Ep. 234 – Roth IRA – 5-Year Rule – Your Retirement – Part 2 with Denise Appleby

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In this Episode of the Secure Your Retirement Podcast, Radon and Murs have Denise Appleby to discuss the Roth IRA 5-year rule in more detail. Denise is the CEO of Appleby Retirement Consulting Inc., a firm that provides IRA tools and resources for financial and tax professionals.

She explains the nuances around two separate Roth IRA 5-year rules and what you need to take distributions from a Roth IRA if you’re aged 59 and a half or below. Listen in to learn the importance of starting your Roth IRA 5-year clock earlier and protecting your records to avoid paying taxes you don’t owe.

In this episode, find out:

• Denise explains the nuances around two separate 5-year rules and what they mean.
• Understanding what you need to take distributions from a Roth IRA if you’re 59 and a half.
• The importance of proper record keeping and protection to avoid paying taxes you don’t owe.
• Why you don’t need to keep tracking the 5-year rule if you’re aged 59 and a half and have had a Roth IRA for at least five years.
• Why it needs to be a Roth IRA to start your 5-year clock instead of a Roth 401k.
• The questions beneficiaries need to ask about Roth IRA when dealing with an inherited account.

Tweetable Quotes:

• “The first 5-year rule is used to determine if a Roth IRA distribution is qualified, and for that 5-year rule, it starts January 1 of the first year for which you fund your Roth IRA, and it never starts over.”– Denise Appleby
• “As taxpayers, we have to be responsible for protecting ourselves as is allowed under the tax code, or we’re going to pay taxes we don’t owe because we don’t know we don’t owe.”– Denise Appleby

Get in Touch with Denise:

• LinkedIn: https://www.linkedin.com/in/deniseappleby/

Resources:

If you are in or nearing retirement and you want to gain clarity on what questions you should be asking, learn what the biggest retirement myths are, and identify what you can do to achieve peace of mind for your retirement, get started today by requesting our complimentary video course, Four Steps to Secure Your Retirement!

To access the course, simply visit POMWealth.net/podcast.

Here’s the full transcript:

Radon Stancil:	Welcome everyone to Secure Your Retirement Podcast. We are certainly happy to have you with us today and we’re going to be talking about a topic I think that a lot of people get confused about. In fact, Murs and I did an episode ourselves on the Roth conversions and the five-year rule and whether it be funding or not funding. We’ve had so many questions on that this year, we actually thought we would bring on the person that we go to to get our questions answered and she is an expert in all things IRAs. Her name is Denise Appleby. So Denise, thank you so much for coming back on. You’ve actually been on the podcast before, so we appreciate very much you revisiting with us.
Denise Appleby:	Absolutely. Thanks for having me on. Always a pleasure.
Radon Stancil:	Good. So we really kind of wanted to go back in, when Murs and I did the episode, we basically took a lot of notes from actually our conversation and tried to lay those things out. But honestly there’s a lot of different parts of the five-year rule. In fact, on our episode we did, Denise, we only talked about somebody over 59 and a half. So today we kind of want to talk about the under 59 and a half and the over. So as we get into this topic, I think I just want to start it right off and say could you just tell us a high level what is the five-year rule and what are we even talking about when we say five-year rule?
Denise Appleby:	Okay. I’m so glad you positioned the question that way because I want to correct you a little bit and say what are the five-year rules, right?
Radon Stancil:	Okay.
Denise Appleby:	Because I think that is the point of confusion for a lot of people, the fact that we have two separate five-year rules. So when you’re having that conversation with clients, the challenge is or the goal is to determine which five-year rule applies to the client. The first five-year rule is used to determine if a Roth IRA distribution is qualified, and for that five-year rule, it starts January 1 of the first year for which you fund your Roth IRA and it never starts over. So if you funded your first Roth IRA in 2010 and you emptied out that account, has a zero balance, come 2023 you start a new Roth IRA. When does that five-year period start? January 1st, 2010.
	Now the second five-year period, you go to only if you are not eligible for a qualified distribution. So part of what we have to do is identify what’s a qualified distribution, right? You meet the first five-year rule that I talked about on one of four requirements, which I know you’re going to get into later. If you meet those two requirements, then you don’t care about the second five-year rule. But if you’re not eligible for a qualified distribution, then you go to five-year rule number two, and five-year rule number two is used to determine if a distribution of Roth conversion amounts are subject to the 10% additional tax or early distribution penalty.
	Now this one’s different because it applies only to conversion amounts or rollovers from pre-tax side of employer plans like 401(k)s and it starts every year that you have one of those transactions. So if you do a Roth conversion in 2020 and you’re taking a distribution, the distribution comes first from a conversion that you do in 2020 before one that you would do in say 2023.
Murs Tariq:	So if you’re listening, you can already understand that there are some nuances here that we need to understand around what the five-year rule is. I think the reason that we’re bringing it up as a full on podcast topic and we’ve had a previous episode on is because we are talking tax strategy right now with a lot of our clients. Part of that recommendation or something that can become an opportunity is hey, taxes are somewhat on the lower side right now. We know taxes are going up in 2026, unless there’s significant legislative change.
	So a lot of our clients right now are doing Roth conversions, but it’s not as simple as deciding to pay the tax and get the money in the Roth account, now you’re good to go. It’s also necessary to understand some of the nuances of the Roth and the five-year rule. Now I think most of our clients are going to be in the scenario where they’re really doing a Roth conversion for future potential use down the road for their own retirement, or they are doing it for their legacy, they’re going to leave this money behind. So for a lot of our clients, the five-year rule really isn’t going to apply all that much, but it’s still something that we need to understand.
	So Denise, can we do this? We also have plenty of listeners that are going to be in the age of say 50 to 55. The key thing here is that they’re under 59 and a half. So can you speak to that crowd that is under 59 and a half. Let’s just go with the example of someone that’s 50 years old right now. They do not have a Roth account and they have an opportunity to start doing Roth conversions because their income situation is low. So we’ve deemed that a Roth conversion makes sense, they’ve never opened a Roth IRA in their life and they’re under 59 and a half. Could you walk us through an example of what that specific person needs to be thinking about?
Denise Appleby:	If they’re going to be taking distributions?
Murs Tariq:	Well, what they would want to think about if they’re going to be taking distributions, yes, before the age of 59 and a half and then we can go-
Denise Appleby:	Right. Yeah. The goal is to wait until I’m retired to start taking money out, but then life happens, right? So you’re age 50, under 59 and a half, and you need to take money from your Roth IRA. If you haven’t had the Roth IRA for at least five years, and we still have to talk about the five-year period because you could be under age 59 and a half and you’re still eligible for a qualified distribution, but let’s assume that this person is not eligible for a qualified distribution because, as you said, it is a new Roth IRA, so they haven’t met the five-year period. If that person takes a distribution from the Roth IRA, we have to go to what is referred to as the ordering rules.
	Under the ordering rules, distributions are taken from a Roth IRA in a specific order. You have what I like to call three tranches or three levels. Let me say levels because I can pronounce that better than tranches. So you have three levels, right? You got to say to yourself, “Where’s my distribution coming from? Which level?” The first level is, so look at it like a cake and you’re eating from the top of the cake, right? The top layer is your regular Roth IRA contributions, and if you rolled over any money from Roth 401(k) plans to your Roth IRA, that would include any basis that was rolled over too.
	So level one, regular contributions basis from Roth 401(k)s, what, 403(b)s, what, 457(b)s. You take those out first, they’re always tax-free and penalty free, right? When you’re done with that level, you go to the second level, which is conversions from traditional SEPs and simples and roll over from the pre-tax side of say 401(k) pension plans. Those amounts, when you take them out, are going to be subject to a 10% additional tax or early distribution penalty unless you qualify for an exception. The question becomes, well what are the exceptions?
	You see those exceptions that apply to traditional IRAs, they also apply here, but there’s a bonus exception which says if you had converted that amount for at least five years, then you get an exemption to the 10% early distribution penalty. So in your example where this person just started the account, which means they haven’t funded the Roth IRA or converted the amount at least five years ago, they’re going to owe the 10% penalty but no income tax.
	Now if they used up all of level two and now they’re in level three, that’s earnings. That’s going to be taxable, that’s going to be subject to the 10% early distribution penalty unless they qualify for an exception. So what I like to tell people is, “Okay, so you feel like you have no choice but to take money from your Roth IRA. Make sure that you stay away from level three because that’s going to be taxable because it’s non-qualified, and if you can, stay away from level two as well because even though it’s not going to be taxable because you paid taxes at the point of conversion, it’s going to be subject to the 10% additional tax unless you qualify for an exception.”
Radon Stancil:	Okay. So that lays out some nice guidelines. I do want to though before we go on and continue to talk, because you brought it up right before we got into this particular question. So let’s go back to the scenario of my conversions and you said each time I do a conversion, I have basically I think a five-year rule on each one of those conversions. Now here’s a tricky question maybe, but whose responsibility is it to track? Because let’s say I do a $10,000 conversion over the next five years, how am I knowing where I’m getting that money from and I’m tracking that? Do I need to have a spreadsheet that says, hey, here’s when I did this, this and this? How do we really need to think about that?
Denise Appleby:	Yeah, ultimately it is the customer’s responsibility. The IRA custodian will not track this. There’s no way they can, right? Because all of your IRAs are aggregated for that purpose. When it comes to IRAs, there’s a lot of aggregation going on. You are aggregated for when you started the first five-year rule. You’re aggregated for what year you did a conversion. So you did a conversion in 2023 and you did a conversion in 2024, 2023 is separate. The IRA custodian doesn’t know if you also did a conversion somewhere else for 2023. So the IRS says, “Custodian, if you don’t know if they qualify for an exception, if you don’t know if they’re eligible for a qualified distribution, report it as a non-qualified distribution that does not qualify for an exception.”
	So now when you go to the CPA to file your tax return, you’re going to have to show them proof that you qualify for the five-year rule or any one of the other exceptions, otherwise you’re going to owe the 10% early distribution penalty. What I usually say to clients is store those documents like your form 5498 that shows the contributions and the conversion, store them in say a Google file that you know you’ll forever have access to as long as you don’t lose your password.
	Because sometimes we have so many mergers and acquisitions, you move over to custodian A, B, C and two years later they can’t find the document that you funded your Roth IRA for the other firm that they moved over from even though they’re required to. But sometimes things happen. So as taxpayers, we have to be responsible for protecting ourselves as is allowed under the tax code or we’re going to owe taxes, we’re going to pay taxes. We won’t owe it, but we’ll pay it because we don’t know that we don’t owe it because we don’t keep proper records.
Radon Stancil:	Okay. I want to build a little quick scenario for you and then we’ll move on to another question. So I’m going to use easy ages and math. Let’s say I got a 60 year old person who has had a Roth now for well over five years, okay? So they’re 60. They’ve got let’s say $100,000 in their Roth, right? But last year they did a conversion, right? So we’re one year into this conversion, and so they did a conversion last year of let’s just say… So they had 100,000, they did another 100,000 on conversions, so now they got $200,000 in their Roth. Now that one conversion that they did, now even though they’re over 60 and they had the Roth open, they’ve got to wait five years on that conversion before they can get to it. Am I understanding that right?
Denise Appleby:	No, and I love the way you posed that question because it allows me to answer the question of what’s the purpose of the second five-year rule. It’s only to determine if you’re subject to the 10% additional tax on a conversion, right? If you’re over age 59 and a half, you don’t owe the 10% additional tax. So you don’t need to keep tracking the five-year rule for conversions. You’re home free. In a case where someone is at least age 60 and has had a Roth IRA for at least five years, we don’t track anything. All we need to prove is that you have met the five-year rule and you’re at least age 59 and a half.
	So that’s a very nice place to be, no longer required to track anything. So if your client is at least age 59 and a half, the only question then becomes: have they had a Roth IRA for at least five years, right? Then if the answer is no, the only thing we need to be concerned with is level three because then distributions from that would be subject to ordinary income tax.
Radon Stancil:	I’m going to say one thing here, then I’m going to let you-
Murs Tariq:	I’ve got another example question too. Go ahead.
Radon Stancil:	Okay, so very quickly, I want this I think to kind of come into somebody’s head and what I’m going to say at this point is even if I only did a very small little tiny conversion, I want to do something I think earlier than later to get my Roth open. So when I get down to that point that I’m going to have it open, whether I do a contribution or a small conversion of some sort, because I’m just trying to establish that I’ve got a Roth open. So for me right now, we actually can do a Roth 401(k). I cannot do a Roth contribution for all the guidelines there, but I could do a small Roth conversion just to make sure I’ve got the Roth open.
Denise Appleby:	Yeah, excellent strategy. I say that to everyone, start your Roth five-year clock right now. Make sure it’s legitimate because that’s part of what you alluded to. Can’t be a regular contribution if you’re not eligible, but it can always be a conversion. So use that to start your five-year clock for qualified distributions.
Murs Tariq:	So I’m going to go back to one more example I think to bring it home. Go back to being a 50 year old person. They’ve never had a Roth, but from 50 to 60 they’re doing $10,000 conversions every single year from 50 to 60. So 10,000 for 10 years, 100,000 of conversions have made it into the account. I’ll say it back to you and tell me if I’m right. They opened the Roth, it’s been open for 10 years. So our five-year rule on that side has been checked. We’ve made it to age 60 before they need to take a distribution. So a qualified distribution rule has been checked. So am I saying it right that on any distribution going forward after they reach age 60 is going to be tax-free, no penalty and they can tap into the growth without penalty as well?
Denise Appleby:	Absolutely. Perfectly said yes.
Murs Tariq:	Okay, great. So I’ve just got a curious question because legislatively, things are always kind of up in the air, right? The RMD age is moving around, and has moved around a lot in the last three years since the pandemic because of the SECURE Act. Have you heard anything about legislative changes coming or that are on the table that hopefully never get passed around Roth IRAs and five-year rules and tax-free growth? Have you heard anything around that?
Denise Appleby:	No, I haven’t heard anything. As you know, a few years ago they tried to take away some Roth provisions. They even included it in a draft proposal, but it never made it. If you look at the provisions on the SECURE Act 2.0, that’s very Roth friendly. They’ve been adding a lot of Roth provisions. My opinion is I don’t think Roth is going anywhere because that’s how the IRS gets their money, right? Traditionally, it’s tax deferred, tax deferred growth and so they have to sit there and wait to get the income taxes. Whereas Roth IRAs, they get paid upfront. I think, like most people, pay me upfront and that works for me because I am sure that I’m getting my money now instead of possibly later. So no, I haven’t heard anything negatively. I don’t think anything is going to happen if my opinion counts.
Radon Stancil:	So real quick, I want to get one clarification. These are all my questions for me, okay? So if I do a Roth 401(k), I want to go back to that, let’s say I start a Roth 401(k), does that start my five-year clock or does it need to be a Roth IRA?
Denise Appleby:	It needs to be a Roth IRA. Excellent question. So you’ve had your Roth 401(k) for six years, right? You’ve never had a Roth IRA, you roll it to your Roth IRA, brand new Roth IRA. Guess what? The five-year period for the Roth IRA just started. Does not carry over.
Radon Stancil:	Okay, excellent. So this is such a great education I think just for everybody because it’s not something… Murs and I work with IRAs all the time, not with the five-year rule all the time. So the idea is, okay, we want to make sure we’re really clear on this and that’s why we’re so happy to have your expertise in helping with us. Now, are there any things that you think that we’ve not asked that you say, “Hey Radon, make sure you guys are thinking about this”? Anything around whether it be the five-year rule, IRAs, Roth IRAs, anything like that that you think, hey, this is something I see that people overlook or we want to make sure that we hone in on that?
Denise Appleby:	Yeah, there are a lot of things to think about when it comes to the five-year rule for determining if a distribution is qualified, right? The one that you just talked about, Roth 401(k) doesn’t start it for the Roth IRA, it starts with a Roth IRA. If a spouse beneficiary inherits a Roth IRA, the five-year period, if the spouse treats it as her own, let me just say her, simpler, if she treats that her own, then her husband’s five-year period and her five-year period are merged and she gets the earlier of the two, right? But if she moves it to a beneficiary IRA or any non-spouse beneficiary, they inherit the five-year period for the decedent.
	So the beneficiary needs to know that this Roth IRA that I inherit met the five-year period because it doesn’t start with me, it starts with the decedent. So accountants need to ask that question for inherited accounts. Do you have documentation that shows when the account was started? Because if it has been at least five years, now we have an inherited account, then everything’s tax free and penalty free because for qualified distributions it’s five years and either death, disability, 59 and a half or up to 10,000 for first time home buyer purposes. So beneficiaries would be tax-free, penalty-free if the five-year period has been met.
Murs Tariq:	All right. Well, very good. Denise, thank you again for hopping on today. Clearly there are things that you need to think about when it comes to Roth conversions, five-year rules, IRAs, retirement planning in general. So that’s why we’ve decided to partner with Denise as a consultant to have in our back pocket when we have questions like this to answer for our clients. But if you’re listening and it’s always going to be good to have an expert on your side when it comes to these nuances that can potentially get you in trouble down the road from a tax perspective if you didn’t think it through all the way. So we are here as always for any questions that you have around this topic, this episode, or anything else that we’ve discussed in the past, and we’re always happy to bring as much knowledge to the table as we can. So Denise, thank you again for being here.
Denise Appleby:	You’re very welcome. they should contact you about R&Bs too. R&B season’s coming up. You guys are very good when it comes to that. So hopefully they’ll contact you with your R*B questions as well.
Radon Stancil:	Yeah, thank you very much Denise for bringing that up too. I always like to remind people, if you do have questions, you can just go to the website, go to the top right hand corner, click on schedule call, and it’s a 15 minute call that you can get on the phone with myself or Murs and we’ll try to answer any questions you have. If we get stumped, we always reach out to Denise. So thank you very much, Denise.
Denise Appleby:	Thank you.
Radon Stancil:	We appreciate you coming on today.
Denise Appleby:	You’re welcome. Thanks for having me on. Have a great day.