Roth IRAs follow strict distribution ordering rules. Contributions come out first, then converted dollars, and then earnings. It does not matter how many Roth IRAs a person has, or if the accounts are held at multiple custodians. The IRS doesn’t care. All the IRS sees is one big Roth IRA bucket, and within that consolidated Roth IRA bucket, there are only three types of dollars: contributions, conversion, and earnings. Any distribution from any Roth IRA follows the ordering rules – contributions first, converted dollars second, earnings last.
Let’s focus on just the EARNINGS within this aggregated bucket of Roth IRA dollars. For the earnings to be tax free (which is the goal of starting a Roth IRA), a person must check two boxes. Box #1: He must own a Roth IRA – any Roth IRA – for 5 years. The 5-year clock starts on January 1 of the year of the first Roth IRA contribution or conversion. Box #2: He must be age 59½ or older (or disabled, purchasing a first home or deceased). Check both boxes, and you are living in a tax-free-earnings world for the rest of your life.
Assume a person is 60 years old, never had a Roth IRA before, and decides to make his first entry into a Roth IRA by doing a $100,000 conversion. When will his earnings be tax free? Answer: In five years. Until he reaches the 5-year mark, he only checks the age 59½ box.
What if this same person does another Roth conversion three years after the first conversion? When will the earnings on that SECOND Roth conversion be tax free? Answer: After only TWO years! Why? Because two years after that second conversion, he will be over age 59½ AND will have owned ANY Roth IRA for 5 years (based on his first conversion). With both boxes checked, the 5-year Roth IRA clock applicable to conversion #2 disappears. Any future Roth IRA contributions or conversions in this person’s life will result in IMMEDIATE tax-free earnings.
Example 1: Tom, age 60, never had a Roth IRA before. Excited by the opportunity to have tax-free earnings, he converts $100,000 from his traditional IRA. Since Tom never owned a Roth IRA, he must wait 5 years before the earnings are tax free. Three years later, when Tom is age 63, he does another Roth conversion. This second conversion has its own 5-year Roth IRA clock to wait out before the earnings are tax free. However, two years later, when Tom is age 65, he has checked both boxes: he is over age 59½ AND he owned a Roth IRA for 5 years. At that point, the 5-year Roth IRA clock applicable to Tom’s second conversion disappears, and ALL his Roth IRA earnings are tax-free. Tom will never have another Roth IRA 5-year clock to worry about. The earnings on any future Roth IRA contribution or conversion will be immediately available tax free.
Example 2: Betty was age 55 when she contributed to her first Roth IRA and started her 5-year clock for tax-free earnings. Three years later (age 58), Betty does a Roth conversion. This conversion has its own 5-year clock. However, two years after that, when Betty is age 60, she will have owned a Roth IRA for 5 years (based on her initial contribution at age 55) AND she will be over age 59½. Both boxes checked. Her conversion clock disappears. All earnings are tax free.
Check both boxes – age 59½ AND own any Roth IRA for 5 years – and all earnings in ALL your Roth IRAs are tax free.
If you have technical questions you would like to have answered, be sure to submit them to mailbag@irahelp.com, to be answered on an upcoming Slott Report Mailbag, published every Thursday.
Check Both Boxes for Tax-Free Roth IRA Earnings
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