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You Need to Know These Two Roth Rules!

The creation of the Roth IRA back in 1998 gave us an entirely new financial planning tool — one that both retirees and those who are still saving for retirement could potentially use. Since that time, it’ turned into a useful tax-advantaged tool for many people to help offset and maybe even eliminate certain taxes post-retirement.  

If you don’t know how the Roth IRA works, it goes like this: You put money into a Roth account on a post-tax basis, and, if you follow the rules properly, any gains you may realize from the investments in that account can be withdrawn tax-free.  I don’t know about you, but we love it when anything is tax free! 

Of course, I did say that there are “rules,” and you do have to follow them.  Roth IRAs have certain stipulations associated with them to make sure their tax-favored status isn’t abused.  In particular, you need to know about the two different Five-Year Rules that are attached to Roth accounts so that you don’t get hit with any tax penalties.  

The first 5-year rule applies to earnings in the Roth, and this rule determines whether the gains in the account will be tax-free to you or not.  The second rule applies to Roth conversions, and that determines whether you can access your converted principal penalty-free.   

Here are the quick facts for you. 

Roth Earnings 

Regarding the first five-year rule, in order for you to get the earnings in the Roth on a tax-free basis, 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. 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. 

And the good news is, once this 5-year rule has been satisfied, it’s been satisfied for good. 

Keep in mind, though, that meeting this 5-year rule is only step one for getting to the earnings tax free.  Even if you meet this 5-year rule, you’ll only be able to get the distribution out tax free if you’ve satisfied the entire test – that is, it’s been 5 years AND you’re at least 59 ½ years old, or through death, disability, or as allowed under the first-time home buyer rules. If both sides of that rule aren’t satisfied, the distribution of earnings could be subject to ordinary income tax and even a 10-percent pre-age 59 ½ penalty tax. 

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 that I talked about a moment ago, each year’s converted amount has its own 5-year clock. So, you’ll have multiple clocks running if you’ve made conversions over multiple years  

If you haven’t met the previous 5 year AND 59 ½, death, disability rules, distributions come out on what’s called a first-in, first-out basis – contributed principal first, then converted principal with the oldest conversion first, then earnings last. But the really nice 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! 

Yes, this can all be really confusing. And even though Roth IRAs are often 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.  

When it comes to tax strategies and tax management, making the wrong move could hurt you in a really big way. If you’re wondering whether a Roth is right for you, or if you need guidance to help determine if a Roth conversion may be suitable for your situation, just give us a call. We do this every single day at Lucia Capital Group, 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 will be 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 information presented serves as the receipt of, or a substitute for, personalized advice from Lucia Capital Group 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.

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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