Penalty-Free Distributions from Roth Conversions; proceed with caution!

Retirement Plan

There are rules that govern your first 5-year period of ROTH after conversion of ROTH TSP and Roth IRA conversions and if you are under age 59 ½.

If you are over 59 ½ (or as soon as they reach 59 ½), you can ignore this rule.

 When a traditional TSP or IRA is converted to a Roth, the under-age-59 ½ account owner must wait 5 years before they can take penalty-free distributions (assuming no exception to the 10% penalty applies). We are not talking about earnings yet – only avoiding the 10% penalty on distributions of converted dollars. This 5-year period will restart for each conversion that is done.

Ted, age 30,  converted his traditional IRA to a Roth in September of that year. The IRS recognizes the conversion as happening on the first day of the year, so Ted’s holding period for the conversion began on January 1, 2015. He must wait five years until January 1, 2020 before he can take penalty-free distributions of the converted assets. Even though Ted will only be 35 in 2020, he will have access to his converted assets tax and penalty-free. If Ted does take a distribution, ordering rules are as follows: contributed dollars come out first, then converted dollars, then earnings.

Tax-Free Distributions of Roth Earnings

Once Roth deals with the purpose of establishing a Roth IRA – tax-free earnings. This holding period starts when the first Roth IRA account is established and does NOT re-start for each Roth IRA contribution or conversion. The holding period begins on January 1 of the tax year for which the first dollar of Roth IRA money is contributed, even if that first contribution was only $1.

Example, Susan established her first Roth IRA with a contribution this year, January 1, 2019, when she was 57. She must wait the full five years, when she is 59 ½ years of age, until January 1, 2024 for the distribution of her earnings to be tax-free (qualified). At age 59 ½, Susan could withdraw the entire account penalty free. However, any earnings would be taxable as she has not met the 5-year holding period. She must wait the five years to earn the benefit of tax-free earnings.

Keys to remember:

There are two circumstances: #1 – Penalty-Free Distributions from Roth Conversions (which can be disregarded at age 59 ½), #2 – Tax-Free Distributions of Roth Earnings.

Ordering rules for Roth IRA distributions are as follows:

  1. Contributions: Can always be withdrawn tax and penalty-free. No age restrictions.
  2. Conversions: Can always be withdrawn tax free. No penalty if withdrawn after 5 years OR after age 59 ½.
  3. Earnings: No tax or penalty if distributed after 5 years AND age 59 ½, deceased, disabled or first time home buyer.

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