Podcast Episode - Suze School: Clearing Up The Roth 5 Year Rule

On this Suze School, Suze responds to the multitude of emails she’s received asking for a deeper diver into the five year rule for Roth IRAs.

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Podcast Transcript:

February 4th 2024 Suze O here. Welcome everybody to the Women and Money podcast as well as everybody smart enough to listen. You know, as I was saying that date February 4th, it dawns on me that one month from now, KT and I will be in Abu Dhabi and that will be the first time in a long time that I am going to take the stage and I will be speaking live.

So that date has finally come for me to do that. However, there is something that I need to do today and that is to clear up a lot of confusion about what's known as the five year rule when it comes to Roth retirement accounts. And what's known as the five year rule only applies to a Roth retirement account, whether it is a Roth IRA or a Roth 401k A Roth 403 B or a Roth TSP, even a Roth 457 plan. So you need to just know that.

I'm not exactly sure why all of a sudden I'm getting so many emails on this topic, but what I'm happy about is I have a feeling that many of you have wisely chosen now to actually start investing in a Roth 401k over a traditional 401k.

And when I say traditional, traditional simply means you have funded it with pre tax dollars. A Roth means you have funded it with after tax dollars. So as I was saying, a lot of you now have wisely taken my suggestions and you're opening up a Roth 401k over traditional 401k, you're bypassing the tax write off the same with a Roth IRA versus a traditional IRA. You are bypassing the tax write off and you are bypassing it because you want to know that what you see in your Roth retirement accounts is what you get to keep.

And that is a big deal. Everybody in comparison to traditional IRAs, what you see there, the numbers on the paper does it mean that's what you get when you go to withdraw the money because it will always be taxed to you as ordinary income at whatever tax bracket happens to be in effect at that time.

But what you do need to know is that the five year rule, which simply is that any money that you have in a Roth retirement account, no matter what kind it is, the Roth retirement account has to have been opened for at least five years and you have to be 59 and a half years of age or older for you to withdraw all the money from that Roth retirement account without any taxes or penalties. What so ever just that simple.

However, the way that it works for a contributory Roth is different than a Roth 401k 1. Again, when I say Roth 401k, I am also referring to the Roth TSPs and Roth 403 Bs. Ok. So they are different and how it works is different. So let's start with the contributory Roth.

And what you need to know is that for me, the contributory Roth is my favorite kind of retirement account bar. None.

And the reason is that any money you contribute to a Roth IRA simply means that you plan to put money in every single year and you can do so or you don't have to do so. But once you have contributed, even if it's just a dollar to a contributory Roth IRA, the time clock has started, it's now ticking.

You put money into a Roth IRA and let's just say you put in $7000 a year.

Let's say you are 30 years of age and you are doing that and you put in $7000 this year, 7000 next year, 7000 a year after that, you have contributed $21,000 over these next three years and you are now, 33 years of age, however, that $21,000 has grown to be $25,000 and now you want to withdraw money, maybe you want to buy a car, who knows what you want to do.

If I were you, it's a mistake to ever take money out. But let's just say you want to, you can take out any amount of money up to the $21,000 that you originally contributed without any taxes or penalties, even though that account has been only open for three years And you are not 59 and a half years of age.

That's why I love contributory Roth IRAs, it is the $4000 that your money has earned that you cannot touch until that account has been open for at least five years. And you are 59 and a half years of age.

So that's really, really important for you to understand.

Remember you have to have had that account open for at least five years, let's say, however, you are now 60 years of age and you have funded your Roth Ira for the very first time. You never had opened a Roth IRA before this and you funded it with $8000 this year. Remember for this year, if you are under 50 the max you can put in is 7000 a year. If you are 50 or older, it's 8000. So here you are 60 years of age, you're past 59 and half. So you can access any money within any retirement account without the 10% penalty.

But here you are, you put in $8000 and now it's worth $10,000. You invested in these stocks and they just skyrocketed and you have $10,000 in there.

And now you think to yourself, I'm going to take out all $10,000 it's all tax free because I'm over 59 and a half years of age.

If you take out all $10,000 you will owe ordinary income tax on the $2000 of growth, not the 10% penalty because you are over 59 and a half.

But you have not had the Roth Ira opened for at least five years.

So the sooner you can open a Roth IRA, even if you fund it with $1 and you never contribute to it again. You have started the fiveyear time clock moving ticking if you had started a Roth IRA five years ago, even with just a dollar.

And now here you are 60 you wanted to take out all $10,000 you could take out all 10,000 without taxes or a penalty whatsoever.

Right. So that's a contributory Roth. Now, a lot of you have already opened up when I'm calling a contributory Roth IRA one that allows you to contribute to every single year.

However, you also have money in a traditional IRA and you want to convert it now and you wanna put it into the Roth IRA that you started years ago, write this down if you convert money from a pre-tax IRA or from any pre taxed retirement account.

So if you convert money to your Roth IRA, the time clock for the amount of money that you converted has nothing to do with how long your Roth IRA has been open, that converted money has its own time clock.

So even though you could access the original contributions of your Roth IRA, any time you want without taxes or penalties, when you convert, even though you have paid taxes on the conversion, the time clock for the five years starts all over again for that amount of money.

Was that clear? Now, it is very important that if you have a contributory Roth that you are contributing to and you have a traditional IRA or a traditional 401k and you convert the money from there into the contributory account, you write down the year and the amount of money that you converted in there because that is really important. You need to meet the five year rule for that along with 59 and a half years of age. So that is important for you to understand.

Next, you need to know that if you keep converting money, let's say you have a lot of money in a traditional Ira or even a traditional 401k and little by little you convert into your Roth IRA that you already have had open every year that you convert. It starts a new time clock for that conversion. So you could have many, many, many different time clocks for the five year rule running if you convert every single year or whenever you do convert.

So you have to understand that a conversion always triggers a new time clock for the amount of money that you converted.

Shake your head. It's just how it works.

Now, let's talk about a Roth 401k.

If you have a Roth 401k and you have a Roth IRA that you opened up years ago, it's already met the five year rule and you roll it over, you don't convert it because it's already a Roth retirement account. Remember, conversion means you have converted a traditional or pre-tax retirement account to a nontaxable retirement account. And when you do that, you owe ordinary income taxes on it in the year that you converted when you have a Roth 401k and you already have a Roth IRA started five or more years ago when you roll that money from a Roth 401k into your Roth IRA. It now takes on the time clock of when you started that Roth IRA.

So even if your Roth 401k has only been open for two years and now you roll it to the Roth IRA, it qualifies for the five year rule again, you have to be 59 and a half years of age or older to take it out without the 10% penalty.

But now you can do your original contributions without any taxes whatsoever. It will still possibly be the earnings within that Roth IRA that you cannot touch until you are 59 and a half years of age or older without the 10% federal penalty. Remember everybody, certain states also charge a state tax penalty as well.

Did that make sense to all of you? Your Roth 401k when you roll, it takes on the time that the Roth IRA has been open.

So it is essential that if any of you have a Roth 401k, that you open a Roth Ira again, I don't care if it's just for a dollar, you open a Roth Ira and start the time clock moving.

However, if you have a traditional 401k and now you convert it to your Roth IRA, the amount of money that you converted, obviously, you owe taxes on that year. But the time clock for that money again has started the year that you converted it. So therefore make sure that you keep a record of how much you converted and the year that you converted makes sense. I hope so.

Now, what's really important also for you to understand is that when it comes to a Roth 401k, how you withdraw money from a Roth 401k is very, very different than how you withdraw money from a contributory Roth. Remember in a contributory w Roth, you can take out any money you originally contributed without any taxes or penalties regardless of how long the account has been opened or your age.

A Roth 401k does not work that way if you have a Roth 401k and you wanna take an early withdrawal from it, withdrawals from a Roth 401k are prorated and they are prorated between the nontaxable contributions that you made and the earnings that are in there. Now, let's just say that you put in $9000 in contributions and you've made $1000 in earnings.

So you have $10,000 in the account and you wanna just take out $4000 you have $10,000 in there. $9000 of your original contributions, $1000 of earnings and all you want to do is withdraw $4000. The way that it would be figured out is this, the $1000 divided by the $10,000 is 10%. So the $1000 of your earnings into the $10,000 that's totally in the account is 10%.

So if you withdraw $4000. 10 percent of that $4000 you want to withdraw, which is $400 you are going to owe taxes and a 10% penalty on that $400.

If you're not 59 and a half years of age or older, no matter what, you're gonna owe taxes on that $400. But if you are 59 and a half years of age or older, then you won't have to pay the 10% penalty. If you do this, then there will be no taxes or penalties. Um, the $3600 the difference between the 4000 and the 400 which is taxable and penalized if you're not of age.

So the $3600 there are no taxes or penalties on that $3600 regardless again of age or how long it has been in there. Do you understand the difference if that had been a Roth IRA and you wanted to take out $4000 you could have done so without any taxes or penalties regardless of your age.

So you just have to remember in a Roth 401 it also has to have been opened for five years and for you to be 59 and a half so that you can access anything, your original contributions or your earnings totally tax free. Prior to that time, they will consider those earnings taxable. If you have a Roth 401k, listen closely to this now that you have had open for, let's say 10 years.

And now you want to roll it over to a Roth IRA and you are opening a Roth IRA for the first time when you roll the Roth 401k over to a Roth IRA that you've just opened or it has not been opened for at least five years. The 401k time clock totally disappears and it takes on the time that the Roth IRA has been open. So it is the opening time clock of the Roth Ira that counts. Not how long you have had a Roth 401k. All right, everybody that is your Suze School for today.

Please don't freak out when you hear all of these numbers and all of these rules. You absolutely have what it takes to understand every single thing that I just said. And that is why you have a notebook. That is why you go over it again and again and once you get it, you'll never get yourself in trouble. It's when you don't understand this rule and you think everything's gonna be tax free and you make a mistake here. You can be in for a big financial shock, right?

So, until next Thursday, when KT who by the way is already out in her garden, she is so happy, so happy to be back on the island. I cannot even tell you and Colo, I know you listen to the podcast all the time. I know you're in Colombia with your wife and your kids. Hi, Annie and your dog that you love so much Toby. We're doing fine. We miss you. We love you and we can't wait for you to come home to us. But until Thursday there's only one thing that I really want you to remember when it comes to your money and it's this: people first, then money, then things and if you can remember that, I promise you you will be unstoppable.