Ask an Advisor: My RMDs Are Near, So I'm Converting $700K to a Roth to Avoid Them. Do I Have to Wait to Access the Money Then?

The first five-year rule dictates that you must wait five years after your initial contribution to a Roth IRA before you can make tax-free withdrawals of any investment earnings. However, the five-year period is retroactive to Jan. 1 of the year in which your first contributions were made.

For example, if you made your first contribution to a Roth IRA in November 2020, the five-year period officially began on Jan. 1, 2020. As a result, you could start withdrawing earnings after Jan. 1, 2025.

But waiting five years alone is only half of the equation. Withdrawals from your Roth IRA must be “qualified” in order for you to avoid taxes and penalties. Luckily, reaching age 59 ½ is the most common way to satisfy this particular requirement.

For instance, funding a Roth IRA at age 45 doesn’t mean someone can make tax- and penalty-free withdrawals from the account five years later. They’ll need to wait until age 59 ½, be disabled or meet one of the other requirements set by the IRS for qualified withdrawals. Likewise, if you open your first Roth IRA when you’re 58, the five years still need to pass before you can withdraw the earnings tax-free. Simply turning 59 ½ isn’t enough in this instance.

Failing to meet both the five-year rule and the rules governing qualified withdrawals may trigger income taxes on the earnings you withdraw, as well as a 10% tax penalty. Jeff, because you opened your Roth IRA in 2015 and you are over 59 ½ years old, you have already satisfied both rules. Plain and simple.

(And if you need help managing your Roth IRA, consider connecting with a financial advisor who serves your area.)

There is also a separate five-year rule for Roth conversions. If a person is under 59 ½ years old, they must wait five years before they can withdraw any money that’s converted from a traditional IRA into a Roth IRA. And unlike the first five-year rule that only needs to be satisfied once, this rule applies to each individual conversion.

Fortunately, you aren’t subject to early withdrawal penalties by virtue of your age, so this five-year rule also doesn’t apply to you. You’ll automatically avoid the 10% penalty on withdrawals from a converted Roth IRA.

However, here’s the context and rationale for this IRS rule:

Someone who’s under 59 ½ is generally subject to an additional 10% penalty on distributions from IRAs. Without this five-year rule, someone could simply convert a traditional IRA into a Roth IRA (paying the taxes on the conversion, of course) and then immediately withdraw the money from the Roth IRA, thereby sidestepping the 10% early withdrawal penalty. The five-year rule on Roth conversions closes this potential loophole.

Keep in mind that each five-year period starts on Jan. 1 of the year in which the conversion was made. (And if you need help doing a Roth conversion, consider speaking with a financial advisor who can guide you through the process.)

As they say, age has its privileges. Because you are over 59 ½ and have satisfied the Roth IRA contribution rule, you no longer have to worry about taxes or penalties on any withdrawals you take from your Roth IRA.

• Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

• If you’re working with a financial advisor but you’re unhappy with the results, you can always consider finding a new professional to work with. Here are some tips for navigating this transition, including how to notify your current advisor about your decision and what you should do before breaking off the professional relationship.

• 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.

• Are you a financial advisor looking to grow your business? SmartAsset AMP helps advisors connect with leads and offers marketing automation solutions so you can spend more time making conversions. Learn more about SmartAsset AMP.

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. Questions may be edited for clarity or length.

Please note that Brandon is not a participant on the SmartAsset AMP platform, he is not an employee of SmartAsset, and he has been compensated for this article. Questions may be edited for clarity or length.

Photo credit: ©iStock.com/Kameleon007

The post Ask an Advisor: My RMDs Start Soon So I’m Converting $700k to a Roth, But I’m Getting Conflicting Info About Having to Wait Five Years appeared first on SmartReads by SmartAsset.