While some Social Security strategies have been discontinued, there are still a few under-utilized strategies…
Most people know that Roth individual retirement accounts (IRAs) have a “5-year rule,” that is, you must have owned your Roth IRA for at least 5 years and be over the age of 59.5 years to withdraw earnings tax-free during retirement; however, very few seem to truly understand the details surrounding this rule.
It is important to understand that the 5-year rule is based on any Roth account and not on each Roth custodian or each Roth investment. For example, if you liquidated a Merrill Lynch Roth IRA at age 55 years before then contributing to a Vanguard Roth account, then the 5-year rule would be reset, meaning that you would need to wait 5 years before withdrawing tax-free earnings from the Vanguard Roth. If at age 60 years you make a contribution to the Vanguard Roth and then liquidate your Merrill Lynch Roth, then the 5-year-rule requirement is met, because you have had a Roth account in existence continuously for at least 5 years.
If you were to withdraw funds from this aforementioned Vanguard Roth account, then Vanguard may not classify the distribution as 100% qualified to withdraw tax-free earnings, because they would not have available the records reflecting that the Merrill Lynch Roth account had been active for 5 years or more. A diligent tax preparer, however, would correctly ascertain that the distribution should be treated as 100% tax-free, given that both the age and 5-year rule requirements were fulfilled.
It is important to note that in the tax law world, 5 years may be considered fulfilled in under 4 years. For example, a Roth IRA is established in April 2019 but serves as a contribution to the previous 2018 tax year. As a result, 5 years will be considered completed on January 1, 2023. Because this Roth account was considered established in 2018, then that is considered as 1 year, 2019 then is equal to 2 years, 2020 is equal to 3 years, 2021 is equal to 4 years, and 2022 is equal to 5 years. Although the Roth account was technically opened in April 2019 and is only 3.75 calendar years old, it is still considered as active for 5 years.
It is important to understand the rules for distribution. Contributions are always distributed first, may be taken at any age (no matter how long you have had the Roth account open), and are 100% tax- and penalty-free. After contributions have been distributed, the next earnings withdrawn are any converted amount from a pre-tax account. For converted assets, income taxes are paid in the year of the conversion, but if within 5 years of each conversion the 10% withdrawal penalty is waived, then a 10% penalty is due. Last, interest dividends and growth are distributed, which are the assets in which the 5-year and age-restriction rules apply. If contributions are all that are being withdrawn, then none of the rules apply, because contributions are always considered tax-free withdrawals.
The 5-year rule is also important, because it makes Roth contributions tax-free on the basis of exceptions to the standard Roth IRA rules. That is, you do not need to wait until you are 59.5 years of age to withdraw penalty-free earnings from your Roth account if the following exceptions apply:
- You are purchasing a home for the first time and require up to $10,000 from your Roth account to cover the down payment or associated costs.
- You become permanently disabled.
- You inherit a Roth IRA account.
- You are unemployed and need to pay for health insurance.
- You are making periodic withdrawals in the same amount from your Roth IRA.
The main point is to open a Roth IRA account for you or your children as soon as possible in an effort to initiate the 5-year rule in the process. No matter your age, determine how you can establish a Roth IRA for yourself, even if you open the account with only a small sum of money. You can contribute to a Roth with earned income, or you can convert IRA monies to a Roth IRA account. Contact your Financial Consulate advisor to open a Roth IRA account and get the 5-year clock ticking.