Roth IRA (Tax Free Account)

The Roth IRA is one of the most misunderstood retirement accounts. There is a lot of misinformation and commonly believed misconceptions out there regarding Roth IRAs. Here are a few of the most common false statements you might hear:

  • “I make too much money to qualify for a Roth IRA.”
  • “I can’t convert any funds to a Roth IRA.”
  • “Congress is going to take away the Roth IRA from us.”
  • “I have to wait 5 years after conversion to take a distribution.”
  • “Roth IRAs are exempt from UBTI.” (They are NOT).

There are CPAs and Tax Attorneys that make these types of statements, but they are all false in their own way. So, let’s break down every aspect of a Roth IRA and tie each aspect back to the proper IRS publications for confirmation and additional information.

Let’s start with the basics: contributions to a Roth IRA. The maximum annual contribution to a Roth IRA as of 2024 is $7,000 if you are under the age of 50, and $8,000 for those who are 50 and older. If you are earning more than a certain dollar amount you will have to take some extra steps to make this contribution, but note that it can still be made. This is once again one of the first things that CPAs often tell their clients they cannot do, which is false.

If you exceed the income limit to for direct contributions to a Roth IRA, then first make a non-deductible contribution to a traditional IRA. After doing so, fill out a tax form 8606, which confirms that you are not taking a tax deduction for this contribution. After that, you can proceed with the Roth Conversion. Your custodian will move that the contribution made to a the traditional IRA into the Roth IRA. This practice is colloquially referred to as a Back Door Roth IRA. When doing a Back Door Roth IRA, you may have to deal with a pro rata contribution if you hold any other retirement accounts.

As of 2024, Roth IRAs can grow tax free for your entire life and you are never forced to pull out funds. Unlike a Traditional IRA that has Required Minium Distributions (RMDs), the Roth does not have any RMDs during your life expectancy.

Another erroneous statement regarding Roth IRAs that is parroted often is that they will be taken away or altered by Congress. Typically, this is said by those who do not actually follow updates in tax code or law. If we look at the most recent updates made by Congress affecting Roth IRAs, they have all been very pro-Roth IRA. They have done things such as increase contribution limits, allow SEP and SIMPLE IRAs to receive Roth contributions, force employers to offer employees of a certain age Roth catch-up contributions, and more. You read all about these Roth-friendly changes in the updated SECURE ACT 2.0. Overall, it seems that the IRS and Congress have become more kind to Roth IRAs in comparison with the traditional IRA.

You can take a distribution from a Roth IRA at any point in time, despite your age or the length of time that you’ve had the account. However, whether that distribution is taxed, penalized, both taxed and penalized, or distributed completely tax free will depend entirely on the qualification rules. For a completely tax free distribution from a Roth IRA, you must meet two requirements. The first requirement is having the Roth open and funded for five tax years, and the second is being over the age of 59 and a half (there are a list of exceptions noted below). If you remove funds from a Roth IRA without meeting these requirements and without an exception, you will receive a 10% penalty tax and the funds may also be taxable at your income bracket. The IRS is kind enough to provide a chart for us on these under IRS Publication 590-B Page 32 (Picture Below) that will help to identify if your distribution is a qualified one or not.

As previously mentioned, the IRS allows you to withdraw funds from a Roth IRA completely tax and penalty free if you have had the Roth IRA open and funded for at least 5 tax years and have met one additional requirement. The additional requirement can either be having reached the age of 59 and a half or one of the following circumstances:

  • You have unreimbursed medical expenses that are more than 7.5% of your AGI.
  • The distribution is for the cost of your medical insurance due to a period of unemployment.
  • You are totally and permanently disabled.
  • You are terminally ill.
  • You are the beneficiary of a deceased IRA owner.
  • You are receiving distributions in the form of a series of substantially equal periodic payments.
  • The distribution is for your qualified higher education expenses.
  • You use the distributions to buy, build, or rebuild a first home.
  • The distribution is due to an IRS levy of the IRA or retirement plan.
  • The distribution is a qualified reservist distribution.
  • The distribution is a qualified birth or adoption distribution.
  • The distribution is a qualified disaster distribution or qualified disaster recovery distribution.

If you are taking a distribution from a Roth IRA for any of the above reasons, then your 10% penalty is waived. If you have also had the Roth IRA for at least five tax years, then the distribution is truly tax free.

When removing funds from any Roth IRA, they will actually come out in a certain order (according to the IRS). This order is best defined as your contributions first, your converted dollars second, and your earnings third. Check out the example below for a clearer picture. These ordering rules exist because there can be certain amounts that are taxable, and certain amounts that on non-taxable.

When making a contribution to a Roth IRA, that contribution is always going to be after tax. Because it is after tax dollars, you can actually remove this amount as a distribution tax and penalty free at any point in time. [CHECK THIS + COMBINE WITH ABOVE SECTION]

When you do a conversion from a tax-deferred IRA (such as a traditional IRA), you have to pay taxes at your current income bracket. This means that if you remove these funds from a Roth IRA, there is a chance they will not be taxed a second time since you paid the taxes when doing the conversion. However, you may be hit with a 10% penalty for removing those funds if it was not for a qualified reason.

Earnings are generated from the investments you make. If you pull these funds out of the IRA for a non-qualified reason, then the funds will be both taxed and penalized.

Example:

Say you have $50K in a Roth IRA. $10K of it consists of contributions made throughout the years, $20K is the amount you converted from a tax-deferred IRA (such as a traditional IRA), and $20K is from investment earnings. Assume you have had the Roth IRA for five tax years and have decided to withdraw $35K to purchase a car. How much comes out tax free, and how much is taxable? (Note: Tax Free and Penalty Free are two different things. Do not mix these two concepts up).

  • $10K comes out tax free, because contributions always comes out tax free and penalty free.
  • $20K comes out tax free because you paid taxes when you did the conversion, but you owe a 10% penalty tax on the $20K.
  • $5K comes out and is fully taxed and penalized because it falls under earnings. You as an individual have not paid taxes on any of these funds, and the reason you are removing them for a distribution is not qualified.

All Roth IRAs have a 5-year seasoning period from the time they are opened and funded. What this means is that if you set up a Roth IRA, regardless of your age, you will not qualify for a tax-free distribution for a minimum of 5 tax years. Notice that a tax year is different from a calendar year. Depending on the time of year, you can make a contribution to a Roth IRA for the previous year, thereby knocking out one full year. For example, if I set up a Roth IRA in January of 2024, I can still make a contribution until April for 2023. So, if you contribute to the Roth IRA in 2024 for the year 2023, you have already had the Roth IRA for 1 tax year.

The 5-year rule is the number one thing that most CPAs will mix up and get wrong for their clients when trying to figure out if you, as an individual, have a qualified distribution. This is because some people may have multiple 5-year clocks within the same Roth IRA, while others will only have 1. Let’s look at examples and when and where these 5-year clocks apply.

Remember your ordering rules when it comes to a 5-year clock. In addition, you want to consider your individual age, mainly whether you are older or under 59 ½ (this is based on tax year 2024).

The last thing to remember is that the 5-year rule is put in place by the IRS, not your retirement custodian. This means if you satisfy your 5-year clock at one company and start a brand new Roth IRA at another company, then that 5-year clock goes with you.

So, when does someone have multiple 5-year clocks? Typically, if you are under the age of 59 ½ and you do a Roth Conversion, that converted amount can have its own 5-year clock. This is where CPAs get confused, and many times they will apply a new 5-year clock when someone does a conversion if they are over 59 ½. Use the chart below to go

Recap

  • Roth IRAs can grow tax free and be distributed tax free.
  • All contributions are after tax.
  • Roth IRA have NO RMDs.
  • Use the charts above to determine a qualified distribution.
  • Roth IRA have ordering rules in which funds are distributed.
  • You must have a Roth for 5 tax years for all qualified distributions.
  • Always speak with a tax professional or retirement expert when taking distributions from your Roth IRA.
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