One of the questions I get alot are from people who have a great deal of money bult up over the years and they want to fund a Roth IRAs by doing conversions from their traditional IRA to a Roth IRA and/or making yearly Roth contributions.
While you can’t deduct the contributions you make to a Roth IRA, the money in the account grows tax-free. Of course, as with most things concerning taxes, there are some rules to prevent from cheating the system. In brief, you are subject to the five-year rule and withdrawals have to be after age 59½ to be not taxable and prevent penalties.
The first rule determines whether distributed earnings are tax-free. This rule states that payouts of earnings after 59½ aren’t taxed if at least five tax years have passed since the owner first funded a Roth IRA. In this case, the five-year clock starts on Jan. 1 of the year you open and first put money into any Roth IRA, through a contribution, rollover or conversion. It doesn’t restart when making additional contributions.
Some examples
#1: You are 64 and you funded your first Roth IRA two years ago. In 2025, you take a distribution. You will be taxed on the earnings part of the payout because the five-year clock began on Jan. 1, 2023, and five years haven’t yet passed.
#2: You are 63 and you funded your first Roth IRA in Nov. 2020. You take a distribution in October 2025. Your withdrawal will be fully tax-free because the five-year clock began Jan. 1, 2020, and you took the payout in Sept. 2025.
#3: You are 71, and you opened a Roth IRA through a conversion in 2017. You added more Roth conversions in each year 2018 through 2025, and you plan to do so again this year. In this case, since your five-year clock began Jan. 1, 2017, you can take tax-free Roth withdrawals this year.
The second rule only affects people who are under age 59½ years of age. This rule states, if someone under 59½ does a Roth conversion, and later takes a payout within five years of the conversion and before turning 59½, then the amount of withdrawn conversion principal is hit with the 10% penalty for pre-59½ payouts. Heres the kicker, under this second five-year rule, each conversion has its own separate five-year period, which differs from the first five-year rule above. So if you do multiple Roth conversions, there are multiple five-year periods, even if each conversion is done into the same Roth that you owned for years. But remember it doesn’t apply to payouts taken after 59½.
Now there are a few other things to consider before opening that IRA
First, you must roll over the same type of property that you received from the IRA. For example, rollover cash to cash or stock to stock.
Second, pay attention to the one-rollover-every-12-months rule. This applies on an aggregate basis to all your IRAs, not on an IRA-by-IRA basis. If you have multiple accounts, you can make unlimited trustee-to-trustee transfers between IRAs in a 12-month period, because these direct transfers aren’t considered rollovers. Ditto if an IRA owner is given a check payable to the new IRA for his or her benefit. However, if you withdraw the money to your personal account and then deposit it to your IRA, you can only do that once a year.
If you are interested in converting your Traditional IRA to a Roth IRA, we have a tax calculator that helps you determine how much you can transfer in a year without bumping you up to a higher tax bracket. You can find details on this at seagulltechnologies.com/consulting
Add new comment