There are two different 5-year rules when it comes to Roth IRAs, and both are important to know about if you have a Roth IRA. One 5-year rule is for Roth contribution IRAs, and another different 5-year rule is for Roth conversion IRAs.
Roth Contribution IRAs
The Roth contribution 5-year rule starts when the Roth is first funded. Your after-tax contributions are always available. Growth on the Roth is subjected to both the 5-year rule and the 59 ½ age requirement for the 10% premature distribution penalty exemption on retirement and annuity assets. Roth contributions are also subject to income limitations. You can contribute up to $6,000 or 100% of income, whichever is less. Also, if your Modified Adjusted Gross Income (MAGI) is too high, you cannot contribute to a Roth. If you are age 50 or older, you can contribute a “catch up” contribution of $1,000 in addition to the normal contribution amount for a total of $7,000. If you end up making too much money for the year, you must remove any contribution amounts and associated earnings and you will be required to pay the tax on the earnings. Roth IRAs can serve as both retirement vehicles and provide resources for other goals such as education, home purchase, or as a resource for emergencies. Exemptions to the 10% premature withdrawal penalty are a $10,000 first time homeowner withdrawal, 72t (systematic equal periodic payments), unreimbursed medical expenses to the extent they exceed 7.5% of AGI, health insurance premiums while unemployed, a total disability, some higher education expenses, and inheriting an IRA.
One good strategy for higher income earners is to do an after-tax to Roth conversion. This allows single taxpayers with MAGI over $125,000 or married taxpayers with MAGI over $198,000 to utilize an after-tax IRA and then convert it to a Roth shortly thereafter. Any earnings at that time will be taxable. Anyone can do an after-tax IRA no matter what their income is. For singles with MAGI greater than $125,000 or married couples with MAGI above $198,000, phase out contribution amounts start to incur. By the time the single taxpayer’s MAGI hits $140,000 or the married taxpayer's MAGI hits $208,000, Roth contributions are no longer available. It is important to remember when doing an after-tax to Roth conversion that any additional IRAs will be included in the conversion for determining tax due. Tax due is determined on a pro-rata basis. Therefore, you should roll existing IRAs into your employer retirement plan if you intend to implement this strategy. For instance, if you contribute $7,000 to an after-tax IRA and you also have a $7,000 pre-tax IRA, converting the after-tax IRA will result in 50% of the conversion amount to be taxable. The calculation is total IRAs divided by the taxable portion to determine the percentage of the conversion that is taxable, which in this case is 50% - not a good result by any stretch of the imagination.
Roth Conversion IRAs
Unlike the Roth contribution IRA, the Roth conversion IRA starts a new 5-year period every time a conversion is made. Unlike the Roth contribution IRA, there are no income restrictions - anyone can do a Roth conversion. Roth conversions cannot be recharacterized like they were able to be in the past - once you do the conversion, you are stuck with it. Conversions will raise your taxable income, and for those on Medicare, conversions can cause Medicare B and D premiums to be higher. The benefit for older investors is that, unlike regular IRAs and retirement plans, there are no required minimum distributions at age 72. This allows for better tax management for those with Roths.
In addition, the SECURE ACT eliminated the stretch IRA provisions for certain beneficiaries allowing IRA beneficiaries to spread the required distribution over their lifetimes. Most beneficiaries will now have only 10 years to take the money out. Exceptions to the 10-year rule are the spouse, minor children, disabled beneficiaries, and those younger by less than 10 years. In those cases, the stretch provision is still allowed. Beneficiaries inheriting Roth IRAs can let the Roth grow tax-free for up to 10 years or more with the stretch provision and then take the money out tax free. Unlike Roths, traditional IRAs will be taxable with each distribution the beneficiary takes, making the Roth a superior investment for beneficiaries.
As always, if you have any questions about your Roth IRA or any of this information, please do not hesitate to reach out.
To discuss this content further or to ask any financial-life question you may have, we encourage you to reach out to us at 724.942.2639 or schedule a FREE/no-obligation time to chat with an advisor at your convenience.
Please don't forget to share, and as always... know that BBA is here to help!
We appreciate our relationship with you and look forward to delivering this value weekly! If you're new to BBA, we welcome you aboard and look forward to getting to know you... Start the conversation!