October 30, 2023 Weekly Update

We do love it when someone refers a family member or friend to us.  Sometimes the question is, “How can we introduce them to you?”   Well, there are multiple ways but a very easy way is to simply forward them a link to this webpage.

Here are this week’s items:

Portfolio Update:  Murs and I have recorded our portfolio update for October 30, 2023

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

Denise Appleby 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.


Roth IRA – 5-Year Rule – Part 2 with Denise Appleby

In our last podcast (read the blog here), we dove right into one of the most common questions our clients and listeners have: Roth IRAs and the 5-year rule. Well, we decided that we need to cover this topic even more in-depth and brought Denise Appleby on the show to clear up any confusion that you may have.

Roth IRA – 5-Year Rule – Part 2 with Denise Appleby

In our last podcast (read the blog here), we dove right into one of the most common questions our clients and listeners have: Roth IRAs and the 5-year rule. Well, we decided that we need to cover this topic even more in-depth and brought Denise Appleby on the show to clear up any confusion that you may have.

Denise is an expert in all things IRAs and an excellent consultant for these types of questions.

What are the 5-Year Rules?

Denise was quick to point out that it’s not the 5-year rule but the 5-year rules. Two main rules are in place and the challenge is determining which rule applies to you.

First 5-Year Rule

This rule is used to determine if a Roth IRA distribution is qualified. This rule starts January 1 on the first year that you fund your Roth IRA, and it never starts over.

For example:

  • 2010, you contribute to a Roth IRA
  • 2023, you start a new Roth IRA because you cleared out the original
  • When did the 5-year period start? January 1, 2010.

Second 5-Year Rule

The second 5-year rule only pertains to you if you’re not eligible for a qualified distribution. Under this rule, we’re looking at Roth conversions and their distributions. If you withdraw the money that you put in within the first 5 years, you’re subject to a 10% distribution penalty.

However, the rule is very complex because it starts over with each conversion.

For example:

  • In 2020, you perform a Roth conversion
  • You take a distribution in 2023

The distribution would come from the 2020 conversion first before any conversion you do at a later date, if that applies.

This rule can be very hard to wrap your head around without an example.

Whose Responsibility Is It to Track Distributions and the 5-Year Rule?

Each conversion you make has a 5-year rule attached to it. Unfortunately, it’s your responsibility to track these conversions and how long ago they were made. For example, let’s assume that you convert $10,000 over the next 5 years.

The IRA custodian will not track these conversions. The IRS says that if a distribution is made and the IRA custodian doesn’t know the following, the custodian will report it as a non-qualified distribution without an exception:

  • If the person is eligible for an exception, or
  • If the person is eligible for a qualified distribution

It’s your burden to provide your tax preparer with the documentation necessary to show that the distributions are penalty-free. You can do this by keeping documents handy, such as your Form 5498.

You must protect yourself by keeping clear documentation of conversions. If you don’t keep proper records, you’ll pay penalties because there’s no proof that the distributions are non-qualified.

As you can see, there are a few nuances around the 5-year rule that can be complex and a bit tricky. Part of the reason why we’re diving deep into this rule for retirement planning is that you can leverage conversions now for tax planning purposes.

We know that unless there are significant legislative changes made before 2026, tax rates are going to go up.

Converting traditional IRAs to Roth accounts now may be beneficial for you and allow your money to grow tax-free. Most of our clients are doing conversions for future potential use way down the road or they’re doing it for their legacy. In these cases, the 5-year rule won’t matter to them.

With this in mind, let’s consider the following example:

Example 1: 60 Year Old with a Roth Balance of $100,000 that is Well Past the 5-Year Rule

If this person did a conversion last year of $100,000, do they have to wait five years to take distributions on this conversion? No. Because they are over the age 59 and a half, the second 5-year rule does not apply, and they can take a distribution without additional tax or penalty.

Anyone over age 59 and a half doesn’t need to track anything aside from having had a Roth account open for at least 5 years. You’re in a very nice place to be at age 60.

Because of this, we recommend that you establish a Roth account, even with a small contribution, as soon as possible. Why? Your five-year period starts ticking down the moment that the account opens. You could potentially not contribute to the account for years, but that five-year period will be ticking down, allowing you the freedom to do conversions in the future and still take distributions from the account without penalties.

Example 2: 50 Year Old, No Roth Account and Has Opportunity to Do a Roth Conversion

Imagine that this individual begins converting their accounts and assumes that they’ll wait until they’re at least 59 and a half to begin distributions. Life happens, and suddenly, the person does need to take money out of the account before then.

If they haven’t had the Roth IRA for 5 years and aren’t eligible for a distribution, then we need to look next at the ordering rules.

What are Ordering Rules?

Ordering rules pertain to your Roth IRA and distributions. Your distribution is taken from your account in the following levels:

  1. Regular Roth IRA contributions or money rolled over from Roth 401(k), 403(b), 457(b). These contributions come out first and are always tax- and penalty-free.
  2. Conversions from traditional SEPs and SIMPLEs and rollovers from the pre-tax side of 401(k) plans. Unless you qualify for an exception, these distributions will have a 10% penalty because of your age and not meeting the 5-year rule. What are the exceptions? If you converted the account at least 5 years prior, you could take distributions without penalty.
  3. Earnings, which are taxable and subject to the 10% penalty.

If you must take distributions early, you want to avoid taking money from levels 2 and 3. Level 2 money still has the 10% penalty unless you fall under very specific circumstances, and level 3 money is both taxable and comes with a penalty.

Example 3: 50 Year Old with Plans to Convert $10,000 Each Year Until 60, Never Had a Roth Before

Over the 10 years, the person has $100,000 in conversions in the account. The account has been open for five years, so one rule is checked off. The person is also 60, so they can start taking qualified distributions if they wish. Any distribution going forward is both tax-free and penalty-free. They can tap into growth without penalty as well. 

Legislatively, everything is always up in the air. Ages can change for these rules. A few years ago, the government did try to make changes to some Roth provisions, but they haven’t tried to do so recently.

Even the Secure Act 2.0 was very Roth-friendly.

Denise does not believe that Roth accounts are going anywhere any time soon because the IRS wants to be paid upfront. The IRS always wants to be paid as soon as possible, so it’s not likely that Roth accounts will be a major legislative target at this time.

Of course, things can change and new rules can be added, but we’ll keep you up to date on these occurrences.

Does a Roth 401(k) Start the 5-Year Clock?

No. A Roth 401(k) does not start the Roth IRA clock. The time that you’ve had the 401(k) open doesn’t apply to your IRA, which is very unfortunate.

What Should People Think About When It Comes to the 5-Year Rule?

Final points from Denise:

  • Having and contributing to Roth 401(k) is not the same as opening and contributing to a Roth IRA.
  • If a spouse beneficiary inherits a Roth IRA and the spouse treats it as their own, the 5-year period is considered to have begun at the earlier of the two spouse’s first Roth IRA contributions. However, if the funds are transferred to a beneficiary IRA, the accounts inherit the decedent’s period. Do you have documentation on these accounts?
  • Beneficiary IRA accounts allow for $10,000 to be used for a first-time home purchase without penalties.

Clearly, there is quite a lot to think about with Roth IRAs, conversions and the 5-year rule. Having an expert like Denise at your side is extremely beneficial when working on these accounts.

If you have any questions, you can schedule a free 15 minute call with us and we’ll be more than happy to have a conversation with you. We can even consult Denise on any complex questions.