Roth IRAs have been with us for more than 20 years. That’s about as long as we’ve had Google, and the same amount of time since the last presidential impeachment hearings. Some things have changed a lot in that time, and some things are the same. The Roth IRA was an unusual idea when introduced and it’s still pretty unusual.
What are the benefits of a Roth IRA?
When used as intended, the Roth IRA can be used to help fund retirement after age 60 through distributions that are free from income tax. That’s pretty cool and quite unusual. Most other sources of retirement income are subject to some amount of income tax when you spend the money. Common retirement income sources like Social Security income benefits, pensions, IRA distributions, 401(k) and other company sponsored retirement plan distributions are all subject to income tax.
What are the rules for withdrawing from a Roth IRA?
All Individual Retirement Accounts (IRAs) are subject to rules and penalties if you do not use them as intended. In the case of Roth IRAs, the most misunderstood rule is the five-year distribution rule. To add to the misunderstanding and confusion, there are actually two five-year rules you need to follow if you want to remove money from your Roth IRA and not pay income tax. Here’s some info about those rules, along with a couple others:
First five-year rule: The distribution must come out more than five years after the tax year you opened up your first Roth IRA account. If you started a Roth IRA when you got your first regular job, that hurdle is pretty easy to clear.
Second five-year rule: If
you do a conversion, the distribution must happen more than five years after
the tax year of the conversion. The five-year clock applies to each conversion
you do. Keep track of how much you converted and when.
Before you make a conversion from traditional IRA to Roth IRA, you should
consider how quickly you plan to spend the money. If you might need the money
before five years, then it’s probably not worth the trouble to convert. The
tax-free distributions are more valuable the longer the money is compounding in
the Roth IRA, so it’s to your advantage to have the money working for a longer
time.
Little-known Roth distribution rule: Distributions that are only deposits are always tax free, regardless when you make them. This is great feature of Roth IRAs that is often overlooked.
Reminder about penalties: All IRAs are subject to a 10 percent penalty if you withdraw money before you turn 59½ years of age.
So if you make a distribution from your traditional IRA before age 59½, that distribution is subject to a 10 percent penalty tax and regular income tax. After age 59½ traditional IRA distributions are only subject to regular income tax.
If you make a distribution from a Roth IRA before age 59½ and the distribution includes growth of your deposits, the growth is subject to a 10 percent penalty tax and regular income tax. If you are older than 59½ and you have had some kind of Roth IRA for at least five years and your last Roth IRA conversion was at least five years ago, then all distributions are free from income tax.
Help with your Roth IRA
If you want to make the best use of a Roth IRA in your retirement income planning, I suggest you work with a highly trained, experienced financial planner who puts your interests first and gets paid only by you. A great place to start looking for that planner is here.
This link will direct you to the CERTIFIED FINANCIAL PLANNER™ professionals in your area. You can contact a few and find the right match for your needs.
As you visit with financial planners, I suggest a couple things to check:
- Is the advisor always the client’s advocate – a fiduciary advisor?
- Is the advisor only paid by clients, not any financial product manufacturer or distribution network? That would be a fee-only advisor.
These two points help assure that you are working with a professional who is committed to your best interest at all times. It seems sort of obvious to me that a professional would work in this way, but it’s not automatic.
A fiduciary, fee-only, CFP® professional can help you make great retirement income choices and develop a comprehensive financial plan that is driven by your goals and priorities and addresses all aspects of your financial life. With a big-picture approach, you will be better prepared to understand your options at every step along the way.
Yes, I am a CFP® professional. I’m always a fiduciary and I only work on a fee basis. And yes, I’m still taking on a few great families to be part of my financial planning practice.
If this article has you thinking about your own circumstances, contact my office at rdunn@dunncreekadvisors.com. I am always happy to meet with people who are working on their retirement plans. Dunncreek Advisors does not provide legal or tax advice, nor is this article intended to do so.
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