Podcast Episode - Suze School: What You Need to Know About The Five Year Rule for Roth

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Since so many listeners have been writing Suze with questions about the Five Year Rule in relation to ROTHs, she decided to do a Suze School about it. Suze starts with a detailed explanation and then asks us questions to make sure we learned the lessons. This is an episode you’ll want to listen to over again, so you can avoid penalties and feel secure in how your money grows.

Podcast Transcript:

February 6th 2022 welcome everybody to Suze school and today, Suze school is all about the five-year rule when it comes to Roth retirement accounts. Now. I know, I know I said Miss Travis would be here this morning. However when we woke up it was so great in terms of being a day for fishing, she said Suze, please can I go fishing? You can do Suze school without me. I said you go girl, so she is off and running. So let's begin Suze school because there's so much that I want to tell you. Okay first of all I just want to talk about Roth IRAs retirement accounts for a second. I have told you forever that I really believe from the bottom of my heart that a Roth retirement account is the absolute best retirement account out there, bar none. And many of you always say to me no, Suse I'm in a high tax bracket. I rather invest in a traditional IRA or retirement account, get a tax write off now and then later on in life I'll be in a lower tax bracket and take my money out of them. A Roth retirement account is a retirement account right that is funded with after tax money, you've already paid taxes on it. A traditional retirement account is a retirement account that you have never paid taxes on the money that you put in its pre-taxed and how that comes to play later on in life Is in two ways. Number one Let's say you're 65 years of age or older and now you're on Medicare, the money that you take out from a traditional retirement account will count towards income and probably increase your Medicare B premiums. Social Security, you're now taking Social Security, possibly the income that you take out from a traditional retirement account will make it so that your Social Security becomes taxable and last but not least when you die, it's not if you're going to die, it's when any money that you leave to your beneficiaries in a traditional retirement account, when they take it out, then they will pay ordinary income tax on it. And maybe they are in a huge tax bracket because they're making a lot of money at that point in time. A Roth IRA or any Roth retirement account, if you follow the five year rules everybody and that's included for inherited Roth retirement accounts avoid the increase in Medicare B premiums to you, avoid your income going up and so therefore your Social Security may not increase in taxes or be taxed at all and your beneficiaries get to inherit it again. As long as they know the five year rule. Absolutely. Tax free, I think those are big deals, but to make the Roth retirement accounts really be as beneficial as they are meant to be. You have to understand the five year rule. So what is the five year rule? It's very simple. You just have to open up a Roth retirement account And if you open it up and it is opened for at least five tax years and I'll explain tax years later on. If it is open for at least five tax years, then you have met The five Year Rule. Just that simple and therefore later on in retirement or whenever you are over 59 and a half, even though you are working any money you withdraw from this Roth IRA will be withdrawn tax free and penalty free. So you need to understand that simply what the five year rule says. So let's begin. There are two different types of Roth retirement accounts. There are individual ones, ones that you open up on your own and then there are ones that you open up with your employer, a Roth 401K a Roth 403B a Roth TSP. Right now, I'm only going to be talking about individual Roths, I'll get to 401Ks, etcetera in a little bit. When you're talking about an individual Roth, there are two different types as well. There is a contributory Roth and a converted Roth, then I want you to write those two words, damn a contributory Roth and a converted Roth. And the five year rule works differently. If you have a contributory Roth versus a converted Roth, what is a contributory Roth? A contributory Roth is very simple, You open up a Roth IRA and every year or whenever you want, you contribute to it, you don't have to contribute to it more than once. You can open up a contributory Roth, put in $100 and never contribute to it again. Okay but you contributed to it with money, you have already paid taxes on a converted Roth is a Roth where you first opened a traditional IRA, a traditional IRA again is money that you have never paid taxes on and now you want to convert it to a Roth and when you convert it to a Roth at that point you will owe income tax in that year on any money that you converted. Now there is another kind of converted Roth IRA And many of you out there have what's known as a back door Roth IRA. And to make it very simple, a backdoor Roth IRA is when you don't qualify income wise for a contributory Roth IRA So you open up a traditional IRA and you fund it with money that is not tax deductible, you don't take a deduction for it. So it's called a non deductible IRA And then you convert it to a Roth and you are allowed to convert it because there are no income limitations on conversions. So all of you that have a backdoor Roth IRA, you need to know that that IRA Is also considered a converted Roth IRA So you need to understand the difference between a contributory Roth IRA And a converted Roth IRA. Next I want you to write down the words contribution and the word earnings contributions are made up of money that you contributed to your Roth IRA you're contributing to it with after tax money earnings. The earnings are the money that the contributions make. So you open up a Roth IRA you invest that money in. Either stocks, exchange traded funds, mutual funds, whatever you want to invest in and that money earns money. So your contribution earns money. Those are known as earnings. So it's important that you understand that the five year rule works differently with contributions versus earnings. So you have to know those two words. Now before I go on everything that I am talking about during this entire section pertains to contributory Roth IRAs only I am not talking about converted Roths during this section. I'll let you know when I switch to converted Roths. The next two words I want you to write down are penalties and income taxes. Now what you have got to understand is that regardless of your age, regardless of how long the Roth IRA has been opened penalties and income taxes can never ever ever apply to contributions. Why is that? Because with a Roth IRA The rule is that regardless of how long the Roth has been open you can withdraw your original contributions that you put in without taxes or penalties regardless of your age, how long the money has been in there, how long the account has been open that money is yours? Why? Because a contribution for a contributory Roth is money. You've already paid taxes. Um so they're never going to penalize you or tax you on money, you've already paid taxes on. So the five year rule does not apply to your contributions. Now let's go on to earnings. When I talk about penalties, penalties only apply to earnings If you are not at least 59.5 years of age when you withdraw the money, If you are 59.5 years of age or older, when you withdraw your earnings from this account, Then the penalties do not apply because why you're already 59.5 or older penalties only apply to age, that's it. If you are under 59 a half years of age and withdraw earnings, you will, oh, A 10% tax penalty. And it does not matter if it's been in there longer than five years, less than five years. You will always, if you are under the age of 59 a half, you will always owe a 10% penalty on that money. Now, listen to me, obviously, if you take money out for a first time home or certain things like that for educational purposes, health purposes, there are caveats to the penalty rule, the 10% federal tax penalty, even if you are younger than 59 a half. But in general, you need to know that penalties for a contributory Roth pertain to age income tax, you will always owe income tax on your earnings if the Roth IRA Has not been opened For at least five years. So again, income tax and penalties only apply to the growth of your contributory Roth never to your contributions. So again, I'll just give you an example. You're 35 years of age. You opened up a Roth this year and you put in $6,000, which is the max and three months later That's $6,000 is worth 8000. Let's just say that's true. You can take out anything that you originally contributed $6,000 in this case without taxes or penalties whatsoever because penalties and taxes will never apply to your original contributions. So the five year rule is not for your contributions, it only applies to earnings. So You put in $6,000, it's now worth 8000. That extra $2,000 is your earnings. If you take that out before the Roth IRA has been opened for five tax years, you not only will owe ordinary income tax on that money, The $2,000, But you will also a 10% federal tax penalty because you were not at least 59.5 years of age when you withdrew it. Just that simple. Now, why do I keep saying tax years because a tax year starts January 1st 2022, January 1, 2021, January 1, 2020. It starts January one of the year. A calendar year is usually one year from when you yourself started something. So let me give you an example. You open up a Roth IRA December 31 of 2021 because it's a tax year. Even though you opened it up on the last day of 2021, It is deemed that that Roth Iva was open from January one of 2021. That's a tax year, A calendar year would be, you opened it up December 31st 2021. 1 year would be December 31st 2022. Do you understand the difference? Because it's a big deal in understanding how long your Roth IRA really needs to be opened To qualify for the five year tax rule. One last thing before we start your quizzie all Roth IRAs the IRS aggregates. What does that mean? You opened up a Roth IRA 10 years ago And you only were able to put in $100. Now you're making money and you haven't contributed to it for all these 10 years now you're working and you're able to contribute, so you open up another Roth IRA somewhere else at a different brokerage firm now you start contributing to it because you had originally opened up a Roth IRA 10 years ago your new Roth IRA is aggregated with your old one, The new one then has already met The five Year Tax Rule. So that is why the sooner you can open up a Roth IRA, even if you can't afford to contribute to it, that is when the five year tax rule clock begins so you can have as many Roth IRAs as you want. Obviously the maximum that you can contribute per year Is in 2022 to $6,000 if you are under 50 $7,000 if you're 50 or older. So let's say you open up five or six Roth IRAs at different places this year, the maximum that you can put in is $1000 in each one or however much you want to put in each Roth IRA but totaling $6000 altogether now you have to know that conversions don't work that way Roth IRAs everything is aggregated conversions which I'll get to in a second again, do not work that way. Alright so do you think that you are ready now for your quizzie now I'm going to try to help you to understand what to look for in these questions. So here we go, You are 40 years of age and you have contributed, listen to the word contributed, remember what I told you about contributions $18,000 over the past three years into your Roth IRA and now it's worth $20,000. And you want to withdraw $10,000 to buy a car. So you're 40, you're under 59.5 You have contributed $18,000. You have $2,000 of earnings And you want to withdraw $10,000 to buy a car. Will you have to pay a penalty and taxes to take that money out? Think carefully. A. Yes B. No. Which one? The answer is no. And the reason is why $10,000 is less than the $18,000 that you contributed. And what did I say to all of you your contributions are never taxed or penalized no matter what. So you can take out your $10,000 in this case without taxes or penalties. Now you may say to me Suze How do they know that that $10,000 is part of my contributions and none of it is part of earnings. When you take money out of a contributory wrath. First there's a rule called first in first out so first your contributions come out then if you do have any conversions in there, your conversions come out and next comes your earnings. So the IRS keeps track of all of that for you. Hopefully your brokerage firm does as well so you don't have to worry about it. You just need to know the rules. Alright, Next question, you are 60 and you have contributed $21,000 over the past three years. Why 21? Because the maximum that you can contribute per year when you are 50 or older is $7,000 a year. So This person contributed the max and they contributed $21,000 over the past three years into their Roth and now That 21,000 is worth 25,000. So $21,000 of contributions, $4,000 of earnings and this person wants to withdraw all of it to buy a car. Well they have to pay a penalty on any of that money. Are you thinking about it? Now notice I said well they have to pay a penalty. I did not ask you if they have to pay taxes and a penalty. I asked you if they have to pay a penalty on any of that money. They are withdrawing all $25,000 at once and they are 60 A. Yes b. No think about it. Everybody. The answer is no. Why is the answer No. Because did I not say to you, penalties never ever apply on any of the money. If you are 59.5 years of age or older when you withdraw money from your Roth IRA. So in this case This person withdrew $4,000 of earnings But there are over the age of 59.5. So penalties Never apply to you. Tax penalties if you are 59.5 years of age or older. However, what happens in regards to income tax? Will this person have to pay income tax on their earnings? A yes or B. No. What are you to look for in this question? This Roth IRA has only been opened for three years. They have $4,000 of earnings, they are now withdrawing the earnings. Are they going to have to pay taxes on those earnings? The answer is yes. Why? Because this Roth IRA was not opened for five tax years at this point in time. That is why you have to understand the difference between penalties and taxes. Are you starting to understand that now I'm going to get a little bit more complicated. You make a contribution to your Roth IRA on April 15th of 2000 and 22? Remember you have until April 15 or whatever the tax day is for that year to make a contribution to last year's Roth IRA. So you are making a contribution on April 15 of 2022 For year 2021 Roth IRA In what year Will the five Year holding period be up? Remember what I said to you about tax years versus calendar years. So you are making a contribution in 2022 But for the 2021 Roth IRA Is your five year tax year up in a 2025 B 2026 or C 2027. Think about it. The answer is a 2025 why? Because Even though it was made April 15 of 2022, it was made for a Roth in 2021. And what did I tell you? It starts the tax year January one of 2021. So January 1st 2021 is one year, 2022 is two years, 2023 is three years, 2024 is four years, 2025 is five years now. What's interesting about that is because the five year holding period is based on tax years and not calendar years. Even though you made the contribution April 15 of 2022, The five year period is up in January 1, 2025. That's three years and eight months of a holding period. That's less than five calendar years. Big time, one year and four months less. So tax years make a big difference. So you need to understand that. Let's ask again in a little different way. So I know you really get it. You are 62 years of age and you have three different contributory Roth IRAs one. you open and funded five tax years ago, 13 tax years ago and 12 tax years ago and all three have done exceptionally well and made money And you want to withdraw everything in all three Roths to pay off the mortgage on your home, how many of these Roth IRAs can you withdraw all your contributions plus earnings without taxes or penalties a one the two Or see all three now? Remember what I said about Roth IRAs being aggregated even though this person or you have three Roth IRAs one of them was opened five tax years ago. So what does that do to the other two that were not opened five tax years ago. The answer is c all three and why is that? Because number one, you are 62 years of age when you are withdrawing everything from this. So remember I told you penalties never apply once, you are 59.5 years of age or older, that 10% federal tax penalty, why are you not paying income tax on your earnings because all three Roth IRAs even though they were opened at different times because you opened up 15 tax years ago or more, All three are deemed to be opened up five years ago. So that's why it's important again that you open up a Roth IRA as soon as you can to start the five year tax clock going next, You are 52 years of age and have three different contributory Roth IRAs one, so you have three different ones now One you opened and funded five years ago, one 3 years ago And one 2 years ago. All three have done exceptionally well. Again made money and you want to withdraw everything in all three rots, how many of these Roth IRAs can you withdraw all your contributions plus earnings without penalties or taxes A all of these or be none of these? Remember what I told you about penalties. The answer is b you cannot withdraw all of these without taxes and penalties Especially because you are not 59.5 years of age. So therefore your earnings Not only will get a 10% penalty but they will also be taxed as ordinary income as well. If you just wanted to take out your contributions you can do that at any time without penalties or taxes regardless of how long the accounts have been open. Now I want to go on. So I think you're now understanding how contributory Roth's work and how the penalties and taxes work. Let's go to converted Roth IRAs because those are very different when you convert money from a traditional IRA to a Roth IRA every time you do. So you start a new holding period. So unlike a contributory Roth that once you establish it, that is the starting date from all the Roths you contribute to or you start with after tax money from that point on with a converted Roth, Every time you convert from a traditional retirement account to a Roth retirement account, so you're going from a traditional IRA to a Roth IRA, you start a new time clock, it has nothing to do with the Roths that you already have and by the way this includes a backdoor Roth IRA as well, that is a big deal. So if you convert from a traditional IRA to a Roth this year, you start a new time clock this year, if you do another traditional IRA to a Roth next year, the time clock starts all over again, it's brand new for that year. Also you have to know that conversions have to be made by December 31 of the year you are converting. So if you convert December 31, 2021 The clock then starts January 1, 2021. So that's important for you to know as well. Here's what's fabulous. However, when you convert a traditional IRA to a Roth IRA, you obviously will pay taxes on any money that you convert that year. So you will convert money from a traditional, Whatever amount you want to a Roth, you will owe taxes on that money. Typically the taxes are not due until April 15 of the year after you converted. So now that money has to stay in there for five tax years for you to have met the five year rule, what does that allow you to do? It allows you now to take out the original amount of money that you converted without any taxes or penalties regardless of your age. That's important. Let's say that you're in your 30 and you really want to be able to access that money. Let's just say you do right or wrong to start a new business. So here you are, you have $10,000 in a traditional IRA and you're really not in that high of a tax bracket. You're not really making any money If you convert that $10,000 to a Roth IRA. Five tax years later you can withdraw even though you're not 59 a half years of age, you can withdraw the amount that you converted and pay taxes on without any taxes or penalties at that point in time. Why is that because you pay taxes on it? So you can get that money in five tax years. Just that simple, that's how a converted Roth works. However, the earnings still have to stay in there Until you are 59.5 years of age to avoid the penalty and income tax on that money. However, listen to me closely. Now again, you converted and you have this money in that you have just paid taxes on and now it's three years later, maybe four years later, whatever it is, you have not had the money in there for five tax years and you decide that you want to withdraw some of the money that you originally converted. If you do that, You are going to pay a 10% penalty on that money. Why are you not going to pay taxes on it Because you already have But you will pay a 10% penalty now for those of you who did a backdoor Roth IRA I'm sure many of you are confused right now because you're like wait a minute. I funded my traditional IRA with after tax money which is why it's called a nondeductible IRA and then I converted it. So Suze does that money still have to stay in there for at least five years before I can touch it. And the answer to that is yes it does. So that money has to meet the five year rule because if you take it out before those five years you will pay a 10% federal tax penalty unless you are 59.5 years of age or older. So again that is how conversions work. Whether you are converting from a traditional IRA that you never pay taxes on and now you're converting it to a Roth or you have a backdoor Roth IRA where you put money into a traditional IRA, it was non deductible and now you are converting it to a Roth IRA So do you understand that? Well let's see You are 25 years of age and you have a traditional IRA that you really want to convert to a Roth as you know if you convert you're gonna have to pay taxes on the amount you convert. So your quiz e. Is, how long does the money you converted have to sit in that converted Roth IRA until you can withdraw the amount you originally converted without tax and penalty, You're only 25 years of age. Think about it. Everybody answer five tax years B you can't do this. Which one? The answer is A and the reason is like I said regardless of your age, when you convert, as long as it has sat there for five tax years you can withdraw your original converted amount without taxes or penalties because you already paid taxes on it. Next you are now 60, you don't have a Roth IRA You haven't opened one up yet and you just converted your traditional IRA to a Roth IRA. And now let's say you converted $60,000 and you just decide you want to do that for some reason. No, I probably would never tell you to do that. But anyway, Now two years later that $60,000 has grown to $70,000 and you want to take out All $70,000 will you have to take a penalty A 10% penalty On the money. The $70,000 that you just withdrew A yes B. No. Remember what I told you about penalties. The answer is be no, you do not have to pay a penalty Because why you are 59.5 years of age or older. Alright. Will you have to pay income tax on the earnings A Yes B. No, But you have $10,000 of earnings on a Roth converted account right that you opened two years ago? Think about it. Well you have to pay income tax A Yes B. No, the answer is yes because the account has not been open for five tax years, so the earnings will be taxed as ordinary income. So you always have to remember when you convert from a traditional to a Roth, a new time clock starts to understand. So it's really important that you get that converted Roth's start a new time clock no matter what contributory Roth IRAs are aggregated all too together. Now let's touch on employer sponsored plans Roth 401 Ks Roth 403 B's Roth tsp s An employer Roth plan also has to meet the five year rule. So it's important when you have, let's say a Roth 401K. And you have worked for an employer for eight years and now you are leaving that employer to go to another employer. If you start a Roth 401K. With your new employer and you roll your old 401K over to your new Roth 401K. With your new employer, your time years comes with it. So your new Roth 401K. Will be deemed to be eight years old. So you have already then met the five year rule. If you have a Roth 401K and you are now rolling that over to a Roth IRA, that has been opened For at least five tax years When you roll a 401K. Roth, You lose your time period from the 401 K. But since you had a Roth opened already, Now your Roth 401K. That you roll over already has been deemed to meet the five year time clock. If you do not have a Roth IRA that you already opened when you roll over a Roth 401K. To a Roth IRA, that's brand new. The five year clock begins them. That's why it's important, especially if you have an employer Roth retirement account that you start a Roth IRA, whether it's for a dollar, $100 it doesn't matter. So you have the five year clock started so that if you ever want to do a Roth IRA, rollover from a Roth 401K. A 403 B. Or a TSP into a Roth IRA, your clock, your five year time clock has already been met. So You have a broad 401K. With an old employer that you opened up five years ago and now you started a new job. If you roll over your old 401k. To your new employer's Roth 401 K. Does the time clock on the five year rule start all over again, answer a yes B. No, the answer is B no because your Roth 401K. With your old employer, the time clock goes with it when you transfer to A Roth 401K. With a new employer. All right, next question. If I Roll My Roth 401K. That I've had for more than five years over to a Roth IRA that I will open up at that time. Has the five year rule been match? Think about what I just told you a is yes B is no, the answer is no Because Roth 401 K. S. The time clock does not apply to Roth IRAs, so if you already don't have a Roth IRA that met the five year rule or is meeting it, the time clock for you starts all over again. That is why you need to open up a Roth today. Now I just have to say this before I wrap up, you have converted Roths, you can take a 401K. Roth and put it into a Roth IRA, you don't have to put all these different accounts into separate Roth IRAs you don't need a converted Roth, you don't need a contributory Roth. All you need is one Roth IRA That you can contribute to, you can convert to and you can roll over your 401K. Roth too. So you only need to open up one Roth IRA And the sooner you do it the better I just briefly want to talk about inherited Roth IRAs now when you have a Roth retirement account and the owner dies, obviously there is no withdrawal penalties for the beneficiaries when they take distributions from it on any level. But I said penalties because remember earnings and contributions are always penalty free when you die and your beneficiaries withdraw the money, even if they have not been in there for five years. However, the question is, will the earnings be tax free? The earnings for the earnings to be tax free? That Roth has got to have been open for five tax years before death occurred. So don't go rushing to take out everything at once. Until you know if the account that you just inherited the Roth account that you inherited, how long has it been open for? So if it has been open for five tax years, you can take any amount you want out without taxes or penalties, if it has not been open for at least five tax years, then what the earnings, if you take them out will be taxed to you as ordinary income. Again, no penalties will ever apply to money that you withdraw. So what you might want to do is if that is the case, know how much his contributions and only withdraw contributions then when the account has met the five year rule then you take out your earnings. What you have to know however, is when it comes to an inherited Roth IRA the rules are very very different. If you are a spouse, a sole beneficiary of that Roth IRA versus a non spouse like kids and things like that. So it's really important that you consult a tax advisor when you inherit a Roth IRA to figure out what is the best way to take money? How much can you take all of those things? So you stay out really of a situation that can get you in trouble. Alright everybody, we are almost at an hour. But I hope that you found this Suze school really really beneficial. Again it's a podcast, you can listen to it over and over again and I think it will help you big time in the future. Now I just got a text from Miss Travis and guess what? They have already caught three huge wahoos on the boat of wahoo is a huge fish. So she will be so happy and I hope you're happy with this Suze school as well. So until Thursday remember all I want for you is to be safe. Strong and secure. See you then.