How to Eliminate Penalties on Early Withdrawals
from Roth Conversion IRAs

by JD Miller on November 3, 2011

JD Miller CPA
The Trusted Financial Planner

Early withdrawal penalties from IRAs can be HUGE! But they can be eliminated by careful planning steps.

Roth IRA withdrawals are subject to the same 10% Federal early withdrawal penalty on the amount withdrawn before the IRA owner is at least 59 ½ years old. But penalties on Roth IRA withdrawals before the IRA owner is at least 59 ½ years old can be eliminated by meeting the second 5 year rule.

To review, meeting the first 5 year rule allows you to withdraw part or all of the money in your Roth IRA accounts income tax free at any time. However, you must meet the second Roth conversion 5 year rule if you want to withdraw part or all of the money you convert to a Roth IRA without paying the early withdrawal penalty.

Once you meet the second 5 year rule, you can withdraw any of the money you converted to your Roth conversion IRA penalty free, even if your are younger than 59 ½. This could eliminate thousands of dollars in penalties.

Note: You must still pay the 10% penalty on any income you withdraw from any of your Roth IRA accounts, if you are not yet 59 ½ years old when you withdraw the income. There’s no exception from that penalty.

In a prior article, I explained how the first 5 year rule works.

Here’s how the second 5 year rule works.

The Second 5 Year Rule Explained

The second 5 year rule determines whether or not you must pay the 10% Federal early withdrawal penalty if you were to withdraw part or all of the amounts you convert to a Roth IRA.

For the second 5 year rule, the 5 year period begins on January 1 of the year that you convert money from an IRA (or a 401k, 403b, or 457 plan account) to a Roth conversion IRA. The 5 year period ends on December 31st of the 5th year after the year you do your Roth conversion.

Unlike the first 5 year rule where once you meet the 5 year rule, you’ve met it for life, with the second 5 year rule, every Roth conversion is a fresh start. Each year you make a Roth conversion, you start a new 5 year period for that Roth conversion.

Here Are Some Examples of How the Second 5 Year Rule Works

Example 1: Suppose you convert $10,000 to a Roth IRA account on December 13, 2010.

The 5 year period begins with January 1 of the year that you did the Roth conversion. In this example, your Roth conversion was done on December 13, 2010. Your first year began on January 1, 2010. The 5 year period for this Roth conversion ends on December 31, 2014, the end of the 5th year.

You must pay the early withdrawal penalty on any of the money that you withdraw from your Roth conversion IRA prior to December 31, 2014.

Beginning January 1, 2015, you could withdraw part or all of the money you converted to your Roth IRA without paying the early withdrawal penalty.

Note: There is no penalty on the amount that you converted. You must still pay the 10% penalty on any income you withdraw from any of your Roth IRA accounts if you are not yet 59 ½ years old when you withdraw the income.

Example 2: Everything is the same as in Example 1 except that you already had money in a Roth IRA. You opened this Roth IRA on April 22, 2001. Your first deposit was $100 on July 5, 2004. On December 13, 2010, you convert $10,000 to a Roth IRA account.

The 5 year period for your $100 Roth contribution ended on December 31, 2008, the end of the 5th year after saved it in your Roth IRA.

There is only one 5 year period for tax free income withdrawals from Roth IRA accounts. You’ve already met it. Once it’s met, it’s met for life.

You could withdraw any or all of the income from any of your Roth IRAs, including your 2010 Roth conversion IRA, tax free. However, you must still pay the early withdrawal penalty on the income you withdraw if you are under 59 ½.

You must also pay the early withdrawal penalty on any part of your Roth conversion if you withdraw it prior to January 1, 2015. After December 31, 2014, the second 5 year rule has been met. You can withdraw any of the Roth conversion amount without paying the early withdrawal penalty.

The 5 year period to avoid the early withdrawal penalty began with January 1 of the year you did your Roth conversion, 2010. It isn’t completed until December 31, 2014, the end of the 5th year after the year of the Roth conversion.

It doesn’t matter that you met the first 5 year rule to avoid tax on withdrawals. Every Roth conversion is a fresh start for the second 5 year rule to avoid the early withdrawal penalty.

Example 3: Everything is the same as in Example 1 except that on September 7, 2012, you convert another $10,000 to a Roth IRA account.

The 5 year period for this Roth conversion would end on December 31, 2016, the end of the 5th year.

The 5 year period begins with January 1 of the year of your Roth conversion, 2012.

It doesn’t matter that you would meet the second 5 year rule for your 2010 Roth conversion in 2014. Every Roth conversion is a fresh start for the second 5 year rule. You meet your second 5 year rule for your 2012 Roth conversion on December 31, 2016.

You must pay the early withdrawal penalty on any part of your second Roth conversion if you withdraw it prior to January 1, 2017, the first day after the second 5 year rule has been met for the 2012 Roth conversion.

Summary

The 5 year rule to protect yourself from the 10% Federal early withdrawal penalty on amounts you withdraw before you are 59 ½ years old is much different than the 5 year rule to make withdrawals tax free.

Once you meet the second 5 year rule, you can withdraw any of the money you converted to your Roth conversion IRA penalty free, even if your are younger than 59 ½.

You must still pay the 10% penalty on any income you withdraw from any of your Roth IRA accounts if you are not yet 59 ½ years old when you withdraw the income. There’s no exception from that penalty.

Not knowing the Roth Conversion 5 Year Rules could cause you to trigger HUGE income taxes and penalties.

Protect yourself. Get the help of a CPA or other tax advisor who knows the Roth Conversion 5 Year Rules.

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