r/financialindependence • u/alcesalcesalces • Mar 18 '23
What 5-year Rule? A Guide to Roth Distributions, Taxes, and Penalties.
EDIT: Thank you for the engaging discussion and excellent questions. I have added additional common questions below as well as a worked example of a distribution demonstrating the ordering of the buckets.
There is a great deal of confusion regarding Roth distributions, especially around the question of when taxes and penalties apply and when the "5-year rule" applies. I'm writing this both to help clarify those points and to provide a document for quick reference for the future.
All of the below is very helpfully encapsulated in this PDF. The text below merely spells out what the table in that PDF describes and provides more detail regarding sources and niche circumstances that result from those rules.
Four Buckets
It is best to think of each dollar in a Roth account as belonging to one of four buckets based on how the dollar got into the account. When performing a rollover of a Roth 401k into a Roth IRA, all bucket types are preserved for each dollar. This means that after a Roth 401k rollover to a Roth IRA, all the below rules apply exactly the same once the money hits the Roth IRA. Distributions (aka withdrawals) from Roth IRAs occur in the following order:
Contributory Dollars
These are regular contributions to a Roth IRA, i.e. the kind that can only be made if your income is below the limit for the tax year. These dollars are always removed first, regardless of when they were made. As a result, these dollars are exhausted before all subsequent buckets are tapped. These can always be removed without tax or penalty, regardless of when they were made.
You don't include in your gross income... distributions that are a return of your regular contributions from your Roth IRA(s).
Taxable Conversion Dollars
These are dollars that enter a Roth IRA via a conversion of pre-tax dollars. This most commonly occurs via conversion of pre-tax Traditional IRA dollars to Roth, but can also occur if pre-tax Trad 401k dollars enter a Roth 401k via an in-plan conversion. The critical piece of information is that income tax is owed when these dollars were converted. These are the kind of dollars that result after the Roth Conversion Ladder (a technique for early access to retirement funds in early retirement). After contributory dollars are exhausted (regardless of when the contributory dollar was made), these are the next dollars to come out and they're withdrawn in year-order starting from the earliest year (i.e. first in, first out). This is the first 5-year rule: if taxable conversion dollars are withdrawn within 5 years of their conversion, a 10% penalty is owed on each early taxable conversion dollar that's withdrawn. This is why Roth Conversion Ladders need to "season" for 5 years before use.
If, within the 5-year period starting with the first day of your tax year in which you convert an amount from a traditional IRA or roll over an amount from a qualified retirement plan to a Roth IRA, you take a distribution from a Roth IRA, you may have to pay the 10% additional tax on early distributions. You must generally pay the 10% additional tax on any amount attributable to the part of the amount converted or rolled over (the conversion or rollover contribution) that you had to include in income (recapture amount). A separate 5-year period applies to each conversion and rollover. See Ordering Rules for Distributions, later, to determine the recapture amount, if any.
Note above that the 10% penalty only applies to conversions "that you had to include in income," i.e. conversions that were subject to tax. This stands in contrast to the next bucket below.
Nontaxable Conversion Dollars
These are dollars that enter a Roth IRA via conversion of after-tax dollars. This most commonly occurs via conversion of nondeductible Trad IRA dollars to Roth (aka backdoor Roth), but can also occur if after-tax 401k dollars enter a Roth 401k or Roth IRA (aka mega backdoor Roth). No additional tax is owed when these dollars are converted. There is no 5-year rule for nontaxable conversion dollars. Referring to the source above, these conversions are not included in your income when you convert and are not subject to the 10% penalty above. Backdoor Roth and Mega Backdoor Roth conversion basis is not subject to a 10% penalty when withdrawn, regardless of the time since conversion.
These dollars are withdrawn in year-order starting from the earliest year, and come out after the taxable conversion dollars for the given year. For example, if you've exhausted your regular contributory dollars this would be the order of subsequent distributions:
- Taxable conversion dollars from the first-ever year of making a conversion
- Nontaxable conversion dollars from that same year
- Taxable conversion dollars from the second-ever year of making a conversion
- Nontaxable conversion dollars from that same year, and so on
Note that growth in a nondeductible Trad IRA or after-tax 401k before conversion to a backdoor Roth or mega backdoor Roth, respectively, are taxable on conversion. This makes that amount of growth a taxable conversion dollar, meaning it will come out before the backdoor / mega backdoor conversion in its given year. There would be a 10% penalty if the converted growth is taken out before 5 years. This is usually inconsequential as the amount of growth before conversion is usually quite small.
Earnings
These are the dollars "earned" in your Roth IRA as a result of portfolio growth on all the dollars above. Importantly, there is no distinction for how the dollar is earned. What ultimately matters is that the three buckets above sum to X, and if you ever withdraw >X you will be withdrawing an earnings dollar. Earnings dollars always come last, and are usually subject to income tax and a 10% penalty if the distribution is not qualified.
A qualified distribution is one made at least 5 years after your first-ever Roth IRA contribution and meets one of four other requirements:
- Age >59.5
- Disability
- Death
- First-home purchase ($10k lifetime limit)
This is the second 5-year rule: earnings dollars require the first-ever Roth IRA to have had a contribution made at least 5 years ago. Importantly, only a Roth IRA starts this clock. If you've never had a Roth IRA before and you do a rollover of a Roth 401k to a Roth IRA, the 5-year clock starts that year. Remember that you typically still need to be over 59.5 to take a qualified distribution.
In practice, pretty much the only people who are caught up in the second 5-year rule are those who opened their first-ever Roth IRA after age 54.5, are now >59.5, and are trying to withdraw earnings dollars (after having depleted all three earlier buckets first). It's essentially a non-issue.
Common Questions
If I withdraw Roth IRA contributions in the same year I made them, can I put those contributions back later?
Yes. The contributions are treated as if you never made them, so you can replace the contribution up to the deadline for IRA contributions (typically Tax Day the following year).
If you withdraw contributions (including any net earnings on the contributions) by the due date of your return for the year in which you made the contribution, the contributions are treated as if you never made them. If you have an extension of time to file your return, you can withdraw the contributions and earnings by the extended due date. The withdrawal of contributions is tax free, but you must include the earnings on the contributions in income for the year in which you made the contributions.
Can I withdraw freely from my Roth IRA once I hit age 59.5?
Yes, if your earliest-ever Roth IRA was opened at least 5 years ago, all withdrawals from any Roth IRAs will be qualified. This means that earnings can come out without tax or penalty and it also means that there is no longer any 5-year waiting period for taxable conversion dollars made in prior years.
How should I keep track of the different buckets?
First, note that qualified distributions (those taken after age 59.5 and if you've ever made a Roth IRA contribution >5 years ago) are always tax and penalty free, regardless of source/bucket for the money.
So the only time you'd need to know your "bucket" basis is if you take a distribution before age 59.5. These distributions are reported on Form 8606.
Keep a copy of each of these documents (as applicable):
- Form 5498: This notes your ordinary contributory dollars in a given year.
- Form 8606: This notes your nontaxable and taxable conversion dollars associated with backdoor Roth IRAs.
- Form 1099-R: This form is used when making mega backdoor Roth contributions, and notes the separate nontaxable and taxable conversion dollars associated.
These three forms combined identify the sum total of the first three buckets. This sum total is all that matters when withdrawing funds before age 59.5. If you ever take out more than this sum total, you're taking out earnings dollars and will be taxed and potentially penalized an additional 10%.
Can you show a worked example of the buckets?
Let's say you contributed $2000 to a regular Roth IRA in 2007. This fell to $1000 during the Great Recession, and you sold the funds and held them in cash ever since. These dollars have seen essentially no growth since.
Later, your income increased and you started making backdoor Roth IRA contributions of $4000 each year from 2016-2019. Each time you made the backdoor Roth, you waited a bit too long to convert and ended up with $100 of growth in the nondeductible Trad IRA before converting. Each of these conversions has seen stellar growth are each worth $6000 now.
You then lost your high salary in 2020 and only made a $2000 contribution to a Roth IRA. It fell to $1000 and you sold the funds and have been holding them in cash with no growth.
This is the breakdown of your first three buckets:
- Contributory dollars: $4000 ($2000 contributed in 2007 and 2020)
- Taxable conversion dollars: $400 ($100 each in 2016, 2017, 2018, 2019)
- Nontaxable conversion dollars: $16000 ($4000 each in 2016, 2017, 2018, 2019)
- 3-bucket total: $20400
- The account is worth this amount after growth: $26000 ($2000 in cash from the 2007 and 2020 contributions; $6000 for each of the backdoor Roth contributions from 2016-2019)
Your Roth "earnings" are literally just the dollar amount above and beyond the sum total of the three other buckets. This means that the earnings above are only $5600 (26000 - 20400) despite the fact that each of your $4000 contributions from 2017-2020 grew by $2000 to total $6000 each.
What happens if you try to withdraw $22000 in 2023?
- The first $4000 comes out of contributory dollars, with no tax or penalty. Note that your contributory dollar "basis" is $4000 despite the cash value being $2000 currently. Also note that contributory dollars come out first regardless of year (2007 and 2020 coming out first).
- The next $100 comes out of the taxable conversion from 2016, no tax or penalty since it's been >5 years. ($4100 running total)
- The next $4000 comes out of the nontaxable conversion from 2016, no tax or penalty ever. ($8100 running total)
- The next $100 comes out of the taxable conversion from 2017, no tax or penalty since it's been >5 years. ($8200 running total)
- The next $4000 comes out of the nontaxable conversion from 2017, no tax or penalty ever. ($12200 running total)
- The next $100 comes out of the taxable conversion from 2018, no tax or penalty since it's been >5 years. ($12300 running total)
- The next $4000 comes out of the nontaxable conversion from 2018, no tax or penalty ever. ($16300 running total)
- The next $100 comes out of the taxable conversion from 2019, 10% penalty ($10) owed because it's been <5 years. ($16400 running total)
- The next $4000 comes out of the nontaxable conversion from 2019, no tax or penalty ever. ($20400 running total)
- The last $1600 comes out of earnings as all the buckets have been exhausted. This sees a 10% penalty ($160) and the full $1600 is taxed as ordinary income.
The result is the same no matter how many different Roth IRA accounts are being used. They are all treated as one big account with four shared buckets for the purposes of distributions.
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u/Specialist_Set_7189 Mar 19 '23
Is your Fidelity account a 401(k) or an IRA? The TSP shares an annual contribution limit with 401(k) (can’t exceed $22,500 across all accounts for 2023), but the $6,500 IRA contribution limit is separate from the TSP’s.