(updated -7/27/2020)
A Roth IRA is an after-tax retirement account, unlike a traditional IRA where contributions are made pre-taxed with immediate tax benefit (IRS tax deduction), subject to AGI limitation.
The pros and cons of Roth IRAs, which were introduced more than two decades ago, are well understood. All money flowing into Roth IRAs is after-tax, so there is no upfront tax benefit. As a trade-off, all qualified Roth IRA distributions can be tax-free, including the parts of the distributions that are payouts of investment earnings.
To be a qualified distribution, the distribution must meet two basic requirements:
First, the distribution must be made on or after the date the account owner reaches age 59½, be made because the account owner is disabled, be made to a beneficiary or to the account owner’s estate after his or her death, or be used to buy or rebuild a first home.
Second, the distribution must be made after the five-year period beginning with the first tax year for which a contribution was made to a Roth IRA set up for the owner’s benefit.
Note that the calculation of a Roth IRA’s five-year period is very generous. It always begins on January 1 of the calendar year.
Example 1: Jane Doe, age 58, opens her first Roth IRA and makes a contribution to it on March 29, 2020. Jane designates this as a contribution for 2019, which can be made until July 15, 2020 (due to the COVID-19, the original April 15 due date was postponed to July 15).
Under the five-year rule, Jane’s five-year period starts on January 1, 2019. As of January 1, 2024, Jane’s Roth IRA distributions are tax-free, qualified distributions because they will have been made after she turned 59½ and after the five-year period has ended. The five-year period is determined based on the first contribution to the Roth IRA; the starting date of the five-year period is not reset for the subsequent contributions. Jane's income tax return preparation may be as simple as reporting nontaxable ROTH IRA distribution if any.
Note that if Jane opens her first Roth IRA late in 2020, even in December, the first contribution will be a 2020 Roth IRA contribution and Jane will reach the five-year mark on January 1, 2025.
Conversion factors
Other than making regular contributions, Roth IRAs may be funded by converting a traditional IRA to a Roth IRA and paying tax on any pre-tax dollars moved to the Roth side. For such conversions, a separate five-year rule applies. There generally is a five-year waiting period before a Roth IRA owner who is under age 59½ can withdraw the money contributed to the Roth IRA in the conversion that was includible in income in the conversion, without owing a 10% early withdrawal penalty.
Similar to the five-year rule for qualified distributions, the five-year period for conversions begins on the first day of the year of the conversion. However, unlike the five-year rule for qualified distributions, the five-year rule for conversions applies separately to each Roth IRA conversion.
Example 2: In 2020, John Doe, age 41, leaves his job and rolls $60,000 from his 401(k) account to a traditional IRA, maintaining the tax deferral. If John decides to withdraw $20,000 next year, at age 42, he would owe income tax on that $20,000 plus a 10% ($2,000) penalty for early withdrawal.
Instead, in 2021, John converts $20,000 from his traditional IRA to a Roth IRA and includes the entire amount converted in income. However, if John withdraws that $20,000 in 2021, he also will owe the 10% penalty because he does not meet the five-year rule for conversions; the rationale is that the IRS doesn’t want people to avoid the early withdrawal penalty on traditional IRA distributions by making a Roth conversion.
The good news is that, in this example, John will have started the five-year clock with his 2021 Roth IRA conversion. Therefore, he can avoid the 10% early withdrawal penalty on the conversion contribution after January 1, 2026, even though he will only be age 47 then. John will owe income tax on any withdrawn earnings, though, until he reaches age 59½ or he meets one of the other qualified distribution criteria.
Note that various exceptions may allow John to avoid the 10% penalty before the end of the five-year period. Altogether, the taxation of any Roth IRA distributions made before five years have passed, and before age 59½ can be complex.
If you have a Roth IRA, discuss your options with a CPA at Whin Global about tax consequences of any distribution you are considering. Generally, it is better to wait until the age 59½ and five-year tests are passed before making Roth IRA withdrawals, to avoid taxes.
Trusted Advice - Roth IRA Distributions
• Roth IRA distributions after age 59½ (and five years after you set up and make a contribution to your first Roth IRA) qualify for complete tax-free treatment. • Distributions that do not qualify for this tax-free treatment may be subject to income tax, a 10% early withdrawal penalty, or both. • Ordering rules apply to non-qualified distributions:
First, come regular contributions, rollover contributions from other Roth IRAs, and rollover contributions from a designated Roth account.
Next, come conversion contributions, on a first-in, first-out basis. The taxable portion comes before the nontaxable portion.
Earnings on contributions are the last dollars to come out.
Your CPA at Whin Global can provide further details if, and when, a Roth distribution is taken out either before or after the age of 59 1/2.
2020 IRA CONTRIBUTIONS LIMITS UPDATES
The Traditional & Roth IRA contributions limits are:
For 2020 and 2019, your total contributions to all of your traditional and Roth IRAs cannot be more than:
$6,000 ($7,000 if you’re age 50 or older), or
your taxable compensation for the year, if your compensation was less than this dollar limit.
For 2015, 2016, 2017 and 2018, your total contributions to all of your traditional and Roth IRAs cannot be more than:
$5,500 ($6,500 if you’re age 50 or older), or
your taxable compensation for the year, if your compensation was less than this dollar limit
The contribution to a Roth IRA may be limited by your Modified AGI and your filing status. For example, Married filing joint couples with MAGI under $193,000 can contribute each the full amount for 2019. See the IRS chart for the Limitations of Roth IRA Contribution
Re-characterization is out:
The new tax law passed in December 2017 still allows conversion from traditional IRA to Roth IRA accounts. However, effective January 1, 2018, pursuant to the Tax Cuts and Jobs Act (Pub. L. No. 115-97), a conversion from a traditional IRA, SEP, or SIMPLE to a Roth IRA cannot be re-characterized. Once you convert to a Roth, you cannot change the character to its original one.
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