Ask Kim
Tax Rules for Roth Withdrawals
There is a waiting period before you can take out earnings tax-free.
By Kimberly Lankford, Contributing Editor, Kiplinger's Personal Finance
July 19, 2010
I am 66 and considering a 401(k) conversion to a traditional IRA and then into laddered Roth IRA CDs. I plan to live on the interest earned by the CDs, but I have been told that if I withdraw the interest within five years of the conversion, it will be taxed. Is that true?
No. The interest you withdraw won’t be taxed, but it’s easy to understand the confusion.
The law does set a five-year waiting period before earnings may be withdrawn from a Roth tax-free, regardless of the age of the IRA owner. You don’t have to worry about that, though, thanks to the so-called ordering rule. It holds that the first money withdrawn from a Roth IRA is considered to be money you put in by annual contributions -- and it comes out tax- and penalty-free at any age. Once you’ve withdrawn all your contributions, you begin to dip into converted amounts (tax-free at any age and penalty-free for those age 59½ and older). Only after you have withdrawn all the contributions and converted amounts do you tap into earnings, which will be taxed if you withdraw them within five years of the conversion.
So you needn’t fret that the money you’ll be withdrawing is really interest earned on the CDs. That’s not the way the law sees it. Only after you have depleted all contribution and converted amounts does the IRS think you’re dipping into earnings. And, if five years have passed since the conversion, that money will be tax-free, too. For more information, see FAQs on the Roth Conversion Rules.
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Reader Comments (3)
Posted by: Ron at 07/19/2010 11:45:19 AM
Thanks for clarifying Roth distributions. Just one caveat; be careful of AMT taxes when you convert.Might want to check with accountant or do the math first if conversions are large.
Posted by: Anita at 07/19/2010 01:21:20 PM
i assume that the person posing the question about Roth interest being taxable is making the middle move (from 401K to traditional IRA to Roth) because he wants the tax benefits for this year (he can contribute $6,000 for himself, another $6,000 for a spouse) and take $12,000 off his earned income. Otherwise, that middle move confuses me. Is that a correct assumption? One would make the move (temporary) to a regular IRA for income tax savings? If that is the case, would you invest in a short-term CD or bond, or must that re-transfer from IRA to Roth require a longer time frame?
Posted by: george at 07/19/2010 11:08:24 PM
a very bad explanation, kim! i am so perplexed. first, you did not explain if you are taxed on these conversions at the personal level. i think you are. second, what the h... is a laddered roth cd? and third what contributions to this roth (are)you talking about? she said she had a 401k plan to begin with. it may have been entirely funded by employer. iam so confused with the story from the retired person...?