Forgetting the 5 Year Rule Can Tax Some of Your Roth IRA Withdrawals

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 IRA distribution requirements. But you have to abide by the 5 year rule; otherwise you may trigger tax consequences on your Roth IRA withdrawals. This is important especially for those pensioners who take out huge amounts from their Roth IRA.

Owing to its aforementioned merits, the Roth IRA qualifies as an ultimate option for savings. The contributions are after-tax funds but the Roth IRA withdrawals come out tax free. With the hope that your investments do well and the balance grows handsomely, the benefit of tax free Roth IRA withdrawals on a future big balance are significant. The catch, though, is that you must fulfill the 'waiting' time so as not to incur any penalty or taxation on your Roth distributions. Your Roth IRA withdrawals are tax-free and devoid of any penalties, provided your age is more than 59½ and you have adhered to the waiting time of 5 years since your investment.

The IRS label for Roth IRA withdrawals which meet the tax-free criteria is "qualified distribution." To verify if your withdrawal has fulfilled all the requirements, see the figure given below.

On what components of non-qualified withdrawals of IRA is the tax imposed? What will be taxable if you've crossed the age of 59½ but haven't waited for 5 years? Since you've already been taxed on whatever you've directly contributed to your Roth or whatever you converted from a traditional IRA to your Roth, you won't be taxed on it again! The sum which is in excess of the directly added amount to your Roth IRA at the time of transfer of traditional into Roth, i.e. the earnings, could be taxable.

When you take Roth IRA withdrawals, IRS dictates the order of distributions as follows:

Contributions; those paid directly into Roth IRA
When you change more than one conventional IRA into Roth IRA, the one that has been changed first will be regarded first
Profits generated from your allocations.

Since profits come out last per IRS ordering rules, the only time you should ever pay tax on a Roth IRA withdrawals, is if it is a total withdrawal. So that you don't dip into that last layer, the layer of earnings (item 3 above), it is advisable to keep a record of dates on which you converted traditional IRA funds to the Roth and make sure they have aged for 5 years.

The 5 year rule works as follows. The waiting time begins on the first of January of the year in which payments were made, for the regular payments. The payment for the particular year can be delayed up to the 15th of April of the subsequent year -- which should be kept in mind -- eventually, reducing the waiting time to less than 4 years! In other words, you may have made a Roth IRA contribution on April 15, 2003 for the tax year 2002. The 5-years start on 1/1/2002 for that contribution.

But for the conversions from a traditional IRA, the 5 year time period starts from the date of transfer to the Roth IRA.