Navigating the Complex World of Roth IRA Conversions
Are you considering converting your pre-tax savings to a Roth IRA to avoid required minimum distributions (RMDs)? If so, you’re not alone. But beware: the five-year rule that governs Roth IRA withdrawals can be a minefield, even for the most seasoned investors.
The Five-Year Rule: A Primer
The IRS has three different five-year rules that apply to Roth IRAs, each with its own set of complexities. The conversion rule, in particular, can be self-contradictory, leaving many investors scratching their heads. To add to the confusion, the IRS doesn’t provide clear instructions on these rules, and different outlets often offer conflicting information.
How the Five-Year Rule Applies
Let’s say you’re 70 years old and want to convert your $900,000 pre-tax savings to a Roth IRA to avoid RMDs. How will the five-year rule apply? There are three different versions of the rule, each based on how you fund or receive your Roth portfolio:
- Earnings from Contributions: You must wait five years from when you first fund a Roth account before taking distributions from any Roth portfolio. This is a one-time rule that doesn’t reset for future contributions.
- Converted Balances: After you make a conversion, you must wait five years before taking distributions from the converted funds. However, this rule doesn’t apply to people ages 59 ½ and older.
- Inherited Roth Portfolios: When you inherit a Roth portfolio, you may be required to withdraw all assets within five years of the original owner’s death. (This version is beyond the scope of this article.)
Roth IRA Basics
A Roth IRA is a retirement account funded with after-tax dollars, meaning you’ve already paid taxes on the money in the portfolio. As a result, later in life, you can withdraw this money (principal and returns) entirely tax-free. Roth IRAs are not subject to RMDs, making them an attractive option for those looking to minimize their tax burden.
Funding Your Roth IRA
There are two ways to fund a Roth IRA: contributions and conversions. Contributions involve investing earned income in your portfolio up to the annual contribution limit ($7,000 per year in 2024). Conversions, on the other hand, involve transferring money from a pre-tax portfolio into a Roth IRA and paying income taxes on the money. There is no limit to how often you can convert assets or in what amounts.
Qualified Distributions
A qualified distribution is when you take a tax-free withdrawal of your Roth portfolio’s earnings. To qualify, you must be 59 ½ or older, have a qualifying disability, or meet the first home buyer requirement, and meet the portfolio’s five-year rule. If your withdrawal doesn’t meet these rules, the IRS will charge you both income tax and a 10% penalty.
Seeking Professional Guidance
Navigating the complexities of Roth IRA conversions can be daunting. Working with a financial advisor who understands the ins and outs of the IRS rules can be incredibly helpful. They can help you complete a Roth conversion, decide how to split your retirement savings between tax-deferred and Roth accounts, and build a comprehensive retirement plan that takes your RMDs into account.
Calculating Your RMDs
Before making any decisions around your RMDs, it’s essential to calculate what they are. SmartAsset’s RMD calculator can estimate how much your first mandatory withdrawal will be and when it’s due.
Finding the Right Financial Advisor
Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one is right for you.
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