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Two Roth Rules You Need to Know

The Roth IRA was made available to us back in 1998, and for many people it’s been a useful tax-advantaged tool to help save for retirement.  If you’re unfamiliar with the Roth IRA, it works like this: You put money in on a post-tax basis, and, if you follow the rules properly, any potential gains you realize from the investments in the account can be withdrawn tax-free.  Not a bad deal!

Of course, we said there were “rules.”  Roth IRAs have certain stipulations associated with them to make sure their tax-favored status isn’t abused.  In particular, there are two different Five-Year Rules that are attached to Roth accounts that you need to be aware of.

Earnings In the Roth

The first 5-year rule applies to earnings in the Roth and determines whether the gains in the account will be tax-free.  The second one applies to Roth conversions, and that determines whether or not you can access your converted principal PENALTY-free.  You really need to know about both.

Regarding the first five-year rule, in order for the earnings in the Roth to come out tax free, five tax years must pass from when your first contribution was made to ANY Roth IRA you own. Once you make your first contribution to a Roth, that 5-year clock starts ticking, which means that any subsequent Roth contributions you make will be based on that initial 5-year clock. So there’s not a new 5-year clock for each Roth contribution, nor is there one for each Roth account you hold. All of them are aggregated to determine whether the rule is ultimately met. Once this 5-year rule has been satisfied, it’s been satisfied for good.

Keep in mind, though, that even if you meet this 5-year rule, the distribution only qualifies as tax free if you’ve satisfied the entire test – that is, 5 years AND you’re at least 59 ½ years old, or though death, disability, or under the first-time home buyer rules.

Roth Conversions From Pre-Tax Retirement Accounts

The second 5-year rule is associated with Roth conversions from pre-tax retirement accounts, and it dictates whether your withdrawals of the converted principal are penalty-free or not.  And unlike the first rule for contributions, each converted amount has its own 5-year clock. So, you could have multiple clocks running if you’ve made multiple conversions. And once you make withdrawals from Roth conversions, they come out on a first-in, first-out basis – contributed principal, then converted principal with the oldest conversion first, then earnings. But the cool thing is that once you reach age 59 ½, this 5-year rule goes away, because being over age 59 ½ is itself an exception to the penalty!

The takeaway here 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 do this every single day, and 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.

Different types of investments and/or investment strategies involve varying levels of risk, and there can be no assurance that any specific investment or investment strategy (including the investments purchased and/or investment strategies devised by Lucia Capital Group (“LCG”)) will be either suitable or profitable for a client's or prospective client's portfolio, thus, investments may result in a loss of principal. Accordingly, 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 LCG or from any other investment professional.

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.

Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA.

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

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.

Rick Plum is a registered representative with, and securities and advisory services offered through LPL Financial, a registered investment advisor and member FINRA/SIPC. The investment professionals are affiliated with LPL Financial and are conducting business using the name Lucia Capital Group, a separate entity from LPL Financial.

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