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.
Tax Deductions For College Savings
Did you know that if you are resident of New York State there are tax deductions waiting for you in the form of a college savings account? As a resident of NYS you are allowed to take a NYS tax deduction for contributions to a NYS 529 Plan up to $5,000 for a single filer or $10,000 for married filing joint. These limits are hard dollar thresholds so it
Did you know that if you are resident of New York State there are tax deductions waiting for you in the form of a college savings account? As a resident of NYS you are allowed to take a NYS tax deduction for contributions to a NYS 529 Plan up to $5,000 for a single filer or $10,000 for married filing joint. These limits are hard dollar thresholds so it does not matter how many kids or grandchildren you have.
529 Accounts
529 accounts are one of the most tax efficient ways to save for college. You receive a state income tax deduction for contributions and all of the earnings are withdrawn tax free if used for a qualified education expense. These accounts can only be used for a college degree but they can be used toward an associate’s degree, bachelor’s degree, masters, or doctorate. You can name whoever you want as a beneficiary including yourself. More commonly, we see parents set these accounts up for their children or grandparents for the grandchildren.
Can they go to college in any state?
If you setup a NYS 529 account, the beneficiary can go to college anywhere in the United States. It’s not limited to just colleges in New York. As the owner of the account you can change the beneficiary on the account whenever you choose or close the account at your discretion.
What if they don't go to college?
The question we usually get is “what if they don’t go to college?” If you have a 529 account for a beneficiary that does not end up going to college you have a few choices. You can change the beneficiary listed on the account to another child or even yourself. You can also decide to just liquidate the account and receive a check. If the account is closed and the balance is not used for a qualified college expense then you as the owner receive your contributions back tax and penalty free. However, you will pay ordinary income tax and a 10% penalty on just the earnings portion of the account.
What if my child receives a scholarship?
There is a special withdrawal exception for scholarship awards. They do not want to penalize you because the beneficiary did well in high school or is a star athlete so they allow you to make a withdrawal from the 529 account equal to the amount of the scholarship. You receive your contributions tax free, you pay ordinary income tax on the earnings, but you avoid the 10% penalty for not using the account toward a qualified college expense.
Don't make this mistake.............
We often see individuals making the mistake of setting up a 529 account in another state because “their advisor told them to do so”. You are completely missing out on a good size NYS tax deduction because you only get credit for NYS 529 contributions. A little-known fact is that you can rollover a 529 with another state into a NYS 529 account and that rollover amount will count toward your $5,000 / $10,000 deduction limit for the year. If a client has $30,000 in a 529 account outside of NYS we typically advise them to roll it over in $10,000 pieces over a three year period to maximize the $10,000 per year NYS tax deduction.
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.
