the portion of the IRA withdrawal subject to taxes.

"5-Year Rule" is the first test. That is, the distribution of earnings must take place five years after the first contribution. Year one starts with the year of contribution. A Roth IRA with its first contribution in tax year 1998 completes the five-year holding period on January 1, 2003. Partial or total withdrawals of earnings on or after that date have cleared this important hurdle.

Roth IRAs became legally operational in 1998. This means qualified distributions first took place in 2003. However, meeting the 5-year holding period by itself is not sufficient to avoid taxes or penalties when distributing earnings. At least one other condition must be present!

Using the Sam Smith example from the first page to show the 5-year rule in operation, let's say Sam withdrew all $12,000 from his IRA in 2002 (he does not meet the 5-year rule).

• $6,000 would be tax and penalty free (his original contribution)
• $6,000 would be taxed as ordinary income (rates up to 36%) with an additional 10% penalty if the reason was not qualified.

5-Year Holding Period Table

• 2000 - Year of contribution counts as year 1
• 2001 - Year 2
• 2002 - Year 3
• 2003 - Year 4
• 2004 - 5-Year holding period completed after December 31, 2004

Examples of Avoiding Tax and Penalty

Owner Turns 59 ½, but Conversion Less than 5-Years Old: Jeff made five ordinary contributions of $3,000 per year to his Roth IRA starting 2001 and ending 2005 (the 5-year test for contributions is fulfilled Jan 1, 2006). He also converted $11,000 from another IRA in 2003 (5-year test fulfilled Jan 1, 2008). He also turns 59 ½ 2006. What are his options for tax-and-penalty free withdrawals in 2006?

• Contributions of $3,000 x 5 = $15,000 tax and penalty free.
• Any earnings associated with his $3,000 x 5 contributions could be withdrawn tax and penalty free.
• $11,000 conversion is subject to penalty if withdrawn in 2006. He must wait until 2008.
• Earnings associated with the conversion are subject to taxes and penalty if withdrawn before the 5-year holding period is fulfilled.
• All withdrawals as of January 1, 2008 would be tax and penalty free.

Owner's Age under 59 ½, but 5-Year Rule Met: William turns 39 in 2007 when he wants to take a distribution. His first Roth IRA contribution occurred in 1998 (5-year rule fulfilled). What reasons could he use to avoid taxes and penalty on distributions?

• Previous contributions could be distributed tax and penalty free.
• Earnings could be distributed tax and penalty free if William qualifies for any of the following:
  • Disability
  • First-time home buyer (subject to lifetime limits)

The Penalty - By Example

Bill owner wants to take a distribution of $12,000 from his ROTH in 2003 when he is 45 years of age and has cleared the 5-year hurdle. His IRA consists of $6K prior contribution and $6K earnings. However, no other exception applies because he is under 59½, his is not disabled, he did not die (meaning this is not a death distribution), and he is not a first-time home buyer.

No matter what this owner does he will need to report $6,000 of the $12,000 withdrawal as ordinary income on his tax return (and pay taxes on it). However, he may be able to avoid the additional 10% tax on the $6,000 portion because he is working on an advanced degree at the local university. Remember the IRS will waive the extra 10% penalty for the following:

• For certain health insurance premiums for qualified unemployed individuals.
• Medical expenses in excess of 7.5% of adjusted gross income.
• IRS levy (the IRS withdraws the money for you).
• Qualified higher education expenses.
• Substantially equal periodic payments.

Consequences from this example are as follows:

• $6,000 would be tax and penalty free (his original contribution).
• $6,000 would be added to gross income and taxed at ordinary rates.
• No penalty. The distribution reason is a qualified exception.