Ep. 233 – Roth IRAs – 5-Year Rule and Conversions in Retirement

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In this Episode of the Secure Your Retirement Podcast, Radon and Murs discuss the 5-year rule around Roth IRAs and what conversions look like. A Roth IRA is a powerful tax-free investment tool, especially as a long-term investment growth vehicle.

Listen in to learn the difference between Roth IRAs’ contributions and conversions and how the 5-year rule applies to each. You will also learn about the five advantages of a Roth IRA: tax-free growth, not subject to RMDs, tax diversification, estate planning benefits, and hedge against future tax increases.

In this episode, find out:

• Understanding the 5-year rule on a Roth IRA’s contribution interest to be tax-free.
• The difference between a Roth IRA contribution and conversion.
• Understanding Roth IRA conversions and how the 5-year rule applies to it.
• How to start your Roth IRA clock by opening an account immediately, even as a high-income earner.
• A scenario to help you understand the power of Roth IRA conversions as a long-time growth vehicle.
• The advantages and disadvantages of a Roth IRA and the importance of knowing them.

Tweetable Quotes:

• “If you’re along the line of thinking that taxes in the future are going to be higher than they’re today, a Roth IRA is an extremely powerful tool.”– Radon Stancil
• “When it comes to developing a withdrawal strategy with a sizable tax-free asset like a Roth IRA, we can blend things to optimize our tax brackets as we go through retirement.”– Murs Tariq

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 to Secure Your Retirement Podcast. Today, Murs and I have a topic that we know that a lot of people today are really concerned about and that is Roth IRAs. It’s a very big topic because if you are along the line of thinking that taxes in the future are going to be higher than where they are today, a Roth IRA is an extremely powerful tool. And the reason why is because whatever I contribute into a Roth now will grow with no taxes on the growth and I can pull those dollars out without taxes. Here’s the caveat. There’s a rule, and the rule is called the five-year rule. And what we want to do today is really talk through this five-year rule and then we’re going to talk through, actually, what a conversion could look like and the power of it. So this is a extremely powerful tool.
	You just need to know the rules, and once you understand the rules, you can do it confidently. You don’t have to worry and think about, hey, is this something I really want to do? First of all, we’re going to talk about the contribution, meaning I’m contributing to a Roth, and then we’re going to talk about a conversion. Two different things. On a contribution, by the way, I have limits of how much I can put in. On a conversion, I don’t. And so Murs will take you through those rules. But I can contribute into a Roth but I have some rules. One of those is my income level. We’re not going to go through that today, just know that there’s an income level. But there’s a way around that some ways, and that is today, many companies are offering what are called Roth 401(k)s where there is not an income limit. There is just a contribution limit, just like you would have on any one of the 401(k)s.
	So again, today, it’s about the five-year rule. So we’re not going to go through all those details. So here’s how it works, if I put money into a Roth, let’s just say I’m contributing to a Roth, not the 401(k) Roth, a traditional IRA Roth IRA, and I’m putting money into it, my contribution is 100% liquid. I can take it back out of the Roth, no matter what my age is, I put $10,000 in, I can take $10,000 back out. The five-year rule actually is about the interest earned on the account. So I’m going to give a couple different examples. Let’s say that I am 40 and I put money into a Roth IRA and I put $10,000 in and let’s say that I am now 50, 10 years later and the $10,000 I put in has now grown to $20,000. So it’s doubled. I’m 50, well, I’m past five years but I haven’t met the next rule.
	The next rule is I’m not 59 and a half. So I’m 50, I got $20,000 in my Roth, I can take back out the 10,000 I put in, I just can’t touch the $10,000 of growth. All right? Now, the majority of our clients and listeners are over 59 and a half. So let me give you an example of a 60-year-old. So a 60-year -old contributes to their Roth IRA, they put the money in and four years later, it has three or $4,000 of interest. They are now bound to the five-year rule on that interest because it was a new Roth, they put the money in, they’ve got to wait five years before they can take their interest. So that’s the five-year rule on contribution. So I’ve got to be 59 and a half and at least five years into the Roth IRA before I can take that interest out without paying a 10% tax penalty and taxes on the interest.
	So if I want it to be 100% tax-free, I’ll say it one more time, on a new Roth, I have to wait at least five years and 59 and a half, and if you want to think about it, whichever one is longer. So I might be 60, well, I’m already there, so the longer is five years. So I’ve got to wait that period of time. Now we’re going to share a little of what we call pro-tip here in just a minute, but I don’t want to go down that path until Murs hits on conversions.
Murs Tariq:	So a key distinction on what is a conversion, so Radon just went through contributions and this gets confused quite often. Contribution, like Radon said, is subject to annual limits. It’s also subject to income limits as to whether or not you can contribute to a Roth IRA. A Roth conversion is not subject to limits at all. So you could convert a million dollars. Where you converting from, you’re converting from pre-tax assets. So if say you have a traditional IRA that’s got a large chunk of money in there, you can convert whatever you want to convert from a dollar perspective. The thing that we have to realize is that on that conversion, we are accepting the fact that we want to pay some tax today to get it into this Roth or this tax-free bucket. So that’s understanding what a conversion is. Now, once we understand what a conversion is, now we have to say, well, how does the five-year rule apply to me?
	And like Radon was saying, for most of our listeners, we’re around that age of 59 and a half and above, so let’s go with Radon’s example. We’ve got someone that’s 60, they’ve got $1 million IRA, all pre-tax, they decide to convert $100,000, say, this year. This is the first time that they’ve ever owned a Roth IRA. That’s a key thing that’s going to come back to our pro-tip here. The first time they’ve ever opened a Roth IRA at the age of 60, they’re converting 100,000 into this Roth IRA. They’re above the age 59 and a half, so that checks one of the boxes. The other boxes that we have to check now is, well, this is their first Roth IRA, so it has to wait five years before we can actually take advantage if we need to withdraw on the tax-free growth.
	Now, they could come back two years later and say, I had an emergency, I need to repair the roof, can I get 30,000 of my 100,000 that I put in? We look again at the rules, they’re above age 59 and a half, so there’s no early withdrawal penalty. And on Roth conversions, just like contributions, you can take out what you put in. You just can’t tap into the tax-free growth until five years has been hit. So that is a simplistic way of looking at the five-year rule on contributions and conversions. Realize that if you are under the age of 59 and a half, there are things that you want to think about.
	And there’s also exceptions to the rule of 59 and a half that can be around disability, death or first-time home buyer. Those are all little exceptions. So if you have any questions around, hey, I’m 50 and I want to get into conversions, well, that really needs… you need to have a conversation with a financial professional around that. Who we’re talking to today is really the person that is around that retirement age and trying to shape up their tax-free bucket for retirement. Now, so that’s the high level on the five-year rule, but what’s our pro-tip, Radon?
Radon Stancil:	So the clock starts from when I open or contribute into my Roth. So go back to the factor, now, we did all of that around this idea of opening a new Roth, but if I did a conversion… let’s say I did a little conversion, nothing big, when I am 55 and now I’m 60 and I do another conversion, now I’m above the 59 and a half guideline and my Roth IRA has been open for five years, so my clock has already been satisfied. And so it gets me into a scenario where I don’t have to worry about the five-year rule going forward. So here’s our pro-tip. If you do not have a Roth open and you want to make sure you get your clock started, go ahead and do a conversion. I don’t care if it’s $100, do a conversion and get it into a Roth, or get it open.
	So you might be thinking, well, I’m 55, I’m a high income earner, I can’t contribute to a Roth. You can do a conversion, you can convert. So if you’ve got a little tiny, then just go ahead and convert and get it in there. You got this little now Roth with 100 bucks in it, don’t worry about that. The point is all we’re trying to do is get the clock started. And so if you do not have a Roth, get the clock started. I’m going to go back to what Murs said, if you’re listening to this and you’re going, whoa, I need to understand this more and I need to get this detail, just go to our website, top right-hand corner, click on schedule call, hop on a 15-minute call with us, we’ll give you some more detail individually on that.
	So now what we want to do though is we want to take you through an example so that you understand the power of the Roth conversion, as well as how… We’re going to walk you through the kind of what’s taxable and what’s not taxable in this scenario. So now, in this scenario, we’re going to make the person 60 because we’re going to have already said we’re 59 and a half, but they’re opening a brand new Roth because they’re going to start doing conversions. And they’ve got some traditional IRA and they’ve decided that over the next five years, they’re going to do $50,000 a year into this conversion, or 250,000. So Murs, can you walk us through what that looks like and give us the, we read it with a very conservative rate of return, just so we can understand this?
Murs Tariq:	So we’re making some assumptions here. The person is 60, so we’re not worried about the 59 and a half rule. They’re converting 50,000 a year for the next five years into a brand new Roth account. So they’ve never had a Roth account before. And the other assumption we’re going to make is on growth. So it’s invested and it’s invested to grow. It’s going to earn 5% annually compounding. And so year one, we have that $50,000 conversion, and we’ll talk about the taxes in a second, but imagine 50,000 makes it into the Roth IRA. We have growth on that Roth IRA. So the 50,000 grows times that by 5%, that’s 2,500 bucks of growth. So by the end of year one, we have our 50,000 conversion plus the growth. So our total account balance is 52,500. We walk into now year two, another conversion, 50,000, 5% growth on the entire bucket.
	It’s cumulative growth. So now our growth has grown to 5,125. And so now our account that was at 52,5, we’ve added 50,000 of a conversion. We’ve also had interest that was earned. Now our balance is 107,625 at the end of the year. Walk into year three, another exact same scenario, 50,000 conversion, but now we have a bigger bucket of money that is earning 5% interest. So the interest is a little bit higher, around 70 or exactly $7,881 and 25 cents of interest that is earned. So now our total at the end of the year, we started with the 107,625, we added the $50,000 conversion, the conversion… or the bucket of money itself earned some interest better than $7,000. So now our ending balance is 165,506 and 25 cents. So you see the power here of just cumulative growth on money, money growing on top of money.
	Year four, same scenario, 50,000 goes in, bigger bucket of money that can earn more interest by the end of this year, year four, now we have grown to 226,281 and 56 cents. And now year five, our final year of conversions, same scenario, 50,000 goes in for the conversion. And so we were at 160… I’m sorry, 226,281 was our beginning balance. We added in a $50,000 conversion. We had interest earned of 13,814 and 8 cents. So now by the end of year five, we started the account at zero five years ago, we’ve contributed $250,000 of conversions and we’ve earned interest along the way. By the end of year five, our balance is now $290,095 and 64 cents. I need to take a break here because that was a lot to go through, a lot of numbers there. Obviously, Radon will remind you that we are going to have a blog that’s going to list all this out. And so now, Radon, let’s walk through, well, what does all this mean?
Radon Stancil:	Yeah. I’m sorry, Murs, did you, year four, talk about the growth and what would-
Murs Tariq:	I have not.
Radon Stancil:	All right, so-
Murs Tariq:	Let’s go through an example of maybe needing to take a withdrawal.
Radon Stancil:	Yeah. So go back to year four and when I’m at year four, just to recap his numbers, we basically now have a balance of $226,281. At year four, we’ve contributed though 200,000. So this is our little test on what we have access to. So right now, I’m going to ask you, what do you have access to on that $226,281? Answer it to yourself. That’s right, you got it, $200,000, you have access to. What you do not have access to yet is the $26,281 and 56 cents. Why? Because that’s growth. And we’re only four years in and it’s a new Roth. Now, the end of the year five, I have access to all of the money, because I’m 65, I’ve got access to it. I want to tell you though, the real power, I want you to understand, because a lot of times, people are doing this for… they say, I don’t want to access this money until I absolutely have to.
	And ultimately, I might want this money just to go to the kids. So either one of those scenarios, let me just walk you through some math. Remember where I’m at now, I’m five years in, I’ve got $290,000. And I said, what if I let this money sit there for 15 years? This doesn’t have to be a person who’s 65. Just forget that part. I let it sit there for 15 years, 15 years earning 5%. Now, my balance is going to be $602,998 and 22 cents. So now, remember how much I put in, I put in 250,000, now I got 602,000. So I’ve made about $350,000 in earnings. Now, here’s the power, imagine that I had to take that 350,000 out and pay taxes, how much would I pay in taxes? Well, depending on our tax bracket, it would be a huge chunk.
	Here’s the power, let’s say that I did these conversions over that five-year period at a 22% tax bracket. How much money did I pay? If it’s 22% on a $50,000 conversion, I paid $11,000 of taxes. Now, I take 11,000 and I multiply that times five, I paid a total of 55,000, so I paid 55,000 to now have $350,000 total net profit 100% tax-free. Does that sound like a pretty good deal? I think it does because now I’ve got all that money. And by the way, we have no idea. What if that $300,000 profit in the future had a 30% tax bracket? What would I owe? $90,000. So I got a much lower tax burden and I got this nice growth. But everything has an advantage and everything has a disadvantage. So let’s just run through quickly here, Murs, advantages of the Roth.
Murs Tariq:	And I like the advantages because I love the Roth. I think it’s very powerful. There’s, in our eyes, five major advantages. One, obviously, is the tax-free growth in retirement. So you’ve got access to a bucket of money that is growing tax-free over time, and we just showed you how powerful those numbers can be, especially if we look at it as a very long-term growth vehicle. The second advantage is going to be that a Roth IRA is not subject to required minimum distributions. Required minimum distributions are once you reach a certain age, either 73 or 75, depending on when you were born, the IRS forces you to start taking withdrawals on your pre-tax assets like traditional IRAs, 401(k)s and other retirement plans that you haven’t paid any taxes on. At that age, you’re forced to withdraw whether or not you want. A Roth IRA is not subject to RMD.
	So now, you get flexibility. You’re back in control of a chunk of your assets, which is very nice. The third is tax diversification. Well, what does this mean? Well, think about it, if we have cash assets, if we have pre-tax assets, and now if we have a sizable tax-free asset, well, now when it comes to developing withdrawal strategies, we can blend things together to optimize our tax brackets as we go through retirement. So that can be pretty powerful as well. And then number four, I think, is huge. The reason why a lot of our clients are doing Roth conversions is the potential benefits for the estate and estate planning. The Roth IRA, say it grows to a large amount because you started early and you never touched it, it grew and grew and grew, maybe it ends up being five, $700,000 by the time that you leave it to your beneficiaries.
	The rule, once you leave it to your beneficiaries, is it has to be cleaned out of the account 10 years after it is inherited. That is a quick way of saying what the inherited IRA rules are. 10 years is where the beneficiary has to have cleaned out the entire account. So the one major benefit is once that beneficiary receives the money, it’s tax-free money. So they can withdraw on it as they want, but the ideal scenario is they get the money, say it’s $500,000 they inherit, they don’t touch it as best as they can. They leave it alone for 10 years and say it grows to a million or more. Now, they clean it out, they’ve got a much larger tax-free growth. They clean it out and there’s no taxes due on that. So from a legacy planning perspective, tremendously powerful. And then, obviously, the last one is going to be we can hedge against future tax rates increasing.
	So if we have a sizable tax-free bucket, we’re not too worried about our income strategy and our withdrawal strategy if our tax rates are going up in the future. We know in 2026, there is a sunset that is happening, tax rates are going up unless there’s significant legislative change. So if we have a tax-free bucket and tax rates go up, well, this bucket is not affected one bit, which is really nice. Now, those are pros, and I think I sold it pretty well, but there are some disadvantages that we have to think about. Not everyone should be doing a Roth conversion, so don’t take that away from this message here today.
Radon Stancil:	I’m going to call these disadvantages, just really things you need to know because I think if you listen to the disadvantages, it’s just things that you need to know about, but not necessarily that bad. First of all, immediate tax burden. I don’t know that that’s a real disadvantage. It’s just going to hurt. Nobody likes paying taxes, and everybody would like to have that tax year where you don’t pay a lot of taxes or no taxes, and now all of a sudden, you’re going to consciously do something to make you pay taxes. So it’s just something you need to know. You’re going to have to do it. Some might call that a disadvantage. The other is a potential of lost benefit. What does that mean? Well, if you did this and you were at a certain tax bracket and 15 years from now, you are at a lower tax bracket, that was not a good deal.
	So if you do it today, you are along this idea that a tax rate in the future is going to be higher. So here’s the thing, Murs talked about what we call tax diversification. Tax diversification says we don’t know what the future tax rates are going to be. Even if you are a person who thinks there’s no way taxes are going to be lower, it could be. We don’t know. It could be for you, at least. That’s why we call it tax diversification. The other is loss of liquidity. If you do the Roth the way we say you should do the Roth, if you have the ability to do, is to not do withholding out of the conversion, but to actually do it from money that’s not in an IRA.
	Maybe it’s cash in the bank, a brokerage account, whatever it might be. So you’re going to now go give that money to the IRS, which means you don’t have it anymore, to be able to do this Roth. So you just have to understand, is it worth it to do that? Then the fourth one and the final one is the five-year rule. Oh, I’ve got one more, Murs says.
Murs Tariq:	Yep, we’ve got one more good one.
Radon Stancil:	Five-year rule, that one, we’ve already explained. Now, the fifth one and the final one is, it says potential impact on other benefits. What this is about, and we have a whole episode on this, is that if I were to convert, and I’m at the age of Medicare age, there’s a thing called IRMA, and I could, in all essence, make my IRMA… my part B and D benefit, I might have a surcharge on it. I call that another tax. So we do throw people into an IRMA surcharge sometimes, but with full knowledge and understanding all the numbers because it’s only one year that we’re impacted on the conversion. And so if you don’t understand IRMA and I just threw you out right there, go find our episode on IRMA and we’re glad we explained that in much detail, and we do one every single year because IRMA surcharges or the way the calculations are done is redone every year.
	All right, we went through a lot. I just want to remind you before we close, there is an entire blog written on this. Just go to our website, pomwealth.net, go to the blog page. There’s a nice blog, has all the numbers that we all went through, so you can see all that, read it and understand it. Want to remind you again, if you’re looking at this and you’re thinking, man, I got some questions, go to our website, top right-hand corner, click on schedule call. You can see our schedule. You can make that 15-minute call. We tell you right up front, we may not be able to give you all the answers in the 15 minutes, but at least we can understand the situation and then schedule a call that we can go into all the details. All right, we hope this has been beneficial. We’ll talk to you again next week.