The Two 5-Year Roth IRA Rules Explained | Here's How They Work

hey everybody welcome back to the financial freedom show my name is rob berger in this video we're going to look at the two five-year rules that apply to roth iras these are rules you don't want to mess up they are significant ramifications including extra taxes and even a 10 percent penalty and i hate to say this but they're kind of complicated however the good news is i think once we begin to understand the purposes behind the rules they make them a little easier to understand so we're going to walk through this i'm going to mention a few resources from the irs uh i will link to those below the video so with that let's get started and i even for you guys put together a a powerpoint presentation for this one so here's what we got planned there are two five-year roth ira rules we're going to look at both of them the first one i call the five-year roth ira account rule and it is one thing that helps us determine whether we'll pay income tax on a portion of a distribution from our auth iras that's the first one we're going to look at then the second one applies specifically to roth ira conversions and that rule helps us determine whether we will pay a 10 penalty so those are the two rules they serve very different purposes we're going to look at them both now as a starting point we need to understand how we get money into a roth ira and there are basically three ways there's the the contributions you know you just open up a roth ira and you contribute up to the the annual limit and those are just simple contributions you can also do either a conversion which we'll talk about in a minute or a rollover usually from a workplace retirement account that's a second way and then of course uh there are earnings on all of those so you can have dividend and interest on your contributions conversions and rollovers or just growth in the value of your investments now why am i walking through that well a primary reason is this and it's something we need to keep in mind roth ira contributions can be withdrawn at any time penalty and tax-free what that means for us is that the five-year rules we're going to look at have absolutely no application whatsoever to roth ira contributions you can take those out anytime you want for any reason or no reason at all penalty and tax free that's probably the simplest part of the two rules we'll cover today all right so with that let's jump into the first rule and that's the five-year rule on roth ira accounts to satisfy this rule you have to have opened up and contributed to a roth ira and held it for at least five consecutive tax years so that's how it's it's done that's what you have to do to satisfy it now the good news is once you satisfy this rule for your you know your first roth ira you've satisfied it for all of them both all your current and all your future roth iras forever and ever and ever so once you've satisfied it you're done it doesn't matter if you have one roth ira or you have 10 roth ira roth ira accounts here it's important to keep in mind that the irs looks at all of your roth ira accounts as just one big pot of money they don't care that you you hold your roth ira accounts your money in one account or 10 accounts it doesn't matter so once you've satisfied it you even have satisfied it for some future roth ira account that you might open whatever five or ten years from now once you've satisfied the rule you're good to go you've satisfied it for all times now what happens if you haven't met the rule well if you take out earnings remember contributions can come out anytime penalty and tax-free but if you take out earnings before you've satisfied the five-year rule those earnings will be subject to tax and here's the important thing to keep in mind that's true even if you're 59 and a half years of age or older and that's part of the rule that can trip folks up they think well if i opened up say a roth ira for the first time when i'm 57 and then take money out at 60 i should be okay because i'm 59 and a half or older not true you still have to satisfy this five-year rule of roth ira accounts if you haven't even if you're 59 and a half or older when you take out earnings they will be subject to income tax and we can take it a step further that's true if you're a first-time home buyer you may have heard that you can take money out of a roth ira as a first-time home buyer without penalty and that's true you can of course you have to meet the rules uh related to to that and you won't get get hit with that 10 penalty but if that withdrawal includes earnings and you haven't satisfied the five-year rule those earnings will be subject to income tax and believe it or not that's true even if you die and you you haven't satisfied the raw the five-year rule and your beneficiaries take out the money before the five-year rule has been satisfied the earnings will be subject to taxable income now as i've pointed out this rule doesn't have anything to do with the 10 percent penalty that's separate if you're 59 and a half and you haven't satisfied the five-year rule and you take money out it'll be subject to income tax because you didn't satisfy the five year rule but because you were 59 and a half or older you won't pay the 10 penalty i know at first glance this is a little confusing you just the key takeaway here in terms of the 10 penalty is that the five-year rule on roth ira accounts doesn't determine whether or not you'll pay a 10 penalty now i think it's helpful to understand what a qualified distribution is and i've got it in the slides here this comes directly from the irs and in fact let me show you that now bear with me here it is this is actually from the irs website we can look at it here it's the same thing and again i'll leave a link to this below the video but in order for a distribution from a roth ira to be what they called a qualified distribution meaning it's not subject to tax or penalty you have to have held it for five year period that's the five year rule we've been looking at and the payment or distribution is made and here are all the rules once you've reached 59.5 or older or because you're disabled or it's a beneficiary or first-time homebuyer so keep that in mind uh that's what a qualified distribution is if you've met one or more of these but you haven't met the five-year rule you'll avoid the 10 penalty but because you haven't met the five-year rule uh the the earnings portion of the distribution will be subject to ordinary income tax i hope you're with me so far i know this could be a bit mind-numbing and i'm doing my best to walk you through it again i'll leave a link to uh that irs document in the video below but before we move to the second five-year rule there's something we really important we have to understand and we'll put this in some perspective because one might ask why have they bothered with this five-year rule why throw that in and and the answer is the irs wants to encourage us to use roth ira accounts as long-term retirement investment vehicles they don't want us to use it for just a couple of years they want us to think long term and so this is the way that they've sort of implemented that that goal or policy is to throw in uh this five five year rule well guess what it applies to roth 401ks as well with a roth 401k you have to have satisfied that five-year rule for distributions from a roth 401k to be considered qualified but that raises a big question what happens if you take a roth 401k and roll it into a roth ira how does the five year rule work well let's walk through it first yes you must satisfy the five-year rule on a roth 401k but what happens when you do a rollover number one you get absolutely no credit for the years you held the roth 401k the roth 401k becomes irrelevant you've moved the money out of it and you've moved it into a roth ira so the only thing that matters is how long you've held all of your roth iras and whether or not you've satisfied the five-year rule for your roth ira and that has some pretty practical implications for example let's say you've only had a roth 401k for two years and maybe you retire and you roll it into a roth ira and you've already satisfied the five-year rule for your roth iras well then you're good to go again it's the roth ira rules that apply once you do the rollover now the flip side is let's say you've had a roth 401k from five years or more and you've satisfied the rule and you're getting ready to retire let's say you're 65 and you open up your very first ever roth ira to roll over that 401k into the ira well you haven't satisfied the five year rules for the roth ira and so any earnings that come out of that roth ira before you've met the five-year rule will be subject to income tax so keep that in mind it's one reason why i believe you want to open up a roth ira whether it's through direct contributions or maybe even from a conversion from a traditional ira as early as possible and get that five-year rule satisfied because again once you've satisfied it you're done you never have to worry about it again all right let's turn to the second five-year rule that applies to roth ira conversions and believe it or not this one is a little more straightforward the first thing to keep in mind as i mentioned earlier is this rule determines whether you'll pay a 10 percent penalty on any distributions and here i think it helps to understand the rationale behind the rule let's imagine you have a deductible regular traditional ira and you want to take money out before you're 59 and a half and you think well i know i'm going to pay taxes on it but i'd really like to avoid that pesky 10 penalty so you think to yourself here's what i'll do i'll convert it to a roth ira because i've heard i can take money out of that taxability free so i'll convert it to a roth ira i'll have to pay my taxes on the conversion but i knew i'd have to pay those anyway and then you think to yourself once it's in the roth i'll just take it out and avoid the 10 penalty well the irs already thought about that and to avoid that what they've done is said no no no we're going to sort of apply that 10 penalty anyway if after the conversion you take the money out before the five years has been satisfied so that's sort of the rationale behind it and because of that rationale there are some nuances we need to understand the first is the five-year rule must be satisfied for each and every conversion remember with the the five-year rule on roth ir ira accounts once you satisfied it once you are done that's not true with conversions you're never done you have to satisfy this rule for each and every conversion and that's the bad news the good news is unlike the first five-year rule we looked at on roth ira accounts that could trigger even if you're older than 59 and a half not this one the five-year rule in roth ira conversions doesn't apply once you reach 59 and a half years of age or older and if that seems a little odd keep in mind the purpose of the rule the purpose of the rule is to prevent us from sort of sidestepping the 10 penalty on traditional iras but if we're already 59 and a half or older there's nothing to sidestep because the 10 penalty doesn't apply all right hope that makes sense the last thing i want to mention here is this concept of a roth ira conversion ladder given this rule this is especially relevant for folks who retire early say before they reach 59 and a half and they're going to be spending some of their money it can often make sense to convert a year's worth of expenses each year over a number of years and then wait for the five-year period to lapse so that you've satisfied the rule and you can take out the money without triggering the 10 penalty again that applies primarily uh to folks that retire early now i know i've thrown a lot at you i hope it makes sense again i'll leave links below the video but there's one other really important thing to keep in mind because you may say well rob this is great appreciate the effort the slideshow could have been maybe a little more colorful but whatever appreciate the effort but when i take out money how do i know if it's a contribution or if it's a conversion or a rollover or maybe it's earnings how does that get determined well the good news is the irs has already figured that out for us and i will link to this uh below the video but i will show it to you now they have what they call ordering rules of distributions and it works in our favor believe it or not so anything you take out is first uh designated as a regular contribution and that's good news right because we don't pay taxes or penalty on contributions we take out and then they're deemed to be conversions and rollovers on what they call a first in first out basis the rules can get a little complicated it also divides it between taxable and non-taxable portions but i can tell you this uh the rules work out in our favor obviously if you've got a series of conversions you're going to want to work through that probably with a tax professional to make sure you understand the consequences but that comes next in the ordering rules and it's only once all of the contributions have come out and all of the conversions and rollovers have come out that earnings are deemed to be distributed and so that's good news for us keep in mind though that the irs treats all of your roth ira accounts as one big pot of money so don't think that you can say well i'll put my contributions in this this roth ira and my earnings over here and i'll try to manipulate the ordering rules and the irs won't let you do that that's maybe the bad news but again the good news is the ordering rules work in our favor all right i know this is a lot it can be complicated i highly recommend that you get professional tax advice before making any important decisions on all of this if you have any questions please do leave them in the comments below i'll do my best to help you out any way i can again i'll leave links below this video to some helpful resources and until next time remember the best thing money can buy is financial freedom

Channel: Rob Berger

Views: 65,417

Keywords: roth ira, roth ira 5 year rule, 5 year rule, roth conversion 5 year rule, roth ira withdrawal rules, roth conversion, 5 year rule roth ira, roth 5 year rule, two 5 year rules, roth ira two 5 year rules, roth 5 year rule explained, roth 5-year rule explained, multiple 5-year rule

Id: -BegvTulSh8

Length: 15min 39sec (939 seconds)

Published: Sat Jan 01 2022