Roth IRAs are powerful retirement accounts that offer tax-free benefits. However, to fully enjoy these benefits, it's crucial to understand and abide by the two five-year rules set by the IRS. In this blog post, we will break down these rules and explore how they can impact your tax-free income and distributions from Roth IRAs. You can also check out the video below if you want to dive deeper.
Before diving into the rules, let's clarify the difference between contributions and conversions in a Roth IRA. Contributions involve after-tax money, where you contribute up to annual limits (currently $6,500 in 2023). On the other hand, conversions entail transferring pre-tax dollars from a traditional IRA to a Roth IRA, subject to taxation on the converted amount.
The first five-year rule applies to contributions and is a lifetime rule. Suppose you make your first contribution to a Roth IRA at age 25. As long as you don't touch that money within five years, the earnings on your contributions remain tax-free. Subsequent contributions do not trigger the five-year rule, as it is already met with the initial contribution. This rule is particularly relevant for individuals who are later in life and have significant tax-deferred accounts but haven't utilized a Roth IRA yet.
The second five-year rule applies to conversions and is specific to each conversion. When you convert pre-tax dollars from a traditional IRA to a Roth IRA, the converted amount must remain in the Roth IRA for five years to enjoy tax-free distributions on the earnings. Each subsequent conversion has its own five-year rule, making it essential to plan conversions strategically.
If you are over the age of 59 and a half, the five-year rules become less relevant. Once you meet the five-year rule and reach this age, you can make tax-free distributions from your Roth IRA without any penalties. This exception provides added flexibility for individuals in their retirement years.
Breaking the five-year rule for contributions results in taxation and potential penalties. If you withdraw earnings from a Roth IRA before meeting the five-year rule, the earnings become subject to a 10% penalty, in addition to taxation. Similarly, breaking the five-year rule for conversions leads to the converted amount being subject to the 10% penalty if withdrawn within five years.
To illustrate the impact of these rules, let's consider a couple of scenarios. In the first example, Tom, aged 58, makes a $4,000 contribution to his brand new Roth IRA and grows to $5000. After three years, he withdraws the earnings of $1,000, which becomes taxed because he hadn't met the lifetime five-year rule.
In the second example, James, also aged 58, converts $100,000 from a traditional IRA to a Roth IRA. After waiting five years, he can make tax-free distributions on the earnings. However, if he withdraws the converted amount before the five-year mark, the converted amount becomes subject to the 10% penalty.
Roth IRAs offer incredible tax-free benefits, but it's crucial to understand and adhere to the two five-year rules set by the IRS. By familiarizing yourself with these rules and planning strategically, you can maximize the advantages of Roth IRAs in your retirement planning. Remember, proper planning is key to ensure you don't inadvertently trigger penalties or taxation. If you have any questions or need assistance, feel free to reach out to us. Happy retirement planning!
Note: The information provided in this blog post is based on the transcript of a video episode by Thatcher Taylor, the owner of ProPath Financial.