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.
The Fiduciary Rule: Exposing Your 401(K) Advisor’s Secrets
It’s here. On June 9, 2017, the long awaited Fiduciary Rule for 401(k) plans will arrive. What secrets does your 401(k) advisor have?
It’s here. On June 9, 2017, the long awaited Fiduciary Rule for 401(k) plans will arrive. The wirehouse and broker-dealer community within the investment industry has fought this new rule every step of the way. Why? Because their secrets are about to be exposed. Fee gouging in these 401(k) plans has spiraled out of control and it has gone on for way too long. While the Fiduciary Rule was designed to better protect plan participants within these employer sponsored retirement plans, the response from the broker-dealer community, in an effort to protect themselves, may actually drive the fees in 401(k) plans higher than they are now.
If your company sponsors an employer sponsored retirement plan and your investment advisor is a broker with one of the main stream wirehouse or broker dealers then they may be approaching you within the next few months regarding a “platform change” for your 401(k) plan. Best advice, start asking questions before you sign anything!! The brokerage community is going to try to gift wrap this change and present this as a value added service to their current 401(k) clients when the reality is this change is being forced onto the brokerage community and they are at great risk at losing their 401(k) clients to independent registered investment advisory firms that have served as co-fiduciaries to their plans along.
The Fiduciary Rule requires all investment advisors that handle 401(k) plans to act in the best interest of their clients. Up until now may brokers were not held to this standard. As long as they delivered the appropriate disclosure documents to the client, the regulations did not require them to act in their client’s best interest. Crazy right? Well that’s all about to change and the response of the brokerage community will shock you.
I will preface this article by stating that there have been a variety of responses by the broker-dealer community to this new regulation. While we cannot reasonably gather information on every broker-dealers response to the Fiduciary Rule, this article will provide information on how many of the brokerage firms are responding to the new legislation given our independent research.
SECRET #1:
Many of the brokerage dealers are restricting what 401(k) platforms their brokers can use. If the broker currently has 401(k) clients that maintain a plan with a 401(k) platform outside of their new “approved list”, they are forcing them to move the plan to a pre-approved platform or the broker will be required to resign as the advisor to the plan. Even though your current 401(k) platform may be better than the new proposed platform, the broker may attempt to move your plan so they can keep the plan assets. How is this remotely in your employee’s best interest? But it’s happening. We have been told that some of these 401(k) providers end up on the “pre-approve list” because they are willing to share fees with the broker dealer. If you don’t share fees, you don’t make the list. Really ugly stuff!!
SECRET #2:
Because these wirehouses and broker-dealers know that their brokers are not “experts” in 401(k) plans, many of the brokerage firms are requiring their 401(k) plans to add a third-party fiduciary service which usually results in higher plan fees. The question to ask is “if you were so concerned about our fiduciary liability why did you wait until now to present this third party fiduciary service?” They are doing this to protect themselves, not the client. Also, many of these third party fiduciary services could standardize the investment menu and take the control of the investment menu away from the broker. Which begs the question, what are you paying the broker for?
SECRET #3:
Some broker-dealers are responding to the Fiduciary Rule by forcing their brokers to move all their 401(k) plans to a “fee based platform” versus a commission based platform. The plan participants may have paid commissions on investments when they were purchased within their 401(k) account and now could be forced out of those investments and locked into a fee based fee structure after they already paid a commission on their balance. This situation will be common for 401(k) plans that are comprised primarily of self-directed brokerage accounts. Make sure you ask the advisor about the impact of the fee structure change and any deferred sales charges that may be imposed due to the platform change.
SECRET #4:
The plan fees are often times buried. The 401(k) industry has gotten very good at hiding fees. They talk in percentages and basis points but rarely talk in hard dollars. One percent does not sound like a lot but if you have a $2 million dollar 401(k) plan that equals $20,000 in fees coming out of the plans assets every year. Most of the fees are buried in the mutual fund expense ratios and you basically have to be an investment expert to figure out how much you are paying. This has continued to go on because very rarely do companies write a check for their 401(k) fees. Most plans debit plan assets for their plan fees but the fees are real.
With all of these changes taking place, now is the perfect time to take a good hard look at your company’s employer sponsored retirement plan. If your current investment advisor approaches you with a recommended “platform change” that is a red flag. Start asking a lot of questions and it may be a good time to put your plan out to bid to see if you can negotiate a better overall solution for you and your 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.
What is the 60 Day Rule and How Should it be Used?
The 60 day rule refers to the length of time an individual has to deposit money back into a retirement account that was previously withdrawn without incurring a taxable event. There are a number of reasons someone would withdraw money from an account whether it be to pay a large tax bill, obtain cash for an unexpected expense, or to rollover the
60 day rollover
The 60 day rule refers to the length of time an individual has to deposit money back into a retirement account that was previously withdrawn without incurring a taxable event. There are a number of reasons someone would withdraw money from an account whether it be to pay a large tax bill, obtain cash for an unexpected expense, or to rollover the balance into another retirement account.
There are multiple ways to rollover a balance from one retirement account to another so we will begin by explaining the more common ways to rollover a balance where the 60 day rule won't come into play.
Direct Rollover
A direct rollover is a transfer from a retirement plan to another retirement plan or IRA where the custodian of your current plan makes payment directly to your new account. This can be in the form of a check made payable to the new account custodian or a direct wire transfer. This method will avoid taxes and penalties because the account owner never had access to the cash during the transfer.
Trustee to Trustee Transfer
Similar to the direct rollover, a trustee to trustee transfer moves money from one IRA to another IRA without the account owner ever having access to the cash and therefore avoiding taxes and penalties.
The direct rollover and trustee to trustee transfer methods both avoid taxes and penalties as cash is never available to the owner and therefore the 60 day rule does not come into effect. In any case where the account owner has access to the cash, the money will have to be redeposited into another retirement account within 60 days or the owner will be taxed on any pre-tax dollars and possibly penalized if the owner is under the age of 59 ½.
The 60 day rule is one of the only ways an owner has access to money in a retirement account without paying taxes or penalties on the distribution. An individual can take advantage of this if they are in need of immediate cash for something like an unexpected expense. The distribution is essentially an interest free loan from your retirement account for 60 days. If the money is not available within the 60 days to redeposit, taxes and possible penalties will be assessed on the distribution.
IRS: One 60 Day Rollover in 12 Month Rule
The IRS recognized that individuals were taking advantage of this rule by taking multiple distributions in a single year and therefore increasing the time period. Beginning after January 1, 2015, the IRS changed the law to state that only one rollover can be made from one IRA to another IRA within a 12 month period. This rule does not apply to the following:
rollovers from traditional IRAs to Roth IRAs (conversions)
trustee-to-trustee transfers to another IRA
IRA-to-plan rollovers
plan-to-IRA rollovers
plan-to-plan rollovers
It shows the one rollover in a 12 month period rule was meant to limit the abuse of the 60 day rule because direct rollovers and trustee to trustee transfers are excluded.
What can be Rolled Over?
Most of the time the entire balance in a retirement account can be rolled over to another account unless the balance includes an amount of money that is required to be withdrawn. Examples include required minimum distributions and contributions in excess of limits (plus earnings on the excess contributions). For retirement plans, in addition to RMD's and excess contributions, any loans outstanding at the time of rollover or hardship distributions taken during the year will be subject to taxes and possible penalties.
Are Taxes Assessed at the Time of Distribution?
Distribution from an IRA: Typically, a tax is not assessed on a distribution from an IRA unless the account owner elects to have taxes withheld. A distribution from a pre-tax IRA account is typically subject to a 10% early withdrawal penalty if taken before 59 ½.
Distribution from Retirement Plan: Any distribution taken from a retirement plan where cash is made available to the owner is subject to a minimum 20% federal withholding. For example, if you request a $10,000 distribution, you will receive $8,000 and $2,000 will go to the government. There is no option to opt out of this withholding even if you intend to rollover the balance within 60 days. For this reason, a direct rollover would be a way to avoid the 20% withholding.
It is important to understand if you intend to rollover a distribution from a retirement account that the entire amount of the distribution must be redeposited within 60 days to avoid taxes and penalties even if taxes were already withheld. Using the previous example, if you take a $10,000 distribution from a retirement account and have the 20% withheld for taxes you must redeposit $10,000 within 60 days even though you only received $8,000 in cash. This scenario may appear that you are losing $2,000 but when you complete your taxes the $10,000 distribution will not be taxable as long as the full amount was redeposited within 60 days. When you file your taxes, the $2,000 will be included in the federal taxes withheld which is how the money is recouped.
How is the Rollover Reported to the Government?
Any time you wish to utilize the 60 day rule, it is important you keep documentation. Any distribution from a retirement account will generate a 1099-R form that must be reported as income on your tax return. Also, the 1099-R will show any taxes withheld from the distribution. You will receive a 1099-R even if a direct rollover or trustee to trustee transfer was done. The way the distribution is coded determines how the IRS treats it for tax purposes. If the distribution is coded as a direct rollover or trustee to trustee transfer, the distribution will not be treated as taxable income. If the distribution gave you access to cash, the 1099-R will be coded in a way that treats the distribution as a taxable event. If you redeposited the amount into another retirement account within 60 days, it is important you notify your tax preparer and bring documentation showing the deposit was made timely. The tax preparer should then treat the distribution as a non-taxable event.
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, pleas feel free to join in on the discussion or contact me directly.
