There has been a lot of talk about Roth conversions so I wanted to help…
Age 59½ is a key age for both a traditional IRA and a Roth IRA, because at age 59½, you may withdraw from either a traditional or a Roth IRA without incurring a 10% penalty. With a Roth IRA, however, you are required to have the account open and active for at least 5 years before you can withdraw any interest, dividends, or growth tax for free. For example, John and Mary—both 60 years of age—plan to add $5,000 to their Roth IRA accounts in 2016. The only other time John had invested in a Roth IRA was in the year 2000, investing $100. Mary has never invested in a Roth IRA. They both buy Under Armor stock, and the stock doubles in value by late 2017. Both John and Mary withdraw the funds from their respective Roth IRA accounts because they are now both 61 years of age. The Roth custodian informs Mary that her withdraw is subject to the 10% penalty on the $5,000 gain, but John’s withdraw is 100% tax-free. John fulfilled the “5-year rule,” even though his was a very small account, but Mary did not, given that she had not previously invested in her Roth IRA at least 5 years previously.
This investment plan is strategic and is why I broadly recommend that if you do not have a Roth IRA open and are eligible, then open one in 2016, even if you open the account with just $50. There are two ways to open a Roth IRA: One way is to make contributions if you are working and make less than $132,000 (single) or $194,000 (married). The other way is to convert an existing IRA or a former company retirement plan, like a 401K or 403B, to a Roth IRA. Once the account is open, even with a trivial amount, the 5-year clock begins to tick. It is important to note that the 5-year clock does not exactly span 5 years. For example, if a client performs a Roth conversion on December 20, 2016, then he or she is completely tax-free (if also over the age of 59½) on January 1, 2022, which is 11 months shy of 5 full years.
So why is this so important? To explain, you must first understand Roth IRAs. A Roth IRA is the reciprocal of a traditional IRA. Money invested into a Roth is not tax-deductible, but money withdrawn from a Roth is completely tax-free no matter the rate of return. It is quite common today for a person to have a traditional IRA that is worth $100,000 or more. It also common to have low taxable income over the course of a year or two due to a variety of factors (e.g., large charitable contributions, high medical bills, or unemployment). The astute tax planner would convert an appropriate amount of traditional IRA monies to a Roth IRA during a year of low taxable income. To miss such a cost-saving opportunity condemns the family to significantly higher tax burdens later. In many cases, the conversions can be performed completely tax-free, transforming the investments to permanently tax-free within the Roth IRA. Setting the 5-year clock in motion years before these events assures 100% tax-free growth, even in the first 5 years after conversion.
This rule is also important for the investor accumulating Roth 401K monies. There is a different 5-year rule that applies to the Roth 401K, separate from the Roth IRA. Using the example of John and Mary again, they are both 60 years old and work for Apple. They have been investing in their Roth 401k—only in Apple stock—for the last 7 years. They both invest $10,000 per year ($70,000 total) into their respective Roth 401K accounts, which grows to $300,000—$70,000 in basis and $230,000 in gains. John and Mary both rollover their stock to a Roth IRA and liquidate the entire account to buy a second home, thanks to Apple. Recall from the previous illustration that John had a very small Roth IRA from 2000 with $100 invested, making his entire distribution 100% tax-free. Mary, however, is informed by the custodian on her account that she does not qualify for tax-free status because her Roth IRA has not been in effect for 5+ years. As a result, she owes a 10% penalty on her $230,000 gain.
This same example would apply to a young person who invests $1,000 per year into his Roth 401K for 5 years, growing the account to $10,000 by the time he leaves the company and decides to roll over the amount into a Roth IRA. With a new job in a new city, this young person decides to withdraw the $10,000—penalty-free—to purchase his first home, but only because he established a Roth IRA 5 years prior.
In conclusion, OPEN A ROTH IRA ACCOUNT THIS YEAR NO MATTER WHAT IF YOUR ELIGIBLE. THERE IS NO REASON NOT TO DO SO!