Ask an Advisor: At 65, I Did a Roth Conversion to Skip RMDs

By Investor Empires On Dec 26, 2024

Imagine you’re 65 and you just completed a Roth conversion during a low-tax year early in retirement to avoid the future Required minimum distributions (RMDs). However, soon after the transfer, you want to withdraw the money you just paid taxes on. But continuing to withdraw without understanding the five-year rule for Roth IRAs could leave you paying income taxes and penalties on the money.

Does the rule apply to you in this case? Unfortunately, the answer is a very unsatisfactory statement: “It depends.” In fact, there are actually several five-year rules you should be aware of with Roth IRAs. We’ll review two that are likely to come into play and explore how they might impact your withdrawal strategy.

Need help planning a Roth conversion or navigating the five-year rule? Contact a financial advisor today.

the first Five-year rulewhich applies to Roth IRA contributions, centers on whether withdrawals of any accumulated earnings will be taxed. This rule requires account holders to wait at least five tax years from the time of their first contribution – whether made directly or by transfer – to withdraw earnings, provided they have reached age 59½. If you make subsequent contributions or open new Roth accounts, the clock will not restart.

In order for the dividends to be distributed eligible – i.e. tax free – you must meet the age requirement and this 5 year rule. There are exceptions to the age requirement in the case of death of the account holder, disabilities, and first-time homebuyers. But even with these exceptions, the five-year rule must be met or any earnings taken from the account will be taxable.

If you are at least 59½ years old but do not meet the requirements of the five-year rule, you will pay income taxes on any earnings withdrawn. Because contributions to Roth IRAs are made with after-tax dollars, you can always withdraw the value of your contributions tax- and penalty-free, but any gains generated and distributed before the five-year period ends will be taxed. The distribution will also be subject to a 10% early withdrawal penalty if you are not 59½ years of age. (Talk to a financial advisor If you need help navigating the five-year rule for your Roth IRA.)

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The second five-year rule specifically relates to Roth conversions and whether… Early withdrawal of the transferred asset will be taxed. In fact, the rule only applies if you take the distribution before you turn 59 ½.

For example, assume you have a Roth IRA underway and complete the conversion when you turn 56. If you want to withdraw this converted principal amount after two years at age 58, the withdrawal will be subject to a 10% early distribution penalty. However, if you wait until you are at least 59 1/2 years old, you will not face the penalty even though it has been less than five years since you converted.

While the five-year clock for Rule 1 begins with the initial Roth contribution, each Roth conversion you perform has its own five-year clock that begins on January 1 of the year you complete the conversion. For example, if you do a Roth conversion in May 2024, your five-year clock will start on January 1, 2024.

As a result, you need to keep your conversion date in mind when receiving distributions. The IRS helps you avoid potential mistakes to some extent by requiring withdrawals of contributions first, transferred balances second, and investment earnings last.

Furthermore, transfer withdrawals are made on a first-in, first-out basis, so the oldest transfers are withdrawn first once direct contributions are fully distributed. (Need more help? A Financial advisor It can help you better understand the withdrawal rules surrounding Roth conversions.)

A man looks at the five-year rules to determine when he can withdraw money from his IRA tax- and penalty-free.

Let’s apply each rule to the hypothetical scenario above to see why this case is not as straightforward as it may initially seem.

We’ll start with the second rule since you’re over 59 ½ in our hypothetical example. As a result, you can withdraw all of the transferred principal without paying a 10% penalty. The first rule is a little more difficult because its application will depend on the answers to some questions. especially:

When was your Roth IRA initially funded?
Did the account make any profits?
How much do you want to withdraw?

If the conversion represents your first time putting money into a Roth IRA, the first five-year rule applies. This means that even though you can withdraw the principal transferred tax- and penalty-free due to your age, you will still owe it R Interviewer On any investment profits you wish to obtain. The key question then becomes how much you intend to distribute if the account has accumulated gains since its initial funding.

Let’s take a look at some possible scenarios since we’re missing some key details to provide a definitive answer. In each scenario, assume you have $50,000 in the account after the conversion and that the conversion was actually the initial funding for your first Roth IRA.

Scenario 1: You completed the transfer five days ago, the account has not made any gains and you want to withdraw the entire account value. Since there are no profits to distribute and the account value is simply the transfer value, the first rule is not relevant. You can withdraw the entire account whenever you want.

Scenario 2: You completed the transfer a month ago, the account has gained $2,000 and you want to withdraw $25,000. In this case, the first rule is also irrelevant since you are only tapping capital and not profits. So, you can essentially withdraw $25,000 and not pay any taxes or penalties.

Scenario 3: Let’s assume the same background as in Scenario 2, but instead you want to withdraw all of the $52,000 in the account. In this case, the first five years rule applies because you did not wait five years to withdraw your winnings. Even though you’re over age 59 1/2, you’ll still owe taxes on the $2,000 gain.

A financial advisor can help you do the math specific to your circumstances. Get matched with a financial advisor today.

Applying these two rules for five years can get somewhat complicated. Just remember that the first rule applies to profits and that the clock starts with your initial funding of the account. You cannot get around this rule even if you are 59 and a half years old. However, initial funding can come in the form of a direct contribution or transfer.

The second five-year rule applies to funds converted to Roth assets. Although this rule becomes moot if you are at least 59½ years old, even if you withdraw the transferred funds less than five years after the transfer is completed.

If a Roth IRA It is part of you Retirement The safest way to avoid confusion and an unexpected tax bill is to start contributing early, not receiving distributions until you reach age 59 ½ (circumstances permitting) and waiting five years of initial funding before beginning withdrawals.
But if you need additional help managing your Roth IRA or implementing a Roth conversion, talk to a financial advisor. Finding a financial advisor is not difficult. Free SmartAsset tool Matches you with up to three vetted financial advisors who serve your area, and you can make a free introductory call with your Match Advisors to determine who you feel is a good fit for you. If you are ready to Find a mentor Who can help you achieve your financial goals, Start now.
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