Roth IRA’s offer tax-free distributions, IF you follow the rules of the game

Roth IRA’s can be fantastic tools for retirement planning, offering the possibility of tax-free growth on funds sheltered under them. It’s not just tax-deferred growth. It’s actual tax-free growth on the distributions that come out of them.

As long you play by the rules of the game.

Fortunately, the IRS has laid out what those Roth IRA rules are.

As of writing this, most people near retirement, or already retired, have the bulk of their retirement assets inside a 401(k), or an IRA that was funded when they rolled over their 401(k) upon retirement. Which means Roth IRA’s make up a smaller percentage of their overall wealth, if any percentage at all.

This also means, that for many the beginning of retirement may be the perfect time to consider converting portions of their IRA to a Roth IRA, which effectively “buys out” Uncle Sam as a “silent partner” in your IRA.

This is where the rules must be followed to make sure later on that your distributions from that Roth IRA are all tax-free.

Let’s begin with the basics.

IRA & Roth IRA Basics

Traditional IRA

A traditional IRA uses pre-tax money (unless some non-deductible contributions were made to it). The funds inside the IRA grow tax deferred. This means when you earn dividends or interest on the IRA investments, you don’t pay taxes on them as long as they remain in the IRA. When you make a distribution from the IRA it counts as ordinary income and is taxed based on your marginal income tax bracket.

“Made Easy” Rationale for IRA’s:

When you make a contribution to an IRA (or 401k) it is in most cases a tax deduction, thus lowering the tax you pay in the year of the contribution. Since you are probably in a higher tax bracket while working than you will be in when you retire, you can lower your taxable income in your working years. Then in retirement, when you are presumably in a lower tax bracket, you can take distributions from your IRA and hopefully pay less income taxes this way.

Roth IRA

The Roth IRA is like a photographic negative of the Traditional IRA. The contributions you make into it are not tax deductible. So you’ve already paid taxes on the contributions that go into a Roth IRA. However, the growth on the earnings inside the Roth are tax-deferred, meaning you don’t pay taxes on any dividends, interest, or capital gains each year. Then when you take a distribution from your Roth, all distributions (even the growth inside it) are tax-free, if you have followed the rules that we will discuss.

“Made Easy” Rationale for Roth IRA’s:

If you are currently in a lower tax bracket, you pay the lower tax rate and contribute the after-tax funds into your Roth. If taxes rise in the future you shouldn’t be affected because all the growth inside the Roth IRA can be distributed tax-free.

What is a Roth IRA Conversion?

A Roth IRA conversion is when you take a portion, or all, of your IRA and convert it to a Roth IRA. This is a taxable event. So if you want to convert $100,000 in your IRA to a Roth IRA, the conversion process will add $100,000 to your taxable income during that year. You will have to pay the taxes on this additional income.

This is how you remove Uncle Sam from being a “silent partner” with you on your IRA.

There are no limits on how much you can convert to a Roth up to the full amount you have in IRA’s.

How are Roth IRA distributions counted for tax purposes?

To discuss how Roth IRA distributions are treated tax-wise, we first have to discuss the 3 types of category of funds that are inside a Roth.

There are a couple of ways to get funds inside a Roth IRA. You can either make a contribution, do a Roth IRA conversion from a traditional IRA, or your existing funds inside the Roth can grow through earnings, interest income, and/or capital appreciation.

Each of these 3 categories of funds for your Roth IRA can be treated differently if you are making a withdrawal from your Roth IRA.

  1. Contributions – Since you’ve already paid taxes on your contributions, you can pull them out anytime without paying any tax or penalty
  2. Conversions – Can be tax-free if you follow the appropriate rules. If not you may be subject to a 10% penalty tax (that’s in addition to the income tax you already paid on the conversion).
  3. Growth – Can be tax-free if you follow the appropriate rules. If not you may be subject to a 10% penalty tax, as well as regular income tax.

So, how do I make sure my Roth distributions are all tax-free?

Contributions you make into a Roth IRA can always come out tax-free. Contributions are limited each year. For 2020 the contribution limit is $6,000, and if you are 50+ the limit is higher at $7,000.

Since contributions can always be taken out income tax free, as well as avoid the 10% penalty, let’s focus on how to make numbers 2 and 3 tax-free: Conversions and Growth.

To do that we need to discuss the two separate 5-year rules that are at play.

5-Year Rule concerning Growth inside a Roth IRA

The first 5-Year Rule is applicable to the Growth inside a Roth IRA. The time clock for this rule begins in the first tax year that you have made a contribution or conversion to a Roth IRA. You have until April 15th of the following year to make a contribution.

So if you contribute $6,000 on April 10th 2019 and count it as a contribution for the year 2018, the clock begins ticking on January 1st 2018. In that case the 5-year rule would be satisfied by January 1st 2023.

Once this first hurdle is met it’s also important to know that there are other stipulations that must be met too for tax-free distributions of growth.

For purposes of this article since it relates to people that are near (or already in) retirement, I’m only going to discuss the age 59 ½ condition that must be met.

Not only do you have to have had a Roth IRA funded for 5 tax years for the earnings to be tax-free upon withdrawal, you also have to be over age 59 ½. If you pull them out before that (unless another exception that we’re not discussing in this article applies) the Growth inside the account may be subject not only to income tax but also an additional 10% penalty.

If you open your first Roth IRA account at age 60, your Contributions could be distributed tax free, but your earnings would not be tax-free until you’ve owned that Roth for 5 tax years. So you’re looking at around age 65 to reach that point.

These stipulations are not too hard to meet. If you don’t have a Roth IRA currently, you could literally open one up and fund it with just $100 to get the 5-year clock ticking. Even if you open up other Roth accounts later, the 5-year clock began counting down when you opened the first one.

Now that we’ve discussed how to make the Growth inside a Roth IRA be tax-free upon distribution, let’s talk about the 5-year rule pertaining to Conversions

5-Year Rule concerning Conversions inside a Roth IRA

Conversions from an IRA into a Roth IRA are also under a 5-year rule. And they, like the first 5-year rule, are based on tax years. Since you have until December 31st to do a conversion, it will apply back to January 1st of that year to start the clock.

If you convert on December 15th of 2019, then the 5-year clock begins counting down on January 1st 2019.

The difference in this rule is that every conversion you do has its own 5-year clock. So if you convert $100,000 in 2019, that converted portion will have a 5-year period attached to it. If you convert another $100,000 in 2020, it will have a separate 5-year period attached to it.

Under this rule, if funds that were Converted are withdrawn from the Roth before 5 years has passed, they would be subject to the 10% penalty, and that’s in addition to the income tax that was already paid on them in the year they were originally converted!

As it pertains to retirees (and those near retirement) perhaps the easiest way to avoid paying the 10% penalty on Roth conversions is by waiting until after age 59 ½ to make a distribution of any converted amounts.

That’s right, if you are over age 59 ½, the 5-year Conversion rule does not apply to you.

“Made Simple” Rationale for this:

The 10% penalty is typically applied to people that take withdrawals from their IRA’s before age 59 ½. If you are over 59 ½ and take a withdrawal from your traditional IRA, you only have to pay the income tax associated with the distribution, not the additional 10% penalty. Since you would have access to traditional IRA funds without the 10% penalty after age 59 ½, the IRS allows you to have access to the Roth converted funds without the additional 10% penalty if you are over age 59 ½. After age 59 ½, the 10% penalty tax goes away.

Here’s the “Made Easy” way to have tax-free Roth distributions

First, satisfy the 5-year rule pertaining to Growth inside your Roth IRA. This rule must be satisfied regardless of your age, even if you are over age 59 ½. If you don’t have a Roth IRA now, consider opening one today, even if you only fund it with $100.

Just get the clock ticking.

Second, wait until you are older than 59 ½ before taking any distributions. Since any Converted funds have already had the income tax paid on them in the year of conversion, the only other tax that can be levied against them is the 10% penalty, which can be avoided by waiting until after age 59 ½.

Remember, there are two separate 5-year rules in play here. The first one pertains to qualifying the Growth of funds inside your Roth IRA to be distributed tax-free. The second 5-year rule pertains to qualifying any Converted principal amounts to avoid the 10% penalty, which can easily be avoided by not taking withdrawals before age 59 ½.

Chris Hammond

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