Watch Out for this Penalty When You Take a Roth IRA Distribution
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The Five-Year Rule for Converted Funds
If you make annual contributions to your Roth IRA, you can always access those funds penalty-free; it’s that easy. However, when it comes to converted funds, it gets a little more complicated. If you are under age 59 ½, you can always access your converted funds tax-free. That makes sense, because you already paid the tax bill when you did the conversion.
It’s a different story when it comes to the 10% early distribution penalty. If you are under age 59 ½, you must satisfy a five-year holding period on funds that were taxable when converted before you can access those funds penalty-free.
The five-year holding period will restart for each conversion. If the conversion was done in 2018, the holding period for this five-year rule begins on January 1, 2018. Don’t confuse this five-year rule with the other five-year rule that applies to Roth IRAs. That is the five-year rule for tax-free distributions of earnings from Roth IRAs, which works differently.
The best way to understand this five-year rule for penalty-free distributions of converted funds is to know exactly what it is set up to prevent. When you take a distribution from your traditional IRA and convert it to a Roth IRA, that distribution is taxable, but not subject to the 10% early distribution penalty. This fact meant that soon after Roth IRAs became law, those looking for tax loopholes started telling IRA owners that they could get out of the 10% penalty by doing a conversion. IRA owners could just convert their IRA to a Roth IRA and then, the next day, withdraw funds from the Roth IRA tax and penalty free.
In response, the IRS and Congress acted fast. Now we have this 5-year rule that says if the converted funds are not held for at least five years or until age 59 ½, any withdrawal before that time would be subject to the 10% penalty the account owner would have to pay if they withdrew from their traditional IRA.
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