Ready For Retirement

Roth IRA Tax-Free Withdrawals: 5-Year Rule Explained

December 05, 2023 James Conole, CFP® Episode 192
Ready For Retirement
Roth IRA Tax-Free Withdrawals: 5-Year Rule Explained
Show Notes Transcript Chapter Markers

James explores the nuanced aspects of Roth IRAs, shedding light on intricacies that can confound even experienced investors. 

Through a listener question from Manfred, a retiree contemplating a $50,000 conversion from a 401k to a Roth account, James dissects the crucial five-year holding period and the order in which contributions, conversions, and earnings are treated during withdrawals. 

James also provides clarity on distribution rules, exceptions, and strategic considerations, offering a comprehensive guide to navigating the complexities of Roth IRAs for optimal retirement planning.

Questions Answered:
How does the timing of subsequent conversions impact the application of the five-year rule?
In Roth IRA withdrawals, what is the specific order of operations, and what implications does that have? 

Timestamps:
0:00 Manfred’s question 
1:39 Get the cheatsheet
2:37 Understanding source nuances
7:01 The five-year rule
8:37 IRS’s order of operations
11:59 Exceptions to the rule
13:49 Only a small impediment
16:14 Back to Manfred’s example

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Speaker 1:

Roth IRAs can be a powerful tool for retirement savings, but there's some tricky things about them that can also be quite difficult to understand. In today's episode of Ready for Retirement, we're going to go over some of these lesser known aspects of Roth IRAs, some of these tricks, so that you know what to avoid and how to make the most of these in your Roth IRA strategy. So I'll come in up next on today's episode of Ready for Retirement. This is another episode of Ready for Retirement. I'm your host, james Cannell, and I'm here to teach you how to get the most out of life with your money. And now on to the episode. So let's jump right in. Today's episode comes from a listener question. The listener's name is Manfred, and Manfred says this. He says I am 65 years old and retired. My spouse is also retired. I'm going to convert $50,000 of a 401K into a Roth account. I already have an old Roth account that is well over 5 years old. I started it in 2015. Do I have to wait the 5 year holding period on the $50,000 that I convert into the old Roth? I would like to know if I have the option of withdrawing it for a large purchase. I will also be converting 401K funds for the next 5 years. Will those subsequent conversions also be held up for 5 years? What is the rule if I were to convert those same funds into newly established Roth accounts in 2023? I have read and gotten verbal, conflicting answers. Thank you for your response and I, like your YouTube channel, look forward to viewing the rest of them. Thank you, manfred. Well, manfred, thank you very much for that question and you probably have received a lot of conflicting answers because there's a lot of conflicting information out there and, believe it or not, as simple as Roth IRA sound, there's a lot of nuance to this and there's a lot of details that you need to understand in order to avoid common mistakes that people make that end up costing a lot of money. Now, before we jump in on today's episode, if you are listening to this on Spotify or listening to this on Apple podcasts, be sure to check this out on YouTube, because in the YouTube show notes, I'm going to have a PDF link or a link to a PDF that contains a cheat sheet for everything that we're going to talk about in today's episode. Some of this can get fairly confusing, so having a cheat sheet where you can actually go through and see your specific situation to understand. Can you withdraw Roth funds penalty free is very helpful, so be sure to check out the YouTube channel. It's going to be in the show notes if you're listening to this on Spotify or Apple podcasts, but the YouTube channel is just James Cannell and you can find all of this there. So today, what we'll be talking about? We'll be talking about the five-year rule. We'll be talking about the impact of Roth conversions. We'll be talking about distribution ordering rules. We'll be talking about conditions that trigger the 10% early distribution penalty, as well as exceptions to the 10% early distribution penalty. And if you're listening and saying, what on earth does any of that have to do with the Roth IRA? You're not alone. A lot of people think of Roth IRAs. They think put money in, let it grow, tax-free, everything's good. But there is quite a bit to know, and that's what we're going to cover on today's episode. So let's start right here. Money in your Roth IRA can only come from one of three sources First, contributions. Second, conversions, and third is growth. So each of those contribution sources, or each of those sources, I should say, of funds, has different rules in terms of how it can come out of your Roth IRA, the timing of when it can come out of your Roth IRA, and whether or not it's subject to taxes and penalties. So let's go through each of these one by one, starting with contributions. One of the greatest things about Roth IRAs is, at any point and at any age, you can pull out the contributions you made to a Roth IRA completely tax-free and completely penalty-free. Does not matter if you're over 59 and a half or under 59 and a half. Any money that you put into your Roth IRA, you can pull that back out at any time without having to wait any period of time, and that money is yours, free and clear. You don't pay any taxes. You don't pay any penalties for doing so. So let's take a look at an example here. Let's assume that you're 40 years old and you put $5,000 into a Roth IRA and you've heard people say you can't touch this money until 59 and a half without penalty or taxes. Well, one year goes by, you're now 46 years old and something comes up and you have a major expense and you really don't have any quick cash available and the Roth IRA is the only place that you're looking to go to get that money. Well, assume your $5,000 contribution now grew to $6,000. You're 41 years old. With $6,000 in your Roth IRA. You can, at that moment, pull out the $5,000 that you put in and not pay any penalties or any taxes to do so. You made that contribution, so it's your money free and clear. Now, the $1,000 of growth on that contribution, that is what you cannot touch until age 59 and a half without paying taxes or penalties. But if you needed that money, that $5,000 is free and clear. It's just the growth that you really couldn't touch. So that's the first source of funds that you could potentially have in a Roth IRA's contributions. The second is conversions and as we go back to Manfred's question, this is really what he is talking about. Here's a really important thing to note Every single time you do a Roth conversion, it has its own separate five-year clock for when you can then pull that money out tax-free and penalty-free. Another important thing to note about this when you're doing a conversion, sometimes it's just a straight Roth conversion. You have money in a traditional IRA that you want to move to a Roth IRA for some tax purpose. Well, if you are doing a backdoor Roth contribution, technically that is a conversion too. So you're putting money into a traditional IRA, you're not deducting it, and then you're immediately converting the after-tax balance into your Roth IRA. And that's what gets people tripped up is they don't necessarily think of a backdoor Roth contribution as a conversion, but really it is. So any conversion that you do, it has its own five-year window for when you can access those contributions penalty-free. Make sure you stay through to the end of this, because I'm actually going to go through this and show you why each conversion, having its own five-year clock for when you can access it, isn't actually as restrictive as many people think it might be. But one of the reasons they think that is because when you retire, or when many people retire, one of the common strategies that people implement is they'll do Roth conversions. In those years where their tax bracket is lower. They will strategically shift money from their traditional IRAs into their Roth IRAs. Now, don't do it all at once. They do a little bit the first year, maybe a little bit the second year, maybe a little bit the third year, and so on and so forth. And so people get concerned. They say look, every time we do this, there's a new five-year rule that goes into effect. That's absolutely right, but, like I said at the end, I'm going to share with you some strategy and why that's actually not as impactful as people think it might be. So that's conversions. We've gone over contributions. We've gone over conversions. The next thing is growth. So, again, money in your Roth IRA can only come of one of three things contributions, conversions and growth. Growth is pretty simple. It's simply how much have your contributions grown by? How much have your conversions grown by? If you've put in a total of $50,000 in contributions over the course of 10 years and your Roth IRA is now worth $80,000, well, put simply, there's $30,000 in there. That is growth, and it's important to understand that each of these is going to be treated differently when it comes to how can you pull money out of your Roth IRA. So I'm going to walk through that in just one second, but before I do, on top of this, you need to be familiar with a rule called the five-year rule, and this is a separate five-year rule than what we just talked about with conversions. This is one of those things where it can get pretty tricky, but, yes, there's a five-year rule where every single conversion you do, you need to wait five years until you can pull that conversion money out of your Roth IRA penalty free and tax free. But there's a separate five-year rule and that rule says you cannot withdraw any earnings in your Roth IRA tax free until it's been at least five years since you originally contributed to the Roth IRA account. A lot of people that hear this and say, well, yeah, of course there is. Why does that matter? Well, where this matters is, for example, if you are already over the age of 59 and a half. Say, maybe you're 60 years old and you've never contributed to a Roth IRA before. Well, maybe you put $5,000 into a Roth IRA and then a year goes by and you have $6,000 there and you need to take that $6,000 out and you say, ok, well, this is a Roth IRA, so the money is tax free and I'm older than 59 and a half, so I qualify from the age perspective. But you really don't, because the five-year rule for Roth IRA says for you to be able to access that growth penalty free after the age of 59 and a half, the account must have been established for at least five years. So that's something that really doesn't come up a whole lot, but does occasionally come up and you need to be mindful of. So what does all that matter? We know that there's contributions, we know there's conversions, we know there's growth. Here's why it matters. When you begin taking money out of your Roth IRA, the IRS is going to view it. They're not going to go in and say, okay, james, well, you get to decide. Is this money that you're taking out growth, or is this money that you're taking out a conversion, or is this money that you're taking out an original contribution? They have an order of operations that is followed regardless of who's taking money out. The order of those operations goes as follows Contributions come out first, followed by converted dollars coming out next, followed by earnings coming out last. So it does not actually matter when you made contributions to your account. It doesn't matter the timing of when you did conversions to your account. It doesn't even matter how much growth is in your account. From the perspective of what the IRS is looking at, they're treating the first dollar you take from your account Doesn't matter if this is the first dollar made by a conversion or by a contribution. They're saying that first dollar is going to be treated as if it was a contribution. Let's look at an example. Let's assume that you make contributions to your Roth IRA of $5,000 per year and you do that for five years in a row. Then let's assume you start making too much money to put a contribution directly into your Roth IRA. There's income limits here. But let's assume that you start doing backdoor Roth conversions. So for the first five years you just put money directly into your Roth IRA. The next five years you don't do it directly, but you're still getting $5,000 per year into your Roth IRA via a backdoor Roth conversion. So you've done that for 10 years. Now this whole while let's assume that your money is invested and it's growing and you have $25,000 of growth. So you did this for 10 years you now have $75,000 inside of your Roth IRA. Let's assume you're under the age of 59 and a half and you need to access some of this money. Well, if you were to go in and take money out, the IRS is just going to say James, if this is your account, the first $25,000 that you take, we're just going to assume as if that was your contributions, because that's how much I'd contributed to my account over the lifetime of my Roth IRA. If I need more than that, they're going to assume in. The amounts above $25,000 are conversions, and then next amounts. Until I fully withdraw, all my conversions are going to be treated as such and then, finally, any amounts above and beyond that are going to be treated as growth. And just to make sure I'm being clear with this example, it actually doesn't matter the order in which I make these contributions. Let's say, for the first five years I was doing Roth conversions via a backdoor Roth contribution and then the next five years I was doing contributions. So same exact example as before, but just flip the timing of it. It really doesn't matter in the IRS's eyes. Still, if I'm going to take money out of my Roth IRA, the first $25,000 I withdraw, the IRS is simply going to assume that that is coming back tax free because it's a return of contribution. I actually recently did this. Not recently, but several years ago. When I started root financial, I was looking to see what's the best way to fund some of these things going forward and because I had been diligent about funding my Roth IRA for the first several years, I was able to pull money out of my Roth IRA completely tax free and penalty free and using some of those dollars to start my company. So sometimes things come up unexpectedly that you say I need money for. Ideally, you have non-Roth funds that you can use in those situations, but if not, it's always nice to know that you have your Roth IRA and can access those contributions at any point. Here's the next thing that you need to know If you are taking money from your Roth IRA and you either haven't met your five year rule in terms of each conversion meeting its own separate five year window, or you're under 59 and a half and not yet eligible to take out growth, there are some exceptions to this, and this is where I'll say download the resource that's in the description on the YouTube page, because there's a lot of these and I'm just going to summarize them real quick. But this is in the resource. But the bottom line is the distribution may qualify for an exception. This is because, number one, you're age 59 and a half or older. So in that case there's no 10% penalty or taxes on a distribution from your Roth IRA, even if it's growth, assuming you've met the five year time period from when the account was first opened up. There's also an exception if you are taking the distribution as a part of what are called series of substantially equal periodic payments. There's an exception if money was used to pay for qualified higher education expenses, unreimbursed medical bills above 7.5% of a just gross income, qualified health insurance premiums while unemployed, a qualified disaster distribution up to $22,000 per disaster for disasters after January 25th of 2021. Or if the distribution was made within one year after the birth or adoption of a child, up to $5,000. So there are some exceptions here, but in general, if it's not your own contribution that you're taking out or it's not a conversion that you've had in your Roth for at least five years, you're going to pay taxes in a 10% penalty for anything else that you take out. Be very mindful of that, because the last thing that you want to do with your Roth is have it all of a sudden be subject to taxes or have it be subject to a penalty, because this is one of the most important accounts in most people's plans, simply because there's so many strong tax benefits to it. Now, one of the things that I mentioned as I said, I'm going to go over strategy a bit to tell you why that five year rule for each conversion isn't actually that much of an impediment, or it shouldn't be for most people. And if I go back to Manfred's question, he was saying he's going to convert $50,000 of his 401k into a Roth account. He also said I already have an old Roth account that is well over five years old. That started in 2015. So, manfred, going back to your question, any dollars that are already in your Roth IRA doesn't matter when you contributed to them. Those are all eligible for you to take out, completely tax free and penalty free because you've already met the five year rule. It doesn't matter if you just put one single dollar into your Roth IRA back in 2015 and then put the rest of it in, say, a year ago or two years ago. That doesn't matter. That five year clock, the five year rule that says your Roth IRA must have been established for five years. Once you've met that time period or that holding requirement, all contributions and growth on that assuming you're over 59 and a half, which Manfred is are completely tax free to you if you were to take them out. However, the conversions so converting the $50,000 from your 401k into your Roth account each of those will have its own five year time frame until you can pull that money out tax free and penalty free. Remember the order of operations. The IRS is going to treat any money you pull out first and foremost as contributions and then those conversions. But to answer your question directly, there is that five-year holding period. Here's why I don't think that's actually such a big deal, at least generally speaking. For most people. The benefit of ARRF IRAs is you get to let that money grow tax-free. Now it's a very obvious statement. I think everyone listening to this probably knows that the benefit of ARRF IRA is that money grows tax-free and then comes out tax-free. But here's the thing you don't get any tax benefits just for putting money into ARRF. In other words, the longer you let your money stay in your ARRF, the greater your benefit will be. It's just longer and longer for that money to grow tax-free, which means greater and greater amounts that can then come out tax-free. But if I were to put money into a Roth IRA today and even want to pull it out in a year from now, I probably haven't gotten a tremendous amount of benefit unless there was some pretty significant growth on my money in that single year. So you want to ideally let your Roth accounts grow tax-free as long as possible, because that's where you're going to get the maximum benefit. So if I go back to Manfred's example and this is definitely not advice, but this is just my general observation I don't really see much of a point to say why would you consider converting 50,000 from a 401k to a Roth IRA just to pull that out in the next handful of years? The goal there, the reason you would do it, is to convert that money and then let it grow tax-free for many, many years. So later on in retirement you would have that money to live on. If you're saying, well, james, I want to pull that money out now because I'm in a lower tax bracket now, but I still want to use it in a few years, well great, maybe pull that money out, but just don't convert it. Just treat that as a distribution, keep it somewhere where it's available to you to use for when you do want to use that money for a purchase. But because you're not going to let it grow for very long, I don't really see much of a benefit to even having a Roth IRA, even if it weren't for that new five-year window of having to wait to access that specific $50,000 conversion. So, manfred, as you're listening or as you're submitting this question, you maybe have different thoughts on this, or maybe there's something that I've just not even seen within the example, or maybe a specific reason why you'd want to convert that money but then turn around and access it pretty soon. Generally speaking, though, without knowing your specific situation, there may not be a whole lot of benefits to that. The benefits really come if you're going to do a conversion today and then that money is going to grow and it's going to double in value, triple in value, and it's going to do all that completely tax-free. Well, that's a huge benefit because as you now take out that value, that's two times your amount, three times your amount. It's all coming out tax-free later on in retirement, along with many other benefits like not being subject to required minimum distributions and other things like that. So that is it for today's episode. Manfred, thank you very much for your question. I know it's a fairly straightforward question with a fairly simple answer, but it can sometimes get confusing, so I hope this was helpful as you're trying to understand what are the rules around taking money out of a Roth IRA. And again, a reminder if you're listening to this on Apple Podcasts or on Spotify or some other podcast player, make sure you check this video out on YouTube, because in the YouTube description I'm going to have a link to a cheat sheet that's essentially a flow chart that guides you through the whole conversation we had today, so you can understand that the money you're taking out of your Roth IRA will be penalty-free and tax-free, or if you might get stuck with a penalty for doing so. So thank you, as always, for listening. That is it for today and I'll see you all next time. Hey everyone, it's me again for the disclaimer. Please be smart about this. Before doing anything, please be sure to consult with your tax planner or financial planner. Nothing in this podcast should be construed as investment, tax, legal or other financial advice. It is for informational purposes only. Thank you for listening to another episode of the Ready for Retirement podcast. If you want to see how Root Financial can help you implement the techniques I discussed in this podcast, then go to rootfinancialpartnerscom. Click Start here, where you can schedule a call to one of our advisors. We work with clients all over the country and we love the opportunity to speak with you about your goals and how we might be able to help. And please remember, nothing we discuss in this podcast is intended to serve as advice you should always consult a financial, legal or tax professional who's familiar with your unique circumstances before making any financial decisions.

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