Reminder: 5 Year Rule on Roth Conversions

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Reminder: 5 Year Rule on Roth Conversions

Postby pkcrafter » Wed Dec 07, 2011 7:29 pm

Roth conversions are treated separately for the 5 year/59-1/2 earnings withdrawal rule, so in some cases it may not be wise to combine them.

Let's start with the person who opens a Roth and makes periodic contributions. That person can withdraw those original contributions anytime with no tax or penalty. The five-year clock for earnings on those contributions starts Jan. 1 of the year for which your first Roth contribution was made, and it doesn't reset each time you make a contribution or open another Roth.

As for the person who converts to a Roth: In a conversion, you have to hold the assets in a Roth for five years or until turning 59½, whichever comes first, to make penalty-free withdrawals of your converted amounts. Here, each conversion has its own five-year clock.
Note on converted Roths--The 5 year rule pertains to contributions and earnings.

http://online.wsj.com/article/SB125754645803734655.html


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Re: Reminder: 5 Year Rule on Roth Conversions

Postby interplanetjanet » Wed Dec 07, 2011 7:51 pm

pkcrafter wrote:Roth conversions are treated separately for the 5 year/59-1/2 earnings withdrawal rule, so in some cases it may not be wise to combine them.

Let's start with the person who opens a Roth and makes periodic contributions. That person can withdraw those original contributions anytime with no tax or penalty. The five-year clock for earnings on those contributions starts Jan. 1 of the year for which your first Roth contribution was made, and it doesn't reset each time you make a contribution or open another Roth.

As for the person who converts to a Roth: In a conversion, you have to hold the assets in a Roth for five years or until turning 59½, whichever comes first, to make penalty-free withdrawals of your converted amounts. Here, each conversion has its own five-year clock.
Note on converted Roths--The 5 year rule pertains to contributions and earnings.

The flip side is that the penalties only apply to portions of the conversion that you had to pay tax on to convert. "Backdoor Roth" conversions can be withdrawn without penalty (though subject to normal Roth ordering rules).

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Re: Reminder: 5 Year Rule on Roth Conversions

Postby FB01 » Wed Dec 07, 2011 8:58 pm

pkcrafter wrote:Roth conversions are treated separately for the 5 year/59-1/2 earnings withdrawal rule, so in some cases it may not be wise to combine them.


Hey Paul,

Can throw some light on this statement "The five-year clock for earnings on those contributions starts Jan. 1 of the year for which your first Roth contribution was made, and it doesn't reset each time you make a contribution or open another Roth"

I started contributing to Roth IRA in 2009 and so it will 3 year. I did not get what does 5 year rule will do.

I would appreciate if you can explain

THanks,
FB




Let's start with the person who opens a Roth and makes periodic contributions. That person can withdraw those original contributions anytime with no tax or penalty. The five-year clock for earnings on those contributions starts Jan. 1 of the year for which your first Roth contribution was made, and it doesn't reset each time you make a contribution or open another Roth.

As for the person who converts to a Roth: In a conversion, you have to hold the assets in a Roth for five years or until turning 59½, whichever comes first, to make penalty-free withdrawals of your converted amounts. Here, each conversion has its own five-year clock.
Note on converted Roths--The 5 year rule pertains to contributions and earnings.

http://online.wsj.com/article/SB125754645803734655.html


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Re: Reminder: 5 Year Rule on Roth Conversions

Postby grabiner » Wed Dec 07, 2011 9:35 pm

pkcrafter wrote:Roth conversions are treated separately for the 5 year/59-1/2 earnings withdrawal rule, so in some cases it may not be wise to combine them.


It doesn't matter whether you combine them or not; withdrawals are taken from your total balance in all Roths regardless of where the money came from. Thus, if you made a 2005 conversion to a Vanguard Roth, and a 2008 conversion to a Fidelity Roth (both from deductible IRAs), you can withdraw an amount from the Fidelity Roth equal to the amount you converted at Vanguard without penalty. However, you cannot withdraw the entire Vanguard Roth if it increased in value since 2005; once you have withdrawn an amount equal to your 2005 conversion, the next dollar is treated as coming from your 2008 conversion, not the earnings on the 2005 conversion (which would be tax-free if you are 59-1/2).

The ordering of withdrawals is direct contributions first, then conversions in the order made (with the already-taxed portion of each conversion withdrawn first), and only then earnings.

IRS Publication 590 has the details.
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Re: Reminder: 5 Year Rule on Roth Conversions

Postby bUU » Thu Dec 27, 2012 9:51 am

So please help me get this straight...

Age 58 in 2012
(rounding dollar amounts for simplicity)
2012: $6k (after-tax) contribution to (first) Roth IRA
2013: $6k after-tax contribution to tIRA, converted to Roth
2014: $6k after-tax contribution to tIRA, converted to Roth
2015: $6k after-tax contribution to tIRA, converted to Roth
2016: $6k after-tax contribution to tIRA, converted to Roth
2017: $6k after-tax contribution to tIRA, converted to Roth
2018: $6k after-tax contribution to tIRA, converted to Roth
2019: $6k after-tax contribution to tIRA, converted to Roth

So in 2020, can we be sure that we can pull $48k (8 contributions of $6k each) out completely free-and-clear, regardless of gains experienced? Specifically, if we picked remarkably poor investments all the way through, and the first $36k contributed actually ended up being worthless at the start of 2019, and somehow that 2018 $6k turned into $60k, we'd still be tax-free and clear for the first $48k pulled out? But how is the five-year rule accounted for with regard to that $54 gain on what was conceptually a 2018 contribution? If what I said, above, is true, then most of that $48k pulled out free-and-clear in 2020 was actually 2018 money. After that, what is the logic used to establish a five year horizon for the gains? I guess I'm asking there is what kind of record keeping we need to do to understand how to pull money out of a Roth so that we aren't breaking the five-year rule.

I think the answer to my questions might be somewhere in this 2009 posting...
viewtopic.php?p=559325#p559325
I'm going to read it over for the tenth time to see if I can decrypt it.

But what I'm reading there doesn't jive with my read of Pub 590.


See below...
Last edited by bUU on Thu Dec 27, 2012 10:18 am, edited 2 times in total.
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Re: Reminder: 5 Year Rule on Roth Conversions

Postby Bob's not my name » Thu Dec 27, 2012 10:00 am

interplanetjanet wrote:The flip side is that the penalties only apply to portions of the conversion that you had to pay tax on to convert. "Backdoor Roth" conversions can be withdrawn without penalty (though subject to normal Roth ordering rules).
$48k in, $48k out.
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Re: Reminder: 5 Year Rule on Roth Conversions

Postby sscritic » Thu Dec 27, 2012 10:05 am

So please help me get this straight...

Read pub 590; read the definition of a qualified distribution; read the ordering rules on page 64; walk through your example. Is any part of your withdrawal taxable?

In particular, are any of your questions relevant?

Doing this exercise will help you get this straight.
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Re: Reminder: 5 Year Rule on Roth Conversions

Postby BigFoot48 » Thu Dec 27, 2012 10:15 am

I'm going to add an alert about this topic in my Roth Conversion Model http://www.bogleheads.org/forum/viewtopic.php?f=1&t=97352&p=1405885#p1405885 but there's no way I would attempt to model it into the calculations. Gadzooks!
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Re: Reminder: 5 Year Rule on Roth Conversions

Postby bUU » Thu Dec 27, 2012 10:21 am

As promised, I read Pub 590 over and bounced my situation against it. However, what I found is that what I read in Pub 590 did not match what I saw in that 2009 posting that I provided the link to above (but I probably misunderstood the posting).

In Pub 590, I see a five-year rule for determining when distributions are "qualified". That seems unequivocal: If you are over 59 1/2, then five years after the first Roth IRA contribution, distributions from all your Roths are "qualified". "Period." (Right?) I also saw a five-year rule for additional tax on the conversion amounts (not on the gains, which is what the 2009 article seemed to indicate to me): If you withdraw the conversion amounts prior to five years after they were contributed, you get hit with additional tax on the conversion amounts, but again, once you're 59 1/2, that additional taxation risk is gone too. (Right?)
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Re: Reminder: 5 Year Rule on Roth Conversions

Postby sscritic » Thu Dec 27, 2012 10:38 am

bicker wrote:In Pub 590, I see a five-year rule for determining when distributions are "qualified". That seems unequivocal: If you are over 59 1/2, then five years after the first Roth IRA contribution, distributions from all your Roths are "qualified". "Period." (Right?) I also saw a five-year rule for additional tax on the conversion amounts (not on the gains, which is what the 2009 article seemed to indicate to me): If you withdraw the conversion amounts prior to five years after they were contributed, you get hit with additional tax on the conversion amounts, but again, once you're 59 1/2, that additional taxation risk is gone too. (Right?)

see these two posts in a thread from yesterday:
The difficulty with most articles is in which path they consider "normal" and which path they consider the "exception". In my view it is much clearer if they follow the example of pub 590 and treat qualified distributions as normal. They should begin "If you are over 59.5 and your oldest Roth is more than 5 years old all of your distribution are tax and penalty free. Stop here, do not read the rest of this article. ... ".
viewtopic.php?p=1563500#p1563500

and the prior summary table:
viewtopic.php?p=1562932#p1562932
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Re: Reminder: 5 Year Rule on Roth Conversions

Postby bUU » Thu Dec 27, 2012 10:41 am

Thanks! That's great info.
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Re: Reminder: 5 Year Rule on Roth Conversions

Postby Alan S. » Thu Dec 27, 2012 1:27 pm

Note that even if you were much younger than 58 when making the contributions in your example, the first 48k that you withdrew would be tax and penalty free.

Tax free because you are getting a withdrawal of your contributions (conversions in this case).

Penalty free because the 5 year conversion holding period only applies to the taxable portion of any conversion. Your conversions are all non taxable (converted TIRA basis only), so you have no conversion waiting period. But any distribution in excess of your contributions would be from earnings, and earnings would be both taxable and subject to penalty if take out prior to 59.5 and 5 years.
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Re: Reminder: 5 Year Rule on Roth Conversions

Postby bUU » Thu Dec 27, 2012 1:45 pm

Alan S. wrote:Penalty free because the 5 year conversion holding period only applies to the taxable portion of any conversion.

Thanks for pointing this out. I've read that but I don't think it stuck in my head until now.

In actuality, we'll each probably have $50 of taxable basis converted.

Unless we don't... The idea here was the try to avoid a $50 fee Fidelity would charge for emptying out our existing pre-tax-only tIRAs, upon rolling them into 401(k)s. By leaving $50 (probably $51 to be safe) in each tIRA, they'll remain open, saving us the fee. (Then we'd put $6500 more in each as our 2013 IRA contributions.) The logic was that paying $22 of tax (each) at the end of the year we do our first Roth conversions is better than paying Fidelity $100 for the privilege of housing our tIRAs there for less than six month.

I wonder if there aren't other hidden gotchas in that plan, making saving the $56 we'd save from the plan foolish nonsense. Though, even if we invoke this penalty you're referring to, it's a 10% penalty on the $50, right? $5 penalty?
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Re: Reminder: 5 Year Rule on Roth Conversions

Postby Alan S. » Thu Dec 27, 2012 2:34 pm

Yes, if you leave $50 in your TIRA (this is pre tax, not basis) and then contribute 6,500 and convert all but $6,500, the non taxable portion of your conversion will be 6500/6550 = .992 or $6448 due to 3 decimal place rounding used on Form 8606. The taxable portion will therefore be $52. If you then withdrew that conversion or any part of it within the 5 year holding period, you would owe $5 as an early withdrawal penalty. Any withdrawal of conversion funds from a certain year is deemed to come first from the pre tax portion of that conversion, meaning your first $52 out would be the taxable amount.

If you repeated this process every year, you would have only $50 in the TIRA year around and 6,550 for only a day or so. It would probably all be basis after the first year due to the 3 decimal place rounding on Form 8606 and the affect on the pre tax amount. In other words, the $50 will always be there, but it may change from pre tax to basis after the first year meaning all future conversions would be fully tax free and no pre tax amount would be in your later Roth conversions.
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Re: Reminder: 5 Year Rule on Roth Conversions

Postby bUU » Thu Dec 27, 2012 2:46 pm

Sorry, Alan, but you've lost me in some of this...
Alan S. wrote:Yes, if you leave $50 in your TIRA (this is pre tax, not basis) and then contribute 6,500 and convert all but $6,500,
Uh, we would convert the whole $6,550. Does that change anything you've said? (Fidelity doesn't charge for opening tIRAs, nor for conversions, so there is no need to leave $50 in there in perpetuity... it's only necessary the first year.)

It think that's what you meant, though, because you then say...
Alan S. wrote:the non taxable portion of your conversion will be 6500/6550 = .992 or $6448 due to 3 decimal place rounding used on Form 8606. The taxable portion will therefore be $52.
Amazing how rounding results in $2 extra in taxable.

Alan S. wrote:If you then withdrew that conversion or any part of it within the 5 year holding period, you would owe $5 as an early withdrawal penalty. Any withdrawal of conversion funds from a certain year is deemed to come first from the pre tax portion of that conversion, meaning your first $52 out would be the taxable amount.

If you repeated this process every year, you would have only $50 in the TIRA year around
Again, the plan would to not have this... to convert all $6,550, pay tax on the $52 which would be considered taxable, just that first year, and be done with the complexity from that point forward (until some employer 401(k) boots us out and we have no place to roll that money into).
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Re: Reminder: 5 Year Rule on Roth Conversions

Postby Epsilon Delta » Thu Dec 27, 2012 3:00 pm

Alan S. wrote:Yes, if you leave $50 in your TIRA (this is pre tax, not basis) and then contribute 6,500 and convert all but $6,500, the non taxable portion of your conversion will be 6500/6550 = .992 or $6448 due to 3 decimal place rounding used on Form 8606.


The form 8606 instructions say "Round to at least 3 decimal places". You can use more if you want, just as you can use pennies on the 1040 if you want.
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Re: Reminder: 5 Year Rule on Roth Conversions

Postby Alan S. » Thu Dec 27, 2012 3:55 pm

You indicated that you wanted to avoid the $50 fee, and this is apparently an annual fee for not keeping a minimum balance in the TIRA. You also need a TIRA account each year to receive your non deductible contributions, therefore keeping whatever small amount in the TIRA seems like a good plan to avoid those fees. If so, you would not convert the full 6,550, just the 6,500 you contributed to keep the min balance of $50 in the TIRA.

With respect to rounding, I believe most tax programs will round to 3 places , but if you chose to override to use some extra places, the first conversion of 6,500 would include around $50 taxable amount either way. For all later years the conversions would be fully tax free because your remaining basis will exceed 6,500.

With respect to the complexity, as long as you make non deductible contributions AND convert in the same year, you will always need both Parts I and II of Form 8606. That applies whether you convert in full or leave $50 behind. This is somewhat more complex if you do a paper return and therefore have to get into the division and decimal place considerations yourself.
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Re: Reminder: 5 Year Rule on Roth Conversions

Postby bUU » Thu Dec 27, 2012 3:58 pm

Alan S. wrote:You indicated that you wanted to avoid the $50 fee, and this is apparently an annual fee for not keeping a minimum balance in the TIRA.
No. At Fidelity, they charge a $50 fee for closing a tIRA account.

Alan S. wrote:You also need a TIRA account each year to receive your non deductible contributions, therefore keeping whatever small amount in the TIRA seems like a good plan to avoid those fees.
There is no charge for opening a new tIRA account, and no charge for the conversion. So there is no need to keep a tIRA account open. The only reason why the $50 fee comes into play is because up until now we've been using tIRAs for pre-tax retirement savings, and need to sweep that money into 401(k)s before doing a Roth conversion.

Alan S. wrote:With respect to the complexity, as long as you make non deductible contributions AND convert in the same year, you will always need both Parts I and II of Form 8606. That applies whether you convert in full or leave $50 behind. This is somewhat more complex if you do a paper return and therefore have to get into the division and decimal place considerations yourself.
I have no intention of ever going without TurboTax, and probably Premier version at that. :) The "complexity" I would worry about is that which would confuse the IRS, or Fidelity, not my tax preparation software. :)
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Re: Reminder: 5 Year Rule on Roth Conversions

Postby Alan S. » Thu Dec 27, 2012 6:48 pm

Then you would need to know how Fidelity defines "closing an IRA". Would it be when you reduce the balance to -0-, 6 months later, or when? Does it apply when you have a balance in a Roth IRA with them even though your TIRA account may have a -0- balance? In your case, you specifically need to know whether there will be a penalty or fee for having a -0- balance in your TIRA for 364 days a year.

Perhaps you no longer need to keep any balance in the TIRA because you will also have a Roth IRA with Fido?
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Re: Reminder: 5 Year Rule on Roth Conversions

Postby bUU » Thu Dec 27, 2012 7:30 pm

Alan S. wrote:Then you would need to know how Fidelity defines "closing an IRA".
The account balance dropping below $50. They said that they actually won't allow you to leave less than $50 in the account.

Alan S. wrote:Does it apply when you have a balance in a Roth IRA with them even though your TIRA account may have a -0- balance?
At Fidelity, tIRA accounts and Roth IRA accounts are separate accounts.

Alan S. wrote:In your case, you specifically need to know whether there will be a penalty or fee for having a -0- balance in your TIRA for 364 days a year.
The way they explained it, effectively, as soon as it gets down to $50, the rest is for Fidelity.
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Re: Reminder: 5 Year Rule on Roth Conversions

Postby jatwell » Fri Dec 28, 2012 1:16 am

I don't know... I've had a tIRA account (and Roth as well) for the past 4-5 years with Fidelity. Every other year I do a non-deductible tIRA contribution followed by an immediate conversion to my Roth IRA after it settles (4-5 days, back-door Roth). During the conversion, their system asks if you want to close the tIRA account - I just pick no. I just checked and my tIRA has a balance of $0.02 from a day or two's worth of interest, and my last activity was in March of 2011.

It's the same w/ the tIRA & Roth accounts my wife has. I've never been charged a $50 fee and the lowly $0.02 is still there.
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Re: Reminder: 5 Year Rule on Roth Conversions

Postby bUU » Fri Dec 28, 2012 5:01 am

I suppose it's worth taking a chance then... If I say transfer $X then they cannot transfer $X+1 (or $X-49 for that matter) so they would have to either refuse to do the transfer or leave the tIRA open. I cannot understand why they would clearly say, both verbally and in their rules that they will charge the fee and then not do so, but heck, its Fidelity... they're pretty customer-oriented.

I know why I want to leave the tIRA open, but why are you? There is supposed to be no fee when you do a Roth conversion, so what do you get out of leaving the account open but empty?
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Re: Reminder: 5 Year Rule on Roth Conversions

Postby retiredjg » Fri Dec 28, 2012 9:54 am

I'm wondering about all this discussion of leaving $50 in a tIRA at Fido.

The back door contribution to Roth IRA has been discussed probably 10,000 times on this forum. Surely a good portion of those involve Fido. I don't recall ever hearing you have to leave money in the account to avoid a fee. That would leave basis on the 8606 and the whole point is to zero out the 8606 each year.

There is a fee if you transfer your tIRA to another custodian. I'm not so sure there is a fee when you convert to Roth and leave a zero balance. If there were, I think it would have come up in these discussions over and over again.
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Re: Reminder: 5 Year Rule on Roth Conversions

Postby bUU » Fri Dec 28, 2012 9:58 am

I'm not sure how the point has been missed a few times in the thread, but the $50 fee has nothing to do with the Roth conversion. It has to do with the rolling-over of existing pre-tax assets in existing tIRAs into current-employer 401(k) plans, which for some of us is a necessary prerequisite to doing our first Roth conversion.
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Re: Reminder: 5 Year Rule on Roth Conversions

Postby Alan S. » Fri Dec 28, 2012 1:29 pm

bicker wrote:I'm not sure how the point has been missed a few times in the thread, but the $50 fee has nothing to do with the Roth conversion. It has to do with the rolling-over of existing pre-tax assets in existing tIRAs into current-employer 401(k) plans, which for some of us is a necessary prerequisite to doing our first Roth conversion.


Apparently there has been a misunderstanding between you and the Fidelity rep. I would call them again and explain what you want to do. Too many other people have been doing exactly what you are, and no one has mentioned a $50 fee. If the Roth IRA is at Fidelity, I don't see any reason for there to be a fee. If the Roth is somewhere else, and FIdelity would only get your non deductible contribution for a day before transferring to another custodian's Roth IRA, I could understand why there could be a fee.

Suppose you find out that there IS a $50 fee if your account dropped below $50. If so, this would probably be an annual fee, and the solution would be as previously discussed. Just leave the minimum amount in the Fidelity TIRA at all times and convert the rest. You would pay income taxes on $50 just one time over many years, so in the unlikely event that you actually do have a fee as described, just leave the min amount in the Fidelity TIRA year round. It would save you money.
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Re: Reminder: 5 Year Rule on Roth Conversions

Postby retiredjg » Fri Dec 28, 2012 1:39 pm

I can see how there would be a fee if the poster is rolling everything out of a tIRA and into a 401k which seems to be what this poster is talking about. They certainly have one if you roll your tIRA from Fido to Vanguard (according to previous posters).
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Re: Reminder: 5 Year Rule on Roth Conversions

Postby bUU » Fri Dec 28, 2012 1:44 pm

retiredjg wrote:I can see how there would be a fee if the poster is rolling everything out of a tIRA and into a 401k which seems to be what this poster is talking about. They certainly have one if you roll your tIRA from Fido to Vanguard (according to previous posters).

Absolutely correct. Again, the fee has nothing to do with the Roth conversion. It is not an annual fee. It is an account closing fee. You see it mentioned as such on the Fidelity website: "Depending on your situation, fees may include low–balance fees, short–term trading fees and account closing fees." From their standpoint, when the tIRA is cleaned out of its pre-tax money, i.e., rolled into the current-employer 401(k), as far as Fidelity can see, it's done-with, kaput, finished. The Fidelity rep says that they close it and assess the fee. I can rake him over the coals again to see if I get a different answer, I suppose, but I don't understand why we should expect a different answer.
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Re: Reminder: 5 Year Rule on Roth Conversions

Postby bru » Fri Dec 28, 2012 3:20 pm

Last year in the Backdoor Both (not Roth) post the 5 year rule was discussed and I think despite me asking point blank I still never understood. And after reading here I am still confused. So I'll try again and I apologize in advance for my thick headedness but it is just not registering.

If I make a Roth Conversion at (say) age 58 what happens at 59.5 when I want to withdraw?

1. As long as I've had other conversions that are over 5 years, every single $ in all my converted Roths can be withdrawn w/o penalty?
2. If the above is not true and the conversions that are less than 5 years would incur a penalty, then I would have to withdraw >5 yo conversions to avoid a penalty.

I think I am correct when I say all contributions no matter how old can be withdrawn w/o penalty. But I'm thinking about the entire Roth balances.

And yes it's probably moot as I wouldn't withdraw everything, but one never knows.
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Re: Reminder: 5 Year Rule on Roth Conversions

Postby Alan S. » Fri Dec 28, 2012 4:00 pm

1) Yes, your Roth is fully qualified at 59.5 if you also have met the 5 year holding. You would not owe tax or penalty.
2) The above is true, but even if your ONLY Roth contribution was the conversions at age 58, you could withdraw that conversion penalty free at 59.5. But any earnings would not be tax free until age 63 since your Roth would not be fully qualified until 5 years passed.

bicker,
You said the fee would not be an annual fee, just an account closing fee. But if you drained the account to -0- every year, you would be closing it every year. That would mean that any such fee could be levied every year. But if you retained $50 or whatever their minimum is in the account by not doing a total conversion, that could save you $50 per year. I thought that this is what you were asking about in your initial question. Also, my earlier question still applies, ie HOW does FIdelity define an account closure for fee purposes?
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Re: Reminder: 5 Year Rule on Roth Conversions

Postby bUU » Fri Dec 28, 2012 4:55 pm

Alan S. wrote:You said the fee would not be an annual fee, just an account closing fee. But if you drained the account to -0- every year, you would be closing it every year. That would mean that any such fee could be levied every year.
I'm going to refer you to talk with Fidelity directly if you have further questions, since my earlier comments in this regard seem to have been inadequate for you.
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Re: Reminder: 5 Year Rule on Roth Conversions

Postby GracieLou » Fri Dec 28, 2012 9:31 pm

retiredjg wrote:I can see how there would be a fee if the poster is rolling everything out of a tIRA and into a 401k which seems to be what this poster is talking about. They certainly have one if you roll your tIRA from Fido to Vanguard (according to previous posters).


I had a $50 fee from Fido when I rolled over an IRA to my new employer's 401K plan (TSP). I have a TIRA with Fido that I am about to empty out due to a Roth conversion - no charge to leave it empty.
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