Podcast Episode - Understanding The Five Year Rule


401k, Retirement, Roth, Roth IRA, Savings


May 02, 2021

Listen to Podcast Episode:

On this podcast, we get an in depth Suze School all about what the “Five Year Rule” means with regard to ROTHs.


Podcast Transcript:

May 2, 2021. Suze O here, welcome to Suze's school. And today we are going to have Suze school on Roth retirement accounts and something known as a five-year rule that you really all need to understand how that affects. Whether you can take money out of your Roth IRA not only income tax free but penalty free as well, so you better sit down and grab a cup of coffee because this is not the most exciting topic. But this is a topic that every single one of you needs to understand because it really affects if you're going to pay taxes and penalties on withdrawals from your Roth retirement accounts, whether it's a Roth IRA, 401K, 403 B or TSP Roth, you need to understand the five-year rule. So first of all, I just want to say thank you all for the incredible emails, thanking us for our new course that we created called the three-step reset. But what I realized is that last week when we talked about it, I didn't give you the place that you can go and get it. So, you're all emailing me saying Suze, where do we get the three-step reset? We all want to take it. So, you simply would go to suzeorman.com/hope and then you'll be able to sign up for it. It is $27 for podcast listeners. Normally it is $54. So, I think you'll love it again for those of you who want a reset in terms of how you think feel and act with money. Can you just check that out? It really, really can change a whole lot in your life so that you do that which you know you should do when it comes to money and you remove the obstacles that are keeping you from being more and having more. So, I just wanted to say that before I forgot. All right now, back to the five-year rule. When it comes to a Roth retirement account, the main reason I have wanted all of you to have a Roth retirement account is because I really want your money in a situation where what you see is what you get in a traditional retirement account, meaning pretax, you might have three or four or $500,000 in your traditional retirement account, but depending on your tax bracket, depending on the tax brackets of your kids when you die and they inherit it, they're not going to get what's in there because they're going to have to pay ordinary income tax on that money, so therefore you need to have Roth retirement accounts. It is no joke anymore, everybody. You can see in many ways how tax brackets are absolutely starting to go up. You can see how many of the tax deductions, such as the step up in basis capital, all of that is possibly going to go away, not just for those who are really wealthy, but eventually maybe for everybody. So can you just get yourself in a situation where your money is in a tax-free situation for you when you go to withdraw as well as your beneficiaries when you leave it to them. There are two things that affect a Roth IRA. The very first one is income tax, the second one is a 10% penalty. And just because you have a Roth retirement account doesn't mean that you don't have to pay income tax on it or the 10% penalty. It just means if you follow the rules you won't have to pay it, but if you don't, you absolutely will. So, let's understand what those rules are. When you have money in a Roth IRA, when you've contributed money to a Roth IRA. Any money that you originally contribute can be withdrawn any time without taxes or penalties regardless of your age or how long that money has been in the account. So, it's not your contributions that I'm ever worried about. I worry about the money that your contributions happen to earn. So, let's say you put in $7,000 this year, $7000 next $7,000 the year after that, you have put in $21,000 and it's grown to be $25,000. And the accounts only been open three years, you can withdraw anything up to that $21,000 without taxes or penalties, regardless of how old you are or the account has been opened. It's the additional $4,000. The earnings that have to stay in that account until you are at least 59.5 years of age. And that account has got to have been open for at least five years. Oh, there's the first time I'm saying five, it's known as the five-year rule. You cannot take earnings out of a contributory Roth without a 10% penalty and ordinary income tax unless you are 59 a half years of age. And the account has been open for at least five years. If it meets both of those qualifications, then you can make what's called a qualified withdrawal and a qualified withdrawal means it qualifies that withdrawal to not have to pay penalties or taxes. If you are not 59.5 years of age and you're taking out the earnings of a contributory Roth and the account has not been open for at least five years, you are going to pay a 10% penalty tax and ordinary income tax. So here is what I want you to do. Obviously if you don't currently have a contributory Roth IRA. I want you tomorrow, first thing to open one up. I don't care if you open up a Roth IRA with $100 with $50. As soon as you open a Roth IRA. The five-year clock starts to tick and I'll explain how that clock works in one second. Once you have opened up a Roth IRA from that point on, no matter how many other Roth IRAs you open, no matter what they're all dated. The five-year clock applies to all of them based on the very first contribution that you made. You know, and I know many of you wait to the tax filing date of a specific year to open up a Roth IRA. So, it is very possible that the tax filing date this year is May 17, that's when taxes are due. So, you have until May 17th of this year to open up a Roth IRA for 2020 even though you just opened it up right here and right now. The five-year clock starts ticking as if you opened it up January one of 2020. So, if you did this right now you would gain an extra almost 1.5 years on that five-year time clock. So again, the five-year clock starts January first of the year that the Roth IRA is for. So, if it's a Roth IRA for the year 2021 you’re funding it or opening it December 31st of 2021 your time clock will have started January 1st 2021. If you're funding a Roth IRA right now, before or by May 17th this year, your time clock will be set as January 1st 2020 because you are opening it for a Roth IRA for a 2020 contribution, you can also make a 2021 contribution if you want. But your time clock, the five-year clock will be dated, starting January first of 2020. Do we have that everybody? You need to understand that because once you have passed that five-year rule that clock, you are essentially home free in terms of when you can take money out without penalty and income tax. Remember you also have to be though 59.5 years of age. Now, I just want to give you an example. Here we have a lot of people who listen to this podcast who are in their 60s and for the very first time they are opening a Roth IRA. So, just because you are over 59.5 years of age when you open a Roth IRA does not mean that you do not have to pay ordinary income tax on the earnings. So, listen again closely. Here you are, let's just say that you are 63 years of age and you're past 59 a half obviously, you're working now and you open up this year for the first time, A contributory Roth and you fund it with $7,000. And for whatever reason that money really grows in next year, it's worth $10,000, and you're like, oh my god, I want that $10,000. You're 64 years of age now and you withdraw all $10,000 because you're over 59 a half, you don't have to pay the 10% penalty. That's just a mute point. However, because the Roth IRA has not been open for at least five years, you will owe ordinary income tax on the difference between what you put in the $7,000 and the $10,000 that you withdrew. So, on $3,000, your earnings, you're going to owe ordinary income tax on that. If you had opened up a Roth IRA, just, let's say you did so years ago with $100. Maybe you did it in the year 2000, you never put another penny in it until this year or last year and now you funded it with an additional $7,000. And now here you are a year later and there's $10,000 in it and you go to withdraw all of it, you won't pay a penny of income tax because the five-year clock started when your original contribution date, maybe years ago. Again, that is why I want all of you. Tomorrow, absolutely. Tomorrow to call and open up a contributory Roth wherever you want to do it with at least $50 or $100 do what you want with that money. But now the five-year clock has started. Just that simple if in fact you make too much money and you don't qualify for a contributory Roth fine, open up a traditional IRA with $100 and then just convert it, just do that so that the Roth IRA, the time clock has then started. So now we understand the five-year rule when it pertains to contributory Roths. Now let's understand the five-year rule when it pertains to what? Converted Roths, because converted Roths or converted 401ks are very, very different than contributory Roths. In terms of the five-year clock, every conversion that you make has its own five-year clock time period. So, unlike a contributory Roth where once you open one up, it applies to every contribution that you ever make from that point on with a converted Roth, every conversion has its own five-year time period when it comes to a converted Roth, the clock starts the year that you converted, so It's December 31st 2021 and you now convert a traditional IRA to a Roth IRA, your five-year clock will start January 1st 2021. You need to know when your five-year clock starts and how it works. It is true that you could take a conversion, you can take your traditional IRA and convert it and put that money into the same account that your contributory Roth is with. But for bookkeeping purposes it is kept separate on the books so you do not have to have one Roth that you make contributions to every year. Another Roth that was a converted Roth. Another Roth that was converted because you took your 401. And converted it to a Roth IRA. No, all you need is one Roth IRA and whether it's a contributory Roth where you contribute money to it or you are converting money from a traditional IRA or roll over into it, it can just be one account. It is recorded as to where the money came from and when the time clock starts, so you don't have to have all these different accounts, but you do need to keep track and you need to know that if you do a Roth conversion, that conversion has its own time clock and is not dictated by the time clock, the five-year time clock, of when you started your contributory Roth, got that, everybody. Now, even if you have a Roth 401K, listen to me closely, and that money has been in your Roth 401K for five years or longer and now you leave that place of employment or whatever and you want to convert or you want to take that 401K money and convert it to a Roth. And you are thinking well because it's been in a Roth four 401K, for five years or longer and I converted to a Roth IRA, I have the five-year time clock met. No, you don't. When you convert it, the time clock starts all over again, you need to know that. So, there are all kinds of rules and regulations about this time clock. But essentially you need to understand that when it comes to a converted account has its own five-year time clock. You also have to understand that it's not just with a converted Roth IRA or a contributory Roth IRA, it's also with inherited Roth IRAs. So here you are and you just inherited a Roth IRA from your mom and your mom started this Roth IRA two years ago, whenever you inherit a Roth IRA, all the money in the Roth IRA is absolutely tax free, not a part of this is going to be taxable to you. It is the 10% penalty that we have to pay attention to. So, if your mom dies, leaves you an inherited Roth IRA that she opened two years ago, you can withdraw all the money you want income tax free, but any money above her original contribution that she contributed, she put in $7,000 and now it's worth $10,000 and you withdraw it all you are going to pay a 10% penalty tax um that $3,000 of earnings because the Roth IRA that you inherited was not opened for at least five years. Do you hear me? So, there are a lot of you out there that are inheriting Roth IRAs that your mom or somebody just opened up a year or two ago and that money has maybe $14,000 in it or so? Or maybe that money was invested and she hit it really, really big and now there's $30,000 in it and you just want to withdraw it all again, if it hasn't been open for at least five years, anything above your mom's original contribution, you are going to pay a 10% penalty tax on, until that account meets the five-year rule. Do you understand why this five-year rule is so important? Also, I just want to talk to those of you who do have money in a Roth 401k, a Roth TSP, or a Roth 403B. Let's say you work for a corporation and you opened up a Roth 401K. Five years ago, let's just say you did. And now you moved to a new job at a new corporation that has a new Roth 401K and you start contributing to it. But you just opened it up, let's just say you did that this year. If you want you can transfer the money that's in your old Roth 401K, at your ex-employers to your new employer and your new 401K. Roth will be deemed to have been open for at least five years or whatever the date was from the money that you rolled into it. So, it will assume the time period of a Roth 401K that you already were in and now you're transferring to your new employer. So that's important for you to know because remember if it hasn't been open for at least five years, you can be subject to that 10% penalty if you go to take money out of it. These are things that you all really need to understand. I just before I blow all of you out of the water. I also want you to understand how the time clock actually works and how it is set. So that's what I really, really wanted you to know. Now I get that this can be boring. But I also get that you have to understand these things because otherwise without you knowing this you can take money out of a Roth. Your beneficiaries can take money out of a Roth and all of a sudden be hit with a really big tax penalty. So those right now are the rules that I simply want you to know and take advantage of. So that's it, that's the Suze school that I want you to have. I just want to say a few more things. However, since I have a few more minutes here, is that Alliant has brought, Alliant Credit union has brought to my attention that over 15% of you who have opened up accounts with the Alliant Credit Union, you haven't funded your accounts. What are you thinking everybody? Thousands and thousands and thousands of you have you opened up your Alliant credit Union account. You're putting in $100 a month. At least many of you are putting in far more. And at the end of 12-months you are going to get that $100 which equates to a 16.7 return on your money. By the way. I just have to say this. A few of you have written me and go that's not a 16.7 return. Suze, it's you put in $1200. And all you get is $100. That's not 16.7%. You're not putting in $1200 all at once, you're putting in just $100 a month or at least $100 a month every month for 12 consecutive months. And then you're getting your $100. Oh yes it is, a 16.7% return on your money. So even if it was less than that it's still a lot. Because as I keep saying over and over again you would have to have at least $18,000 in a savings account making .55% interest. Which is exactly what Alliant is paying for you to earn $100 in interest. So why you're not all taking advantage of that is beyond me. Absolutely beyond me. But if you've gone to the trouble to open up your Alliant account, you've been approved, you have an account. Can you start putting money in? Otherwise, why did you even bother to do that? And I just want to say, can you just try it everybody? It's just so very, very important. Okay. That's all I wanted to say today. I know you all miss KT. Right? You all wrote and said how much you loved that? The fact that she was crying and in the podcast and everything last Thursday. She's so sweet, isn't she the sweetest little thing you ever saw? All right. I know you miss her. I know that this might not have been the most exciting podcast, but I got news. It's probably one of the most important you can ever listen to. All right. Everybody see you next Thursday with Ask Suze and Katie Anything. Stay safe.


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