The Roth 5-Year Rule Explained

One thing to consider when you're talking about conversions, it's not just the ordinary income tax that you have on the conversion, it's the unintended consequences.

So sometimes if you are in the 24% bracket, do you want to go up to the 32%? Those conversions could push you up to where maybe they're used to paying kind of an effective rate or an average rate of, we'll say, 15%, and all of a sudden, because their income is boosted up, that all of a sudden, maybe their effective rate is 20. They may be in the 24% or 32% bracket, whatever the case may be. So before you do a conversion, make sure you are looking at that.

Welcome to the Healthy and Wealthy Retirement, where your certified retirement counselor, Mark Struthers, takes a holistic approach to retirement. Going beyond finances and embracing holistic well-being, this YouTube channel will address not just the financial part of retirement, but also the social, the physical, and the emotional parts of retirement. Everything you need for healthier, a wealthier, and a happier retirement.

Hi, welcome to the Healthy and Wealthy Retirement. My name is Mark Struthers, and I am your host here to help you have a healthier, a wealthier, and a happier retirement. It's March and usually around this time, I get a lot of Roth questions. Part of it is people are doing their taxes. So sometimes you have them around open enrollment or the end of the calendar year because that's when Roth conversions have to get done.

Or sometimes it's around this time when people have taxes on their mind. And, One major question that comes up, one major source of confusion, especially with Roth conversions, is the five-year rule. So we're not going to spend a ton of time on the Roth versus traditional debate, to convert or not to convert. We have other episodes. We'll be doing more episodes on those.

But we are going to keep it fairly short and just talk about the five-year rule, mostly around Roth conversions, but we'll touch on the other ones. The tough part about all this complexity is that it keeps people from acting. And it's understandable. Finances are not, it's not a hobby for most people. So if they run into friction, like confusions over the five-year rule, they won't act.

So hopefully this helps. Hopefully this helps us not to say that a Roth or a Roth conversion or a Roth 401k is the right choice for you. But you want to make sure that you are making an informed decision and that by having some knowledge, you're producing some friction. Keep in mind, anytime you are talking about financial planning and especially tax planning, you're guessing. So when we do projections that are 5, 10, 20, 30 years out, we're guessing at rates of return.

We're guessing at inflation rates, we're guessing at spending, we're guessing at healthcare, we're guessing at taxes. But it's better to plan and make an educated guess and certainly know what possible

outcomes are going to be than do nothing. And, When we are talking about the Roth, I find that when it comes to especially not really main reporters or media, you know, some use clickbait, but as most of you know, I have worked a lot with reporters over the years, and some of them very closely, and they often, they make a real effort to provide some good information most of the time. But with some influencers, the Roth is often sold as this magic bullet.

You know, that clickbait, that if you are behind, if you're spending too much or behind in saving, the Roth is going to fix everything. And that's probably not the case. Could a Roth improve your probability of success because of taxes, especially deeper into retirement? Absolutely. Could it turn what might be an acceptable probability of success or a decent chance into a better chance? Or if you were, say, if you were looking at a 70% probability of success,

that means something different for everyone. Just using that as an example. Could it turn a 65% chance into a 70-75% chance? So from where it's iffy to where it looks, things look good. And again, this all depends on the client and a number of other factors, but it could. So it's certainly going to improve your situation, and it also could have other benefits.

And as soon as we go through the five-year rule here, I'm going to close on some thoughts on some FYIs, things to look at without going into too much detail. And for those of you who are healthy and wealthy newsletter subscribers, Sona Wealth newsletter subscribers, we're going to include a 2025 tax sheet. It's updated to 2025 figures and a one-page flowchart regarding the five-year rule. It has to do with, will the distribution from your Roth IRA be tax and penalty

free? So covering the five-year rule. And if you're not a healthy and wealthy subscriber and you want a copy of the flowchart, we'll put a link below. Just sign up. I think if you enjoy this podcast, you'll enjoy our weekly newsletter. We have investing in retirement tips, and it's some good stuff. Most of it is written by myself or someone here at Sona. Before we dive into the five-year rule, let's just do some basics.

So a Roth is a type of account. A traditional or pre-tax account is another type. So with Roth IRAs, we'll focus on the IRA here, money goes in post-tax. You pay taxes on it for the year you contribute. And then those monies grow tax-deferred and for qualified distributions come out tax-free. The key word there is qualified. So for a normal contribution Roth, qualified means age 59 and a half. And that Roth IRA, doesn't have to be the one you're accessing, just underneath your social.

Was funded at least five years ago. That's why, and we're going to mention this several times, that's why it's good to get a Roth IRA started just to start that five-year clock for a number of different reasons. So when we talk about qualified distributions, we're talking about access to not just contributions, but earnings. Contributions and earnings separate the two. For a normal Roth, your contributions are available anytime tax or penalty-free. It's a pretty nice feature of a Roth.

And it kind of makes sense. Not all tax things make sense, but having access to those contributions that you paid taxes on, it does. It does. You can understand the government, the IRS, wanting to restrict some things around retirement accounts. Unfortunately, sometimes they might get more complicated than they should be. For earnings, it's a different story. The earnings is what you need that qualified distribution for. It's what you have to answer those two questions.

Are you age 59 and a half or older? There's some other exemptions, some other qualifiers. We're not going to touch on those right now. We're going to talk about kind of the normal qualified distribution. So one, are you age 59 and a half, meaning are you retirement age? Has your Roth been open? Have you opened up a Roth IRA for at least five years? So you could have opened up one at Fidelity.

And 20 years ago with $10, but maybe you're only using the one that you have at Schwab, and that's the one you're accessing, just so you open up one more than 10 years ago. I have two teen boys, 17 and 19. I'm going to use them as an example. So they've had Roths since they were 15. And actually before that, they both had earned income before that. So let's say that they get to age 40. They've been contributing for 20. We'll just use 20 years, age 20 to age 40.

And let's say they're able to do five grand a year. That's pretty tough to do when you're in your 20s, but let's say they are. So they have contributions of $100,000, 20 times five.

And let's say they doubled their money, which if you're young and invested aggressively, which you should be in order to get a return above inflation, that's not a very good return to just double your money in 12 years. It should be something more like 7 to 10. But for our example, we're going to keep it simple. So say at age 40, they decide they need to access or want to access some funds.

They can take out those $100,000 in contributions. Now, keep in mind, ideally, if it's planned, you're taking into account that you're losing out on growth of those funds. It is a retirement account, but it is an awful nice feature. Could it be a better option than credit card debt? It could. Might it be necessary for a home down payment? As long as you are aware of the possible outcomes and are planning, it's certainly something that you could do.

They could take out the $100,000 and no tax and no 10% penalty, the contributions. The other $100,000, that is the growth, the earnings, whether it's capital gains, dividends, interest, whatever. If they take that out, they have to pay ordinary income tax for the year they take it out and a 10% penalty. Why? Because they're under age 59 and a half. Now, let's say they go to age 60. So say they stopped contributing up to age 40.

They have 100,000 contributions. Now at age 60, let's say they have $400,000 in the account, $300,000 worth of earnings of gains. Well, as always, is that $100,000 is available anytime tax or penalty free. The $300,000, is that available tax or penalty free? The earnings? It is because they meet those two qualifiers. They're over age 59 and a half, and they've had a Roth for over five years, well over five years in our case.

Now, where things get a little more confusing is when you're talking about Roth conversions. And there's actually another five-year rule for Roth 401ks, and we'll touch on it briefly. But Roth conversions is where most people have problems.

So we're going to go back to my sons. Let's say they are at age 40, and they decide they have a large 401k. We'll say they have $100,000 in a 401k, pre-tax money. Well, let's say they moved it to an IRA. So they have $100,000 in a traditional or pre-tax IRA, and they decide they want to convert it. So they convert the $100,000. That $100,000 is ordinary income, so it's on top of any other income they have, which could push them into higher tax brackets.

And when they convert it, some folks might say, well, Mark, you pay taxes on the contributions. Those are available right away. Are the conversion dollars available right away because they pay taxes on it? It kind of makes sense. The answer is no. So that conversion has its own five-year clock, which having that restriction does make a little sense. These are retirement accounts. They don't want you to convert it and then access the money right away.

Some folks say it's very logical. I don't know. But the bottom line is, in my example, my boys could do that at age 40. They can convert it, pay the tax. And then if they wanted to access the dollars converted at age 45, 46, they could. Could they access the earnings on those converted dollars? We have a smart audience. The answer is no. No, they could not. So if they were to do a conversion, each year they did the conversion, it has its own five-year clock.

So if they did a conversion at age 40, 41, 42, each of those conversions have their own five-year clock. Some of you might be thinking, when might you do something like that? Well, one, you could convert because you're afraid. Maybe you're more afraid about taxes in the future. You could have a low-income year. Also, a lot of times we do this if folks need to access income before a retirement date.

We will sometimes do Roth conversion ladders where if they need to access money, say if they want to retire at age 50, but they need to access money penalty-free before the age of 60 or 55 to 60 or something like it. So using my boys as an example, say they did these conversions in their 40s, and then as long as the five-year clock, they could have done one at age 45 to access after the age of 50 and then 46.

We come up with a ladder where each year we have new conversion dollars that are available. It's a good way of getting money into a Roth IRA. The earnings are still there. For most people, that's not a problem. Now, for those who retire early, we're often taking into account their contributions. But what you find is the five-year issue for the conversions is not...

It's not as big a deal because when the IRS thinks about the money coming out, it says you access contributions first, conversion second, then earnings. So while often the conversions are available after five years, most people, if they go in and access funds, they're taking out their contributions. Could they be grabbing contributions and conversions? They could. They could. But you can see where keeping track of all this is a big deal.

So one thing to consider when you're talking about conversions, it's not just the ordinary income tax that you have on the conversion. It's the unintended consequences. So sometimes if you are in the 24% bracket, do you want to go up to the 32? Those conversions could push you up to where maybe they're used to paying kind of an effective rate or an average rate of, we'll say, 15%. And all of a sudden, because their income is boosted up, that all of a sudden, maybe their effective rate is 20.

They may be in the 24% or 32% bracket, whatever the case may be. So before you do a conversion, make sure you are looking at that. But also, it's not just the tax brackets, it's the credits or deductions. So people get used to having some of these credits or deductions and that if your income's too high, you might lose it. And in Minnesota, the property tax rebate's a big one.

Some folks, even for those that are very high net worth, if their income is lower, because maybe they're working with us and they manage their taxes really well, that even though they have a large asset base, especially before RMDs, required minimum distributions from the pre-tax accounts, that. That their income is lower, that they get used to that. Sometimes there's emotion attached around that. So you could lose those.

You could lose need-based college aids, FAFSA, or the other ones that layer on top of FAFSA for mostly private school, CSS, or consensus. So you could lose financial aid if you're retirement age, if you're getting Medicare, that Medicare surcharge could get more expensive. That's a big one. That takes more planning two years in advance. And that one's trickier. So just think of all the credits or deductions you might get that you could lose out on because of that Roth conversion.

So it's not to say that you shouldn't do it. For some folks, it's just about making sure you look at the numbers, saying, if I do this conversion, or often we just will fill up tax brackets and we'll model that and we'll say, if we convert this amount, this is our extra tax. If we convert this amount, this is our extra tax.

And thank goodness, we have very nice software like Holistoplan is one that comes to mind that is really, really, it takes a lot of guesswork and time from the financial planning. Also, remember, you know, in most cases, you need to pay taxes for the Roth conversions, not from the Roth itself. That's the best thing to say. It does take a lot of planning if you're thinking about Roth conversion.

Well, I've been talking, a lot of you might be thinking, well, if a conversion has a five-year window, what happens if I convert five? Between age 55 and 59 and a half. What if I do a conversion at 58? That's a good question. It gets a little confusing. Again, this is why there's only ifs, ands, and buts. This one, I'm not sure entirely makes sense.

For all your Roth conversion, all your five-year clocks that you have going, assuming they haven't expired, they all just go to zero once you turn 59 and a half the conversion dollars are all available which is a good thing now for the earnings again you have to for any earnings you have to have that age 59 and a half and you have to have that roth open for roth ira open for five years there are other five-year rules the roth 401k gets

trickier the roth for and i would be surprised if this changes at some point. The Roth 401k, the five-year clock is per 401k. We're not going to get into Roth 401k to Roth 401k transfers. I think we've already made things complex enough. Well, not us. The IRS has made things complex enough for you. But quite often, folks will roll the Roth 401k into the Roth IRA, and it generally takes on the characteristics of that Roth IRA.

So again, another reason why opening the Roth IRA and funding it sooner rather than later is critical, assuming that rule holds that allows you access to the Roth 401k contributions when most people do when they roll it out of their work. So I hope that helps add some clarity to the five-year rule can help you make some informed decisions. Lastly, I'm going to touch on, well, taxes.

Last year, especially, we were debating the, and we did several things on this, on the expiration of the TC, the Tax Cut and Jobs Act, the TCJA, because most people saw a tax decrease. So I think you had 22 bracket, the 24 bracket on the 22, and some of the brackets got wider, some got narrower. But for the most part, people saw a tax cut, and there's a lot of debate on making moves like a Roth conversion before that tax cut, those taxes were to expire.

Now, given these were Trump tax cuts, chances are something will be renewed. We don't know if it'll be exactly the same. So there's less worry out there than there used to be as far as taxes increasing. But when you do enough of these financial plans, when you are projecting not just one, two, three, four years in the future, but five, 10, 15, 20, there it becomes trickier.

You know, I'm always hesitant when people kind of have recency bias, and I'm not sure that's the right definition for recency bias, but when they're just caught up into what the headlines are now. Sometimes a little bit of fear can be good. So most people do need to, and this is where when we run stress tests, we model in some bad tax increases scenarios. The idea that taxes stay where they are, even if we do get government spending under control with entitlements is tough to believe.

That's where you really do need to take a look at Roths because the idea that taxes don't change over that longer period of time just seems unlikely. Financial planning is all about making informed decisions. So just because you make an informed decision doesn't mean you do a Roth. I've often shown this to folks that said, you know what? Yep. Your net worth, if you live to age 90 or 95 or 100, is going to be X amount higher with a Roth.

Some folks say, you know what? I don't want to take that chance. If I'm lucky enough to live into my 80s or even 90s, I'm going to live with it. I'd rather take those tax dollars now. It's a lot like claiming Social Security early for a lot of folks. They say, you know what? I know, Mark, that I get this higher amount. I get this risk-free rate of return for life and the inflation adjustment on Social security is higher for life and it's compounding because it's off a higher amount.

And I get that, but it's about making sure you are making that informed decision. Roths are a funny one because they are underused, but even for some folks, they get so caught up in the clickbait. There are some folks who use them when they really shouldn't, unless you had a really large increase in taxes in retirement.

Because one thing to keep in mind that people lose sight on is that when you're comparing your, it's not just about your tax rate now versus your tax rate in retirement, it's your marginal tax rate now versus quite often, not always, your effective tax rate in retirement. And it's a deeper conversation. But what I mean by that is if you are in the 24% bracket, and if you make a contribution to a traditional account, just on the federal side, not even account in state, you might save 24%.

Where being your wages, your wages, it may be investments, your wages are filling up all the lower tax brackets, the deductions, standard or itemized.

Well, in retirement, you might have RMDs filling up required minimum distributions from your pre-tax account filling up those lower brackets but quite often at least some of the lower bracket social security as well are being filled up by the distribution so you know it's got a case of you know unless you assume a much higher tax rate are you trading at 24% savings now for saving 15% in the future and, It also depends on how long you live because when you have that tax savings

now, a dollar now has more – one dollar now has more value than one dollar in the future. That tax savings now, you could invest it. It could grow. It could be spent. It has utility. Whereas by definition with just the very nature of inflation –. That $1 in the future is going to have less value. That being said, Roths are a lot like cowbells or Will Ferrell and the cowbell. Most people could use a little more cowbell in their life.

If you're a Jaxxer or a baby boomer, you know that from Saturday Night Live.

But Roths, for a lot of people, are a very good thing. They are often like a tax insurance. Tax diversification is critical because we don't know what we don't know. We don't know what the future holds. But like with any insurance, you often don't get your premiums back. You pay for the peace of mind. You know, how much in premiums do you pay for homeowner's insurance and how much have you actually used?

So for some people, the Roth IRA, even if the numbers don't look great, perfect going forward, for a lot of them, it is a form of tax insurance. That's why really most people should be looking at Roths, even when, well, the young, especially when they're younger because their tax rates are lower. But usually once a year, you should be looking at Roths or Roth conversions.

As you get older, twice a year, especially when you think about from age 50 to 70, those kind of those pre-retirement years and before Social Security and RMDs required minimum distribution start. Financial planning is all about making informed decisions and making informed decisions about Roths, whether to use them or to not, or convert or not, can help you have a healthier, a wealthier, and a happier retirement. Don't forget to hit subscribe. Music.