76. What you Need to Know About the Confusing Roth IRA 5 Year Rule

Oct 29, 2021

What you Need to Know About the Confusing Roth IRA 5 Year Rule

Are you familiar with the five year rules for Roth IRAs? It’s important that you understand these somewhat confusing rules whether you’re opening a Roth IRA now, considering converting your traditional IRAs, or you’re inheriting them. 

In today’s episode, we explain how these five year rules work, what you need to do for planning, and what your options are for avoiding penalties.

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Show Notes

Subscribe to the Weekend Read (2:17)

Information You Need to Know about Roth IRAs (3:15)

Converting to Roth IRAs (4:33)

Two Durations of Roth IRAs (4:50)

The Importance of the First 5 Years (7:27)

The Two Rules: 

  1. The Five-Year Rule For Income Taxes 
  2. The Five-Year Rule for the 10% Penalty

The Five-Year Rule For Income Taxes (8:03)

Five years must have passed since the first contribution to any Roth IRA to withdraw tax free income.

Being Opportunistic (8:36)

Setting Up Separate Roth IRAs for Conversions and Contributions (10:58)

Roth IRA Withdrawals For Less than Five Years Since the First Contribution (15:52)

The Five-Year Rule for the 10% Penalty (17:49)

This determines whether a distribution of principal from a converted IRA is subject to the 10% early distribution penalty. This rule applies only to the penalty.

Impacts on Dependants When Doing a Roth Conversion (20:23)

Five Year Rule on Inherited Roth IRAs (21:02)

Disclaiming Inherited Assets (22:28)

Links

redefiningwealth.info

lswealthmanagement.com

Weekend Read: redefiningwealth.info/weekend-reading

Schedule a Review: https://redefiningwealth.info/schedule/

Listen & Subscribe

Ron Stutts:

Welcome to Retirement Talk: The Redefining Wealth Show, your source for financial information for pre retirees and retirees to help you better navigate during these financial times. We are here to discuss thoughts and ideas with some of today’s foremost experts in the field of finance and retirement, as well as discuss trending topics that could impact your bottom line. These discussions can help you make better financial decisions and be informed so you can live the lifestyle you imagine and make better financial choices.

Ron Stutts:

Laura Stover is a registered financial consultant and CEO of LS Wealth Management, as well as founder and owner of LS Tax, a consulting firm. She’s been featured in Forbes, CNBC, and The Wall Street Journal. I’m Ron Stutts. Our topic for today comes from our weekend reading edition, it’s from Forbes, what you need to know about the confusing Roth IRA five year rule. If you’d like to learn more on today’s topic, head on over to redefiningwealth.info and subscribe to The Weekend Read. You’ll receive The Weekend Read each and every Friday along with Laura’s breakdown of the topics important to you and your retirement.

Laura:

Hello, hello, hello. I am joined today by my good friend and cohost, Michael Wallin here with me. Hello, Michael. How are you?

Michael:

Doing great. It’s great to be here.

Laura:

Well, it’s always good to be here. I don’t know what the alternatives might be, and we’ll save that for another discussion. But we have-

Michael:

Palm trees. Palm trees.

Laura:

That now, I could digress physically to, let’s say, instead of just imagining. That time of the year, the weather’s starting to change just a little bit, depending on where you live. I guess even if you’re in a beautiful state like Florida, it’s getting a little cooler there, but still a little toasty, some of my South Florida friends tell me. But we have a great show in store today. It’s our opportunity to cover one of our weekend reading articles with all of you. Now what is weekend reading? This is stuff that if you’re going to retire, or you’re already retired, you need to be doing some homework on the weekends.

Laura:

This is actually not homework, this is enjoyable. These are four hand selected articles that I choose each and every week on trending topics in the financial planning space, and we provide short summaries. So it’s kind of a quick read, but you will learn a lot. And there’s some takeaways and breakdowns from myself. You can sign up is the best part of it all, for free if you go to redefiningwealth.info. Redefiningwealth.info, sign up for The Weekend Read, and that’s where it all starts, so you have access to the podcast.

Laura:

You’ll get a link along with all the show notes, and more information on our key topic for today, which is from Forbes here, all about Roth IRAs. And if you are making Roth contributions, or maybe you are thinking about a Roth conversion, it’s likely that you’re going to want to read up a little bit more on the article today because we’re going to talk about some aspects that you probably don’t hear a lot about. This is a popular topic right now. Everyone has taxes on their mind. Everyone has taxes on their mind. We just did a webinar. For access to that, let us know. We’ll be happy to send you a replay of the webinar, where we break everything down in 45 minutes, a little more in depth than even on the show today.

Laura:

But what you need to know about the confusion that the Roth IRA in regards to the five year rule, it’s kind of snarly there, Michael. And some people read about it and probably really don’t fully understand the rules. Maybe they haven’t even heard about this because you always hear tax free, tax free, tax free, but that’s not 100% of the case. And we’re going to, as you say, unpack all of that here today. And some people are probably a little hesitant if they do know about the five year rule because of some tax ramifications. So there’s a lot of interest in converting these IRAs, 401(k) to Roth, especially this year, and that’s mostly because everybody, and rightly so in my view, and I think your view too, they should be concerned about the future of rising taxes.

Michael:

One of the things I think, Laura, that’s so confusing is when Roth IRAs were created, there was two durations, two different aspects of Roth IRAs, but the duration that was applied to them were five years. So a lot of times, people get the two five years rules backwards. So when we’re looking at Roths, all future distributions from a Roth IRA are tax free when they are qualified distributions. And they have to meet that standard of being a qualified distribution. Meeting the five year rule is one of the requirements for a distribution to be qualified. And so that’s: How long are you allowing those dollars to stay deferred, plus any of the gains that are inside of it? Because the dollars that you originally put in, those dollars are qualified immediately for a distribution, but you are looking at the gains inside of it, so that those come out tax free.

Michael:

Another aspect of it is when you’re talking about a Roth IRA, is that you’re looking at the dollars that are put in immediately. It is a first in, first out. And I think it’s important for all listeners to know is it’s first in, first out, not last in, first out, like a lot of the other type of financial products that are out there. As you said, it’s confusing because there really are two five year rules. One five year rule determines if a distribution from a Roth IRA avoids income taxes. The other five year rule determines if a distribution taken before age 59 and a half avoids the 10% early distribution taxation.

Laura:

Yeah. So we’re going to, as you say, Michael, I love this little phrase now. I guess it’s our phrase exclusive to the show.

Michael:

It is.

Laura:

We’ll trademark it.

Michael:

We’ve got to trademark that.

Laura:

Time to unpack this now. So there’s some interesting aspects to this, so I think it’s really important for people to at least be aware of it. And again, most of these monies are not monies that most folks are going to be dependent upon in terms of income. And that’s where we go back to the income planning aspect of this, knowing when you’re taking income from various sources because that really eliminates any worries about even knowing anything about this five year rule if you have that planned out from the get go. Right?

Michael:

Absolutely.

Laura:

If you know exactly when you set the account up and when you’re going to access the funds. So let’s talk about this five year rule a little bit more and why it’s relevant, because the first five years determine whether a distribution of the earnings passes one of these tests to be qualified, and therefore free of income tax. So it’s after tax money that’s contributed or rolled over to a Roth IRA. And then like you said, it’s a withdrawal of the principle free of income tax.

Michael:

What we’re looking at there is two tests must be met for a distribution to be qualified. One test is that five tax years must have passed since the first contribution was made to any Roth IRA for the taxpayer. This is a broad rule. According to the Treasury regulations, the five year period starts whenever money is put into a Roth IRA for a taxpayer, and that is on a contribution. Under this rule, contributions include both direct contributions and converted amounts.

Laura:

So I think the big takeaway, the big takeaway people may want to be opportunistic. Now it’s usually in life not good to be known as an opportunist. Is that a Dr. Laura show? But opportunistic in approaching the tax planning, if the market drops, it’s not always bad when the market drops. We know then there’s going to be significantly higher taxes down the road when the market drops. This could be a good time when the value on these accounts are a little lower if you have qualified money. Thus, a good time to potentially consider a conversion at that time. There’s no crystal ball and it’s a case by case basis, but I think it makes a lot of sense. And we’ve always talked about this on the show a lot. To have as much as possible in that tax free bucket, we know it’s a proper balance between taxable, tax deferred, and tax free. That’s the art of tax planning, being proactive and making sure we have the right amounts.

Laura:

We see all these webinars online. And some of them are quite good. That’s educating people about the topics. But I was kind of chuckling, someone was advertising one recently. And they’re like, “Life insurance and annuities.” It’s more than that, it’s about planning because we may be in some of the highest tax brackets that we’ve seen in many, many years. We spoke a few weeks ago, I mean, during World War Two, people may not realize because most people in this generations alive now weren’t here during World War Two. But the highest marginal bracket was over 94%. We know with the debt that we have, we’re going to be in very high tax brackets at some point in time. The question is when that’s going to take place. So having diversification with your taxes along with the investment diversification, while taxes are lower right now. Our team’s been talking about this a lot the last few years, in fact. And as Alan, our CPA, always says, “Taxes are on sale right now.”

Michael:

And it’s interesting. I mean, you bring up a good point right there that I hope the listeners picked up on is when you’re looking at diversification, one of the things, and I met with a client two days ago, and one of the things that we were talking about there was wanting to do a Roth. They were wanting to move their assets over. And I told them that, let’s set up two Roths, one Roth for the conversion, one Roth for contributions, because they were wanting to make this. I was like, “Let’s not co-mingle those because the Roth IRAs have different rules around those.” One is resetting the five year clock on those contributions. The conversions are starting it from day one. So let’s not co-mingle those and then try to unpack it, unwind it down the road to figure out which dollars were coming out. And how did it apply?

Michael:

Another aspect of it is really understanding that 401(k) Roth that’s there because there’s a different set of rules around it. So when you’re looking at those different buckets of money, as we’re looking at them, take your dollars and split those Roths into different groups. And then you have the aggregation. So when we’re going to be looking at a distribution, you’re looking at all the Roth IRAs together. And distribution, the first thing out, is the contributions. And so those are the dollars that you’ve put in. You’ve already paid taxes on those dollars, and so those dollars are able to be taken back out of the account penalty free. So it’s important to be able to align those investment accounts you have based upon that income plan that you were talking about earlier, Laura, is: Which bucket of money are we going to take it out of? And we’re not going to run ourself into a situation that upon distribution, we’re needing to jump over hurdles or run the gauntlet to get the money out in a tax favored position.

Laura:

Yeah. So the big takeaway I think, Michael, is the Roth IRA as far as taxpayers are concerned, money flowing into the Roth IRAs are aggregated to come up with one five year period, so that’s kind of the essence of this article here. And essentially, once you’ve satisfied this five year rule for one Roth IRA, you’ve satisfied it for life for all Roth IRAs, and that’s the reason some advisors say if you’re going to convert all or part of a traditional IRA to a Roth IRA in the future, you should convert or maybe contribute a small amount to the Roth IRA now, so the five year clock will start running, so to speak.

Michael:

Yeah. And I even advise many of our clients that take some taxable income, open a Roth now. You do not want the Roth IRA plan to at some point in the future, if the government decides to do away with it, you want to be grandfathered. I advise everybody that has earned income, or has had earned income, that they can do a conversion. Set up a Roth IRA. And I’ve shared with you, I’ve got a young child that is of age to be able to start earning income. And this year, that individual will be setting up their first Roth IRA. We will take that income. We will file a tax return on those dollars, and we will establish her with her first Roth IRA because that way, she has it in perpetuity in the future, and that five year clock is already started at today’s age.

Michael:

And then when she’s into high school and when she out of college, she can continue making contributions into this plan. But she will always have access to it because if the government does what they’ve always done, that account would be grandfathered where they may do away with it in the future. Those that have them will always have them.

Ron Stutts:

We’re talking today about the confusing Roth IRA five year rule. If you’d like to read more on today’s topic, take advantage of a free subscription to The Weekend Read. Go to redefiningwealth.info, Weekend Read, and click subscribe. You’ll stay on top of all the latest news and financial trends. Finally, we want to invite you to our upcoming webinar. Laura and Michael will take a deep dive into important concepts that will help educate on making informed decisions for your retirement. These resources are available to you by going to redefiningwealth.info. Subscribe to The Weekend Read. We help get you on track and stay the course. Now back to Retirement Talk: The Redefining Wealth Show, with Laura Stover and Michael Wallin.

Laura:

So the second test for qualified distributions I think is much broader when we look at the distribution made on or after at least one of the following events. And these are kind of milestones that we talk in the financial world if you’re 59 and a half, if you’ve passed that magic age of 59 and a half, things really loosen up considerably. I guess that’s the only good thing about getting older, Michael, AARP and 59 and a half, some of these penalties are disappearing if you need access to funds. And if you’ve had your Roth IRA for more than five years, you can withdraw those earnings from the account for any reason without paying the tax in terms of the penalties. And if you’ve had the account for less than five years, the earning portion of the withdrawal, then that’s going to be taxable, but you wouldn’t have to pay penalties.

Michael:

I think the big part of this is just to remember Roth IRAs are retirement accounts. And part of the rules that have been put into place is to get individuals to not invade those dollars early for expenses that they may have during their accumulation years, but really, make sure that you are putting these dollars aside. Make sure that you have got those dollars made available to you as you go into the preservation and income phase so that you have it for retirement. There’s always the wants that will come up during those accumulation years, and you see that pot of money that you’ve got set aside. And you go, “Wow, I’d like to buy this new car. I’d like to buy this new TV,” or any of those other discretionary spending items. The reality, this is set aside for retirement and needs to be treated for retirement.

Laura:

Well, with inflation as high as it is now, everyone should wait on buying stuff anyhow. So the five year rule for converting a traditional IRA to a Roth IRA, there’s a second five year rule. Let’s talk about that real quick here, Michael. It applies only to funds that are part of a Roth conversion. We know a lot of clients are into conversions as fashionable. It’s en vogue these days. A Roth conversion is when you roll over money from a traditional IRA into a Roth. Some people are doing it maybe a little bit incrementally, or maybe I have some clients wanting to do it all at once and get it over with now because they’re very, very concerned about future taxes. So you pay the income tax on the rollover, or the converted amount, in the year you do the Roth conversion.

Laura:

And that’s why people usually only do Roth conversions if, number one, they believe their tax bracket’s going to be higher in retirement, paying that tax on that conversion now at the current tax rate. Taxes are on sale, as Alan always says. It’s preferable to the higher rates later. Or number two, if the income’s lower than usual this year, well, a lot of people aren’t wanting to work, so this may be a good year if you’ve had a long extended COVID vacation, or whatever the case may be, to put some of those funds, convert it to a Roth with a lower tax impact.

Michael:

A lot of retirees, Laura, that I have sat down and looked through, looked at their tax returns, for many of them, when you look at what their personal exemptions, standard deductions are, many times their standard deduction is actually greater than the amount of income they have. And they leave dollars on the table of the standard deduction that they could convert $2000, $3000, $4000 a year extra over into a Roth and eliminate having that portion that would have in the future, a required minimum distribution at a higher tax rate as it goes forward. Another thing to look at too is you mentioned some of the clients that come in, and they’re wanting to do a full conversion. A lot of your means tested benefits, again we talked a couple of weeks ago about MAGI. So you want to look at any means tested, your Medicare premium. Be very careful fully converting a Roth because if you’ve got Medicare premium, you could be subjecting yourself to higher premiums for a two year period.

Michael:

Also, if you happen to have a dependent that’s in school and are receiving some type of loans or grants that are dependent upon your income, if all of a sudden you do a full Roth conversion, you may take at that time and cause that individual not to qualify for those loans, grants, or federal aid for at least a two year period, so be very careful that you’re looking and considering all aspects of what this additional income could be doing to your overall income plan, as well as any type of dependency plans that you have in place.

Laura:

So let’s talk a little bit here about the five year rule in terms of its effect on inherited Roth IRAs. So this is another, IRAs come in many flavors, so we want to dissect. And they each kind of have a little different nuance in terms of how they’re treated. The five year rule applies to inherited Roth IRAs, so if you’re a beneficiary of a Roth IRA, you can withdraw the contributions from an inherited Roth account any time. In fact, you’re required to. But the withdrawals, the earnings part, are tax free. And the account must have been open for at least that five year window when the original account owner or the holder of the account died. So let’s talk about that a little, and if that account has not been open that long, there’s a few options. You can disclaim the inherited assets. I don’t think a lot of probably will do that option, but technically, you could.

Laura:

You could not to accept the funds if you don’t need the money, or you don’t want to deal with the tax consequences. And this probably gets a little bit into the new rules with the SECURE Act now, and not being able to stretch this over the lifetime of the beneficiaries. And that’s condensed now to the 10 year, so let’s talk about inherited IRAs a little bit here, Mike.

Michael:

Yeah. Like you mentioned, you always have the ability to disclaim the inherited assets. And I think one of the things that makes it very prudent is if you are the beneficiary of a Roth IRA or any IRA, is that you sit down with a professional tax preparer, and you say, “If I take these dollars, let’s do a what if.” Let them sit down at their tax software, put in your last year, put in any adjustments of what your current lifestyle is. And then take that dollars that you’re going to be receiving and plug it into the system to see what that actual impact would be to you. So if you’re looking at it might be in your best interest to disclaim and let those dollars go to maybe another family member that could benefit more from them, or withdraw the money if a lump sum. If you’re over on the other end, and it’s not going to cost you greatly in your amount of taxes, let’s just say it’s a small Roth IRA.

Michael:

Let’s just say if you’re in that situation, you don’t really want to take $25 a year out on a distribution. Just take it all out at one time if it’s going to not really impact your tax bracket you’re in. Pay the taxes, reinvest it, and allow that account to continue growing. But you don’t necessarily need to have those dollars deferred for a long period if it’s not going to be beneficial to you.

Laura:

And anyone that’s interested in having a what if scenario, I’ll offer to the first three callers if you’re listening on radio, or if you’re listening to the podcast, simply go to redefiningwealth.info, redefiningwealth.info. Click schedule review. There’s an option for a 15 minute strategy session. Someone on our team will connect with you. And I’ll have Alan, our CPA, provide what ifs for the first three people that connect with us along those lines. And we’ll do an analysis and determine what those costs are going to entail and break this all down because there is a lot of planning that is necessary for making the right decisions with some of this.

Laura:

Now if funds are withdrawn annually, that’s typically going to be based on a person’s life expectancy. Now that option is available when we’re talking about inherited IRAs to surviving spouses, minor children of the account holder, maybe if you’re disabled or chronically ill. Then the beneficiaries, if they’re less than 10 years younger than that deceased person, of if it’s a sibling, for example, the beneficiary’s life expectancy’s based on that IRS single life expectancy table. And the other option, you can roll the inherited funds into your own Roth IRA, or a new Roth IRA account.

Laura:

That option’s only available to surviving spouses. And I don’t think a lot of people realize that. So I think the whole takeaway here, Roth IRAs can absolutely be an excellent source of tax free income, but you have to understand all these nuances, the withdrawal rules, particularly this five year rule. And it’s all many aspects to this, especially if you’re under the age of 59 and a half. You have to plan carefully. Otherwise, you could wind up owing unavoidably, taxes and penalties. We do not want to give Uncle Sam a penny more than what we legally have to. Thank you for listening.

Ron Stutts:

You’ve been listening to Retirement Talk with Laura Stover and Michael Wallin. Connect with them personally for your own 15 minute strategy session with Laura and Michael. Go to redefiningwealth.info and click review.

Ron Stutts:

Redefining Wealth is a registered trademark of LS Wealth Management. Investing involves risk, including the potential loss of principle. Any references to protection, safety or lifetime income generally refer to fixed insurance products, never securities or investments. Insurance guarantees are backed by the financial strength and claims paying abilities of the issuing carrier. This show is intended for informational purposes only. It is not intended to be used as the sole basis for financial decisions, nor should it be construed as advice designed to meet the particular needs of an individual situation.

Ron Stutts:

LS Wealth Management LLC is not permitted to offer, and no statement made during this show shall constitute tax or legal advice. Our firm is not affiliated with or endorsed by the US government or any governmental agency. The information and opinions contained herein provided by third parties have been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed by LS Wealth Management LLC. Investment advisory services offered through Optivise Advisory Services, and SEC registered investment advisor. LS Wealth Management is a separate entity.

Dan:

Like what you’re hearing on the show? You can learn more on today’s topic by subscribing to The Weekend Read. Just head on over to the redefiningwealth.info and subscribe to The Weekend Read. You’ll receive several articles every Friday with Laura’s breakdown on the topics that are important to you and your retirement. You can also schedule a 15 minute strategy session with Laura and Michael. Finally, we want to invite you to an upcoming webinar. Laura and Michael will take deep dive into important concepts that’ll help educate you and help you make informed decisions about retirement. You can find all that and more at redefiningwealth.info. That’s redefiningwealth.info.

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