By Ian Berger, JD
IRA Analyst
Don’t forget to turn your clocks back this weekend!
With that reminder comes another: pay attention to the Roth IRA distribution clocks. The key point to remember is that there are two different clocks, each used for a different purpose.
The First Clock: Is a Distribution of Converted Dollars Subject to Penalty?
When you do a Roth IRA conversion, you’re not subject to the 10% early distribution penalty at that time – even if you are under age 59 ½. But if you receive a distribution of converted Roth amounts when you’re under 59 ½, you could be hit with the penalty. This is the only time that the first five-year clock comes into play. This clock starts ticking on January 1 of the year of the conversion. If you’re under 59 ½ and take out the converted amount before the end of the five-year period that starts on that January 1, you’ll be penalized (assuming no penalty exception applies). If you do Roth conversions in different years, each conversion has its own five-year clock. But remember: If you don’t touch the converted funds until after age 59 ½, the first five-year clock will never come into play.
The Second Clock: Is a Distribution of Earnings Subject to Taxes?
The second clock is completely different than the first one. This clock helps determine whether earnings on Roth IRA contributions (and conversions) are taxable when distributed. Earnings avoid taxes if two conditions are met: The 5-year clock is satisfied, and you are at least age 59 ½ (or disabled or a first-time home buyer). When both conditions are satisfied, you’ve received what’s called a “qualified distribution.”
This second clock (which we like to refer to as the “5-year forever clock”) starts ticking on January 1 of the year of your first contribution or conversion to ANY Roth IRA. There is no separate 5-year forever clock for any subsequent contribution or conversion. If you take out earnings on your Roth contributions or conversions before the end of the five-year period that starts on that January 1, those earnings will be taxable. Getting the 5-year forever clock ticking is why it’s so important to open up a Roth IRA as early as possible – even if it’s funded with $10 or $20.
But don’t fret if your Roth IRA distribution is not “qualified.” Roth IRA ordering rules allow contributions and conversions to come out before earnings. This means that you can always receive a tax-free distribution of an amount equal to your Roth contributions and conversions without even reaching your earnings (in other words, before the second clock even comes into play).
Confused? Well, you do have an extra hour this weekend to figure it all out.