December 5, 2023 • 19 mins
James explores the nuanced aspects of Roth IRAs, shedding light on intricacies that can confound even experienced investors.
Through a listener question from Manfred, a retiree contemplating a $50,000 conversion from a 401k to a Roth account, James dissects the crucial five-year holding period and the order in which contributions, conversions, and earnings are treated during withdrawals.
James also provides clarity on distribution rules, exceptions, and strategic considerations, offering a comprehensive guide to navigating the complexities of Roth IRAs for optimal retirement planning.
Questions Answered:
How does the timing of subsequent conversions impact the application of the five-year rule?
In Roth IRA withdrawals, what is the specific order of operations, and what implications does that have?
Timestamps:
0:00 Manfred’s question
1:39 Get the cheatsheet
2:37 Understanding source nuances
7:01 The five-year rule
8:37 IRS’s order of operations
11:59 Exceptions to the rule
13:49 Only a small impediment
16:14 Back to Manfred’s example
Create Your Custom Strategy ⬇️
Mark as Played
Transcript
Episode Transcript
Available transcripts are automatically generated. Complete accuracy is not guaranteed.
Speaker 1 (00:00):
Roth IRAs can be a powerful tool for retirement
savings, but there's some trickythings about them that can also
be quite difficult tounderstand.
In today's episode of Ready forRetirement, we're going to go
over some of these lesser knownaspects of Roth IRAs, some of
these tricks, so that you knowwhat to avoid and how to make
the most of these in your RothIRA strategy.
So I'll come in up next ontoday's episode of Ready for
Retirement.
This is another episode ofReady for Retirement.
(00:24):
I'm your host, james Cannell,and I'm here to teach you how to
get the most out of life withyour money.
And now on to the episode.
So let's jump right in.
Today's episode comes from alistener question.
The listener's name is Manfred,and Manfred says this.
He says I am 65 years old andretired.
My spouse is also retired.
I'm going to convert $50,000 ofa 401K into a Roth account.
(00:46):
I already have an old Rothaccount that is well over 5
years old.
I started it in 2015.
Do I have to wait the 5 yearholding period on the $50,000
that I convert into the old Roth?
I would like to know if I havethe option of withdrawing it for
a large purchase.
I will also be converting 401Kfunds for the next 5 years.
Will those subsequentconversions also be held up for
5 years?
(01:07):
What is the rule if I were toconvert those same funds into
newly established Roth accountsin 2023?
I have read and gotten verbal,conflicting answers.
Thank you for your response andI, like your YouTube channel,
look forward to viewing the restof them.
Thank you, manfred.
Well, manfred, thank you verymuch for that question and you
probably have received a lot ofconflicting answers because
(01:27):
there's a lot of conflictinginformation out there and,
believe it or not, as simple asRoth IRA sound, there's a lot of
nuance to this and there's alot of details that you need to
understand in order to avoidcommon mistakes that people make
that end up costing a lot ofmoney.
Now, before we jump in ontoday's episode, if you are
listening to this on Spotify orlistening to this on Apple
podcasts, be sure to check thisout on YouTube, because in the
(01:49):
YouTube show notes, I'm going tohave a PDF link or a link to a
PDF that contains a cheat sheetfor everything that we're going
to talk about in today's episode.
Some of this can get fairlyconfusing, so having a cheat
sheet where you can actually gothrough and see your specific
situation to understand.
Can you withdraw Roth fundspenalty free is very helpful, so
be sure to check out theYouTube channel.
It's going to be in the shownotes if you're listening to
(02:10):
this on Spotify or Applepodcasts, but the YouTube
channel is just James Cannelland you can find all of this
there.
So today, what we'll be talkingabout?
We'll be talking about thefive-year rule.
We'll be talking about theimpact of Roth conversions.
We'll be talking aboutdistribution ordering rules.
We'll be talking aboutconditions that trigger the 10%
early distribution penalty, aswell as exceptions to the 10%
early distribution penalty.
(02:32):
And if you're listening andsaying, what on earth does any
of that have to do with the RothIRA?
You're not alone.
A lot of people think of RothIRAs.
They think put money in, let itgrow, tax-free, everything's
good.
But there is quite a bit toknow, and that's what we're
going to cover on today'sepisode.
So let's start right here.
Money in your Roth IRA can onlycome from one of three sources
(02:53):
First, contributions.
Second, conversions, and thirdis growth.
So each of those contributionsources, or each of those
sources, I should say, of funds,has different rules in terms of
how it can come out of yourRoth IRA, the timing of when it
can come out of your Roth IRA,and whether or not it's subject
to taxes and penalties.
So let's go through each ofthese one by one, starting with
(03:15):
contributions.
One of the greatest things aboutRoth IRAs is, at any point and
at any age, you can pull out thecontributions you made to a
Roth IRA completely tax-free andcompletely penalty-free.
Does not matter if you're over59 and a half or under 59 and a
half.
Any money that you put intoyour Roth IRA, you can pull that
(03:37):
back out at any time withouthaving to wait any period of
time, and that money is yours,free and clear.
You don't pay any taxes.
You don't pay any penalties fordoing so.
So let's take a look at anexample here.
Let's assume that you're 40years old and you put $5,000
into a Roth IRA and you've heardpeople say you can't touch this
money until 59 and a halfwithout penalty or taxes.
Well, one year goes by, you'renow 46 years old and something
(04:00):
comes up and you have a majorexpense and you really don't
have any quick cash availableand the Roth IRA is the only
place that you're looking to goto get that money.
Well, assume your $5,000contribution now grew to $6,000.
You're 41 years old.
With $6,000 in your Roth IRA.
You can, at that moment, pullout the $5,000 that you put in
(04:20):
and not pay any penalties or anytaxes to do so.
You made that contribution, soit's your money free and clear.
Now, the $1,000 of growth onthat contribution, that is what
you cannot touch until age 59and a half without paying taxes
or penalties.
But if you needed that money,that $5,000 is free and clear.
It's just the growth that youreally couldn't touch.
(04:41):
So that's the first source offunds that you could potentially
have in a Roth IRA'scontributions.
The second is conversions and aswe go back to Manfred's
question, this is really what heis talking about.
Here's a really important thingto note Every single time you
do a Roth conversion, it has itsown separate five-year clock
for when you can then pull thatmoney out tax-free and
(05:04):
penalty-free.
Another important thing to noteabout this when you're doing a
conversion, sometimes it's justa straight Roth conversion.
You have money in a traditionalIRA that you want to move to a
Roth IRA for some tax purpose.
Well, if you are doing abackdoor Roth contribution,
technically that is a conversiontoo.
So you're putting money into atraditional IRA, you're not
deducting it, and then you'reimmediately converting the
(05:27):
after-tax balance into your RothIRA.
And that's what gets peopletripped up is they don't
necessarily think of a backdoorRoth contribution as a
conversion, but really it is.
So any conversion that you do,it has its own five-year window
for when you can access thosecontributions penalty-free.
Make sure you stay through tothe end of this, because I'm
actually going to go throughthis and show you why each
(05:47):
conversion, having its ownfive-year clock for when you can
access it, isn't actually asrestrictive as many people think
it might be.
But one of the reasons theythink that is because when you
retire, or when many peopleretire, one of the common
strategies that people implementis they'll do Roth conversions.
In those years where their taxbracket is lower.
They will strategically shiftmoney from their traditional
(06:08):
IRAs into their Roth IRAs.
Now, don't do it all at once.
They do a little bit the firstyear, maybe a little bit the
second year, maybe a little bitthe third year, and so on and so
forth.
And so people get concerned.
They say look, every time we dothis, there's a new five-year
rule that goes into effect.
That's absolutely right, but,like I said at the end, I'm
going to share with you somestrategy and why that's actually
(06:28):
not as impactful as peoplethink it might be.
So that's conversions.
We've gone over contributions.
We've gone over conversions.
The next thing is growth.
So, again, money in your RothIRA can only come of one of
three things contributions,conversions and growth.
Growth is pretty simple.
It's simply how much have yourcontributions grown by?
How much have your conversionsgrown by?
(06:50):
If you've put in a total of$50,000 in contributions over
the course of 10 years and yourRoth IRA is now worth $80,000,
well, put simply, there's$30,000 in there.
That is growth, and it'simportant to understand that
each of these is going to betreated differently when it
comes to how can you pull moneyout of your Roth IRA.
So I'm going to walk throughthat in just one second, but
(07:10):
before I do, on top of this, youneed to be familiar with a rule
called the five-year rule, andthis is a separate five-year
rule than what we just talkedabout with conversions.
This is one of those thingswhere it can get pretty tricky,
but, yes, there's a five-yearrule where every single
conversion you do, you need towait five years until you can
pull that conversion money outof your Roth IRA penalty free
and tax free.
But there's a separatefive-year rule and that rule
(07:32):
says you cannot withdraw anyearnings in your Roth IRA tax
free until it's been at leastfive years since you originally
contributed to the Roth IRAaccount.
A lot of people that hear thisand say, well, yeah, of course
there is.
Why does that matter?
Well, where this matters is,for example, if you are already
over the age of 59 and a half.
Say, maybe you're 60 years oldand you've never contributed to
(07:54):
a Roth IRA before.
Well, maybe you put $5,000 intoa Roth IRA and then a year goes
by and you have $6,000 thereand you need to take that $6,000
out and you say, ok, well, thisis a Roth IRA, so the money is
tax free and I'm older than 59and a half, so I qualify from
the age perspective.
But you really don't, becausethe five-year rule for Roth IRA
(08:16):
says for you to be able toaccess that growth penalty free
after the age of 59 and a half,the account must have been
established for at least fiveyears.
So that's something that reallydoesn't come up a whole lot,
but does occasionally come upand you need to be mindful of.
So what does all that matter?
We know that there'scontributions, we know there's
conversions, we know there'sgrowth.
Here's why it matters.
(08:38):
When you begin taking money outof your Roth IRA, the IRS is
going to view it.
They're not going to go in andsay, okay, james, well, you get
to decide.
Is this money that you'retaking out growth, or is this
money that you're taking out aconversion, or is this money
that you're taking out anoriginal contribution?
They have an order ofoperations that is followed
regardless of who's taking moneyout.
The order of those operationsgoes as follows Contributions
(09:03):
come out first, followed byconverted dollars coming out
next, followed by earningscoming out last.
So it does not actually matterwhen you made contributions to
your account.
It doesn't matter the timing ofwhen you did conversions to
your account.
It doesn't even matter how muchgrowth is in your account.
From the perspective of whatthe IRS is looking at, they're
(09:25):
treating the first dollar youtake from your account Doesn't
matter if this is the firstdollar made by a conversion or
by a contribution.
They're saying that firstdollar is going to be treated as
if it was a contribution.
Let's look at an example.
Let's assume that you makecontributions to your Roth IRA
of $5,000 per year and you dothat for five years in a row.
Then let's assume you startmaking too much money to put a
(09:49):
contribution directly into yourRoth IRA.
There's income limits here.
But let's assume that you startdoing backdoor Roth conversions
.
So for the first five years youjust put money directly into
your Roth IRA.
The next five years you don'tdo it directly, but you're still
getting $5,000 per year intoyour Roth IRA via a backdoor
Roth conversion.
So you've done that for 10years.
(10:11):
Now this whole while let'sassume that your money is
invested and it's growing andyou have $25,000 of growth.
So you did this for 10 yearsyou now have $75,000 inside of
your Roth IRA.
Let's assume you're under theage of 59 and a half and you
need to access some of thismoney.
Well, if you were to go in andtake money out, the IRS is just
(10:34):
going to say James, if this isyour account, the first $25,000
that you take, we're just goingto assume as if that was your
contributions, because that'show much I'd contributed to my
account over the lifetime of myRoth IRA.
If I need more than that,they're going to assume in.
The amounts above $25,000 areconversions, and then next
amounts.
(10:54):
Until I fully withdraw, all myconversions are going to be
treated as such and then,finally, any amounts above and
beyond that are going to betreated as growth.
And just to make sure I'm beingclear with this example, it
actually doesn't matter theorder in which I make these
contributions.
Let's say, for the first fiveyears I was doing Roth
conversions via a backdoor Rothcontribution and then the next
five years I was doingcontributions.
(11:15):
So same exact example as before, but just flip the timing of it
.
It really doesn't matter in theIRS's eyes.
Still, if I'm going to takemoney out of my Roth IRA, the
first $25,000 I withdraw, theIRS is simply going to assume
that that is coming back taxfree because it's a return of
contribution.
I actually recently did this.
Not recently, but several yearsago.
(11:36):
When I started root financial,I was looking to see what's the
best way to fund some of thesethings going forward and because
I had been diligent aboutfunding my Roth IRA for the
first several years, I was ableto pull money out of my Roth IRA
completely tax free and penaltyfree and using some of those
dollars to start my company.
So sometimes things come upunexpectedly that you say I need
(11:56):
money for.
Ideally, you have non-Rothfunds that you can use in those
situations, but if not, it'salways nice to know that you
have your Roth IRA and canaccess those contributions at
any point.
Here's the next thing that youneed to know If you are taking
money from your Roth IRA and youeither haven't met your five
year rule in terms of eachconversion meeting its own
(12:17):
separate five year window, oryou're under 59 and a half and
not yet eligible to take outgrowth, there are some
exceptions to this, and this iswhere I'll say download the
resource that's in thedescription on the YouTube page,
because there's a lot of theseand I'm just going to summarize
them real quick.
But this is in the resource.
But the bottom line is thedistribution may qualify for an
exception.
This is because, number one,you're age 59 and a half or
(12:39):
older.
So in that case there's no 10%penalty or taxes on a
distribution from your Roth IRA,even if it's growth, assuming
you've met the five year timeperiod from when the account was
first opened up.
There's also an exception ifyou are taking the distribution
as a part of what are calledseries of substantially equal
periodic payments.
There's an exception if moneywas used to pay for qualified
(13:00):
higher education expenses,unreimbursed medical bills above
7.5% of a just gross income,qualified health insurance
premiums while unemployed, aqualified disaster distribution
up to $22,000 per disaster fordisasters after January 25th of
2021.
Or if the distribution was madewithin one year after the birth
or adoption of a child, up to$5,000.
(13:22):
So there are some exceptionshere, but in general, if it's
not your own contribution thatyou're taking out or it's not a
conversion that you've had inyour Roth for at least five
years, you're going to pay taxesin a 10% penalty for anything
else that you take out.
Be very mindful of that,because the last thing that you
want to do with your Roth ishave it all of a sudden be
subject to taxes or have it besubject to a penalty, because
(13:46):
this is one of the mostimportant accounts in most
people's plans, simply becausethere's so many strong tax
benefits to it.
Now, one of the things that Imentioned as I said, I'm going
to go over strategy a bit totell you why that five year rule
for each conversion isn'tactually that much of an
impediment, or it shouldn't befor most people.
And if I go back to Manfred'squestion, he was saying he's
(14:06):
going to convert $50,000 of his401k into a Roth account.
He also said I already have anold Roth account that is well
over five years old.
That started in 2015.
So, manfred, going back to yourquestion, any dollars that are
already in your Roth IRA doesn'tmatter when you contributed to
them.
Those are all eligible for youto take out, completely tax free
(14:27):
and penalty free because you'vealready met the five year rule.
It doesn't matter if you justput one single dollar into your
Roth IRA back in 2015 and thenput the rest of it in, say, a
year ago or two years ago.
That doesn't matter.
That five year clock, the fiveyear rule that says your Roth
IRA must have been establishedfor five years.
Once you've met that timeperiod or that holding
(14:49):
requirement, all contributionsand growth on that assuming
you're over 59 and a half, whichManfred is are completely tax
free to you if you were to takethem out.
However, the conversions soconverting the $50,000 from your
401k into your Roth accounteach of those will have its own
five year time frame until youcan pull that money out tax free
(15:11):
and penalty free.
Remember the order of operations.
The IRS is going to treat anymoney you pull out first and
foremost as contributions andthen those conversions.
But to answer your questiondirectly, there is that
five-year holding period.
Here's why I don't think that'sactually such a big deal, at
least generally speaking.
For most people.
The benefit of ARRF IRAs is youget to let that money grow
(15:33):
tax-free.
Now it's a very obviousstatement.
I think everyone listening tothis probably knows that the
benefit of ARRF IRA is thatmoney grows tax-free and then
comes out tax-free.
But here's the thing you don'tget any tax benefits just for
putting money into ARRF.
In other words, the longer youlet your money stay in your ARRF
(15:53):
, the greater your benefit willbe.
It's just longer and longer forthat money to grow tax-free,
which means greater and greateramounts that can then come out
tax-free.
But if I were to put money intoa Roth IRA today and even want
to pull it out in a year fromnow, I probably haven't gotten a
tremendous amount of benefitunless there was some pretty
significant growth on my moneyin that single year.
(16:16):
So you want to ideally let yourRoth accounts grow tax-free as
long as possible, because that'swhere you're going to get the
maximum benefit.
So if I go back to Manfred'sexample and this is definitely
not advice, but this is just mygeneral observation I don't
really see much of a point tosay why would you consider
converting 50,000 from a 401k toa Roth IRA just to pull that
(16:39):
out in the next handful of years?
The goal there, the reason youwould do it, is to convert that
money and then let it growtax-free for many, many years.
So later on in retirement youwould have that money to live on
.
If you're saying, well, james,I want to pull that money out
now because I'm in a lower taxbracket now, but I still want to
use it in a few years, wellgreat, maybe pull that money out
(17:00):
, but just don't convert it.
Just treat that as adistribution, keep it somewhere
where it's available to you touse for when you do want to use
that money for a purchase.
But because you're not going tolet it grow for very long, I
don't really see much of abenefit to even having a Roth
IRA, even if it weren't for thatnew five-year window of having
to wait to access that specific$50,000 conversion.
So, manfred, as you'relistening or as you're
(17:22):
submitting this question, youmaybe have different thoughts on
this, or maybe there'ssomething that I've just not
even seen within the example, ormaybe a specific reason why
you'd want to convert that moneybut then turn around and access
it pretty soon.
Generally speaking, though,without knowing your specific
situation, there may not be awhole lot of benefits to that.
The benefits really come ifyou're going to do a conversion
today and then that money isgoing to grow and it's going to
(17:44):
double in value, triple in value, and it's going to do all that
completely tax-free.
Well, that's a huge benefitbecause as you now take out that
value, that's two times youramount, three times your amount.
It's all coming out tax-freelater on in retirement, along
with many other benefits likenot being subject to required
minimum distributions and otherthings like that.
So that is it for today'sepisode.
(18:05):
Manfred, thank you very much foryour question.
I know it's a fairlystraightforward question with a
fairly simple answer, but it cansometimes get confusing, so I
hope this was helpful as you'retrying to understand what are
the rules around taking moneyout of a Roth IRA.
And again, a reminder if you'relistening to this on Apple
Podcasts or on Spotify or someother podcast player, make sure
you check this video out onYouTube, because in the YouTube
(18:25):
description I'm going to have alink to a cheat sheet that's
essentially a flow chart thatguides you through the whole
conversation we had today, soyou can understand that the
money you're taking out of yourRoth IRA will be penalty-free
and tax-free, or if you mightget stuck with a penalty for
doing so.
So thank you, as always, forlistening.
That is it for today and I'llsee you all next time.
Hey everyone, it's me again forthe disclaimer.
(18:46):
Please be smart about this.
Before doing anything, pleasebe sure to consult with your tax
planner or financial planner.
Nothing in this podcast shouldbe construed as investment, tax,
legal or other financial advice.
It is for informationalpurposes only.
Thank you for listening toanother episode of the Ready for
Retirement podcast.
If you want to see how RootFinancial can help you implement
(19:08):
the techniques I discussed inthis podcast, then go to
rootfinancialpartnerscom.
Click Start here, where you canschedule a call to one of our
advisors.
We work with clients all overthe country and we love the
opportunity to speak with youabout your goals and how we
might be able to help.
And please remember, nothing wediscuss in this podcast is
intended to serve as advice youshould always consult a
financial, legal or taxprofessional who's familiar with
(19:30):
your unique circumstancesbefore making any financial
decisions.
Roth IRAs can be a powerful tool for retirement
savings, but there's some trickythings about them that can also
be quite difficult tounderstand.
In today's episode of Ready forRetirement, we're going to go
over some of these lesser knownaspects of Roth IRAs, some of
these tricks, so that you knowwhat to avoid and how to make
the most of these in your RothIRA strategy.
So I'll come in up next ontoday's episode of Ready for
Retirement.
This is another episode ofReady for Retirement.
(00:24):
I'm your host, james Cannell,and I'm here to teach you how to
get the most out of life withyour money.
And now on to the episode.
So let's jump right in.
Today's episode comes from alistener question.
The listener's name is Manfred,and Manfred says this.
He says I am 65 years old andretired.
My spouse is also retired.
I'm going to convert $50,000 ofa 401K into a Roth account.
(00:46):
I already have an old Rothaccount that is well over 5
years old.
I started it in 2015.
Do I have to wait the 5 yearholding period on the $50,000
that I convert into the old Roth?
I would like to know if I havethe option of withdrawing it for
a large purchase.
I will also be converting 401Kfunds for the next 5 years.
Will those subsequentconversions also be held up for
5 years?
(01:07):
What is the rule if I were toconvert those same funds into
newly established Roth accountsin 2023?
I have read and gotten verbal,conflicting answers.
Thank you for your response andI, like your YouTube channel,
look forward to viewing the restof them.
Thank you, manfred.
Well, manfred, thank you verymuch for that question and you
probably have received a lot ofconflicting answers because
(01:27):
there's a lot of conflictinginformation out there and,
believe it or not, as simple asRoth IRA sound, there's a lot of
nuance to this and there's alot of details that you need to
understand in order to avoidcommon mistakes that people make
that end up costing a lot ofmoney.
Now, before we jump in ontoday's episode, if you are
listening to this on Spotify orlistening to this on Apple
podcasts, be sure to check thisout on YouTube, because in the
(01:49):
YouTube show notes, I'm going tohave a PDF link or a link to a
PDF that contains a cheat sheetfor everything that we're going
to talk about in today's episode.
Some of this can get fairlyconfusing, so having a cheat
sheet where you can actually gothrough and see your specific
situation to understand.
Can you withdraw Roth fundspenalty free is very helpful, so
be sure to check out theYouTube channel.
It's going to be in the shownotes if you're listening to
(02:10):
this on Spotify or Applepodcasts, but the YouTube
channel is just James Cannelland you can find all of this
there.
So today, what we'll be talkingabout?
We'll be talking about thefive-year rule.
We'll be talking about theimpact of Roth conversions.
We'll be talking aboutdistribution ordering rules.
We'll be talking aboutconditions that trigger the 10%
early distribution penalty, aswell as exceptions to the 10%
early distribution penalty.
(02:32):
And if you're listening andsaying, what on earth does any
of that have to do with the RothIRA?
You're not alone.
A lot of people think of RothIRAs.
They think put money in, let itgrow, tax-free, everything's
good.
But there is quite a bit toknow, and that's what we're
going to cover on today'sepisode.
So let's start right here.
Money in your Roth IRA can onlycome from one of three sources
(02:53):
First, contributions.
Second, conversions, and thirdis growth.
So each of those contributionsources, or each of those
sources, I should say, of funds,has different rules in terms of
how it can come out of yourRoth IRA, the timing of when it
can come out of your Roth IRA,and whether or not it's subject
to taxes and penalties.
So let's go through each ofthese one by one, starting with
(03:15):
contributions.
One of the greatest things aboutRoth IRAs is, at any point and
at any age, you can pull out thecontributions you made to a
Roth IRA completely tax-free andcompletely penalty-free.
Does not matter if you're over59 and a half or under 59 and a
half.
Any money that you put intoyour Roth IRA, you can pull that
(03:37):
back out at any time withouthaving to wait any period of
time, and that money is yours,free and clear.
You don't pay any taxes.
You don't pay any penalties fordoing so.
So let's take a look at anexample here.
Let's assume that you're 40years old and you put $5,000
into a Roth IRA and you've heardpeople say you can't touch this
money until 59 and a halfwithout penalty or taxes.
Well, one year goes by, you'renow 46 years old and something
(04:00):
comes up and you have a majorexpense and you really don't
have any quick cash availableand the Roth IRA is the only
place that you're looking to goto get that money.
Well, assume your $5,000contribution now grew to $6,000.
You're 41 years old.
With $6,000 in your Roth IRA.
You can, at that moment, pullout the $5,000 that you put in
(04:20):
and not pay any penalties or anytaxes to do so.
You made that contribution, soit's your money free and clear.
Now, the $1,000 of growth onthat contribution, that is what
you cannot touch until age 59and a half without paying taxes
or penalties.
But if you needed that money,that $5,000 is free and clear.
It's just the growth that youreally couldn't touch.
(04:41):
So that's the first source offunds that you could potentially
have in a Roth IRA'scontributions.
The second is conversions and aswe go back to Manfred's
question, this is really what heis talking about.
Here's a really important thingto note Every single time you
do a Roth conversion, it has itsown separate five-year clock
for when you can then pull thatmoney out tax-free and
(05:04):
penalty-free.
Another important thing to noteabout this when you're doing a
conversion, sometimes it's justa straight Roth conversion.
You have money in a traditionalIRA that you want to move to a
Roth IRA for some tax purpose.
Well, if you are doing abackdoor Roth contribution,
technically that is a conversiontoo.
So you're putting money into atraditional IRA, you're not
deducting it, and then you'reimmediately converting the
(05:27):
after-tax balance into your RothIRA.
And that's what gets peopletripped up is they don't
necessarily think of a backdoorRoth contribution as a
conversion, but really it is.
So any conversion that you do,it has its own five-year window
for when you can access thosecontributions penalty-free.
Make sure you stay through tothe end of this, because I'm
actually going to go throughthis and show you why each
(05:47):
conversion, having its ownfive-year clock for when you can
access it, isn't actually asrestrictive as many people think
it might be.
But one of the reasons theythink that is because when you
retire, or when many peopleretire, one of the common
strategies that people implementis they'll do Roth conversions.
In those years where their taxbracket is lower.
They will strategically shiftmoney from their traditional
(06:08):
IRAs into their Roth IRAs.
Now, don't do it all at once.
They do a little bit the firstyear, maybe a little bit the
second year, maybe a little bitthe third year, and so on and so
forth.
And so people get concerned.
They say look, every time we dothis, there's a new five-year
rule that goes into effect.
That's absolutely right, but,like I said at the end, I'm
going to share with you somestrategy and why that's actually
(06:28):
not as impactful as peoplethink it might be.
So that's conversions.
We've gone over contributions.
We've gone over conversions.
The next thing is growth.
So, again, money in your RothIRA can only come of one of
three things contributions,conversions and growth.
Growth is pretty simple.
It's simply how much have yourcontributions grown by?
How much have your conversionsgrown by?
(06:50):
If you've put in a total of$50,000 in contributions over
the course of 10 years and yourRoth IRA is now worth $80,000,
well, put simply, there's$30,000 in there.
That is growth, and it'simportant to understand that
each of these is going to betreated differently when it
comes to how can you pull moneyout of your Roth IRA.
So I'm going to walk throughthat in just one second, but
(07:10):
before I do, on top of this, youneed to be familiar with a rule
called the five-year rule, andthis is a separate five-year
rule than what we just talkedabout with conversions.
This is one of those thingswhere it can get pretty tricky,
but, yes, there's a five-yearrule where every single
conversion you do, you need towait five years until you can
pull that conversion money outof your Roth IRA penalty free
and tax free.
But there's a separatefive-year rule and that rule
(07:32):
says you cannot withdraw anyearnings in your Roth IRA tax
free until it's been at leastfive years since you originally
contributed to the Roth IRAaccount.
A lot of people that hear thisand say, well, yeah, of course
there is.
Why does that matter?
Well, where this matters is,for example, if you are already
over the age of 59 and a half.
Say, maybe you're 60 years oldand you've never contributed to
(07:54):
a Roth IRA before.
Well, maybe you put $5,000 intoa Roth IRA and then a year goes
by and you have $6,000 thereand you need to take that $6,000
out and you say, ok, well, thisis a Roth IRA, so the money is
tax free and I'm older than 59and a half, so I qualify from
the age perspective.
But you really don't, becausethe five-year rule for Roth IRA
(08:16):
says for you to be able toaccess that growth penalty free
after the age of 59 and a half,the account must have been
established for at least fiveyears.
So that's something that reallydoesn't come up a whole lot,
but does occasionally come upand you need to be mindful of.
So what does all that matter?
We know that there'scontributions, we know there's
conversions, we know there'sgrowth.
Here's why it matters.
(08:38):
When you begin taking money outof your Roth IRA, the IRS is
going to view it.
They're not going to go in andsay, okay, james, well, you get
to decide.
Is this money that you'retaking out growth, or is this
money that you're taking out aconversion, or is this money
that you're taking out anoriginal contribution?
They have an order ofoperations that is followed
regardless of who's taking moneyout.
The order of those operationsgoes as follows Contributions
(09:03):
come out first, followed byconverted dollars coming out
next, followed by earningscoming out last.
So it does not actually matterwhen you made contributions to
your account.
It doesn't matter the timing ofwhen you did conversions to
your account.
It doesn't even matter how muchgrowth is in your account.
From the perspective of whatthe IRS is looking at, they're
(09:25):
treating the first dollar youtake from your account Doesn't
matter if this is the firstdollar made by a conversion or
by a contribution.
They're saying that firstdollar is going to be treated as
if it was a contribution.
Let's look at an example.
Let's assume that you makecontributions to your Roth IRA
of $5,000 per year and you dothat for five years in a row.
Then let's assume you startmaking too much money to put a
(09:49):
contribution directly into yourRoth IRA.
There's income limits here.
But let's assume that you startdoing backdoor Roth conversions
.
So for the first five years youjust put money directly into
your Roth IRA.
The next five years you don'tdo it directly, but you're still
getting $5,000 per year intoyour Roth IRA via a backdoor
Roth conversion.
So you've done that for 10years.
(10:11):
Now this whole while let'sassume that your money is
invested and it's growing andyou have $25,000 of growth.
So you did this for 10 yearsyou now have $75,000 inside of
your Roth IRA.
Let's assume you're under theage of 59 and a half and you
need to access some of thismoney.
Well, if you were to go in andtake money out, the IRS is just
(10:34):
going to say James, if this isyour account, the first $25,000
that you take, we're just goingto assume as if that was your
contributions, because that'show much I'd contributed to my
account over the lifetime of myRoth IRA.
If I need more than that,they're going to assume in.
The amounts above $25,000 areconversions, and then next
amounts.
(10:54):
Until I fully withdraw, all myconversions are going to be
treated as such and then,finally, any amounts above and
beyond that are going to betreated as growth.
And just to make sure I'm beingclear with this example, it
actually doesn't matter theorder in which I make these
contributions.
Let's say, for the first fiveyears I was doing Roth
conversions via a backdoor Rothcontribution and then the next
five years I was doingcontributions.
(11:15):
So same exact example as before, but just flip the timing of it
.
It really doesn't matter in theIRS's eyes.
Still, if I'm going to takemoney out of my Roth IRA, the
first $25,000 I withdraw, theIRS is simply going to assume
that that is coming back taxfree because it's a return of
contribution.
I actually recently did this.
Not recently, but several yearsago.
(11:36):
When I started root financial,I was looking to see what's the
best way to fund some of thesethings going forward and because
I had been diligent aboutfunding my Roth IRA for the
first several years, I was ableto pull money out of my Roth IRA
completely tax free and penaltyfree and using some of those
dollars to start my company.
So sometimes things come upunexpectedly that you say I need
(11:56):
money for.
Ideally, you have non-Rothfunds that you can use in those
situations, but if not, it'salways nice to know that you
have your Roth IRA and canaccess those contributions at
any point.
Here's the next thing that youneed to know If you are taking
money from your Roth IRA and youeither haven't met your five
year rule in terms of eachconversion meeting its own
(12:17):
separate five year window, oryou're under 59 and a half and
not yet eligible to take outgrowth, there are some
exceptions to this, and this iswhere I'll say download the
resource that's in thedescription on the YouTube page,
because there's a lot of theseand I'm just going to summarize
them real quick.
But this is in the resource.
But the bottom line is thedistribution may qualify for an
exception.
This is because, number one,you're age 59 and a half or
(12:39):
older.
So in that case there's no 10%penalty or taxes on a
distribution from your Roth IRA,even if it's growth, assuming
you've met the five year timeperiod from when the account was
first opened up.
There's also an exception ifyou are taking the distribution
as a part of what are calledseries of substantially equal
periodic payments.
There's an exception if moneywas used to pay for qualified
(13:00):
higher education expenses,unreimbursed medical bills above
7.5% of a just gross income,qualified health insurance
premiums while unemployed, aqualified disaster distribution
up to $22,000 per disaster fordisasters after January 25th of
2021.
Or if the distribution was madewithin one year after the birth
or adoption of a child, up to$5,000.
(13:22):
So there are some exceptionshere, but in general, if it's
not your own contribution thatyou're taking out or it's not a
conversion that you've had inyour Roth for at least five
years, you're going to pay taxesin a 10% penalty for anything
else that you take out.
Be very mindful of that,because the last thing that you
want to do with your Roth ishave it all of a sudden be
subject to taxes or have it besubject to a penalty, because
(13:46):
this is one of the mostimportant accounts in most
people's plans, simply becausethere's so many strong tax
benefits to it.
Now, one of the things that Imentioned as I said, I'm going
to go over strategy a bit totell you why that five year rule
for each conversion isn'tactually that much of an
impediment, or it shouldn't befor most people.
And if I go back to Manfred'squestion, he was saying he's
(14:06):
going to convert $50,000 of his401k into a Roth account.
He also said I already have anold Roth account that is well
over five years old.
That started in 2015.
So, manfred, going back to yourquestion, any dollars that are
already in your Roth IRA doesn'tmatter when you contributed to
them.
Those are all eligible for youto take out, completely tax free
(14:27):
and penalty free because you'vealready met the five year rule.
It doesn't matter if you justput one single dollar into your
Roth IRA back in 2015 and thenput the rest of it in, say, a
year ago or two years ago.
That doesn't matter.
That five year clock, the fiveyear rule that says your Roth
IRA must have been establishedfor five years.
Once you've met that timeperiod or that holding
(14:49):
requirement, all contributionsand growth on that assuming
you're over 59 and a half, whichManfred is are completely tax
free to you if you were to takethem out.
However, the conversions soconverting the $50,000 from your
401k into your Roth accounteach of those will have its own
five year time frame until youcan pull that money out tax free
(15:11):
and penalty free.
Remember the order of operations.
The IRS is going to treat anymoney you pull out first and
foremost as contributions andthen those conversions.
But to answer your questiondirectly, there is that
five-year holding period.
Here's why I don't think that'sactually such a big deal, at
least generally speaking.
For most people.
The benefit of ARRF IRAs is youget to let that money grow
(15:33):
tax-free.
Now it's a very obviousstatement.
I think everyone listening tothis probably knows that the
benefit of ARRF IRA is thatmoney grows tax-free and then
comes out tax-free.
But here's the thing you don'tget any tax benefits just for
putting money into ARRF.
In other words, the longer youlet your money stay in your ARRF
(15:53):
, the greater your benefit willbe.
It's just longer and longer forthat money to grow tax-free,
which means greater and greateramounts that can then come out
tax-free.
But if I were to put money intoa Roth IRA today and even want
to pull it out in a year fromnow, I probably haven't gotten a
tremendous amount of benefitunless there was some pretty
significant growth on my moneyin that single year.
(16:16):
So you want to ideally let yourRoth accounts grow tax-free as
long as possible, because that'swhere you're going to get the
maximum benefit.
So if I go back to Manfred'sexample and this is definitely
not advice, but this is just mygeneral observation I don't
really see much of a point tosay why would you consider
converting 50,000 from a 401k toa Roth IRA just to pull that
(16:39):
out in the next handful of years?
The goal there, the reason youwould do it, is to convert that
money and then let it growtax-free for many, many years.
So later on in retirement youwould have that money to live on
.
If you're saying, well, james,I want to pull that money out
now because I'm in a lower taxbracket now, but I still want to
use it in a few years, wellgreat, maybe pull that money out
(17:00):
, but just don't convert it.
Just treat that as adistribution, keep it somewhere
where it's available to you touse for when you do want to use
that money for a purchase.
But because you're not going tolet it grow for very long, I
don't really see much of abenefit to even having a Roth
IRA, even if it weren't for thatnew five-year window of having
to wait to access that specific$50,000 conversion.
So, manfred, as you'relistening or as you're
(17:22):
submitting this question, youmaybe have different thoughts on
this, or maybe there'ssomething that I've just not
even seen within the example, ormaybe a specific reason why
you'd want to convert that moneybut then turn around and access
it pretty soon.
Generally speaking, though,without knowing your specific
situation, there may not be awhole lot of benefits to that.
The benefits really come ifyou're going to do a conversion
today and then that money isgoing to grow and it's going to
(17:44):
double in value, triple in value, and it's going to do all that
completely tax-free.
Well, that's a huge benefitbecause as you now take out that
value, that's two times youramount, three times your amount.
It's all coming out tax-freelater on in retirement, along
with many other benefits likenot being subject to required
minimum distributions and otherthings like that.
So that is it for today'sepisode.
(18:05):
Manfred, thank you very much foryour question.
I know it's a fairlystraightforward question with a
fairly simple answer, but it cansometimes get confusing, so I
hope this was helpful as you'retrying to understand what are
the rules around taking moneyout of a Roth IRA.
And again, a reminder if you'relistening to this on Apple
Podcasts or on Spotify or someother podcast player, make sure
you check this video out onYouTube, because in the YouTube
(18:25):
description I'm going to have alink to a cheat sheet that's
essentially a flow chart thatguides you through the whole
conversation we had today, soyou can understand that the
money you're taking out of yourRoth IRA will be penalty-free
and tax-free, or if you mightget stuck with a penalty for
doing so.
So thank you, as always, forlistening.
That is it for today and I'llsee you all next time.
Hey everyone, it's me again forthe disclaimer.
(18:46):
Please be smart about this.
Before doing anything, pleasebe sure to consult with your tax
planner or financial planner.
Nothing in this podcast shouldbe construed as investment, tax,
legal or other financial advice.
It is for informationalpurposes only.
Thank you for listening toanother episode of the Ready for
Retirement podcast.
If you want to see how RootFinancial can help you implement
(19:08):
the techniques I discussed inthis podcast, then go to
rootfinancialpartnerscom.
Click Start here, where you canschedule a call to one of our
advisors.
We work with clients all overthe country and we love the
opportunity to speak with youabout your goals and how we
might be able to help.
And please remember, nothing wediscuss in this podcast is
intended to serve as advice youshould always consult a
financial, legal or taxprofessional who's familiar with
(19:30):
your unique circumstancesbefore making any financial
decisions.
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