#7 | The 5-year Rule With Roth IRAs and Roth 401Ks

Today, Bruce Hosler of Hosler Wealth Management sits down with Jon Gay to talk about the “5-year rule” regarding Roth IRA and Roth 401K accounts. These rules are in place to encourage investors not to withdraw from their Roth accounts before age 59 1/2.  And if these rules aren’t followed, they can result in stiff tax penalties!

Bruce explains:

  • When the clock starts on the 5-year rule
  • The difference between a qualified and non-qualified distribution
  • What is a triggering event?
  • What are the differences in rules between Roth 401K accounts and Roth IRA accounts?
  • How can you get around the 5-year rule?
  • What if you have an emergency and need to withdraw the funds early?

For more information about anything related to your finances, contact Bruce Hosler and the team at Hosler Wealth Management.

Call the Prescott office at (928) 778-7666 or our Scottsdale office at (480) 994-7342.

To listen to more Protecting & Preserving Wealth podcast episodes, click here.

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Podcast Host

Bruce Hosler Image

Bruce Hosler is the founder and principal of Hosler Wealth Management, LLC., which has offices in Prescott and Scottsdale, Arizona. As an Enrolled Agent, CERTIFIED FINANCIAL PLANNER™ professional, and Certified Private Wealth Advisor (CPWA®), Bruce brings a multifaceted approach to advanced financial and tax planning. He is recognized as a prominent financial professional with over 27 years of experience and a seven-time consecutive *Forbes Best-In-State Wealth Advisor in Arizona. Bruce recently authored the book MOVING TO TAX-FREE™ Strategies For Creating Tax-Free Retirement Income And Tax-Free Lifetime Legacy Income For Your Children. www.movingtotaxfree.com.

In the Protecting & Preserving Wealth podcast, Bruce and his guests discuss current financial topics and provide timely answers for our listeners.
If you have a topic of interest, please let us know by emailing info@hoslerwm.com. We welcome your suggestions.

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Jon “Jag” Gay: Welcome to episode number seven of Protecting and Preserving Wealth. I am Jon Jag Gay. I’m joined again by Bruce Hosler from Hosler Wealth management, Bruce. Always gonna be with you.

Bruce Hosler: Thank you, Jon. Great to be with you today.

Jon: Alright, so we’re talking about the five year rule with Roth IRAs and Roth 401ks.

Tell me about this five year holding period rule. If you would, please.

Bruce: This is a regulation by the IRS trying to encourage Roth IRA owners to not withdraw their IRA funds before the retirement age of 59 and a half.

Jon: Mm-hmm .

Bruce: And if you’d miss it, then what it can do is subject to growth or the earnings in your Roth IRA to taxes. And potentially because you’re under 59 and half a 10% penalty if you don’t distribute it at the right time and in the right way.

Jon: Yeah, that distribution is so important. So if I contribute to a Roth IRA or a Roth 401k, or even if I convert some of my traditional IRA to a Roth IRA, say August 1st, this year 2022, when does the clock on that five year holding period start?

Bruce: It doesn’t matter when it is during the calendar year that you contribute to the Roth IRA. Or when you convert funds from your traditional IRA that very first year. The five year clock starts running in January. The first of the very first year that you contribute to your Roth or you convert funds from an IRA or other retirement account, you could even convert funds from your IRA to a Roth IRA in the last week of the year between Christmas and new year’s and the clock would start running clear back on January 1st, the first day of the calendar year. And you would pick up almost a whole year for your holding period.

Jon: I like that. So in our example, if I had done a conversion on August 1st, 2022, that clock would’ve started on January 1st, 2022. Do I have that?

Bruce: Absolutely. Absolutely.

Jon: All right. So I’ve heard of a qualified Roth IRA distribution versus a non-qualified Roth IRA distribution.

What are the differences between the two?

Bruce: A qualified Roth IRA distribution, and a non-qualified distribution have two different requirements that differentiate them. That must be met in order to have this qualified Roth IRA distribution. And that’s what we’re looking. For the first, is you have to meet a five year holding period to satisfy that requirement.

And that means from January 1st of the calendar year, you made your first Roth contribution or traditional IRA Roth conversion. You have to hold that Roth IRA account for at least five years. The second is that you must have a triggering event in order to have a qualified Roth distribution. a triggering event is one of the following.

Jon: Mm-hmm.

Bruce: You have to achieve the age of 59 and a half before the distribution. That means you must be that old first.

Jon: Okay.

Bruce: If you encounter a disability or you die so death and or if you’re qualified to be a first time home buyer. You must have one of these triggering events and it must take place to have your distribution qualified as a qualified Roth IRA distribution.

Jon: So the obvious, uh, question here is, if that triggering event is death, that would mean your beneficiary would get to take the money out as opposed to you, cuz you’re not here.

Bruce: Jon, that is a great question because everybody forgets. If someone passes away and you inherit an IRA. The 10% early withdrawal penalty no longer applies to any of those beneficiaries of an inherited IRA.

So the spouse, the children, the grandchildren, they can pull that money out without a 10% early withdrawal penalty. That is what this qualified distribution means.

Jon: As a beneficiary. Got it. Okay. Does the five year holding period for the 401k Roth also count for the Roth IRA?

Bruce: So that’s a great questions.

Some nuance of IRA and 401k rules and they’re very capricious. Yeah. So it seems like it might be unfair, but the rules are the rules. And let me tell you what the IRS does not care, how you feel about them. So let’s identify some of the differences.

Jon: Yep.

Bruce: Pretty much all of the retirement plans, 401k Roth plans, 403B plans, 4 57 plans, require you to achieve a five year holding period for each specific plan before you can hope to qualify for a qualified distribution.

So that means the five year holding period for a retirement account, like a 401k is plan specific.

Jon: Ah.

Bruce: It cannot count for a second 401k plan. You may have a second plan from a second job. It will not count for your Roth IRA either in any of those circumstances. That is not the case for IRA Roth accounts.

Jon: Okay.

Bruce: So Roth IRA accounts can be commingled together to count the rules, but not the plans. So if you have multiple Roth IRA accounts and you achieve the five year holding period in one of ’em and you’re 59 and half, you can take a qualified distribution from any one of your Roth IRA accounts that you may own.

And the qualified distribution is not specific to the oldest account that you may have.

Jon: So I just wanna make sure I’m with you so far, Bruce, the Roth IRAs, once you hit that holding period, you’re good for all of them, but the 401ks are plan specific. You have to hit the requirements for each individual plan to take the money out.

Bruce: That’s right. So if you have a, a first job you worked at, you left it, you left your 401k there. You come back and you hire a new, you hired a new company, you have a new 401k. You have to have the five year rule at each of those plans separately before it qualifies for that.

Jon: Okay.

Bruce: Now, Jon, do you wanna know the secret of how a 401k Roth owner can get around this rule?

Jon: I do, and I’m sure our listeners do as well, Bruce.

Bruce: So, you convert your 401k Roth account to an existing Roth IRA account. So, if you have a Roth IRA that has satisfied the five year holding rule, even if your 401k has not yet been held for five years, you can roll that Roth 401k into a Roth IRA account, and it will assume the characteristics of the Roth IRA rules.

Making it available to take a qualified distribution, even if you’ve satisfied the five year rule on your Roth IRA and are at least 59 and a half, you can take the money out of that. 401k Roth, and you avoid all the 401k Roth rules.

Jon: Okay. So I wanna make sure that our listeners are still with us. So, the Roth 401k rules are more stringent.

The Roth IRA rules are a little bit more lenient in being able to take everything out, once you hit those, uh, lines of demarcation, so to speak. So the solution here is to move that Roth 401k money over to a Roth IRA, and play in that ballpark, by those rules. We’re talking like American league and national league, before they put the DH everywhere.

Bruce: Absolutely. And there’s some complications to that. For example, a lot of people may not be able to roll over that 401k Roth plan until they separate from service. And separation from service means you were fired. You quit. You retired. Those are our triggering events. So you may leave the money growing in that Roth 401k until one of those triggering events happens.

But once it does now, you’re free to roll that into your Roth IRA.

Jon: Okay. Next question, Bruce. If I have an emergency, I’m not yet 59 and a half, and I have to take funds out of that Roth IRA, what happens?

Bruce: Jon, the Roth IRA is so beautiful. When you contribute to a Roth IRA or you convert funds from your traditional IRA, those funds or contributions or conversion amount, become your basis in the Roth. Now the basis is if you think of it, the amount of money that you put in.

Jon: Mm-hmm.

Bruce: You can withdraw your basis from a Roth IRA at any time, no matter your age, and you don’t have to pay the tax on that amount of money. Why is that? Because you’ve already paid the income tax on those funds the year you made the contribution or the conversion.

Jon: Ah.

Bruce: Yeah, you made the contribution and didn’t get a deduction for your tax return that year. So you’ve already paid the taxes. So even if you’re a young person in your thirties, you can take the money out of that and not have to pay the taxes on it. Now, if you take out more than your basis, You’ll have to pay the tax on the amount of growth that you take out.

And if you’re under 59 and a half, you’re gonna be subject to a 10% early withdrawal penalty. Got it. That’s why it’s so important for each of our listeners to understand how important it is to get this five year clock started and open up their first Roth IRA account. This year, the sooner they get the five year rule satisfied on a Roth IRA amount.

The more flexibility they’ll have later on in retirement, and they can have the five year rule satisfied as soon as possible. ]

Jon: So you wanna get past that hurdle of the five year rule as early as possible, but in case of emergency – break glass, you can pull out the original funds you put into it. You just can’t pull out any of the growth until you’ve met that 59 and a half and five year conditions.

Bruce: That’s exactly right. And if you’re under 59 and a half, you may have a 10% penalty, but you can still get out the money and not have to pay the taxes on it. You can start your IRA with either a Roth contribution, but some people have their income too high. So they have to make a Roth conversion from either a traditional IRA or a 401k.

It does not have to be any specific amount. It just has to be enough to open up a Roth IRA account for this year and get that clock started Jon.

Jon: Is there a minimum on the Roth IRA account?

Bruce: There is not, except that maybe the financial institution may have a minimum, a thousand, 2000, something like that for a minimum account balance, but there’s no IRS requirement that it has to be a minimum amount to open one of those accounts.

Jon: That is good to know. And again, if you’re confused on this stuff, there’s a lot of moving parts here and a lot of rules. And Bruce. I think you did a really good job over the last 10 minutes or so of breaking this down. If our listeners have questions about this stuff, I know you and the team at Hosler Wealth Management are always willing to have a conversation, explain this and make sure that the people understand what’s going on, because this is their money.

And you can really make costly mistakes in this, if you are not careful and don’t understand the rules. If someone wants to come talk to your team at Hosler Wealth management, what are the best ways to reach you?

Bruce: So of course, the website https://hoslerwm.com. Right on the website, you can schedule your free introductory appointment and we can have a conversation that way.

If you want call one of our offices, you can reach us in Scottsdale at (480) 994-7342. And of course in Prescott (928) 778-0499.

Jon: Also worth mentioning, we now have a website for the podcast. If you wanna check out additional episodes of the show stuff we’ve talked about in our previous six, you can either scroll on whatever podcast app you’re using right now, or visit our website for the podcast.

protectingwealthpodcast.com. Thanks Bruce. Talk again soon.

Bruce: Thanks Jon

Jon: Securities and advisory services offered through Commonwealth financial network member FINRA, SIPC a registered investment advisor. Forward looking commentary should not be misconstrued as investment or financial advice. The advisor associated with this podcast does not monitor for comments and any comments should be given directly to the office at the contact information specified.

Any tax advice contain in this communication, including any attachments is not intended or written to be used and cannot be used for the purpose of 1) avoiding federal or state tax penalties or 2) promoting marketing, or recommending to another party, any transaction or matter address herein. The accuracy, completeness, and timeliness of the information contained in this podcast cannot be guaranteed. Accordingly Hosler Wealth Management, LLC does not warranty guarantee or make any representations or assume any liability with regard to financial results based on the use of the information in this podcast.


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