The Roth IRA 5-Year Rules

Roth IRAs are a favorite among the tribe.  They have huge advantages for most young, and even not-so-young military and veteran families.  As with all financial tools, they come with rules.  Getting money into a Roth IRA is easy, but when you start to grow your WRM stockpile, you’ll want to know about the rules for starting to deploy your financial weapons.  Today, we’ll talk about the 5-year rules.

Roth IRA Recap

As a quick recap, a Roth IRA allows you to contribute up to the annual IRS limit, $6K in 2021, to an investment account at a custodian (e.g. Vanguard, Schwab, E-Trade, etc.).  You pay ordinary income tax on those dollars in the year you make the contribution.  But if you follow all of the rules, when you withdraw the money in retirement, both the contribution and earnings are tax-free.

A Traditional IRA, the common counterpart, allows you to contribute up to the same limit and deduct that contribution from your earnings in the year you make the contribution.  However, you’ll pay ordinary income tax on the contribution and earnings when you use the money in retirement.

Neither IRA is superior at face value.  Not only does a family need to evaluate the best tax choice in each contribution year, but they also have to check their crystal ball to estimate their tax situation in retirement—potentially half a lifetime into the future!

If you expect a lower retirement tax bracket based on your earnings, sources of taxable income, and decades of tax policy whiplash from Washington D.C., then you’re probably better off with a Traditional IRA.  This sounds swell, but military retirees receiving Social Security are most likely trapped in higher tax brackets until the pension-earner passes away.  Not to mention, your income may very well trap you above the deductible Traditional IRA limits anyway!

If you expect a higher tax bracket, even by 1%, then a Roth IRA makes more sense.  If you expect the same tax bracket in the contribution year as the withdrawal year, then mathematically, there is no difference.  Check out the math:

ROTH: 

$6,000 – ($6,000 * 24%) = $4,560

$4,560 compounded at 10% for 30 years is $79,569 of spendable dollars.

TRADITIONAL:

$6,000 compounded at 10% for 30 years is $104,696 of pre-tax dollars.

$104,696 – ($104,696 * 24%) = $79,569 of spendable dollars.

Clearly this example has some trickery, as most savers will contribute the full $6,000 to the Roth and forgo the $1,440 of current spending power lost to current income tax in order to have the full $104,696 of spendable dollars in retirement.

Roth IRAs have other benefits that many of us won’t consider until turning base-to-final for retirement:

• Roth IRAs allow you to pre-pay taxes for your heirs. If you leave a $1M Traditional IRA, you’ve lit a 10-year fuse that will cause your heirs to choose compounding or taxation.  That may not be the gift that you intended.
• Roth IRAs don’t have to be used at any particular time. Traditional IRAs have to be distributed (and taxed) starting at age 72 via Required Minimum Distributions (RMDs), regardless of whether you need the income. The Roth can just keep compounding until you need it or leave it to your heirs.
• Roth IRAs encourage you to spend less today, but earn and save more over the decades. As seen above, a Roth IRA causes current-year tax drag on your spending.  But in retirement, it doesn’t add to your military/airline pension, distributions from TSP/401(k), distributions from a Traditional IRA, rental income from your real estate empire, or your taxable social security dollars.  As such, knowing you’ll have tax-free income available in retirement encourages you to earn more and save more knowing you won’t be taxed at the income level you’re actually feeling in retirement.

Putting the pom-poms back down, Roth IRAs have lots of advantages but there are some draw backs too…

The 5-Year Rules

Tax Uncle, Aunt Iris, or your preferred epithet for the IRS, does not make benefits such as tax-free earnings and distributions completely pain-free.  There are three 5-year rules that significantly effect distributions from a Roth IRA.

5-Year Rule #1- Initial Contributions

You must wait 5 years after January 1^st of the tax year of your first Roth IRA contribution to withdraw earnings without taxes or penalties.  There’s a chunk of nuance in this rule:

• Even if you opened a separate account for every contribution, every year, for 40 working years—the IRS looks at your Roth IRA dollars as a single lump.
• If, as a butter bar, you contributed $1 to a Roth IRA on December 31^st of 2001, the 5-year clock started ticking January 1^st of 2001, so your 5-year bell rang December 31^st of 2005 even though the money was technically only in the account for 4 years.
• You still need to be age 59.5, or meet one of the exceptions discussed below to avoid taxes and penalties on the earnings.
• Beneficiaries of your IRA must still wait out the 5-year clock to avoid the 10% penalty for early withdrawal of earnings or conversions. This is only a factor if you perish in or near your working years.

5-Year Rule #2- Conversions

You must wait 5 years after January 1^st of the tax year of each conversion from a traditional IRA/401(k)/TSP to a Roth IRA to withdraw principal or earnings without paying taxes or penalties.  And now for the nuance:

• As with contributions, the conversion clock starts on January 1^st of the tax year of the conversion, not the date of the contribution. Since many families wait until late in the tax-year to do conversions when income is known for the year, this shaves months off the 5-year clock.
• Beneficiaries of your IRA must still wait out the 5-year clock to avoid the 10% penalty for early withdrawal.

5-Year Rule #3- Inherited IRAs

Starting in 2020, if you die and your beneficiary is not a natural person (e.g., your trust), that entity must withdraw 100% of the IRA by the end of the 5^th year following the year of your death.  Your spouse still gets to stretch distributions over her/his lifetime or combine the IRA with their own.  Your non-spouse beneficiaries, e.g., children, get 10 years to deplete the account.

• If you die December 31^st 2021, your trust beneficiaries would need to withdraw 100% of the IRA by December 31^st
• The tax on money left in the IRA after that period is 50%!

Let There be ORDER!

Now that we’ve got our hackles up about these pesky 5-year rules, let’s look at why they probably won’t ever be a factor for you.

IRS Ordering Rules

When you take a distribution for your Roth IRA, the IRS orders the dollars as:

• Contributions (which were already taxed), then…
• Conversions (which were taxed in the year of conversion), then…
• Earnings (which won’t be taxed if you comply with all of the rules)

So, if at age 49.5 you withdraw $60,000 to buy a (plane, Tesla, elective surgery, tuition bill, etc.) but you had $60K of contributions to your Roth IRA, then the 5-year rule doesn’t apply because of the ordering principle.

If you had $50K of contributions and $10K of conversions in the account, then the 5-year rule, age 59.5 rule, and exceptions rules would determine taxes and penalties.

The ordering rules could matter for your beneficiaries if you die after having recently converted money to your Roth, but only if your heirs withdraw more than the earnings prior to the 5-year clock expiring.

Exceptions to the Rules

Even with the 5-year rules, there are exceptions to the 10% penalty for early withdrawal for Roth IRAs.  IRS publication 590B is the bible on this topic, but here’s how you avoid the 10% penalty:

• Age 59½
• Beneficiary of a deceased IRA owner.
• The distributions are part of a series of substantially equal payments (rule 72t)
• The distribution is a qualified reservist distribution.
• Up to $10K for a first-time home purchase (first-time = haven’t owned in previous 2 years)
• Higher education costs (you, spouse, child, grandchild)
• Health insurance if unemployed
• Healthcare cost in excess of 7.5% AGI threshold
• Total and permanent disability

Reality Check

If you thought Roth IRAs were all sunshine and lollipops, and now feel like there’s a dark underbelly of the much-lauded retirement account, let’s take a look at how most of us use our Roth IRA:

• Contribute the max we can until earnings drive Backdoor Roth IRAs then keep maxing them out anyway
• Convert Traditional dollars in low-income years, frequently right after military retirement and then again between age 59.5 and 72
• Deplete retirement accounts in Taxable, Tax-Deferred/Pre-tax, then Tax-free order
• Leave something for the kiddos

If your plan today… decades from the first time you plan to touch a Roth dollar… looks about like this, then you can safely kill off the brain cells that are worried about 5-year rules with your beverage of choice.

On the other hand, if you’re leaning towards a F.I.R.E strategy of some sort, you want to at least make sure you’re tracking your 5-year clocks.

Cleared to Rejoin

Roth IRAs remain a superb retirement planning tool, but they’re still instruments of the IRS and therefore have more than a few devilish details.  The 5-year rules are designed to prevent abuse of the tax code, which surely isn’t your intent, but can trip you up anyway.  If your first contribution was over 5 years ago, you really only need to worry about conversions and how you handle beneficiary status for your heirs—i.e., naming individuals versus non-person entities.  Finally, if you work with a financial planner or tax professional, make sure you’re covering this topic when evaluating conversions, distributions, and estate planning.

Fight’s On!

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