IRA Alert

2010 Roth conversions are now penalty-free

With the five-year period satisfied, many clients meet the requirements for qualified distributions

Feb 1, 2015 @ 12:01 am

By Ed Slott

This year marks an important milestone for 2010 Roth IRA conversions. Back in 2010, the Roth IRA conversion rules changed. Before then, there was an income limit for Roth conversions. If your income exceeded $100,000, you could not convert to a Roth IRA.

The law was repealed permanently in 2010, opening the floodgates for new Roth conversions for higher-income clients.

When it comes to Roth IRAs, qualified distributions, which are 100% tax- and penalty-free, are the name of the game. Once a client meets the requirements for a qualified distribution, all distributions from any of their Roth IRAs will be tax- and penalty-free for the rest of their life. Beneficiaries of such Roth IRAs can also take tax- and penalty-free distributions of inherited amounts.

In order for clients to have a qualified distribution, they must meet two requirements. First, they must have held any Roth IRA for more than five years. The five-year clock starts on the first day of the year for which a client's first contribution is made and applies to all of a client's Roth IRAs.

Thus, any client who completed a Roth conversion in 2010 has now met this requirement.

In addition, a qualified distribution requires one of the following:

1. That the Roth IRA owner reaches age 591/2.

2. That the owner has a disability (as defined by the tax code).

3. The death of the owner.

4. A first-time home purchase (lifetime cap of $10,000).

NON-QUALIFIED DISTRIBUTIONS

The tax treatment of a non-qualified Roth distribution depends on the type of money being distributed. When determining the type of money being distributed, ordering rules are applied. In addition, all of a client's Roth IRAs are treated as one IRA account. The basic ordering rules are as follows:

1. Contributions are the first funds to be distributed.

2. After all contributions have been distributed, Roth IRA conversions are distributed. If more than one conversion has taken place, they are distributed on a first-in, first-out basis.

3. After all contributions and conversions have been distributed, earnings are distributed.

Roth IRA contributions can always be distributed tax- and penalty-free, but that's not true for converted funds or earnings. Distributions of conversions are tax-free because the tax was paid at the time of the conversion, but they may be subject to the 10% early-distribution penalty. To be exempt from that penalty, converted funds must be distributed after the owner reaches age 591/2 or more than five years after the Roth IRA conversion, whichever is sooner.

The five-year clock here is different than the five-year clock for qualified distributions. Like the latter, this clock begins on Jan. 1 of the year a conversion is completed. Unlike that clock, however, every conversion begins its own five-year clock.

Any conversion completed in 2010 has now met this five-year rule, so even pre-591/2 clients with no prior Roth funds can now distribute their 2010 Roth IRA conversion funds tax- and penalty-free.

Example: Earl completed a $100,000 Roth IRA conversion in 2010. Since then, his converted funds have accumulated $40,000 of earnings. These are the only Roth IRA funds he has. If Earl, who turns 45 in 2015, needs to take a distribution, he can take up to his initial $100,000 Roth IRA conversion amount without triggering any tax or penalty.

Following the ordering rules, his entire $100,000 conversion will come out of his Roth IRA before the first dollars of earnings come out. Those converted funds will be tax-free because Earl has already paid the tax on those funds. Furthermore, even though he is not yet 591/2, there will not be a 10% penalty because the conversion has met the five-year Roth IRA conversion requirement. Once Earl reaches 591/2, his earnings can also be distributed tax- and penalty-free as part of a qualified distribution.

Of course, just because clients can take tax- and penalty-free distributions of their Roth IRA funds doesn't mean that they should. In fact, if clients don't have to take such distributions, it often pays not to.

Roth IRA money should be left alone for as long as possible since it not only grows tax- and penalty-free, but is unencumbered by required minimum distributions for the life of the owner.

Ed Slott, a certified public accountant, created the IRA Leadership Program and Ed Slott's Elite IRA Advisor Group. He can be reached at irahelp.com.

0
Comments

What do you think?

View comments

Recommended for you

Upcoming Event

Jul 09

Conference

Boston Women Adviser Summit

The InvestmentNews Women Adviser Summit, a one-day workshop now held in six cities due to popular demand, is uniquely designed for the sophisticated female adviser who wants to take her personal and professional self to the next level.... Learn more

Featured video

Events

How are broker-dealers helping 401(k) advisers adapt to a changing market?

Bryan Hodgens, co-head of LPL Financial's Retirement Partners group, says the industry is getting much better at connecting advisers to wealth management opportunities and helping scale their businesses.

Latest news & opinion

IBD report: Another impressive year

Despite a stock market decline, revenue is up. And the streak isn't expected to end anytime soon.

IBDs with the most CFPs

How many of the more than 83,000 certified financial planners are employed by the big independent broker-dealers?

Richard Thaler wants to use 401(k)s to boost Social Security payments

The Nobel laureate wants to simplify drawing down retirement assets, which he thinks is 'way harder' than saving the money.

InvestmentNews announces 2019 Innovation Awards winners

Sheryl Garrett is this year's InvestmentNews Icon.

Morgan Stanley rides wealth management train to solid first quarter

Chairman and CEO James Gorman expresses excitement about expanding into workplace plans with purchase of Solium.

X

Hi! Glad you're here and we hope you like all the great work we do here at InvestmentNews. But what we do is expensive and is funded in part by our sponsors. So won't you show our sponsors a little love by whitelisting investmentnews.com? It'll help us continue to serve you.

Yes, show me how to whitelist investmentnews.com

Ad blocker detected. Please whitelist us or give premium a try.

X

Subscribe and Save 60%

Premium Access
Print + Digital

Learn more
Subscribe to Print