“If someone converts funds that are both deductible and NON deductible from an IRA to a Roth and needs to take withdrawals later, the funds are withdrawn in FIFO order—after tax contributions first then conversion then growth. After tax money is always tax and penalty free.”

The above conclusions are somewhat misleading. Assuming a non qualified distribution, the funds taken out are NOT taken in FIFO (chronological) order, but under the ordering rules. Regular contributions come out first, whether made before or after a conversion, and they are tax and penalty free. But once these funds have been distributed and the taxpayer starts to tap conversions, the conversions themselves come out in FIFO order, but for conversions made with a mix of pre tax and after tax dollars, a particular converion’s pre tax dollars come out first, and this means that the 10% penalty will apply if the 5 year holding period has not been completed. The after tax portion of a conversion comes out after the pre tax, and this portion is not taxable and therefore not subject to the 10% penalty if the conversion 5 year holding period has not been met. Your final statement IS correct, however, ie after tax conversion money comes out tax and penalty free.

“Can pre existing Roth accounts – for example, one that is 5 years old already—owned by the individual doing the conversion–receive the converted funds and thus create a completed 5 year holding period immediately? ”

No, a holding period cannot be completed depending on WHICH Roth account receives a conversion. The holding period is determined in the same way for contributions to a new account OR an existing account, and is based solely on the date the particular conversion contribution is made.

“For spouses inheriting IRA funds, can they use either their own Roth or their spouse’s inherited Roth which may be OLDER than their own and thus accelerate the holding period?”

Yes, the holding period is the oldest of the two spouse’s holding periods if the inherited Roth is rolled over or assumed. But if maintained in inherited format, the inherited Roth IRA and an owned Roth IRA by the surviving spouse each have different holding period dates.

“Or, does EACH conversion take on it’s own 5 year timeframe?”

If a Roth is inherited from a spouse, any 5 year holding period for conversions disappears because the account holder’s death will result in an exception to the 10% early withdrawal penalty for converions held less than 5 years. But the 5 year holding requirement for a Roth to become qualified for tax free earnings distributions is based on the year of first contribution of either spouse.

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So the 5 year holding period on coverted money into a ROTH doesnt apply if the person is over 59 1/2??

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Clarification of the terms “contribution”, “conversion” and “earnings”.

Do “contributions” constitute new deposits to a Roth once established that are not from any pre-established retirement plans? Are after tax contributions to an IRA that is converted to a Roth considered “contributions”?

For example, if an IRA with 10k after tax contribution and a 50k account value is fully converted to a Roth, would $10k (the after tax portion) be available for immediate withdrawal without consequence, regardless of holding period and age of account holder?

Or, is ALL the money in the converted retirement (the IRA, in this example) account considered “conversion” money regardless of the pre/post tax status within the retirement account?

Is the definition of “earnings” to be only the growth within the Roth after funds are deposited/converted over?

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If a converted IRA is comprised of all after tax contribution money (which could happen due to the drop in the market) is it true you could incur a 10% penalty if this money is removed prior to age 59-1/2 or 5 year holding?

If you removed the same money from the original IRA, would it also have a penalty even with NO growth portion?

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pmk,
The 8606 calculates the taxable and non taxable amounts by pro rating the adjusted balances as of year end. You are correct that the after tax amount is neither taxed or subject to the early withdrawal penalty, even though the 1099R will be coded as “early” (Code 1). This holds true for both taxable distributions and Roth conversions.

There is no “layer” created until the funds are in a non qualified Roth IRA. At that point, if you distribute the conversion funds from the Roth the ordering rules indicate that the older conversions come out first, and from EACH of a given year’s conversions, the pre tax amount amount comes out prior to the after tax amount. Those pre tax amounts are subject to the 5 year holding requirements to escape the 10% penalty, but the after tax amounts do NOT incur the penalty.

If the Roth is qualified, it means that that this distinction is irrelevant since there will not be an early withdrawal penalty in any event. However, special rules apply to a failed conversion in determining if an early withdrawal penalty would have been due for an early distribution from the TIRA for these amounts that were never actually eligible for conversion. The issue of failed conversions will disappear for conversions done after 2009 because anyone would be eligible from then on.

Robert –
No, that is not true. If the entire Roth conversion was done with fully after tax funds per Form 8606, there would never be a 10% tax, even when the conversion is not held 5 years. The reason for this is that the early withdrawal penalty only applies to pre tax funds in the first place, never to after tax funds.

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Right.

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