Regular readers of this space know I LOVE Roth IRAs and their stepsister Roth 401(k)s. They are an outstanding wealth building tool that I believe most people do NOT use enough.
Lately, I have been getting lots of questions from clients and friends asking about he Five-Year Rule for Roth IRAs. So, here is what you should know.
The five-year Roth IRA Conversion rule is actually just one of three different five-year rules related to Roth IRAs. One of the rules might apply if:
- You withdrawal growth from an Roth IRA.
- Your convert some money from a Traditional IRA to Roth IRA; or
- You inherit a Roth IRA.
All three of these rules, have their roots in the IRS Code Section 408A(d)(2)(B). Simply put, you can take money out of a Roth IRA after age 59.5 AND after you have had ANY Roth IRA for five years and have NO TAX AND NO PENALTY. So if you meet both of those requirements, all money comes out totally tax free. Now, to look at the five year rules.
How Does the Roth IRA 5-Year Rule Work?
Free Distributions from Roth IRA – Any Time, Any Reason
It’s a little-known fact that ALL DEPOSITS to a Roth IRA can be removed at any time for any reason with NO tax or penalty due. This is one reason that Roth IRAs can be an excellent tool for accumulating Emergency Money or College Savings.
Five Year Rule on Removal of Growth from Roth IRA
In order to remove growth from a Roth IRA without taxes or penalty, you must meet TWO requirements:
First, you must be at least 59.5 years old.
Second, you must have made your FIRST Roth IRA deposit at least five years ago. Take note, this is a Roth IRA contribution. Roth 401(k) deposits DO NOT count.
With removal of growth from a Roth IRA that you funded with deposits, ONE Roth IRA deposit made five years ago, satisfies the five-year rule for ANY Roth IRAs owned by the same person.
Five Year Rule on Roth IRA Conversions
In order to remove money from a Roth IRA conversion free from income tax or penalty, you must meet the following requirements.
First, the Roth IRA Conversion has been in place for FIVE TAX YEARS.
Second, you are at least 59.5 years old.
Important NOTE, each Roth IRA Conversion has its OWN five-year rule.
PRO TIP Since the Five-Year Clock is based on tax years, sometimes you can remove the money sooner than 60 months.
For example:
- You converted $10,000 from your Traditional IRA to a Roth IRA on 15 December 2015.
- You paid tax on the $10,000 of additional income on your 2015 tax return.
- You turn 59.5 in October of 2019.
- You could take all the rollover money out of the Roth IRA in January of 2020 without penalty. That’s about 52 months.
Five Year Rule on Inherited Roth IRAs
When you inherit a Roth IRA, there are a few things to know.
- If the inherited Roth IRA is less than 5 years old, removal of any GROWTH is subject to income tax. However, if you plan to empty the IRA over 10 years, your first distributions will be counted as deposits and the five-year rule may be satisfied by the time you remove the growth.
- The beneficiary can take distributions from a Roth IRA without tax or penalty, regardless of age.
- Under the SECURE Act of 2019, if you inherit ANY IRA, you must distribute ALL the money over the course of 10 years from the date of death of the original owner.
Note, that you can sometimes take growth out of any Roth IRA at any age, if you meet one of these EXCEPTS to the Five-Year RULE.
- You can take $10,000 out for a first-time home purchase.
- Pay for college for yourself, a spouse, a child or grandchild.
- You have medical bills more than 10% of your adjusted gross income.
- You become totally disabled.
The Case for a Roth IRA
All of the five-year rules assume that you have a Roth IRA. Why would you want a Roth IRA?
Comparing Roth IRAs to Traditional IRAs.
- If your income tax rate is the same in the year you make deposits and the year you make distributions, the NET SPENDABLE MONEY from a traditional IRA and Roth IRA account is the same.
- If you DO NOT think tax rates in retirement will be the same as now, then:
- Favor a Traditional IRA if you believe YOUR income tax rate will be lower in retirement.
- Favor a ROTH IRA if you believe YOUR income tax rate will be higher in retirement.
- Which IRA is best for you depends on what you believe your retirement looks like:
- Will you spend more or less money when you are retired?
- Smaller house.
- Less travel.
- Less dinners out.
- Older car.
- Less health care.
- Will income tax RATES rise or fall in retirement?
- Will your cash flow come from pensions and Social Security, or retirement distributions?
- If you have regular pension checks, you can set your withholding to pay the income tax due, otherwise you will need to make quarterly tax payments.
- If you make quarterly tax payments, you may need to make retirement distributions to cover those payments. For most of my retired clients, the IDEA of taking out $14,000 to spend $10,000 just makes them crazy.
- Remember the big picture:
- Income tax rates are historically low today.
- In 1945 the top income tax rate was 94% for income over $200,000 ($1.84M in 2020 money).
- Today, the max tax rate is 37% for income more than $622,050 per couple.
- Federal debt is at a historical high.
- Income tax rates are historically low today.
- Will you spend more or less money when you are retired?
- In 1970 the debt was about 40% of Gross Domestic Product, today it’s almost 140%.
Each of these two facts suggest, that the U.S. government MIGHT raise taxes in the next 15 to 30 years. So, if you are in your 60s or younger, I would suggest you can expect to see higher income tax rates again in your lifetime.
If I am right that income taxes are likely to be higher during your retirement, that favors a Roth IRA (or Roth 401k) today.
So, if you think a Roth IRA is right for you, what are the pros and cons?
Pros and Cons of a Roth IRA Conversion
If it’s clear to you that you want to have MORE Roth IRA money and less traditional IRA money then there really is no down side to a Roth IRA conversion. This is the perspective looking through the wealth-building lens.
Converting from a traditional IRA to a Roth IRA is easy. You just open a Roth IRA to receive the conversion and complete a form to instruct your IRA custodian to liquidate some of your Traditional. IRA holdings and move the money to your Roth IRA account. After the money arrives, you reinvest it for growth, and you are all set.
At the end of the year, you will get an IRS Form 1099 that shows the converted amount as a taxable income. You include it on your tax return and pay the tax as part of your normal filing. If you are currently paid on a W-2, you can adjust your withholdings for the year you are making the Roth conversion to send more money to the IRS from every paycheck. That can reduce the extra tax you need to pay at the end of the year.
How Do I Avoid Taxes on a Roth IRA Conversion?
It’s hard to totally avoid paying taxes on a Roth IRA conversion. But, there are a couple ideas to consider.
First, time the conversion during a market downturn. Think about March 2020. A typical investment account was down more than 20% from January to April 1. If you converted $50,000 in Traditional IRA money in March of 2020 and put it into a Roth IRA, it likely grew more than 40% over the rest of the year. (Market estimates based on Yahoo Finance historical data.) That would be $20,000 of growth inside the Roth IRA. All Tax Free forever.
Second, time the conversion for a year when you have a disruption of income. If you are between jobs for a part of the year, and your income is down, that’s a great time to convert some traditional IRA money. If your family income fell from $100,000 to $75,000 in a year, you might move from the 22% tax bracket to the 12% tax bracket. A conversion in that year saves 10% on taxes.
Both of these conversion strategies take a bit of thinking. You will likely benefit from some solid advice from an experienced, well-trained professional. I’m happy to talk with you, just follow this LINK to connect with me.
A great place look for more advice is to talk with a couple CERTIFIED FINANCIAL PLANNER™ professionals.
To find a CFP® professional near you, start your search here.
As you visit with financial planners, I suggest a couple things to check:
- Is the advisor always the client’s advocate – a fiduciary advisor?
- Is the advisor only paid by clients, not any financial product manufacturer or distribution network? That would be a fee-only advisor.
These two points help assure that you are working with a professional who is committed to your best interest at all times. It seems sort of obvious to me that a professional would work in this way, but it’s not automatic.
A fiduciary, fee-only, CFP® professional can help you make great retirement income choices and develop a comprehensive financial plan that is driven by your goals and priorities and addresses all aspects of your financial life. With a big-picture approach, you will be better prepared to understand your options at every step along the way.
Yes, I am a CFP® professional. I’m always a fiduciary and I only work on a fee basis. And yes, I’m still taking on a few great families to be part of my financial planning practice.
If this article has you thinking about your own circumstances, contact my office. I am always happy to meet with people who are working on their retirement plans. Dunncreek Advisors does not provide legal or tax advice, nor is this article intended to do so.