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Retirement Answers is a podcast built to help you succeed in retirement. The thought of retirement can be overwhelming and downright scary for many... but it doesn't have to be!
The goal of this podcast is to provide thoughtful insights and strategies to give you the confidence you need to retire successfully. At the end of the day, my ultimate goal for my clients and podcast listeners is to live a fulfilling retirement.
Follow along as I publish a new episode each week covering everything from retirement income planning, tax planning, Social Security, insurance planning, investing, and much more.
Here's to learning everything you need to know to live out your dream retirement!
Hey, friends, and welcome back to another episode of Retirement Answers. My name is Jacob Duke. I'm your host as always. Today on the show, I want to talk about the five year rules for Roth IRAs. And in fact, there are actually two different rules that we've got to pay attention to here, so we're going to break this down, and hopefully this can act as almost like a complete guide to everything you need to know around your five year rules and your Roth IRA, and then you can make the most of it whenever it comes to saving for retirement in this tax free capacity, but also doing conversions in the future and then also taking money out in retirement.
Jacob Duke:So we're gonna break all this down. We're gonna some examples, and I wanna make this as hopefully clear as possible because it can get confusing. But first, before we jump in, I wanted to let you know that I've got a free Roth distribution flowchart that I'm happy to give to you. If you wanna download it, you can do so. There's a link down in the description of this episode where you can go grab your free copy to help make a little bit more sense around the things we're talking about here today, and you can see that in a visual format in a flowchart form.
Jacob Duke:So if you want a copy of that, go download it. And also, if you're new here, welcome. I really appreciate you being here. Again, my name is Jacob Duke. I'm a certified financial planner, and I also own River Tree Wealth, a retirement planning firm that helps people just like you plan smarter and retire better.
Jacob Duke:Alright. Let's go ahead and jump in and talk about the Roth IRA five year rule at its most basic level. So for a Roth IRA, you've probably heard or understand that you got to be 59.5 and have the account open for at least five years before you can start taking money out of that account tax and penalty free. And that might be partially true because your contributions, the money that you add to your Roth IRA, that money is always tax and penalty free regardless of how old you are and regardless of how long the account has been open. So just as a quick example, if you put $8,000 into a Roth IRA, you're gonna be able to take that money out tomorrow if you'd really like to.
Jacob Duke:Okay? There's no wait period. There's no age requirement because you've paid taxes on the money that you put into your Roth IRA. Therefore, that money is yours. You can do whatever you would like with it.
Jacob Duke:So really, the Roth IRA five year and that 59.5 age requirement, that's really just gonna apply to the earnings, at least how we're talking about it now. We'll talk about conversions here in a second separately, but really that's just talking about earnings. Okay? So that says that your earnings on your contributions, that is what has to follow that five year and 59.5 requirements. So going back to our example of $8,000 of a contribution, let's say that that $8,000 then grows to $10,000 and you've got $2,000 of earnings in the account.
Jacob Duke:You can access the 8,000 tax and penalty free, but the 2,000, that is what is subject to the five year and 59 and a half requirements. So if you take your money out before 59 and 0.5 and the account has been not been open for five years, the earnings will be taxed as an ordinary income and then also penalized for an early distribution of 10%. Now, just know here, the ordinary income taxation piece and then the 10% early distribution piece, those technically can be separated. Okay, so if you are making a contribution, let's say, at 58, all right, and then you wait until 60 to start taking earnings out, Well, by the time you reach age 60, the 59.5 requirement, that is actually behind you. Okay?
Jacob Duke:So you've actually eclipsed that age by being 60 years old, so technically you can take your earnings out along with your contributions because that's always tax and penalty free. You can take your earnings out without the early distribution penalty of 10%. Now, you've not yet met the five year window, that clock has not been met, so you would pay ordinary income taxes on those earnings, but you wouldn't have to do the 10% early distribution penalty because you are over 59.5. Now, this assumes, okay, that you have not had any sort of IRA or Roth IRA before now, meaning you did it at 58, right? That was your first contribution ever.
Jacob Duke:If you made your first contribution, the account was opened back at say 50 5 or 54, and then you get to 60, both of these things are eliminated. The five year clock has been met and you're 59.5, therefore your earnings are tax and penalty free. Okay? So just know the taxation on your earnings and then also the penalty for early distributions technically can be separated. It's not both that have to apply depending on how you do your contributions and distributions.
Jacob Duke:Now, it's really important to note here before we jump into more about, the five year rule for conversions is actually what's the order in which money has to be distributed out of our Roth IRA. So the first thing to know is that your contributions, those will always come out first. So let's say that you've put in $50,000 into your Roth IRA over time and the account's worth $80,000. It's not doing a pro rata distribution. It's not dividing the account down by how much contribution versus earnings you have and then sending you a taxable portion based on that.
Jacob Duke:So it's not doing it pro rata. It's not sending your earnings first. It always sends you your contribution first. So if you've put $50,000 into your Roth IRA and the account balance is now worth 80, technically, you can pull 50,000 out of that 80 at any point and pay no tax on that $50,000, leaving $30,000 left in the account, which is all of the earnings, that would be subject to the five year and fifty nine and a half requirements. Okay?
Jacob Duke:But just know that your contributions always come out first, and this is important when it comes to withdrawal ordering rules for your Roth IRA. The second thing to come out is actually going to be any rollovers or conversions, and we'll talk about conversions in the five year rule in just a second. And then finally though, in this sequence of withdrawals here is your earnings. So your earnings technically come out last. And what I'll say is this, normally, most people don't run into any early distribution and or tax issues around Roth IRAs, especially before fifty nine and a half, if they have at least some sort of balance on the account that's it's not super small.
Jacob Duke:Because most of the time, people don't just take all of their money out of their Roth IRAs. They'll take a portion out, and most of the time, that portion is just contributions that they made over time, meaning there's no tax or penalty on that. So the hard part there is you've got to understand that you have to keep track of your basis, which is your contribution amount, in the account to know what you do or don't have to pay tax on over time. The way to do this is by maintaining record of your fifty four ninety eights, which is just a form that your custodian should be sending you every single year that you do make contributions to the account. So if you keep record of all those, just hold those on file forever.
Jacob Duke:That will let you know what your total contributions are to the account, and then you'll be able to prove that you do or do not owe taxes on certain dollars there as you take money from your Roth IRA. Okay. So that's a lot of talking, but let's jump into the five year rule for conversion. So the reason there is a five year rule, it's technically separate in how it applies to conversions, is because if you think about it, if you had a traditional IRA, which you tax deducted, so you didn't pay tax on that money when it went to the account, You wanted to convert that to a Roth, then immediately the next day, you wanted to just take that money out tax free. Really what the five year rule does here is it actually limits you and is almost like a I don't know if it's a I don't if the right word is like a vesting schedule or a vesting period, but what it does is it says it takes five years for the dollars that you convert to actually be then classified as a contribution.
Jacob Duke:So let's just say that you do a Roth conversion of, I don't know, $50,000 at age 50, okay? And then at 52, that money is then worth $55,000, so you have 5,000 of growth there. Well, in order to take out the full $55,000, you can take that from the account, but you will pay taxes and penalties on the earnings, the $5,000, and you then will pay a 10% penalty for early distribution on the $50,000 converted amount. Although, you will not pay income taxes again on the conversion amount because that money has already been taxed. So you're not paying taxes twice on the converted amount.
Jacob Duke:You really just have to worry about that 10% early distribution penalty by being under 59 and a half. Now, the $5,000 of earnings in that scenario, those, if you're not yet 59 and a half, you would be paying tax on those earnings as ordinary income, but then also that 10% early distribution penalty as well. So that's a little bit about how the the five year rule on conversions work. Now what gets a little confusing sometimes is what happens whenever things happen around that 59 and a half mark. So as an example here, let's just say that you do a Roth conversion of $50,000 at 58, and then you withdraw that total amount at 60.
Jacob Duke:So let's say you convert 50 at 58, and then it grows to $55,000, and then you take it all out at 60. Well, when you do that, the converted amount of $50,000, you're not gonna pay income tax on that because you already paid it. And now that you are over 59.5 when you're 60, you're not going to pay that 10% penalty either. The 5,000 of earnings though that you would be taking out at this point, you're not going to be paying that 10% penalty because you are over 59.5, but the five year clock has not been met yet, so you will pay ordinary income tax on that $5,000 of earnings. So again, you can see the levels of what you will or won't pay, that changes depending on where you're at in regards to your age and this five year clock.
Jacob Duke:Now, here is what's really interesting. A lot of people have the question, Jacob, what happens if I've never had a Roth IRA before and then I get to retirement and I start doing all these Roth conversions like you and everybody else talks about? So I'm, let's say, 62 and I do my first conversion from traditional IRA to Roth at 62, and I didn't have any other money in that account up until this point. Well, what would happen there is, is you make that conversion, and let's say you put again, let's say you do a 100,000 conversion at 62. Well, that $100,000, that okay?
Jacob Duke:That's gonna be tax and penalty free right away because the 59.5 has been met. Okay? So you're not taking early distribution. So really, whenever you're past the 59.5 mark and you make a conversion for the first time, what you're doing is is all that converted amount can be accessed immediately. Okay?
Jacob Duke:Really, what you have to pay attention to here is the earnings on that converted amount. And this is where it gets a little bit tricky. So really, what you've got to do is you've got to wait five years for the earnings to not be taxed. Okay? And then let's say we do a conversion again next year at, 63.
Jacob Duke:So you do another $100,000 at 63. So you've converted $200,000, and now let's say the account is worth 220,000 total. So you got 20,000 of growth. The 200,000 you've converted each of those two years, you're 59 and half, but you haven't had the account for five years, it doesn't matter. You can take the 200,000 out today and have no issue.
Jacob Duke:The 20,000 of growth, that is subject to taxation because the five year rule has not been met on those conversions yet, and then you wouldn't have any 10% penalty on those earnings because you are, again, over 59.5. So the question here is this, Jacob, I've heard that every conversion has its own five year clock, and that is accurate especially before fifty nine and a half. Okay? So every conversion has its own five year clock. So you can't do a conversion at, let's say, 30 years old and expect to have freedom to to do whatever you want with any future converted dollars in your Roth.
Jacob Duke:Every single Roth conversion you do has its new reset clock for itself. Okay? Where this is different once you do get to 59 and a half is that if you have not had the account open at all before, you do a conversion for the first time, that's your first time having money go into a Roth IRA, what you've got here is the five year clock, it starts then. Okay? And then let's say you do the conversion, another conversion next year, and then the next year, and then next year.
Jacob Duke:So you're kind of doing this laddered conversion approach. You're doing a little bit every single year. Technically, the first year's conversion, the earnings has a five year clock. And then the second conversion you do, the next year, has a four year clock, and then a three year clock, and then a two year and a one year clock. Because the first converted amount actually sets the clock for all earnings, whether they're converted earnings or just contribution earnings.
Jacob Duke:K? The first conversion, that sets the clock, then all your future conversions have shorter clocks. They don't the earnings on those do not have their own five year clocks after that. Okay? So as an example, again, going back to '62, let's say we do our first conversion and then you do a conversion every single year, '63, '64, '65, '66.
Jacob Duke:Okay? Well, at '67, you can go access all of the earnings from all five years of conversion. So even if you just made a conversion last year at 66 and you made $5,000 on that, technically, you can go grab that $5,000 even though it has only been in the account for a full year, your five year earnings test and requirement has been met because of the first conversion you did back at 62. Okay? So I know this is really confusing, and hopefully it makes a little bit of sense, but really what you know here is if you're post 59.5, any converted dollars, you can take the conversion amount out immediately.
Jacob Duke:If the account has not been open for five years and you just started it by doing that conversion, then you have to wait five years before your earnings can actually be accessed tax free. Now this begs the question, Jacob, what if I had a Roth IRA that I started at age 40? Good news. Your contribution or your conversion, I'm sorry, and the earnings, those are tax and penalty free immediately. Okay?
Jacob Duke:At any point, there's no five year clock on the converted amount once the account has been open for five years. Because again, the the five year rule for the Roth IRA, it is really just talking about earnings within the account. Whether those earnings are from conversion dollars or contribution dollars, it's just talking about earnings. Okay? And so this is where a lot of people get confused on, hey, Jacob, what if I do a Roth IRA conversion first year retirement?
Jacob Duke:I've never had a Roth before. Well, good news is you can access most of that money. The bad news is you can't access the earnings. And then most people, again, have heard of the five year requirement for each conversion. Well, that applies, yes, before 59 a half, but technically doesn't apply the same way after 59 a half.
Jacob Duke:And all your subsequent conversions have shorter and shorter requirements there. They're not all five years. It can be four years, three years, two years, and one year just as I described earlier. So lots going on there. I don't know if that's actually helpful or more confusing and please please let me know.
Jacob Duke:Shoot me an email and say, Jacob, I think I get it, or I've got a question on this, or whatever you might have. Hopefully, makes sense. I just know that a lot of people have questions on this. So the main thing to remember here is that you've got two different five year rules. You got account level five year rule that a Roth IRA must be open five years for the earnings to be tax free once you're 59.5, and you have a conversion level five year rule where each conversion has a five year clock that matters mainly if you're under 59.5 and want to access converted dollars without penalty.
Jacob Duke:But again, the key takeaways here are this, just open your Roth IRA as soon as you possibly can, just to get the five year clock started. I don't care if you're young or old, just do it and it won't hurt. It can only help you. Also, you gotta remember the ordering sequence as you pull money from your account. Just remember that contributions are always coming out first, your converted dollars are second, and all earnings are last.
Jacob Duke:You've got the five year account level clock and then the conversion level five year clock applying to either earnings or conversions. So I hope this helps as you navigate these different questions and, hey, Jacob, what money can I access out of my Roth and when once I'm in retirement, and how does it all work, and am I going to be penalized or taxed? My account hasn't been open for long enough. Hopefully, this breaks it down a little bit, and some of these examples hopefully give you an idea of what you can expect in your world. But if you're someone who's like, Jacob, I I hear it, but I don't want to understand it.
Jacob Duke:Can I have someone help? Great. You can book a call with us to see if we are the right team to help you with your retirement planning needs. But regardless, if this was helpful, I'd love it if you shared it with a friend who might could benefit from it as well. And if you are enjoying the show and have been listening for quite some time, I would ask you to leave a rating and review there on Apple Podcasts or Spotify.
Jacob Duke:It helps other people just like you find the show and benefit from these same conversations. Thanks so much for tuning in to this week's episode of Retirement Answers. My name is Jacob Duke. We'll see you next time. Hey, it's Jacob again, and I wanted to remind you that nothing discussed in today's episode is meant to be financial, legal, or tax advice.
Jacob Duke:Retirement Answers is for educational purposes only. Thanks for tuning in to this week's episode. I look forward to talking with you again next week.