Roth IRA ladder - 5 year holding period, and avoidance of 10% penalty

[dcunitedfan]

I've slogged through form 8606 instructions and believe I understand the mechanics of how contribution basis and conversion basis protect your Roth IRA distributions from being subject to income tax in the year of distribution.  Now I'm moving onto Forms 5329 and 1099 R and the 10% penalty tax on early distributions.  My intended scenario is this:

After ER, make Roth IRA conversions from my traditional IRA account, in successive years (say at age 51, 52 and 53 = call them RC1 through RC3)
Wait 5 years on each one (living off of money previously saved in a regular taxable account), then take each amount in a distribution 5 years after it's contribution year.  So if RC1 was 2020, RD1 would be 2025, R2: C 2021/D 2026, R3: C 2022/D 2027, etc)

How then do I want my 1099R's to look so that I can signal to the IRS that these distributions are not subject to the penalty tax?  And does that then simply mean that line 1 of the 5329 will be zero, or alternatively that lines 1 and 2 will be equal (in both cases line 3, the amount that determines the penalty tax, is also zero)?

Kind of frustrating because the FI literature seems to understand this scenario well enough but does not go into the nitty gritty of the IRS paperwork, and most summaries of Roth IRAs that do, do not handle the particular scenario of the pre-age-59.5 Roth conversion ladder.

[dcunitedfan]

C'mon, surely someone out there has done a converted Roth IRA from 2009 or before and filed their 2014 taxes. (Or earlier years that support the Roth Conversion / Early Distribution scenario)

I'm basically asking what the relevant fields on your 5329 and 1099 Rs look like (not the amount you distributed, just the relevant fields that result in a zero dollar "10% early nonqualified distribution penalty".  I've run across some comments that indicate that you fill out line 1 of the 5329 with a zero, but no good justification on why, from a IRS publications or tax code perspective.  I get that it is one of 2 arithmetic means of ending up at zero penalty tax (the other being that lines 1 and 2 on the 5329 are equal nonzero amounts, where line 2 cancels out line 1, ending up at zero again, and that because Publication 590 states that distributions < 5 years after a Roth conversion are possibly subject to the 10% penalty tax, the implication is that any such distributions taken 5+ years after conversion are not.  But I have yet to find anything in a IRS or US tax code document that clearly spells this out, and that's the level of authority I'm after.

[MetalCap]

I'm a bit away of this but this is my planned MO as well.

Its possible you may want to have a CPA do it for you and walk you through it year 1 so you can do it with confidence from then on.

[dandarc]

Look at form 8606 and the instructions.  That's where you report this.  Specifically line 24 involves your basis in conversions.

http://www.irs.gov/pub/irs-pdf/i8606.pdf
http://www.irs.gov/pub/irs-pdf/f8606.pdf

[dandarc]

To elaborate, I don't think your 1099R will show anything in regards to basis.  Would show the total distribution.  The company that prepares the 1099R has no way to know about your basis.

Ex - prior to 2014, we contributed to American Funds Roth IRAs.  Then we started contributing to Vanguard Roth IRAs.  If we take a distribution from Vanguard, they don't even necessarily know that we had prior contributed at American Funds.  So all they can really report is "we sent you a distribution for $XXXX".  No way for them to know for sure if it is taxable or not, or the portion that would be.  IRS sees all of your Roth IRA accounts at various places as one big Roth IRA.

[dandarc]

So then there is form 5329.  This is where you compute the 10% additional tax.

http://www.irs.gov/pub/irs-pdf/i5329.pdf
http://www.irs.gov/pub/irs-pdf/f5329.pdf

The example in the instructions is illustrative.  So you take the amount from line 25 on 8606 (which is likely 0 if doing the pipeline - generally the idea is not to withdraw more than properly aged basis, let alone more than total basis), then add any recapture amount.

If you converted or rolled over an
amount to your Roth IRAs in 2010
through 2014 and you received an early
distribution for 2014, the recapture
amount you must include on line 1 is the
amount, if any, of the early distribution
allocated to the taxable portion of your
2010 through 2014 conversions or
rollovers.

Then describes how you allocate to the conversions on a first-in, first-out basis, and taxable portion first, not-taxable second on each conversion.  So when you're allocating, you'll see that your amount doesn't get into a 2010-2014 conversion, and your recapture amount is therefore 0.

[seattlecyclone]

I'm not in the withdrawal phase yet, so I don't have any 1099s to look at. My guess is they should report the full withdrawal amount as non-qualified (because it is).

As for the other forms, here's what you do:

• Suppose you have $250k in a Roth IRA:
  • $10k of direct contributions,
  • $25k converted from your traditional IRA each of the past eight years, and
  • $40k of gains.
• Suppose this is the first year you withdraw from your Roth IRA, and you withdraw $25k.
• You report the amount withdrawn on Form 8606, Part III.
  
  • Line 19 will be the full $25k withdrawal. These distributions count as "nonqualified" because they're taken before age 59½ and no other exception for qualified distributions applies.
  • Line 22 will be the $10k of direct contributions.
  • Line 23 will be $15k ($25k of withdrawals - $10k of contributions).
  • Line 24 will be $200k ($25k of Roth conversions per year * 8 years).
  • Line 25 (taxable amount) will be zero (because $200k > $15k). You don't need to report any income from these withdrawals on your 1040.
• If any of the withdrawals were subject to the 10% penalty, you would report them on Form 5329. However because your withdrawals came from contributions and conversions more than five years old, you don't need to file Form 5329. Quotes from the Form 5329 instructions below:

Who Must File
You must file Form 5329 if any of the following apply.

• You received an early distribution from a Roth IRA, the amount on line 23 of Form 8606, Nondeductible IRAs, is more than zero, and you are required to enter an amount that is more than zero on Form 5329, line 1 (see Distributions from Roth IRAs, later)
• a bunch of other bullet points that don't apply to Roth IRA withdrawals

Distributions from Roth IRAs.
If you received an early distribution from your Roth IRAs, include on line 1 the part of the distribution that you must include in your income. You will find this amount on line 25 of your 2014 Form 8606. You will also need to include on line 1 the following amounts.

• A qualified first-time homebuyer distribution from line 20 of your 2014 Form 8606. Also include this amount on line 2 and enter exception number 09.
• Recapture amounts attributable to any conversions or rollovers to your Roth IRAs in 2010 through 2014. See Recapture amount subject to the additional tax on early distributions next.

TIP: If you did not have a qualified first-time homebuyer distribution in 2014, and you did not convert or roll over an amount to your Roth IRAs in 2010 through 2014, you only need to include the amount from line 25 of your 2014 Form 8606 on line 1 of this form.

The TIP above is key here: if you didn't withdraw any money from conversions less than five years old, you only need to report the amount from line 25 of Form 8606 (zero in this case) on Form 5329. And since you aren't "required to enter an amount that is more than zero on Form 5329, Line 1," you don't have to file the form at all!

[dandarc]

From the IRS perspective:

Tax Year 2009 - 8606 shows a conversion of $10K.
Tax Year 2010 - 8606 shows a conversion of $10K.
..
Tax Year 2014 - 8606 shows a conversion of 10K.  Also shows a distribution of 10K.  You get a 1099 showing a 10K distribution.

In section 3 on that form, you enter 10K on line 19.  For simplicity - there are no regular basis or first time home buyer's amounts, so line 23 is also 10K.  Line 24 is 60K, so line 25 is 0.

Per instructions for Line 23, you move over to 5329.  Per the instructions, you allocate the 10K distribution to your conversions on a first-in, first-out basis, so this 10K gets allocated to the 2009 conversion.  You also see that you only have to include amounts allocated to conversions in tax years 2010-2014, so on line 1, you enter $0 (Line 25 from form 8606) + $0 (recapture amount calculated) = $0.

Note that from all of your past 8606's, the IRS has the information to do this the same as you do.

[RedefinedHappiness]

Great posts. This is exactly the detailed level of instructions that I was looking for as well.  Commenting to follow discussion.  Thanks everyone.

[Cressida]

IRS sees all of your Roth IRA accounts at various places as one big Roth IRA.

To clarify - is this the case for all of a married couple's Roth IRAs?

[dandarc]

IRS sees all of your Roth IRA accounts at various places as one big Roth IRA.

To clarify - is this the case for all of a married couple's Roth IRAs?

No - the I is for "individual" and they mean it.

[dcunitedfan]

Thanks to all, esp. to dandarc and seattlecyclone - the citations from 5329 instructions were what I was looking for (and I guess not parsing the first time I tried going through the publication).

I *knew* someone on this forum had to have prior experience with the Roth conversion ladder scenario.  It just defied belief that no one in this group would not have already started into the process (not just planning for it as I am now)

[livetogive]

This might be one of the most interesting posts I've read on MMM and renewed my interest in funding an IRA.  Kudos and thanks to everyone who posted.