Beware of the 5 Year Rule for Your Roth Assets
Being able to save money in a Roth account, whether in a company retirement plan or an IRA, has great benefits. You invest money and when you use it during retirement you don't pay taxes on your distributions. But is that always the case? The answer is no. There is an IRS rule that you must take note of known as the "5 Year Rule". There are a number
Beware of the 5 Year Rule for Your Roth Assets
Being able to save money in a Roth account, whether in a company retirement plan or an IRA, has great benefits. You invest money and when you use it during retirement you don't pay taxes on your distributions. But is that always the case? The answer is no. There is an IRS rule that you must take note of known as the "5 Year Rule". There are a number of scenarios where this rule could impact you and rather than getting too much into the weeds, this post is meant to serve as a public service announcement so you are aware it exists.
Advantages of a Roth
As previously mentioned, the benefit of Roth assets is that the account grows tax deferred and if the distributions are "qualified" you don't have to pay taxes. This is compared to a Traditional IRA/401(k) where the full distribution is taxed at ordinary income tax rates and regular investment accounts where you pay taxes on dividends/interest each year and capital gains taxes when you sell holdings. A quick example of Roth vs. Traditional below:
Roth Traditional
Original Investment $ 10,000.00 $ 10,000.00
Earnings $ 10,000.00 $ 10,000.00
Total Account Balance $ 20,000.00 $ 20,000.00
Taxes (Assume 25%) $ - $ 5,000.00
Account Value at Distribution $ 20,000.00 $ 15,000.00
This all seems great, and it is, but there are benefits of both Roth and Traditional (Pre-Tax) accounts so don’t think you have to start moving everything to Roth now. This article gives more detail on the two different types of accounts and may help you decide which is best for you Traditional vs. Roth IRA’s: Differences, Pros, and Cons.
Qualified Disbursements
Note the “occurs at least five years after the year of the employee’s first designated Roth contribution”. This is the “5 Year Rule”. The other qualifications are the same for Traditional IRA’s, but the “5 Year Rule” is special for Roth money. Not always good to be special.
It seems pretty straight forward and in most cases it is. Open a Roth IRA, let it grow at least 5 years, and as long as I’m 59.5 my distributions are qualified. Someone who has Roth money in a 401(k) or other employer sponsored plan may think it is just as easy. That isn’t always the case. Typically, an employee retires, and they roll their retirement savings into a Traditional or a Roth IRA. Say I worked at the company for 10 years, and I now retire and want to use all the savings I’ve created for myself throughout the years. I can start taking qualified distributions from my Roth IRA because I started contributing 10 years ago, correct? Wrong! The time you we’re contributing to the Roth 401(k) is not transferred to the new Roth IRA. If you took distributions directly from the 401(k) and we’re at least 59.5 they would be qualified. In most cases however, people don’t start using their 401(k) money until retirement and most plans only allow for lump sum distributions once you are no longer with the company.
So what do you do?
Open a Roth IRA outside of the plan with a small balance well before you plan to use the money. If I fund a Roth IRA with $100, 10 years from now I retire and roll my Roth 401(k) into that Roth IRA, I have satisfied the 5 year rule because I opened that Roth IRA account 10 years ago. The clock starts on the date the Roth IRA was opened, not the date the assets are transferred in.
About Rob.........
Hi, I’m Rob Mangold. I’m the Chief Operating Officer at Greenbush Financial Group and a contributor to the Money Smart Board blog. We created the blog to provide strategies that will help our readers personally, professionally, and financially. Our blog is meant to be a resource. If there are questions that you need answered, please feel free to join in on the discussion or contact me directly.
How Do Phantom Stock Plans Work?
In the world of executive compensation, there are a number of ways that a company can reward key employees. Although most companies are familiar with traditional deferred compensation plans, one of the lesser known options which is growing in popularity is called a “phantom stock plan”. Especially in small to mid-size companies.
In the world of executive compensation, there are a number of ways that a company can reward key employees. Although most companies are familiar with traditional deferred compensation plans, one of the lesser known options which is growing in popularity is called a “phantom stock plan”. Especially in small to mid-size companies.
Here is the most common situation, a closely held business or family business has a key employee that they would like to reward but also further tie that employee to the company. The current owners of the company do not want to give up equity but they want to tie this reward system to the actual performance of the company as if that key employee was an owner or shareholder. This can be accomplished via a phantom stock plan.
These plans provide select employees with additional compensation equal to the appreciation of a percent of the company for a partnership, LLC, or PLLC, or in the case of an S-corp or C-corp a given number of shares in the company even though the ownership only exists in theory. For example, I own a company that is incorporated as a partnership and I would like to reward a key employee by providing them with an annual cash reward equal to a 5% ownership stake in the company without formally making them a partner. Once the books are closed at the end of year I will issue a cash bonus to that employee equal to 5% of the net profits for the year. From the employee’s standpoint, they are receiving the monetary reward mimicking a 5% ownership share of the company so they have an incentive to continue to grow the company. From the employer’s standpoint, they have taken further steps to retain a key employee, they can deduct the additional comp pay to the employee, and the current owners have retained full control of the company.
The features of these plans and how they are design are limitless because they are just another flavor of nonqualified executive compensation plan. A few plan design features are listed below:
Companies have full discretion as to who is covered and not covered by the plan
Instead of paying out the benefit each year as compensation, the company can attach a vesting schedule to essentially put “golden handcuffs” on the key employee. If they leave the company prior to a stated date they lose the benefit.
When awarding the shares or ownership the company can limit the award to just the appreciation of their shares or ownership percentage and not award the full current value of the ownership percentage. These are called “appreciation only” plans. Appreciation only phantom stock plans can be viewed as a favorable option to key employees because it does not require them to make a cash outlay to purchase their ownership interest as would normally be required by an actual equity or share purchase.
How do these plans work from an operation standpoint? The ownership percentage or shares are issued to the employee as hypothetical units or “phantom units” that are just tracked internally by the company. The employee is taxed on the benefit and the company can take the deduction for the compensation paid when there is no longer a “risk of forfeiture”. In other words, when the employee vests in the benefit whether they decide to “sell their phantom shares” or not. As soon as the employee has the ability to “sell” their phantom interest in exchange for compensation that triggers the taxable event.
When designed correctly, these plans can be a valuable tool for small to mid-size companies in their efforts to retain key employees.
About Michael……...
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
