By Andy Ives, CFP®, AIF®
Buckle your seatbelt and hang on to your hat. This ride could get bumpy. We are about to embark on a conversation that might give some readers vertigo or whiplash or all of the above.
An article I wrote about the two 5-year clocks for Roth IRA conversions and earnings remains a popular education piece (“Roth IRA: 2 Clocks,” May 13, 2019). However, based on a steady stream of questions and continued confusion, I am compelled to expand on the topic. This new article is NOT about the 5-year clock that allows penalty-free distributions from Roth conversions for those under 59 ½. That 5-year clock will restart for each conversion that is done for anyone under 59 ½. Here we discuss something I have begun referring to as… [insert dramatic music here] …the “Roth 5-Year Forever Clock.”
In an extreme example of the 5-Year Forever Clock, James is 43 years old. He opens his very first Roth IRA with a $5,000 contribution. Two years later, when James is 45, the account is worth $6,000 and James is in financial straits. He withdraws the entire $6,000 and closes the account. Since a Roth IRA owner always has access to his Roth contributions tax- and penalty free, the first $5,000 comes out clean with no strings attached. If no eligible exception applies, the $1,000 in earnings are taxable to James and he will owe a 10% penalty of $100.
For the next 15 years James has no open Roth IRA account. However, when he is 60, James decides to start saving again. He opens a new Roth IRA and contributes $7,000 ($6,000 plus $1,000 over-50 catch-up.) At the same time, James converts $100,000 from his pre-tax 401(k) into his Roth IRA and pays the taxes due. (His work plan did not have a designated Roth account option.). James now has $107,000 in his Roth IRA. One year later, when James is 61, the account is worth $120,000. At that point, 61-year-old James withdraws the entire $120,000 from the Roth and closes the account.
Is there a penalty? Are any taxes due? Has James met the holding requirements? Enter the Roth 5-Year Forever Clock.
The full $120,000 is tax- and penalty free to James upon withdrawal. The $7,000 contribution, the $100,000 conversion, and the $13,000 in earnings all come out clean as a whistle. But how is this possible? Wasn’t the current Roth IRA only open for one year? Heck, the original Roth IRA opened way back when James was 43 was only in existence for two years.
James’ withdrawal of the $120,000 is a qualified distribution of earnings because A.) James is over 59 ½, and B.) His Roth IRA 5-Year Forever Clock started 18 years earlier – on January 1 of the year he opened his first Roth IRA when he was 43 years old. It matters not that the account was closed after two years. What matters is that a Roth IRA was originally established more than five years ago.
This is the 5-year Roth clock that deals with the fundamental purpose of opening a Roth IRA – tax-free earnings. The holding period starts when the first Roth IRA account is established via either a contribution or conversion and does NOT re-start for each subsequent 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 or converted, even if that first contribution was only $1. Once you hit 59 ½ AND after five years, you have met the qualifications. Your Roth IRA is now an open door to tax-free earnings and penalty-free withdrawals.