I want to do three Roth conversions in the next three years before I turn 73 in 2027 so that my beneficiary doesn’t have to deal with taxes. If I should die soon after the last conversion, will my beneficiary be subject to the five-year rules?
– Tom
This is a good question. The five-year rules are a regular source of confusion. We field a lot of questions about them in this column. The good news is the answer is clear in this case: No, your beneficiary does not have to worry about the five-year conversion rule. Let’s take a closer look at the five-year rules and the rules for beneficiaries.
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First, let’s address the fact that there are two five-year rules for Roth IRAs: One that only needs to be satisfied once and another that applies to each individual Roth conversion.
The first five year rule dictates that in order for a Roth IRA distribution to be qualified, you must have opened and maintained a Roth IRA for at least five years (in addition to being 59 ½ or older). You only have to satisfy this rule once in your lifetime. After that, it’s met for all future Roth IRAs and contributions to them. Withdrawing investment earnings before the five-year period has elapse will trigger a 10% early withdrawal penalty, even if you’re 59 ½ or older.
The second rule applies specifically to Roth conversions. Tom, you are correct that a separate five-year waiting period applies to each Roth conversion.
If someone does a Roth conversion this year and they’re under 59 ½ years old, five years must elapse before they can withdraw the money tax- and penalty-free. If they do another Roth conversion next year it will have its own five year cooling off period.
However, the rule doesn’t apply if you’re 59 ½ or older. (And if you need help navigating the five-year rules, speak with a financial advisor.)
A Roth conversion is a common retirement-planning strategy that can help you forgo RMDs and potentially save money on taxes.
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Each five-year rule has a different purpose and I think understanding them can help you remember when each rule will apply. It also may be helpful to preface this discussion with a reminder that you can always withdraw your own contributions to a Roth IRA tax and penalty free – any time, for any reason, at any age.
The first rule relates to whether or not you can withdraw the earnings tax-free. So, assume you contribute $7,000 to a Roth IRA, and it grows to $8,000 within the first three years. You have $1,000 of gain. If this is your first Roth IRA (and you therefore haven’t satisfied the first five-year rule), you’ll have to pay income tax on that $1,000 if you withdraw it. This is true regardless of your age. Even if you are 59 ½ or older, this rule must be satisfied to qualify for tax-free withdrawals of investment gains.
The five-year rule associated with Roth conversions is meant to prevent those who are under 59 ½ from circumventing the 10% early withdrawal penalty.
Imagine this scenario in the absence of the five-year conversion rule: Suppose you are 50 and have $25,000 in a traditional IRA that you’d like to withdraw. You are free to do so of course, but in addition to regular income tax you’ll have to pay an extra 10% because you’re withdrawing earnings early. Instead, you convert it to a Roth IRA and then immediately withdraw it. Sure, the conversion is subject to income tax, but you would circumvent the 10% penalty because you can always withdraw your contributions from a Roth tax and penalty free.
The five year conversion rule specifically closes this loophole. To be considered a “qualified” withdrawal – one not subject to taxes or penalties – this rule must be met after a conversion.
(And if you need help planning your Roth conversions and withdrawals, consider working with a financial advisor.)
A 70-year-old man reviews his IRA balance and plans a series of Roth conversions.
So, here’s where your specific question comes into play. The five-year rule for Roth conversions determines whether you are subject to a 10% early withdrawal penalty. You personally don’t have to worry about the five-year conversion rule because you are over 59 ½ and the early withdrawal penalty simply no longer applies to you.
The five-year conversion rule exists to prevent IRA owners from circumventing the 10% early withdrawal penalty. However, this rule doesn’t apply if you are 59 ½ or older. Additionally, beneficiaries who inherited converted IRAs don’t need to worry about each of the conversion periods because the 10% early withdrawal penalty doesn’t apply to inherited IRAs.
Market downturns early in retirement can deplete savings faster. To mitigate this, consider a “bucket strategy,” allocating funds across different time horizons – cash for short-term needs, bonds for mid-term and equities for long-term growth. Alternatively, using a dynamic withdrawal strategy can adjust spending based on market performance, reducing the risk of running out of money.
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Keep an emergency fund on hand in case you run into unexpected expenses. An emergency fund should be liquid — in an account that isn’t at risk of significant fluctuation like the stock market. The tradeoff is that the value of liquid cash can be eroded by inflation. But a high-interest account allows you to earn compound interest. Compare savings accounts from these banks.
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Brandon Renfro, CFP®, is a SmartAsset financial planning columnist and answers reader questions on personal finance and tax topics. Got a question you’d like answered? Email AskAnAdvisor@smartasset.com and your question may be answered in a future column.
Please note that Brandon is not an employee of SmartAsset and is not a participant in SmartAsset AMP. He has been compensated for this article.Some reader-submitted questions are edited for clarity or brevity.
