A Roth IRA is a really flexible and powerful retirement savings tool that
can help you get tax free income in retirement, and it can help
you pre pay your taxes if you think that's the right thing to
do. But if you're not entirely clear on what happens when you take
money out of those accounts, that's what we're going to talk about here,
so we'll figure out if you can get tax free income,
or what happens when you take early withdrawals from a Roth. As a
quick refresher, the question is, "do you want to pay taxes on the
seed that you plant or on the tree that eventually grows?"
and that's an analogy for your Roth IRA. When you pay taxes on
the seed, you're paying taxes on the investment that you put into the
account up front, and the idea is that you won't pay taxes on
the eventual tree or the amount that it grows to. Ideally,
over many years, your investment will grow to be quite a bit bigger,
and you can take that money back out, you have a pool of
funds to draw from tax free in retirement[again, if all goes well].
There are three factors that can help you figure out if you're going
to pay taxes on a Roth withdrawal or an early withdrawal.
One is the type of money you're taking out, so. Those regular contributions
that you put in, if you're making the $6000 or $7000 per year
contribution, those are your regular contributions, and you can take those
back out of the account at any time without taxes and penalties.
That's what makes a Roth really flexible. There may also be some earnings
in your account, so that's a different type that would be on top
of the contributions you put in, and that's where we may potentially have
some taxes... We're going to get into that in a minute.
Your age is also important. So the question is, are you over or
under the age 59.5? And then we also want to know,
have you had your Roth account open for at least five years before
you take that distribution? So let's go through those types of money,
again, we have the regular contributions, and just... Here's a visual representation
of it. Let's say you put in 6000,
this is just one year's worth of contributions, for example, and over some
period of time, it gained $600 of earnings or 10%...
Well, that's $6000 you could pull from... It's kind of like pulling from
the bottom of your stack there, and you would not owe taxes or
penalties on that, in fact, the IRS sets an order of withdrawals,
and that says that that money is going to come out first,
and again, it's tax free and penalty free money. Next, we have the
earnings or any growth on your contributions, and that's where we need to
pay attention to your age and the amount of time you've had your
Roth account. One other type of money or bucket of money you might
have is conversion money. So if you converted a pre tax IRA or
a portion of your pre tax IRA to Roth, so that it would
be ideally tax free later, that is a little bit different money type,
and we're going to talk about how that works, but each conversion is
treated separately. So if you've been doing partial Roth conversions, doing
a little bit each year, then each of those is going to be
treated separately with its own five year rule, and you might wonder about
Roth 401k or Roth 403b savings. How do those fit into all this?
Well, what usually happens is clients, at least typically move that money
into a Roth IRA. They don't always do that, you don't necessarily have
to... And there are some pros and cons. I've got videos that discuss
that, but if you decide to take control of the money,
maybe you can get more investment options, maybe you can get lower expenses,
you can move the Roth 401k into your Roth IRA and then take
your distributions from there. If you're going to go that route,
it's a good idea to open up a Roth IRA if you don't
already have one, and that way you can start the five year clock
ticking so that when you do roll the money in, the account has
been open for five years. It's important to not only open a Roth,
but also fund it. So you can do that with a low cost
investment provider or something, where you can just make a small contribution,
if that's all you qualify for. Either way you want to get that
clock ticking. We're getting a little complicated here, so the thing to
know is that if you just want to make it easy,
the way to get those tax free withdrawals from a Roth is to
satisfy two requirements. One is that you're over age 59.5, and number two
is that you have had the Roth open for at least five years
before you take that withdrawal. You don't always have to do that,
but that's the easiest way to just get the tax free withdrawals and
satisfy the requirements. Now, let's look more closely at your age because
this is a really important thing to potentially avoid taxes and or penalties.
So there's a lot packed into this slide here. I'm going to include
a link or two in the description that help you make more sense
of this so that you can dig into these details yourself later and
double and triple check everything. When you're over age 59 and a half,
and again, you've had your account open for at least five years,
then you can take those earnings out. Not only the contributions,
but the earnings on top of it. You can take that money out
without taxes and penalties, that's what's called a qualified distribution,
but if you don't meet that five year rule requirement, then you may
have to pay income tax on the distribution, or at least on the
earnings portion of the distribution. So there's not a 10% penalty tax,
but there may be income tax when you're under age 59 and a
half, but you have met the five year rule, you're going to pay
income taxes potentially on that earnings portion. And if you haven't met
that five year requirement, then you can have income tax plus an additional
10% penalty tax. Like I said, this can get really complicated with a
couple of different moving parts. You've got your age and then a five
year rule, and you've got these potential exceptions that can help you avoid
some taxation. A few of those exceptions are listed here. The important
thing to do is look them up and make sure you know what
they are and stay current on all of these rules, and then communicate
that to your CPA or your tax preparer. So if you do take
an early withdrawal, they know that you can potentially get an exception
applied and reduce the amount you owe. Now, let's touch on conversions.
Again, if you have taken pre tax money in a traditional IRA,
for example, and converted that over to Roth type money, there are separate
five year rules for that, and there's a separate rule for each conversion.
The reasoning behind this is that the IRS doesn't want people to use
Roth conversions as a way to get around the early withdrawal penalties on
their pre tax money. So if you had money in a pre tax
account and you're under age 59 and half, you might say "Well,
gee, I can just convert that money, pay the taxes on it,
and then pull it out of my converted Roth, and I don't have
to pay an early withdrawal penalty." The IRS apparently caught on to that,
and so when you are under age 59.5, you can still potentially pay
a 10% early withdrawal penalty even on the amount you convert,
so you pay taxes on it, you might think it's free and clear,
but you might still owe a 10% penalty tax on that.
So just be very careful. Another question that comes up is often,
What if they change the rules? So I go ahead and pre pay
my taxes thinking that I'll get a benefit in the future,
hoping that that will work out, but what if they pull the rug
out from under me and decide to tax those distributions?
Anything is possible. What I would say is it's just really hard to
predict future, and trying to get too fancy is often something that can
backfire for people. There are several ways that lawmakers could raise revenue
for the Treasury, and maybe there's a value added tax, or a consumption
tax that's similar to a sales tax that you might pay locally.
So you don't necessarily want to just assume that the only way they
do that is by taxing your Roth. There's some research out there that
shows what would happen if they did decide to try and tax those
earnings. So we can say, out of all of the available revenue sources,
if the IRS was to start taxing the earnings from Roth accounts,
how much would that be? And what you can see is that that
slice is actually a really small piece. That doesn't mean it's nothing.
So it certainly could be attractive for taxation, but the political price
that lawmakers might have to pay if they decided to go down that
road could be steep, and the pay off is not necessarily huge.
So the question is, will they do that or not? Obviously,
we don't know anything is possible, but at least at this time,
it doesn't look like a huge risk to reward thing for lawmakers.
But again, those balances could grow substantially over the years, making
it a more attractive source of funds. Just remember the benefits of Roth,
and that is that if all goes well, you can potentially pay taxes
at a lower rate today, and I've got some videos that discuss the
math behind that if you want to look into it, and it's not
just your federal income tax that matters with Roth versus pre tax type
retirement accounts, you can also just minimize your income, which can help
your tax return, which might cause you to not have to pay taxes
on your Social Security income, it could keep your healthcare expenses low.
So there are a number of benefits, if this all goes well.
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Thank you and to take care.