The 5-Year Freeze
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A lot of people don’t realize it, however, multi-year cash flow planning is critical to a successful Roth IRA conversion. Assuming you will incur tax liability in connection with your conversion, it begins with determining what funds you have available to pay the tax. Per Three Roth IRA Conversion “Show Stoppers,” if you don’t have sufficient funds in checking, savings, money market, and other nonretirement investment accounts outside of your IRA to pay the tax attributable to a Roth IRA conversion, you aren’t a good candidate for a Roth IRA conversion.
Assuming you have sufficient funds in nonretirement accounts to pay the tax attributable to a Roth IRA conversion, you have completed Step 1 of Roth IRA conversion cash flow planning. Step 2 requires an understanding of IRS’ “5-Year Freeze” rule. If you do a Roth IRA conversion, in addition to being at least 59-1/2, you must wait at least five years from the first day of the year in which you do a conversion to take a distribution from your Roth IRA in order to avoid a potential 10% tax on early distributions.
If you take a distribution from your Roth IRA within five years from the first day in which you do your Roth IRA conversion, you will be assessed a 10% tax on any amount attributable to the part of the amount converted that you had to include in income when you did the conversion plus post-conversion earnings unless you meet one of the 12 exceptions to the 10% tax which are beyond the scope of this blog post.
When you do a Roth IRA conversion, the amount of the conversion that’s attributable to nondeductible IRA contributions is nontaxable. Consequently, the 10% tax on distributions within five years of the conversion is not assessed on the portion of the conversion that’s attributable to nondeductible IRA contributions.
If you’re planning for potential Roth IRA conversions over multiple years, it’s essential to keep in mind that the 5-year period that’s used for determining whether the 10% early distribution tax may apply is determined for each conversion. This is different than the 5-year period that applies to Roth IRA contributions whereby once you open and fund a Roth IRA, and assuming that you are at least 59-1/2, you won’t be subject to the 10% early distribution tax on any of your Roth IRA contributions once you get beyond five years from the beginning of the calendar year in which you opened and funded your first Roth IRA account.
After paying the tax attributable to a Roth IRA conversion, you need to prepare a 5-year cash flow projection to make sure that there is a strong probability that you will have sufficient income and other sources of funds at your disposal to meet your needs without tapping your Roth IRA for at least five years. Furthermore, if you are under 59-1/2, you should make certain that your other sources of funds from which you will need to take withdrawals do not include retirement plan accounts such as 401(k) plans and traditional IRA’s since distributions from these plans will be subject to income tax and a 10% premature distribution penalty.
Unless there’s a sizeable increase in the value of your Roth IRA within the first few years of conversion, generally speaking, you will need to refrain from taking distributions from your Roth IRA for at least five years from the date of conversion in order to overcome the dent in your net worth from paying the tax attributable to your Roth IRA conversion. The “5-Year Freeze” rule helps reinforce this reality.
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.
