The Roth IRA is a remarkable retirement-planning tool, as investors can avoid taxes on investment earnings by following certain rules. With a self-directed Roth IRA, those earnings can come from alternative investments in real estate, private lending, private equity, or almost any other strategy of your choosing.
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Key to achieving tax-free status on Roth earnings is the five-year rule. Let’s look at how the five-year rule can affect Roth IRA activities and explore scenarios in which it could make sense to hold multiple Roth IRAs.
What Is the Five-Year Rule? How Does It Impact Tax-Free Distributions?
The account holder of a Roth IRA may withdraw Roth contributions tax free at any time because the contributions were not tax deductible when initially deposited. However, the five-year rule stipulates that the account must be five years old for the earnings to distributed tax free.
To determine your account’s age, you must start with the “birthday” of the account. The IRS conveniently assigns January 1 of the tax year of your initial contribution as the “birthday” of the Roth IRA. For instance, if you open your Roth IRA and make your first contribution in April 2021 for the 2020 tax year, the five-year clock starts on January 1, 2020. So, on January 1, 2025, you can withdraw* any earnings from the prior five years tax free.
*It’s also important to note that, in addition to the five-year rule, qualified tax-free Roth distributions can only take place once the account holder reaches age 59 ½.
What Is the Five-Year Rule for Roth Conversions?
A Roth conversion is the movement of cash or assets from a pre-tax account (e.g., a Traditional IRA) into a Roth IRA. This can be an efficient way to consolidate your retirement holdings for future tax-free withdrawals, but Roth conversions are subject to their own five-year periods within calendar year start dates.
Returning to our previous example, let’s say you make your first Roth contribution in April 2021 for tax year 2020 and then execute a Roth conversion in March 2022. The five-year period for the initial contribution amount starts on January 1, 2020 (and would remain so for any future contributions), but the five-year period for the conversion amount would be January 1, 2022. An additional conversion in September 2023 would also have its own five-year clock starting on January 1, 2023.
How Multiple Roths Can Help Ensure Qualified Distributions
Making Roth contributions and executing conversions can help you optimize your retirement investing approach, but managing multiple five-year time frames can be confusing. An occasional but unfortunate side effect of the five-year rule is that non-qualified distributions can occur unbeknownst to the account holder, generating income taxes and sometimes early distribution penalties.
A possible way to avoid this unwanted outcome is to hold multiple Roth IRAs, one for each five-year period your overall post-tax portfolio is subject to. Keeping things separate can help keep things clear. If we again return to our example, having one Roth IRA whose five-year period begins in 2020, another whose begins in 2022, and a third whose begins in 2023 can provide more visibility into when exactly you can take advantage of tax-free Roth distributions.
Let NDTCO Help You Walk the Investment Path That’s Right for You
As with anything in self-directed investing, the size and scope of your retirement strategy are entirely up to you. New Direction Trust Company is here to help make your vision a reality.
Give us a call at 877-742-1270 or send us a message through the Client Portal to discuss your options or inquire about your account.