Broker Check

The Five Year Rule

| April 12, 2019
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I’m out on a date with my wife—we just enjoyed a delicious tuna dinner (paid with a gift card of course) at McCormick and Schmick’s followed by watching Captain Marvel saving planet earth from her evil Kree brethren.

And I receive this voicemail from a client. His tone was downtrodden, beaten up, and even a little frustrated. Here’s what he said…

“Hey Dave, this is (John and Jane). We’re getting our taxes done and because of Jane’s distribution (from her Roth IRA), they are trying to tax us on it. We don’t know why that would be.

It’s a Roth IRA and we shouldn’t be paying any taxes on it. Just wondering if you knew anything about why that may be happening. If you get a chance, give us a call.”

I couldn’t believe it!

What the heck was the CPA doing?

Roth IRA’s aren’t taxable! I’ve even written about it before.

Just check out this blog post where I lay out why you SHOULD consider doing a back door Roth IRA.

And also this blog post where we talk about the pros and cons of Roths.

You might get taxed on converting money into a Roth IRA, but NOT from withdrawing from them…. Or could you?

I was starting to question myself and the advice I give. Was I missing something?

You see what happened is the client took money out of their Roth IRA in BOTH 2017 and 2018. Yet, the CPA never mentioned an issue in 2017. Why were they bringing it up this year?

When the client received a distribution from the Roth, they received a tax form called a 1099R. The 1099R had a box checked called the box “T”.

A code T in box 7 of 1099-R is for a Roth IRA distribution when an exception applies.  It is used for a distribution from a Roth IRA if the IRA custodian does not know if the 5-year holding period has been met but: 

  • The participant has reached age 59 & 1/2
  • The participant died, or
  • The participant is disabled.

That made sense.

This client was OVER 60 years old. They aren’t subject to the 10% early withdrawal penalty on the EARNINGS.

An article on Bankrate.com did a great job of breaking it down

Since we’re talking about contributions, it’s important to note that anyone (of any age) who contributes to a Roth IRA can withdraw their contributions at any time without penalty. The key word here is contributions though since you cannot normally withdraw your earnings prior to age 59 ½ without paying a 10% early withdrawal penalty. Earnings can generally be withdrawn without penalties after age 59 ½ provided you meet the five-year rule.

Savers don’t need to do anything special to ensure that only the contributions are withdrawn since the IRS has rules that dictate which funds are removed from the account first.

The IRS decrees that Roth IRA distributions are taken in this order:

  1. Contributions
  2. Conversions or rollover contributions
  3. Earnings on investments”

 

So, let’s review a few important points here.

  • You can WITHDRAW contributions to Roth IRAs with no penalty
  • If you are above 59.5 years old, you can WITHDRAW both your contributions AND earnings tax-free as long as you meet the ‘five-year rule’
  • If you are BELOW 59.5 years old, you can WITHDRAW contributions with no penalty BUT if you withdraw your whole account, you could get a 10% early withdrawal penalty on JUST the earnings (unless you do a 72t, more on that in the future)

So, it’s not always true that Roths are COMPLETELY tax-free, if you are below 59.5--- you could have a penalty on the earnings.

Let’s continue to discover about the 5-year rule.

  

While plenty of people understand the tax savings one can glean by investing post-tax income into a Roth IRA, another lesser known rule could foil your withdrawal plans if you don’t know about it ahead of time.

The 5-year rule for Roth IRA distributions stipulates that 5 years must have passed since the tax year of your first Roth IRA contribution before you can withdraw the earnings in the account tax-free. Keep in mind that the five-year clock begins ticking on January 1st of the year you made your first contribution to the account.

The Roth IRA is a retirement saver’s dream, but only after this important rule has been followed. Five years must have elapsed since the tax year of your first Roth contribution before the earnings can be withdrawn tax-free. That applies across the board to retirees, even if the account owner is 110 years old, a first-time homebuyer or deceased.

Also, note that Roth IRA conversions have their own five-year clock that starts on January 1st of the year the conversion was made. Inherited Roth IRAs have their own clock as well, but it starts with the original account owner and when they made their first contributions — not when the person inherited it.”

 

Let’s reiterate here--- the 5-year rule STARTS from when you put your very 1st dollar in a Roth--- doesn’t matter whether it is $1 or $100 or $1,000 --- once you fund your Roth IRA, the clock starts ticking.

If you started your account on 1/1/2013 or before, you are good! The five-year rule doesn’t apply to you anymore.

Now, this isn’t all of the story.

There are exceptions to get around the 5-year rule, but we’ll have to leave that for another day.

 

Final Thoughts

In reviewing the records, My clients actually established their Roth wayyyyyy back in 2005. So, they were far past the funding deadline.

The client with the Roth was over 59.5.

Five-year rule--- met! Over age 59.5--- check!

However, their CPA did ask them for their cost basis for the Roth.

Basically, they asked for the contribution history. Luckily, we were able to obtain ALL of that info through annual statements and the IRS form 5498.

So, my friends--- make sure you have great record keeping! You need to know the following when you have a Roth IRA:

  • The date you started it
  • The contribution history. Keep your form 5498s and year-end statements even if they got back 15 or 20 years
  • When you turn 59.5
  • If there might be any special exceptions that could allow you to avoid the 10% early withdrawal penalty if you are below 59.5

Have more questions?

Feel free to reach out to me at [email protected] or give me a ring at 952-831-8243.

Advisory services through Capital Advisory Group Advisory Services LLC and securities through United Planners Financial Services of America, a Limited Partnership. Member FINRA and SIPC. The Capital Advisory Group Advisory Services, LLC (CAG) and United Planners Financial Services are not affiliated.

The views expressed are those of the author and may not reflect the views of United Planners Financial Services. Material discussed is meant to provide general information and it is not to be construed as specific investment, tax, or legal advice. Individual needs vary & require consideration of your unique objectives & financial situation

 

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