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On December 22nd, 2017, former president Donald Trump signed the tax cut and jobs act into law. In short TCGA, as it's often referred to reduced taxes for individuals, corporations, and estates.
In addition to many other changes to the tax code, this act temporarily reduced tax rates at almost all levels of income and shifted the thresholds for several of the income tax brackets. For example, the 25% federal tax bracket was reduced to 22% and the 28% bracket was reduced to 24%.
As it stands today, the tax bracket changes are set to expire or sunset in 2026. In other words, we only have two more years this year and next year to take advantage of lower tax rates before they jump back up to prior levels.
One of the popular ways retirees have taken advantage of lower rates is to aggressively pursue Roth conversions before tax rates go up again. As a result, I've had more questions than ever about the five-year rule, specifically as it relates to Roth conversions. Podcast listeners and newsletter readers remain wildly confused about this rule, and I don't blame them. It's confusing and often poorly communicated and covered throughout the mainstream media.
Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte. And today, once and for all, I'm going to set the record straight on the Roth conversion five-year rule. I'm
I'm also going to share some brief thoughts on the expiration of the Tax Cuts and Jobs Act with 2024 being an election year. And given the very understandable confusion around the Roth IRA five-year rules, I'm sharing a one-page flowchart with all Stay Wealthy Newsletter subscribers this week. This flowchart will allow you to quickly determine how the five-year rule applies to your exact situation.
If you're not a newsletter subscriber and you want a copy of the flow chart, just head to youstaywealthy.com forward slash email. That's youstaywealthy.com forward slash email. In addition to cheat sheets and resources like this one, I also personally write and send a retirement focused article every single week. So if you enjoy this show, I'm confident you'll also enjoy the weekly email.
Lastly, as always, to grab the show notes for today's episode, just head over to youstaywealthy.com forward slash 212. In early 2022, I published an in-depth two-part series on Roth conversions. I also published two episodes sharing reasons why you might not want to pursue them. If you miss the episodes or want to listen again, I'll be sure to link to them in today's show notes for quick access.
Now, while I'm a huge fan of Roth conversions, especially if there's an opportunity to pursue them while tax rates are low, I like to highlight that this strategy is not going to fix a broken retirement plan. For someone who has a healthy plan, Roth conversions are one of the many strategies that can potentially reduce the amount a person pays to the IRS between now and end of life. It's
It's also a way to create more tax diversity and tax efficiently give to their heirs at end of life if that's a goal.
At the end of the day, it's impossible to guarantee the long-term outcome of Roth conversions. We are, after all, making assumptions about the future. They are or should be well-informed and educated assumptions, but they're still assumptions. So as you explore this opportunity or as you evaluate recommendations from financial professionals, please keep this in mind.
Roth conversions can be a powerful way to optimize your plan, take control of your tax bill, and avoid leaving the IRS a tip, but they aren't this magical strategy that will make up for overspending or undersaving. With that reminder out of the way, let's dive into the five-year rule specifically as it relates to Roth conversions.
First, to ensure everyone is on the same page here, just a quick recap of the Roth conversion process. Not a Roth contribution, but a Roth conversion. A Roth conversion is the process of transferring or converting money that you already have in a pre-tax retirement account, like a traditional IRA, into an after-tax Roth IRA.
Yes, the IRS allows this transfer, but the catch is that you're required to pay the tax bill on the amount of money that's removed from the traditional IRA in the tax year that the conversion was processed. So if I convert and transfer $100,000 from my traditional IRA into my Roth IRA this year in 2024, I have to pay income taxes on that $100,000 next April when I file my taxes.
And that should make sense. Money in your pre-tax IRA has never been taxed. So the IRS wants their share if you're going to move it out of that pre-tax account.
But naturally, as you consider pursuing a conversion, it's common to wonder about the rules and restrictions for withdrawing money from your Roth IRA after a Roth conversion has been executed. And this is where the questions and confusion about the Roth IRA five-year rule begin to surface.
The root of the confusion often lies in the fact that there are two different Roth IRA five-year rules that are out there, one for Roth conversions and one for Roth contributions. Conversions and contributions are two very different transactions, and journalists and media outlets and financial influencers often get them twisted and or fail to clearly spell out the differences between the two.
Now, while the two five-year rules are intertwined and overlap, I'm strictly focused today on explaining how to interpret them as they relate to Roth conversions. If you want to learn more about each rule independently or you have a unique scenario, I'll link to a couple of good articles in today's show notes, which again can be found by going to youstaywealthy.com forward slash 212.
That being said, the one rule that affects both Roth IRA contributions and Roth conversions that you do need to take note of is that any earnings inside of your Roth IRA, i.e. the growth of the dollars that are invested, earnings inside of your Roth IRA cannot be withdrawn until age 59 and a half or older without incurring taxes and a penalty.
Yes, I know there are some unique exceptions out there, but we're going to push those aside for now. Just know that you can always withdraw your Roth IRA contributions without penalty or tax or any restrictions. Withdrawing dollars from a Roth conversion is where the nuances lie. And that's what we're going to zone in on today.
So the five-year rule as it relates to Roth conversions, it's actually pretty simple. You just need to answer two important questions. Question number one, do you currently have a Roth IRA that was funded with any dollar amount at least five years ago?
Question number two, are you 59 and a half or older? I'll say those again. Question number one, do you currently have a Roth IRA that was funded with any dollar amount at least five years ago? Number two, are you 59 and a half or older?
If the answer is yes to both questions, you don't have any restrictions or limitations on withdrawing converted dollars from your Roth IRA. In fact, you can withdraw money that you've converted from a traditional IRA. You can withdraw prior Roth IRA contributions that you've made, and you can even withdraw earnings or growth from your Roth IRA.
all without any taxes or penalties. You are in the clear. For example, if you converted $100,000 to a Roth IRA today, and you can answer yes to both of those questions, you can withdraw the entire $100,000 from your Roth IRA tomorrow without any restrictions or penalties.
If you decided not to withdraw it right away and that $100,000 grew to $120,000 over the next year or two, you're also able to withdraw the $20,000 of growth or earnings without restrictions or penalties. And if they exist, you can also withdraw any other prior contributions that you've made to your Roth IRA when you were younger, as well as the associated growth or earnings from those contributions.
All without penalty or taxes. As long as you are over age 59 and a half and you funded a Roth IRA with any dollar amount five or more years ago, you don't have to worry about any tricky withdrawal rules getting in the way of your Roth conversions.
Now let's look at another scenario. Let's say that your answer is no to the first question, but yes to the second one. In other words, you do not currently have a Roth IRA that's open and funded. However, you are over age 59 and a half.
In this scenario, if you opened a Roth IRA this year for the very first time in your life and immediately did a $100,000 Roth conversion, you would need to wait five years to withdraw any of the investment growth associated with that $100,000 conversion. You can withdraw the $100,000 conversion amount at any time. You already paid the tax bill on it and you're over age 59 and a half.
So you can take your converted dollar amount whenever you want. The IRS doesn't care. However, you will need to wait five plus years from the year of your conversion in order to withdraw any of the growth that was associated with that $100,000 to avoid taxes and penalty.
For example, if the $100,000 conversion is invested in the first Roth IRA that you've ever opened and funded in your life, and that $100,000 grows to let's say $120,000, you'll need to wait five plus calendar years from the year that you did the conversion in order to withdraw the $20,000 of growth and avoid ordinary income taxes and a 10% penalty.
Although you are 59 and a half in this example, you need to have funded a Roth IRA at any time in your life and have it open for at least five years to be able to withdraw the earnings from your Roth conversion penalty and tax free.
Now let's flip it around. Let's say that you answer yes to the first question, but no to the second question. In other words, you opened and contributed to a Roth IRA five plus years ago, but you are under the age of 59 and a half.
Since I'm strictly focused on Roth conversions today, I'm going to keep it really simple. And I'm going to say that the Roth IRA that you originally funded, you only funded it with $1. In other words, the original contribution started the five-year clock, but the dollar amount is not meaningful or important here to this example. So,
Your Roth IRA was opened and funded with $1 five plus years ago, but you are under the age of 59 and a half. In fact, you're well below 59 and a half. Let's say you're 45 years old.
So you're 45 years old and your Roth IRA was opened and funded with $1 five plus years ago. In this scenario, even though the Roth was opened and funded five plus years ago, every Roth conversion you do is going to have its own five year clock. And that's because you're under age 59 and a half.
For example, if you do a $50,000 Roth conversion this year at age 45 and decide to take a $25,000 withdrawal from your Roth IRA in three years at age 48, the $25,000 withdrawal will be hit with a 10% early distribution penalty. To avoid the penalty on the withdrawal of the $25,000, you would have needed to wait five or more years from the year you did the conversion.
It's important to note that each subsequent conversion that you do in future years will be treated similarly. In other words, if you do another $50,000 Roth conversion next year at age 46, that conversion will start its own five-year clock.
Each conversion you do under age 59 and a half will have its own five-year clock. Again, I kept the example simple by saying that your original contribution that you made five plus years ago was $1. And that's because the IRS has this order of operations when you go to take withdrawals from a Roth IRA. And I just wanted to isolate the conversion there. But in case you're wondering about the order of operations, here's how it works.
When you take a withdrawal from a Roth IRA, Roth IRA contributions come out first, Roth conversions come out second, and finally earnings or growth on your money in your Roth IRA, they'll come out last.
Remember, you can always withdraw your contributions from a Roth IRA without any restrictions or age limits. For example, if you contribute $5,000 to a Roth IRA and one day later or one year later or even 10 years later, you want that $5,000 contribution back, you can withdraw it without penalty or taxes.
Going back to that last example, if we tweaked the scenario slightly and we said that the total amount of contributions that you made to your Roth IRA five plus years ago totaled $25,000 instead of just $1, well, three years after your $50,000 Roth conversion at age 48, you could have taken that $25,000 withdrawal that you wanted free and clear, no tax, no penalty. And that's because of the order of operations that I just explained.
that $25,000 withdrawal would have represented your prior contributions, not your recent Roth conversion since contributions will come out first according to the order of operations.
Now, let's look at a more unique scenario that sometimes trips people up. Let's use that same example that we just went through. But instead of being age 45, let's say that you're age 58. So you opened and funded a Roth IRA with a meaningless $1 contribution five plus years ago, and you're 58 years old. This year, at age 58, you do a $50,000 Roth conversion.
Two years later, at age 60, your Roth IRA has grown from $50,000 to $60,000. And you decide to liquidate and cash out everything to cash out your Roth IRA.
Contrary to what many people think, you can do this without any restrictions, taxes, or penalties because you're now able to answer yes to both questions. You have a Roth IRA that's been open and funded for five plus years, and you are now over age 59 and a half. And this one trips people up because the conversion was done at age 58. And according to the rules that started a five-year clock.
But after you turned 59 and a half, the clock doesn't matter anymore because you can answer yes to both of the two questions. You have a funded Roth IRA for five plus years, and you're now over age 59 and a half.
I recognize that these five-year rules are wildly confusing. And I think one reason why they're met with so much confusion is that the why behind these rules is rarely discussed. When you understand why they exist, the rules often start to make more sense. So why do they exist? Let's walk through one final example or scenario based on our two questions to better understand why this rule exists.
Let's say that I'm 40 years old and I do not have a Roth IRA. In other words, I answer no to both of our two questions. I'm under age 59 and a half and I do not have a Roth IRA. Now, while I don't have a Roth IRA, I do have a pre-tax traditional IRA with $100,000 in it.
If I wanted to withdraw that $100,000 today, I would have to pay ordinary income taxes on that withdrawal. And I would also have to pay a 10% early withdrawal penalty since I'm not 59 and a half.
Now, remember, unlike Roth contributions, anyone at any age can do a Roth conversion of any amount. So if the five-year rule did not exist, I would be able to get my hands on that $100,000 of pre-tax money right now without paying the 10% penalty. I could just convert the $100,000 from my traditional IRA to a Roth IRA and then subsequently withdraw it.
But since the five-year rule does exist, I can't do that. That loophole doesn't exist. I would have to convert the $100,000, dig into my savings to pay income taxes on the $100,000 in the current tax year. And then I'd have to wait five years to be able to withdraw the $100,000 converted amount from my Roth IRA penalty-free.
So yes, I'm still able to access this $100,000 at age 45, well ahead of turning age 59 and a half, but I had to cut a nice check to the IRS five years prior and then just sit and wait. That doesn't really benefit me if I'm in dire need of money and I need to raid my retirement accounts.
It's hard to get money into a Roth IRA. And if I'm going to go through all this effort to do a conversion, pay the tax bill and wait five years, well, I'd probably do everything I can during those five years to get my finances in order so that I don't have to touch that money. Once I get money into a Roth IRA, whether it's through a contribution or a conversion, I want to grow it tax-free for as long as possible.
To summarize, the five-year rule exists to prevent someone who is under the age of 59 and a half from accessing pre-tax retirement account dollars without penalty.
Thinking about your scenario through that lens and referencing the order of operations on Roth IRA withdrawals should help you arrive at the right answer. And if there's one key takeaway for everyone here, it's that you should consider opening and funding a Roth IRA of any dollar amount as soon as possible. If you think that Roth conversions might be something that you want to pursue in the future,
Opening and funding a Roth IRA with any dollar amount will begin that five-year clock and help you satisfy question number one in the two questions that helped us drive the scenarios today.
Okay, before we wrap up today's episode, I want to briefly discuss the Tax Cuts and Jobs Act and what may lie ahead. As noted at the top of the show, this law and the associated tax cuts are set to expire in 2026. By expire, I mean that tax rates as they stand today will be going back up. The 22% federal tax bracket will revert back to the 25% and the 24% will revert back to 28%.
Assuming these tax cuts do sunset as planned, retirement savers would be wise to seriously explore Roth conversions this year and next year if they aren't doing so already.
But what if things don't go as planned? With 2024 being an election year, it's anyone's guess how things might play out. Republican or Democrat, it's unlikely that the newly elected president wants to be blamed for higher tax rates, especially if those higher tax rates on individuals cause harm to the economy.
Julio Gonzalez, CEO and founder of Engineered Tax Services, recently warned of a harsh reality facing Congress, stating, quote, We're in a situation in which many American families and businesses are hanging on by a thread. Letting the non-permanent provisions of the Tax Cuts and Jobs Act expire could be catastrophic to our overall economy and the well-being of many working families.
In addition to the potential negative impact to our economy, the U.S. government's balance sheet is also at the top of the list for existing and incoming leaders in Washington, D.C. Higher tax rates will, of course, lead to more revenue, which might just be what's required to balance the budget.
So while the Trump era tax cuts are currently set to expire in 2026, we truly don't know what the outcome will be for another year or two. Given that, what does this mean for retirement savers who are considering aggressive Roth conversions these next two years? Well, at the end of the day, TCGA or no TCGA, Roth conversions are a bet, a bet on future tax rates, or more specifically, a bet on your future tax rates.
If your tax rates will be higher in the future than they are today, then the Roth conversion bet will likely pay off. As Ed Slott wisely put it, quote, Roth conversions, I believe, are really just something I call tax insurance. You're insuring against the uncertainty of what future higher tax rates could do to you in retirement.
Remember, there's no way around paying taxes on your pre-tax retirement dollars. You can either pay them now on your terms or wait for the government to tell you when to pay them. And if you don't pay some or all of your taxes now, your tax liability will just continue to grow. In other words, as your pre-tax IRA gets bigger and bigger, so too does the amount that you'll owe the IRS in the future. You owe the government money. Do you want to pay them back on your terms or on their terms?
In addition, depending on your goals, paying taxes on your pre-tax money now and getting the funds into a Roth IRA to grow tax-free might be an important factor in your personal decision here. Because if you don't do any Roth conversions now and you wait for the IRS to come knocking on your door in the form of required minimum distributions at age 73 or 75, you're
you won't have the same opportunity to get money into a Roth IRA. You cannot satisfy a required minimum distribution by doing a Roth conversion. And once those required distributions begin at either age 73 or 75, your tax situation is pretty much set in stone. There's not a whole lot you can do once they kick in to manage and reduce taxes in retirement outside of charitable giving and managing your investments digitally.
tax efficiently inside of your taxable brokerage accounts. Depending on the size of your pre-tax IRA, those RMDs might also trigger new phantom taxes such as Medicare IRMA in your 70s and beyond. If IRMA surcharges kick in as a result of large required minimum distributions, those surcharges are likely to continue until the end of life.
So while we don't know for sure what will happen with the Tax Cuts and Jobs Act, there are a number of other factors to take into consideration when determining if it makes sense to pursue Roth conversions these next two years and potentially beyond. Most notably, do you think your tax rate will be higher in the future than it is today? And does getting money into a Roth to grow tax-free support other goals that you have?
What's most important is that you take the time to go through the exercise each and every year, sometimes multiple times per year, to determine if Roth conversions make sense for you and your plan. If you need help, consider leaning on a professional. My team and I have capacity to help a handful of new families this year, and we do continue to offer a free retirement and tax analysis to those who want to properly evaluate our firms.
You can go to freeretirementassessment.com to learn more or visit the Stay Wealthy website and click on the work with me button. As always, if we don't appear to have the right expertise to help, or you just aren't interested in hiring a full service firm like ours, shoot me an email at podcast at youstaywealthy.com. And I would be happy to help you find the right person or the right resource. I read and respond to every email.
Okay. I know we went through a lot today and I hope you found this episode helpful. Please, please let me know if you have any questions or if you think I missed something in this episode that should be clarified. And if you have any questions, please let me know in the comments below.
And don't forget to join the stay wealthy newsletter. If you haven't already, all newsletter readers will receive my freshly updated Roth IRA five year rule flow chart. So they can easily determine exactly how these confusing rules impact their unique situation. Once again, to join the stay wealthy newsletter, just head over to you stay wealthy.com forward slash email. I'll also provide a link to join directly in your podcast app in the episode description for quick access.
Thank you, as always, for listening, and I will see you back here next week.
