John Grobe, Federal Career Experts
There are two separate five year rules that apply to Roth IRAs and they often confuse investors. One of the rules applies to any distribution you take from a Roth IRA prior to having a Roth account for at least five years. In order for a Roth distribution to be tax-free, your withdrawal from the Roth must be considered “qualified”. If a Roth withdrawal is not qualified, you will have to pay federal income taxes on the earnings portion of your withdrawal. Withdrawals of contributions are always tax-free because they were already taxed at the time you contributed them.
To be qualified, you must be at least 59 ½ and you must have had a Roth account for at least five years. The five year period begins with your first Roth contribution (or conversion) and does not re-start with each subsequent contribution (though there is a different five year rule (see the next paragraph) that does restart with each conversion). This five year period begins on January 1st of the year in which you made your first Roth contribution. If you contributed to your first Roth IRA in 2016, your five year period would come to an end on the first of January in 2021. If you had contributed to a different Roth IRA in the past (say, in 2002), even if you closed out that Roth IRA in 2008, you would have met your five year period in 2007 and would not have to worry about the five years ever again. Of course, you would still have to worry about the age 59 ½ part of the equation.
The other five year rule applies to funds that you have converted to a Roth IRA from a traditional instrument, such as a traditional IRA or your traditional TSP. This rule only applies if you are under age 59 ½ and specifies that if you withdraw any funds that were converted within five years, you will be hit by a 10% penalty for the converted funds that you withdrew. This rule applies to, and re-starts with, each conversion. So, if I’m under 59 ½ and I withdraw, before 2022, funds that I converted in 2017, I get zapped by this penalty. Funds I converted in 2018 can’t be taken out penalty-free before 2023, and so on.
As long as we’re talking about taxes, let’s take a look at the “rollover tax trap”. Unless you do a direct rollover from one plan (maybe the TSP) to another (say an IRA), 20% will be withheld for taxes. This trap used to catch a lot of people, but not so much anymore. All you need to do to avoid it when rolling TSP funds over to an IRA is to be sure to have the custodian of the IRA to which you are rolling your funds, fill out the transfer portion of the TSP form that you are using for the rollover. If you withdraw the money and have it sent to your own account before rolling it into the IRA, Uncle will withhold 20%. Yes, we love our Uncle Sam, but we don’t want to give him money if we can legally avoid it.
Here’s an unrelated item to think about – Here’s a quote from an investing book that was written back in 1940.
“An out-of-town visitor was being shown the wonders of the New York financial district. When he reached the Battery, one of his guides indicated the handsome ships riding at anchor. He said, ‘Look, those are the bankers’ and brokers’ yachts.’ ‘Where are the customers’ yachts?’ asked the naïve visitor.”