Thursday, 29 October 2020

Roth IRA 5-Year Rule: What You Need to Know

Roth IRA 5-Year Rule: What You Need to Know
13 Feb
9:29
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Depending on your financial situation, a Roth IRA is one of the savviest ways to save for retirement. It’s an investment account whose contributions are taxed today, but whose earnings then grow tax-free — and can then be a source of tax-free income upon retirement.

Roth IRAs have a wide array of additional benefits, too, like their immunity to the required minimum distribution rules many other retirement accounts carry. However, there’s an important caveat to keep in mind if you want to open a Roth IRA and plan to take distributions sooner, rather than later: the Roth IRA five-year rule. It’s a fairly straightforward concept, but there are some particularities to be aware of.

What is the Roth 5-year rule?

As its name suggests, the Roth five-year rule states that in order to maintain tax-free status with the IRS, distributions can only be taken from a Roth if it’s been open for at least five taxable years. While your contributions are after-tax (and thus always available for tax-free withdrawal), the account’s earnings will be subject to income tax and a 10% early withdrawal penalty.

As with all things in the tax code, it’s important to pay attention to the details. For example, the IRS states that five taxable years must have passed since the year in which you made your first Roth IRA contribution (or someone else made a contribution for your benefit). Since you can make contributions to an IRA until April 15 from the prior year, that means you may not have to wait five full calendar years to meet the requirements.

For example, let’s say you opened a Roth IRA in March of 2016 and funded it to its maximum contribution limit, ensuring those contributions count toward the 2015 tax year. In that case, you’d only have to wait until 2020 (as opposed to 2021) to fulfill the five-year rule. The important date is the one that’s on your tax return, so that’s where you should look when you’re running your calculations.

There are some exceptions to the five-year rule, such as being totally and permanently disabled or paying medical insurance premiums during an unemployment period.

Roth IRA 5-year rule on conversions

Traditional IRAs can be converted to a Roth IRA penalty-free. This is sometimes known as a “backdoor Roth IRA,” which can help those who earn more than the IRS limit take advantage of Roth benefits.

How does the five-year rule affect a traditional IRA account that has been open for many years prior? Converted Roth IRAs must be held for five years as a Roth before qualified distributions can be made. The countdown clock starts in the year you made the conversion.

However, unlike opening a new Roth IRA, you don’t have until April for your conversion to count toward the previous tax year. Instead, the important date to remember for a converted Roth is Dec. 31. Any conversions made by that date will count for that taxable year.

Each Roth conversion has its own five-year countdown period, and if you take early distributions from a converted Roth, you’ll run into the same tax scenario described above.

Roth IRA 5-year rule on contributions

Remember, the Roth IRA five-year rule applies only to account earnings. You pay income tax on the money you put into a Roth account when you contribute (or when you convert the account), which means you can always take those contributions back out without incurring any additional taxes or penalties.

“Distributions” refers to withdrawals of both contributions and gains made through compound interest. In order to make qualified (tax-free) distributions from a Roth IRA, you must fulfill the five-year rule and also meet a second requirement.

Since Roth IRAs are intended to be used as an income stream in retirement, the easiest and most common way to take distributions is to wait six months after your 59th birthday. However, qualified distributions from a Roth IRA can also be made under the following circumstances:

  • You become totally and permanently disabled.
  • You’re using up to $10,000 worth of Roth IRA distributions to fund the purchase of your first home.
  • You pass away and distributions are then made to your estate or beneficiary.

Roth IRA 5-year rule for beneficiaries

One of the most attractive things about Roth IRAs is the fact that they’re not subject to required minimum distributions (RMD), which means you can leave your money to grow for as long as you live — and even thereafter. Having the ability to pass the Roth IRA onto heirs and beneficiaries after the account opener’s death makes it a popular option.

However, the death of the original Roth IRA owner does not eliminate the five-year rule for heirs or reset the clock. In order to make tax-free, qualified distributions, beneficiaries must wait for the account owner’s projected end-date had he/she have survived. However, unless you are the spouse of the deceased account holder, you will be subject to RMDs on your inherited Roth account.

Bottom line

Although the five-year rule keeps you from instantly accessing your tax-free earnings, Roth IRAs are still a powerful vehicle for aggressively saving money and one of the best ways to fund a stress-free retirement.

Ready to open one of your own? Check out our step-by-step Roth IRA guide to get started, and review our smart investment choices for Roth IRAs.

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Jamie Cattanach

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Source: https://www.magnifymoney.com/blog/investing/roth-ira-five-year-rule/

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