CPA here? I've got a (Roth) distribution question...

[Richard]

I'm asking for "a friend" (smile)

Scenario, numbers are made up because their accuracy doesn't matter, just the process.

If I have say, $100K in a Roth IRA and I'm 65 years old. I can (since it's been held for well over 5-years) I can take any amount out and it's tax free. I rather keep funds in there 'forever' and use that bucket of assets to create some (tax free) cash flow and just take the earnings out.

I just converted $50K from traditional 401K to the Roth side of my same 401K.... now I owe taxes AND now this new money has to age 5 years before it (the earnings) would be tax free to me.

Presuming I'm on base here.....

Now, I retire. I move all converted Roth 401K funds into the Roth IRA. Now I have say, $150K sitting in the Roth IRA. $100K is aged and tax free. $50K is converted and NOT yet 5-years old. I buy dividend paying stocks. I start to write covered calls against them to enhance the cash flow from the dividends. Now (on my $100K) I can pull the Call premiums out, dividends out and all that is going to be tax free. If I have the converted $50K inside this same account, repeat with these funds..... it's not aged 5-years yet. My understanding is when doing distributions, PRINCIPAL is considered to come out first and THEN last, the earnings.

Here's the crux of my question:

Forget the $100K, it's all tax free.

If I write some Covered Calls against the stocks.... I'm going to create some income. Let's just call it $500 for easy numbers.

I'm scratching my head thinking, if PRINCIPAL comes out first, and THEN earnings..... then I might be able to take $500 (of the now balance of $50,500) and it's going to be treated as a distribution of my PRINCIPAL, not necessarily my earnings. Therefore, the principal amount would be tax free while the earnings are still baking in the oven.

Since money is fungible, that would imply I could create some cash flow from the $50K (which hasn't yet aged 5-years BUT I'm 65) and I can pull the PRINCIPAL of $500 out and let the $500 from the Call premiums and dividends "replace" the principal inside the account. So ostensibly, I COULD write covered calls on the $50K portion of the account and extract the amount of the earnings, but it would be calculated as a distribution of principal, therefore, tax free.

Literally, this just hit me about 3 minutes before typing this post as I rushed here to ask. I'm scratching my head thinking well yeah, it makes sense..... THEREFORE, if it makes sense, I have to be missing something. I'm thinking there has to be some snake in the grass that I'm not thinking about.

Thoughts??


"My Friend", thanks you in advance!

 

[Richard]

I might have just had a "Wow, I could have had a V-8 moment"

Inside 401K, the funds are segregated. They're conversion funds, so they don't show on the Roth source of funds.

I'll bet a McDonalds order of fries, that I can't roll that directly into my (now properly aged) Roth/IRA. I'll bet it has to go into a Roth conversion account until said 5-years which submarines my entire line of thinking above.

hmmm....I think I just deflated my anticipation.

 

[Tpondel]

Once a Roth IRA is five years old everything is tax free including any newly added rollovers.

It’s why everyone should open a Roth even with $100 just to get the clock started.

 

[Richard]

Once a Roth IRA is five years old everything is tax free including any newly added rollovers.

I'd ask you to clarify your comments.

Once a roth is 5 years old, doesn't mean it's tax free.... you ALSO have to be aged 59 1/2.

Are you "rolling over" another ROTH account, then yes, once you meet the criteria, it's tax free.

My question was about a conversion. I've heard mixed comments that conversions (to someone who's got a qualified Roth account) do NOT have to bake for 5-years, and I've heard that conversions (again, for someone who's got a qualified account) DO have to bake for 5 years.

NEW contributions would be immediately tax free (once 5-year rule and you are 59 1/2)

This is for converting non-roth funds into a roth (I'm presuming the 5-year wait applies, if it doesn't for CONVERSIONS (into a qualified situation) then it's a moot point.

I hope it's the latter, just presuming it's not so there is a wait.

 

[Richard]

For clarification, found this "AI" online comment: The question was do all conversions have to wait 5-years:
(highlight to comments done by me)

___________________________________________
No, not all Roth conversions have to wait five years, but the five-year rule is a critical concept to understand. Each conversion to a Roth IRA starts its own five-year clock for qualified distributions of converted earnings. However, you can generally withdraw the converted principal (the money you converted) without penalty, even before five years, because taxes were paid when you converted it. The five-year rule is specifically for avoiding the 10% early withdrawal penalty on the earnings generated on the converted money.

___________________________________________
So if account is creating dividends and call premiums, I'm contending I CAN take those out because in the real world, they will fall to the "back of the line" for order of distribution and if I were to take my $100K out, (which would come first as principal) then by the time I get to the back of the line, it would likely be 5-years, therefore those funds would be tax free.

Since the base amount i(that is qualified for tax free distributions, I'm 65 and Roth is 20+ years old) I'm thinking I can take the VALUE of the newly created income out but from a distribution point of view, i've got enough cushion in the base $100K principal amount to cover any dividends and call premiums.

I'm not a CPA but I'm thinking this would work UNLESS the funds have to roll into a conversion account, thereby keeping them segregated. But yet again, I could take the value of the dividends, AS a distribution of principal and that would be tax free.

Heck, my head is spinning!!!

 

[Tpondel]

You’re confusing 401k rollovers and Roth conversions.

Your 401k to Roth is a rollover not a conversion thus tax free in an old Roth IRA.

 

[duffer]

Agree with Tpondel. Treatment of "conversions" vs "rollovers" is different.
As far as your $500 income from covered calls: You're not pulling that out, but rather substituting $500 of principal IF you haven't met the 5 year aging. (which it looks like you have)

You stated earlier that you have a ROTH 401k. That rollover should be exempt from the aging barrier for withdrawals. But if it's a traditional 401k rollover, then it would be taxed before it goes into the Roth IRA.

Be aware that you will get a 1099-R for the 401k rollover, even if it is a Roth 401k rollover. If you do your own taxes, be sure to include the code in box 7 on the 1099 on your tax software. (that will negate the taxation of the rollover, assuming it's a Roth 401k rollover)

 

[Richard]

Guys.... trust me...I am *not* confusing rollovers with conversions.

If I have a 401K that is pretax and I "roll" that to a pretax IRA, then convert to Roth, I have a 5 year rule to contend with. I have done TWO moves.... a rollover and then, a conversion.

What I've been able to do (and you may also if your account allows.... my 401K "turned this feature on" about 2-3 months ago)

anyway, what I've done is taken some of the PRETAX portion of the 401K, I have CONVERTED to an AFTERTAX portion INSIDE the same 401K. So the 401K holds both pretax AND after tax funds.

Consequently, I have a 5-year wait on the internally converted funds. (so this is not a rollover....YET) If I NOW, roll those funds to a Roth IRA, that doesn't absolve me of the 5-year holding period on those converted funds....BUT, and this is where my mind was above....

If those CONVERTED funds created some cash (of any form) I'm contending that I *CAN* take those earnings out tax free BECAUSE the way the rules are, the PRINCIPAL funds are considered to come out first.

So if I took $5,000 out (let's call that earnings of the converted funds)..... technically still under the 5-year hold. Well.... if I've got $30,000 sitting in cash that HAS met the 5-year mark (remember, we said I had $100K in the qualified account), then as a practical matter, I'm simply taking out $5,000 of my PRINCIPAL amount even though it was actually created by income. I don't think I'd run into issues unless I took the $100K out, the converted amount out (which has now been taxed therefore would come out tax free) and THEN had the residual $5,000..... from a cash flow point of view, that might be funds that are/were 5-years old and I still have to wait my new 5-years before that's tax free.....but as said above, I simply replaced my tax free principal amount with the (taxable until 5-year hold finishes) income.