How do you avoid the headache of the “five-year rule” for withdrawals from Roth IRAs?
Posted on June 28, 2024
I converted some Traditional IRA to Roth in 2018 and in 2019 and withdrew some in 2021. The rules that determine whether or not my withdrawal would be tax-free were a bit confusing. This post describes the key “five-year rule” or aging period for withdrawals from a Roth account. You avoid the headache of this rule if you limit withdrawals from your Roth to no more than the cumulative amount you’ve converted until you’ve fully met the “five-year” rule.
== Five-year Rule ==
I write this for retirees who, like me, have converted Traditional to Roth. If you’ve held the amount converted for “five years”, withdrawals are “qualified” and the growth portion of a withdrawal is not reported as taxable income and is (10%) penalty-free. (This is a more detailed description of all the rules involving withdrawals from IRAs, but, to me, it’s a bit overwhelming.)
If you don’t meet that five-year test, a withdrawal is “nonqualified” and you must report it on your tax return, Part III of form 8606.
The calculation on that form will show that if you are not withdrawing any component of the growth in your Roth, you don’t have any taxable income or penalty: withdrawals of amounts you’ve contributed or converted to Roth are never taxed; you already paid tax. That is what you want to do: limit your withdrawals to the amount you’ve converted until you’ve met the “five-year rule”.
== My example ==
I had no Roth IRA when I started retirement and wanted some Roth to use as a source of cash for our spending that keeps our taxable income at the right level. Selling securities in Roth gives us cash to spend and does result in taxable income. I can use Roth prudently to avoid getting hit by Medicare’s Income Related Monthly Adjustment Amount (IRMAA). Too much taxable income (MAGI, to be specific) can trigger added Medicare premiums deducted from our Social Security benefits. (See here; here is the the detail of MAGI tripwires and surcharges for 2024.)
• I converted $10,000 in December 2018 and another $50,000 in December 2019. (My tax forms 5498 for my Roth account show the amounts converted; the amounts converted are reported to the IRS.) The table below shows when I would meet the “five-year rule” for each contribution such that a withdrawal is qualified: clearly any withdrawal after January 1, 2024 is qualified; I don’t have to think about whether some portion could be taxed and penalized.
• I withdrew $15,000 on December 1, 2021, before I had met the five-year rule on either conversion; this was a nonqualified withdrawal. (My withdrawal is reported to the IRS on my 1099-R for my Roth account.) I generally sell securities the first week of December to get the amount I want for our spending for the upcoming year into cash-money market. Using that $15,000 from Roth with no taxable income kept my MAGI under my estimate for the nearby tripwire that would apply to my 2021 tax return.
My total of $60,000 conversions – my basis in my Roth – had increased to $85,000 value by then. Those were two very good years for stocks.But the real key is my basis or total amount that I converted.
• I had to report my withdrawal from Roth as a “nonqualified” withdrawal, but form 8606 shows that my withdrawal was from my prior contributions with no taxable income or penalty.
And after that withdrawal, I was not close to reaching any of growth portion in my account. I could have withdrawn more, but that would still be less than my basis. That made no difference since I did not withdraw from my Roth in 2022 and 2023. Now, in 2024, all future withdrawals are “qualified”, and I don’t have to sweat details of reporting nonqualified Roth withdrawals on form 8606 ever again.
Conclusion: The rules governing withdrawals from Roth IRAs created from converting Traditional to Roth can be a bit hairy. The growth portion of a withdrawal could be subject to tax and 10% penalty if withdrawn before a “five-year” aging period. You avoid the headache of this by limiting your withdrawals to the amount you’ve converted until you’ve met the “five-year rule”: withdrawals of the amount you’ve contributed or converted to Roth are never taxed; you already paid tax.
I used my Roth account to pay for a car. Would it be advisable for me to transfer some of my traditional retirement account into the Roth or may I add to the Roth in any other way?