Like the Roth IRA? Beware the 5-Year Rule

They say that good things come to those who wait. And when we’re talking about Roth IRAs, this is certainly true, since we don’t typically reap their benefits for years. Often referred to as the “the Swiss Army knife” of retirement planning tools because of its flexibility and tax-free nature, many retirees and near-retirees are realizing how powerful the Roth can be. 

If you have money in your company’s 401k or in a traditional IRA, you may be considering converting these funds into a Roth IRA now while tax rates are historically low. The idea is that if you pay income tax on your retirement money now – especially when many account balances are significantly down – future gains in the Roth are tax free. But you need to understand the 5-year Rule.

I had this conversation recently with one of my neighbors, I’ll call him “Hank”. Hank and I ran into each other at Mary Ellen’s Portuguese Bakery and sat down for a few minutes to catch up over a cup of coffee. Hank’s youngest daughter, Becky, was recently engaged and thrilled to be planning her wedding to Josh, a recent college graduate from Boston University. Hank’s wife, Joann, had some grand plans for Becky and Josh’s special day as well. Hank was in sticker shock at how much it costs to plan even a medium-sized wedding. He was happy to help foot the bill for his youngest, but the timing wasn’t great.

You see, Hank had changed jobs about 18 months ago, and at the time he decided to roll his company 401(k) into a Roth IRA. When Becky got engaged, he assumed he would take a withdrawal from his Roth to cover the wedding. He knew that the purpose for this money was to eventually provide him and Joann with income in retirement but thought that he could tap into it in the meantime if necessary. 

The tax free features of a Roth IRA are mighty – but they come with some conditions, as Hank found out. Your contributions to a Roth can be withdrawn at any time, but you can’t touch the earnings unless the account’s been open for at least five years. So, if you’re rolling another retirement account into a Roth IRA in 2023, for example, you need to make sure you don’t need the earnings until at least 2028. And if the account for the rollover is your first Roth IRA account or you opened your first Roth less than five years ago, the earnings will be taxed when withdrawn. And the 5-year rule applies even if you’re older than age 59-1/2. You need to satisfy both requirements or you lose the tax break on your gains.

And for a conversion of an Individual Retirement Account into a Roth, there’s more. The 5-year rule on Roth conversions requires you to wait the full five years before withdrawing any converted balances — contributions or earnings — regardless of your age.

In Hank’s situation, he couldn’t withdraw any of his earnings because he was under age 59-1/2 and the account was less than 5 years old. The IRS will let you withdraw some funds without the 10% early withdrawal penalty for things like a first-time home purchase, for qualified higher education expenses, if you become disabled or pass away, or a few other reasons – but you will still owe income taxes on the earnings which negates the purpose of converting to a Roth in the first place. Unfortunately none of these situations applied to Hank.

This doesn’t mean that a Roth IRA conversion is not a valuable retirement strategy, however. Many savers choose a Roth rollover or conversion when they want to avoid the required minimum distribution rules (RMD) that kick in at age 73 – even on Roth 401(k) accounts. The Roth IRA is exempt from RMD requirements, which allows the money you would have been forced to withdraw to continue growing, untouched by taxes.

Unfortunately not everyone can open a Roth IRA because there are income limits that apply to contributions if your adjusted gross income (AGI) is more than $144,000 for a single filer or $214,000 for joint returns. However you may be able to get around the income limits by doing what’s referred to as a “back-door” Roth conversion. This entails rolling an existing traditional IRA into a Roth IRA, since traditional IRA accounts do not have income limits. You might want to do consider this soon, since some Congress members have been talking about closing the back-door loophole for a while now. 

Converting a traditional IRA to a Roth can be a savvy move for many, but you need to understand the commitment necessary to fully realize the benefits. My mom always told me that patience is a virtue – in life and in money, as is the case for a Roth IRA!

So as always – be vigilant and stay alert, because you deserve more!

Have a great week.

Jeff Cutter, CPA/PFS is President of Cutter Financial Group, LLC, an SEC Registered Investment Advisor with offices in Falmouth, Duxbury, and Mansfield, MA. Insurance offered through its affiliate, CutterInsure, Inc.

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