Two Roth Rules You Need to Know

Back in 1998, which seems like a long time ago now, Roth IRAs came into existence.  It was a brand-new concept: you put money in on a post-tax basis, and as long as you follow certain rules, the earnings can all be withdrawn tax-free.  IRAs before that worked just the opposite: money goes in on a deductible basis, and then all of it is taxed upon withdrawal.

The key phrase I mentioned a moment ago was “follow the rules.”  Yes: Roth IRAs have certain stipulations associated with them to help ensure that their tax-favored status isn’t abused.  To be specific, a Roth IRA has two different sets of 5-year rules that you need to know about to avoid losing the tax-free or penalty-free status.

The first five-year rule has to do with the earnings and tax-free gains.  In order for your Roth earnings to come out tax free, five tax years must pass from the first tax year your first contribution was made to ANY Roth IRA you own.  Once you’ve made that first contribution, the 5-year clock starts ticking, meaning that any Roth contributions you make after that will be based on the initial 5-year clock.  So in other words, there isn’t a new 5-year clock for each subsequent Roth account you hold, nor is there one for your later contributions.  They’re all aggregated to determine if the rule has ultimately been met.  Once you’ve satisfied this 5-year rule, it’s satisfied for good, as long as you maintain a Roth balance in any Roth account.

One thing to keep in mind, though: even if you’ve met this 5-year rule, you’ll only get a tax-free distribution of earnings if you’ve satisfied the entire test: meaning you’re at least 59 ½ years old, or through death, disability, or first-time home buyer rules.

The second 5-year rule has to do with Roth conversions from pre-tax retirement accounts, and whether or not your withdrawals of converted principle are subject to penalties.  And in this case, unlike the first rule regarding contributory Roths, each converted amount has its own 5-year clock.  So if you’ve made multiple Roth conversions in different tax years, you’ll have multiple 5-year clocks running at the same time.

And when you take money out of a converted Roth, it’s done on a first-in, first-out basis.  First out is contributed principal, then converted principal (with the oldest conversion first), then earnings.  One nice thing, though, is that once you reach age 59 ½, this particular 5-year rule no longer applies at all, because being over age 59 ½ is itself an exception to the penalty!

The main takeaway is that even though Roth IRAs can be really useful savings tools for some people, if you’re not aware of the rules, your tax-free investment could wind up costing you both taxes and penalties.  If you need guidance on this or any other tax strategies, just give us a call, or contact us right here through our website.  We’re always here to help!

Important Information:

The information provided should not be considered specific tax, legal, or investment advice and is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances. This material was gathered from sources believed to be reliable, however, its accuracy cannot be guaranteed.

You should always seek counsel of the appropriate advisor prior to making any investment decision. All investments are subject to risk including the loss of principal.

This material was gathered from sources believed to be reliable, however, its accuracy cannot be guaranteed. No client or prospective client should assume that the presentation (or any component thereof) serves as the receipt of, or a substitute for, personalized advice from Lucia Capital Group or from any other investment professional.

Roth IRA distributions of principal from a Roth IRA are tax-free; however, any earnings will be taxed at ordinary income rates and a 10% penalty tax will apply if withdrawn prior to age 59½ or within five years of the date the Roth IRA was established, whichever is longer.

IRA withdrawals will be taxed at ordinary income rates. Withdrawals prior to age 59½ may also be subject to a 10% penalty tax.

Rick Plum is a registered representative of, and offer securities through, Lucia Securities, LLC, a registered broker/dealer, member FINRA/SIPC. Advisory services offered through Lucia Capital Group, a registered investment advisor, and an affiliate of Lucia Securities, LLC. Registration with the SEC does not imply a certain level of skill or training. John Dean is an associated person of Lucia Securities, LLC.

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