ALBUQUERQUE, N.M. — Q: I am 61 years old and have a Roth IRA funded with conversions from a traditional IRA. When I started doing conversions I was informed of the five-year rule that restricts when the money can be removed without a penalty. Since I am now past age 59½, some advisers have told me that the five-year rule no longer applies to me. Others have said it still applies. Can you clear this up?
First, there are several five-year rules, and they can be complicated because there are general rules and exceptions. It’s difficult to deal with every situation so I’ll focus on two basics of these rules.
If you fund a Roth IRA with contributions, there is a rule that you must wait five years before taking distributions penalty-free. This five-year period is measured from the first day of the year that you made your initial contribution to a Roth.
So, if you first funded the Roth in 2011, the five-year period ended Dec. 31, 2015. If contributions were made each year after 2011, the five-year period still ends on Dec. 31, 2015 for all contributions.
A different rule applies to conversions from a traditional IRA. Each conversion has its own five-year waiting period to take penalty-free distributions. The five-year period is again measured from the first day of the tax year of the conversion.
So if you made annual conversions beginning in 2011, each conversion must satisfy a five-year period. If you take withdrawals, they are assumed to come from the earliest conversions. This allows some ability to control the penalty imposition.
But the important thing to consider is why this waiting period exists. Distributions from a traditional IRA funded with pre-tax dollars are taxable. Because retirement accounts are supposed to be for retirement, a penalty of 10 percent of the distribution applies if the funds are withdrawn before age 59½.
There are exceptions to the 59½ rule, but Congress understood that a way to avoid the penalty would be to convert the funds to a Roth IRA and then take a distribution.
Roth conversions are taxable, which then usually allows the Roth funds to be withdrawn without paying any additional tax. The growth on Roth investments can be removed tax free and penalty free.
A 50-year-old might see this treatment as an opportunity to access IRA funds early. If funds are converted from the traditional IRA to a Roth, and then withdrawn, the account owner could argue that since the distribution was tax-free then no penalty should apply.
The five-year rule for conversions is designed to preserve the penalty for early distributions. If that 50-year-old withdrew Roth funds shortly after the conversion, the income tax could be avoided because the conversion was taxable and all “regular” taxes have already been paid.
The 10 percent early withdrawal penalty will still apply if the five-year waiting period has not been satisfied. Without such a rule, it would be easy to avoid the early withdrawal penalty.
You can already take funds from your traditional IRAs penalty free, so there is no longer any restriction on your ability to withdraw traditional-to-Roth converted funds.
You received different advice because even seemingly simple tax questions can be complex when one tries to read the tax law. I have always found it helpful to first consider why a particular provision exists, and I can then, most of the time, reach the right answer.
Q: You have written about opportunity zone investments and connected them to real estate exchanges. I am considering purchasing an existing business in an opportunity zone. Can that qualify for tax deferral like real estate would?
In theory, it can, although it would need to satisfy the same requirements as other opportunity zone property. One requirement is that the use of the property be new to the opportunity zone. This can be satisfied if substantial improvements are made to existing-use property.
“Substantial” means that within 30 months, you add improvements exceeding the tax basis of the business. With an operating business (that is, not real estate), I think that would be a difficult hurdle to clear. It is not even clear how one “improves” an entire business.
Jim Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at firstname.lastname@example.org.