Ready For Retirement
Ready For Retirement
Your Roth IRA Could be Locked For 5 Years. Here's Why
Roth IRAs are a great way to build tax-free retirement income—but the withdrawal rules can be tricky. In this video, I’ll break down the five-year rules, how contributions, conversions, and growth are treated, and smart strategies to avoid unnecessary taxes.
Understanding these rules can help you make the most of your Roth IRA and keep more of your money tax-free. Let’s dive in!
Questions answered?
1. When can you withdraw money from a Roth IRA without paying taxes or penalties?
2. How do the two different five-year rules for Roth IRAs affect withdrawals?
Questions answered?
1. When can you withdraw money from a Roth IRA without paying taxes or penalties?
2. How do the two different five-year rules for Roth IRAs affect withdrawals?
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Timestamps:
0:00 - The 5-year rule
1:09 - Contributions
3:39 - Conversions
5:36 - Growth
6:51 - An example
8:55 - Conversions before 59.5 years
10:23 - Summary
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Roth IRAs can be a powerful tool for your retirement savings, but they can also be quite complicated, specifically when it comes to rules around when you can withdraw your Roth IRAs and have those withdrawals be fully tax-free. So in today's video, I'm going to walk you through some unknown benefits of Roth IRAs, as well as mistakes you need to avoid to make sure that you're maximizing the tax-free potential of these accounts. This is another episode of Ready for Retirement. I'm your host, james Canole, and I'm here to teach you how to get the most out of life with your money. And now on to the episode With Roth IRAs.
Speaker 1:Many people don't actually know there's something called a five-year rule, and most people don't actually know there's two different versions of this five-year rule. This five-year rule is critical because the whole goal of Roth IRAs is to create tax-free income, but if you violate those rules in any ways, you may end up paying taxes and a potential penalty on your Roth distributions. So the first thing that we need to understand in order to make sure that we're maximizing the effectiveness of Roth IRAs is to understand that money in Roth IRAs can only come from one of three different sources. Number one it can be a contribution. Number two, it can be a conversion. And number three, it can be growth. Each of those is critical to understand because the way in which you pulled those dollars out is different based upon the source. So let's walk through these one by one. The first and the most simple is contributions. Contributions that you make to your Roth IRA are completely free for distribution and withdrawal at any time, without penalty and without taxes. Doesn't matter if you're older than 59 and a half, younger than 59 and a half. The money you put in as a direct contribution is always available to you. So if you're 40 years old and you put $5,000 into your Roth today and next year, you have an emergency and you need to draw funds from somewhere. You have access to that $5,000 of your Roth. Today and next year you have an emergency and you need to draw funds from somewhere. You have access to that $5,000 contribution completely tax-free and completely penalty-free. This is because you didn't get any type of tax benefit for putting money in. That principal amount is available for you to withdraw without any tax penalties on the way out.
Speaker 1:Now to continue that example if you put $5,000 in and next year it's worth $6,000 because of growth, you have to look at that $6,000 differently. 5,000 of it is contributions, 1,000 of it is growth. So you can pull a 5,000 out without penalty or without taxes. But if you pull that $1,000 of growth out, that $1,000 is both subject to taxes at whatever your marginal tax bracket is, as well as a 10% penalty because you pulled the money out before the age of 59 and a half.
Speaker 1:Some of you might be asking how do I know if what I'm pulling out is growth or contributions? I'm going to get to that once I walk through each of the three types of ways. You can actually have money in your Roth IRA, but I want to establish the rules for each of these and then we can talk about that Now. Here's the last thing to know about contributions. In order to be eligible for a qualified distribution from your Roth IRA which means you can take money out and everything can be tax-free you both have to be older than 59 and a half and your Roth IRA has to have been funded for five years. So if you're 60 years old and you put money in your Roth IRA today and the following year, you want to pull out your money plus growth. We can always pull out the contributions.
Speaker 1:As I mentioned, it doesn't matter your age, but that growth. In order for it to also be tax-free, you have to have had money in your Roth for five years. This is the initial five-year rule. It doesn't matter if you just started with one single dollar. Money has to have been in your Roth for five years in order to be eligible for a qualified distribution. Now, if you have multiple Roth IRAs in order to be eligible for a qualified distribution, now, if you have multiple Roth IRAs, say, you started a Roth IRA at age 40 with one single dollar and at 60, you start a separate Roth IRA that initial contribution you made at age 40, that five-year clock has passed, which means all future contributions. Does it matter if you have different accounts, although there's not typically a great reason to have multiple accounts? But even if you did, it's not five years per contribution or five years per account even. It's five years from the initial funding of your first Roth IRA.
Speaker 1:Now the second source that funds in your Roth IRA could potentially come from is conversions. Here's a really important thing to understand about conversions. Each conversion has its own separate five-year rule. Now this is not the case once you're over 59 and a half If you've already met the initial five-year rule that we just talked about for your initial contribution. If you've had a Roth IRA at any time and it's been more than five years, this does not apply to you if you're older than 59 and a half, but if you are under 59 and a half, every conversion that you make is subject to its own five-year rule. So if you're 50 and you make a conversion this year and a conversion next year and the conversion the following year, each of those conversions has its own separate five-year rule. That helps you understand when you're eligible to take that converted amount out and not have it subject to taxes. And just in case it's not clear, when it comes to contributions, every single year you have a contribution limit for how much you can put into your IRA or Roth IRA. For 2025, that number is $7,000 per year if you're under the age of 50, and $8,000 per year if you're 50 or above.
Speaker 1:When it comes to conversions, there is no limit. A lot of people ask well, am I not limited to how much I can convert to my Roth IRA each year? The answer is no, but keep in mind any pre-tax balances you're converting from an IRA or a pre-tax account into a Roth IRA, that entire amount is taxed at ordinary income. So if you have a million dollars in a traditional IRA and you convert all of it in one single year, that million dollar conversion is as if you earned a million dollars. Now it's not subject to payroll taxes, but it's fully subject to federal taxes and then state taxes, depending on the state that you live in. That's going to quickly push you up into the top marginal bracket and probably be a very expensive mistake for many people if they were actually to do that, depending, of course, on their overall situation.
Speaker 1:But I just want to reiterate that fact that conversions do not have a contribution limit in the same way that contributions do. But those conversions are the second source. So source number one is contributions. Source number two is conversions. Source number three is growth. So you've been putting money into your Roth IRA and that money's been growing. That growth is subject to different withdrawal rules than are contributions or conversions. As I mentioned, with contributions you can pull those dollars out at any time without taxes or penalties. With conversions, you can pull those dollars out, assuming you've met each successive five-year rule for each successive conversion that you've made. With the growth on those dollars, though this growth cannot be touched until you are 59 and a half, unless some other exception applies.
Speaker 1:Now the natural question becomes how do I know if every dollar that I pulled off my Roth is from a contribution or a conversion or its growth? Well, the IRS, thankfully, makes this pretty straightforward. They simply assume that the first dollars that you pull out are always contributions, meaning you don't actually have to track. You put these dollars in and invested in these assets, and this is what your contributions were versus these assets were from conversions, versus this growth on these assets. You don't actually have to track any of that. The IRS is going to assume that the first dollars you pull out are contributions. Once you've exhausted all of your contributions, the next dollars that you pull out are from conversions, and once you've exhausted all of your conversions or maybe you've just never done a conversion then you go to the growth on those dollars.
Speaker 1:So let's look at an example to illustrate how this would work. Let's assume that you're 45 years old and you start making Roth IRA contributions of $5,000 for the next five years. So you contribute $5,000 today, $5,000 at 46, at 47, at 48, and 49. Then, at age 50, you start making too much money to make a direct Roth IRA contribution, so you do something called a backdoor Roth conversion. I have other videos where I explain in more depth how that process actually works, so I'm not going to explain it in depth today.
Speaker 1:But let's assume that you do that. Technically, each of those is a conversion. So from age 50 to 54, you are doing a conversion of $5,000 to still get money into your Roth IRA. So you have five years of contributions at 5,000 per year and then you have five years of $5,000 conversions technically into your Roth IRA. And let's assume that you also get $25,000 of growth over the course of that 10-year time period. What that means is you have $25,000 of contributions, $25,000 total of conversions and then $25,000 of growth on those assets.
Speaker 1:Well, if you're now 55 and you're wanting to pull money out of your Roth IRA, you don't have to have tracked which specific assets are contributions, conversions and growth. You can simply pull money In the first $25,000 that you pull. The IRS is just going to assume that those were your contributions. Once you've exhausted those dollars, the next dollars that you're going to pull are going to be conversions. This is very important because some of those conversions may not have met their five-year rule yet. You have to wait five years for each conversion to have met its time period. To have met its waiting period until you can pull that out and not be subject to taxes. To have met its waiting period until you can pull that out and not be subject to taxes. Then, finally, once you've exhausted all that, the remaining assets. The IRS is going to consider growth for the sake of understanding, are those assets taxed or not when they come out? Now the good news here, like I mentioned, is as soon as you turn 59 and a half, all this goes out the window, with the exception, of course, of the initial five-year rule where your Roth IRA has to have been funded for five years and once that clock, once that time has been met, you are good from there on out, from 59 and a half and beyond.
Speaker 1:Now here's what I see, actually quite a bit, is people who are doing Roth conversions and maybe they're doing this before the age of 59 and a half, maybe they retired early, maybe they're in a lower income year, for whatever reason, they do conversions before the age of 59 and a half. They get concerned. You say do I really want to do this if I can't touch these funds for five years or more. Well, strategically speaking, if you're not going to let those funds grow for some period of time, there's not much of a benefit for doing the conversion. The conversion saves you no money in taxes up front. In fact, it typically costs you money to do the conversion up front. The benefit comes as those dollars are now growing tax-free, and the longer they can grow tax-free, the better off you're going to be.
Speaker 1:So, yes, it's very natural to have concerns of do I really wanna do this conversion that means I can't touch these assets for five years. Ideally, you have other assets that you can access, whether that's cash or brokerage assets or income or whatever the case might be. But also keep in mind that if you're not going to do a conversion and have those assets invested in growing in your Roth for probably at least five years or more, I would question whether or not it even makes sense to do the conversion in the first place. So I just wanted to point that out, because sometimes this five-year rule becomes a hindrance to people when in reality, if you look at things strategically, it maybe shouldn't be when you start to consider when those Roth assets should actually be used, which in many cases, the further out retirement they're being used, the better off you're going to be, because each year that asset grows, that's more tax-free income. That's more tax-free growth that you're going to have for the rest of your life. So, as I mentioned at the beginning, roth IRAs can be powerful tools to create tax-free income throughout retirement and even as a legacy tool beyond. But you have to understand some of these key rules here. There's a five-year rule that determines when you can access any of the growth in your Roth IRA tax-free. There's a separate five-year rule that determines how you can access conversions in your Roth IRA. When you understand the difference of how contributions are treated, conversions are treated and then growth is treated, you can start to put together a strategy that works the best for you to maximize the tax efficiency of your portfolio throughout retirement.
Speaker 1:Root Financial has not provided any compensation for and has not influenced the content of any testimonials and endorsements shown. Any testimonials and endorsements shown have been 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 and click start here, where you can schedule a call with 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.
