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The law does set a five-year waiting period before earnings may be withdrawn from a Roth tax-free, regardless of the age of the IRA owner.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 It holds that the first money withdrawn from a Roth IRA is considered to be money you put in by annual contributions -- and it comes out tax- and penalty-free at any age. Once you’ve withdrawn all your contributions, you begin to dip into converted amounts (tax-free at any age and penalty-free for those age 59½ and older). Only after you have withdrawn all the contributions and converted amounts do you tap into earnings, which will be taxed if you withdraw them within five years of the conversion.
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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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