Tax-loss harvesting, Roth conversions and more: Joe and Big Al explain how bear markets are the time to utilize these investing strategies in your retirement portfolio. And the fellas go over those Roth IRA 5-year withdrawal rules – again. They also cover some Roth withdrawal mistakes and Roth rollover consequences, and they have a mea culpa for one of their peers.
- (00:35) Sports: Cancelled
- (02:58) Retirement Portfolio Strategies for Investing in a Bear Market
- (13:16) Mea Culpa: Apologies to Josh at Heritage Wealth Planning
- (16:35) 5-Year Clock on Roth IRA Withdrawals – part 1
- (26:11) 5-Year Clock on Roth IRA Withdrawals – part 2
- (31:39) 5-Year Clock on Roth IRA Withdrawals – part 3
- (35:02) I Didn’t Track Roth IRA Contributions and Withdrew Money. Now What?
- (40:39) Roth IRA Rollover Consequences
Resources mentioned in this episode:
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Click here to Subscribe to Your Money, Your Wealth® on YouTube
DOWNLOAD THE WHITE PAPER: Roth IRA Basics Guide
LISTEN | YMYW Podcast #255: Breaking Down the Confusing Roth 5-Year Clock Rules
Today on Your Money, Your Wealth®, Joe and Big Al discuss investing strategies to utilize in trying times like these, and since they did such a bang-up job of explaining the 5 year Roth clocks back in episode 255, today the fellas go over those withdrawal rules one more time – well actually, three more times. They’ll cover some Roth mistakes and consequences, and they have a mea culpa for one of their peers – yes, peers. But first, sports. I’m producer Andi Last, and here are the hosts of Your Money, Your Wealth®, Joe Anderson, CFP®, and Big Al Clopine, CPA.
Joe: Been an interesting week to say the least. Hopefully everyone is safe. And not sick.
Al: That’s the main thing at times like this. We haven’t really had too many of these types of things to go through. We’ve had other pandemics. But they’ve never really hit the US to this extent, I would say.
Joe: Right. So unchartered territory I guess, for me anyway.
Al: It is and you and I are sports fans. So we could talk about the market but I’d rather talk about sports.
Joe: Everything’s canceled, so why even talk about it?
Al: I want to sort of bring up what’s canceled. So PGA Tour, they’re going to continue the tour but with no spectators.
Joe: March Madness, gone. Canceled. That’s my favorite part of the year.
Al: I know it is. And in fact, all the college basketball tournaments through this weekend are canceled. NBA suspended their season. NFL teams are curtailing or stopping scouting operations. So Major League Baseball- their opening days has been delayed by at least 2 weeks.
Al: We got NHL, National Hockey League, they’re pausing their season. We’ll see what that means. NASCAR the next 2 weeks is without fans. The Indy Car is to open the season without spectators. Major League Soccer is shutting down for 30 days.
Joe: It’ll be interesting just to- I’m watching the PGA Championship. They had fans on Thursday.
Al: Yeah they did.
Joe: Then Friday, Saturday, Sunday, there’s no fans.
Al: They’re not. Right. Because they just announced-
Joe: They did that one time in Mexico or- it wasn’t because of anything like this. It was just like really bad weather and it wasn’t really set up for it. And then like Tiger Woods hit a putt. And then he was like he tipped his hat-
Al: And no one was there?
Joe: -and no one was there. He kinda felt like an idiot. He’s like ‘yeah I kinda tipped my hat to no one.’
Al: That happened a few years ago the Farmer’s Open in San Diego. They went to Monday and there was hardly- there were fans, but not very many. It was very few.
Joe: Is that when Jason Day won.
Al: Yes. First playoff hole. Had to wait all night for that.
Joe: I know. All right. We got a lot of emails to go through today. If you do have questions, concerns, thoughts or anything like that in regards to our show, go to YourMoneyYourWealth.com. You can ‘Ask Joe and Al On The Air‘.
Retirement Portfolio Strategies for Investing in a Bear Market
So first one comes in from Kenny from Granite City. “Still loving the podcast. Just as everyone else, I saw my investments dip over the last 3 weeks and have a few ideas on how to capitalize on it. I was hoping Big Al and Joe could comment.” Well Kenny, I think this is a perfect time to read your email. He’s got some ideas.
Al: Yeah, let’s see what they are.
Joe: So a little bit of a dip in his portfolio.
Al: As most of us have seen that.
Joe: I’m sure a few of us kinda feel this way.
Al: Yeah, very concerned.
Joe: Unless you’re sitting in cash. “First question- is now an-
Joe: oppor- I was gonna say-
Al: -opportune time-
Joe: -don’t worry about it – “opportune time to perform my Roth conversion for 2020?”
Al: Gave me a little pause, I kinda worried there.
Joe: It’s called a pregnant pause Al. It’s called radio business.
Al: It wasn’t a good spot for a pregnant pause.
Joe: Got it. I know. You know, my eyes might be going bad a little bit.
Andi: You mentioned that last week too.
Joe: I know. God.
Al: Should I bring my reading glasses?
Joe: You might have to. You turn 35 and the next thing you know, everything kinda blows up on ya.
Al: 10th anniversary of your 35th?
Joe: “I haven’t done it yet.” So he wants to do Roth conversion. “I haven’t done it yet. My thought is that when, not if, the market recovers it’ll be the best to have the money to recover under the tax shelter of the Roth 401(k).” Let me answer that question first. Absolutely Kenny. I mean Al, you remember 2008. We did most of our clients’ Roth conversions.
Al: A lot of conversions and we were very clear about that. That the times to do Roth conversions- first of all when your tax bracket warrants it. That was number one. Number two is when the market is low, wouldn’t you want to get those equity dollars in your Roth and have it grow that much more quickly? The recovery.
Joe: So let’s say the market’s down 30%. So if you do a conversion- if you believe that the market is going to recover and that let’s say in the next year or two that the market is going to be higher than it is today then why wouldn’t you do the conversion? Pay the tax, get it into a tax free environment and then let that conversion- I mean let the money recover in the Roth.
Al: Yeah. That-
Joe: I mean it’s an awesome idea.
Al: It’s definitely the best time and remember back when there was re-characterizations? We actually had some clients do Roth conversions even in the highest tax bracket and have all equities in their Roth. They had safe money in their other accounts. So let’s be clear- what they didn’t take any more risk in their overall portfolio but they had all equities in the Roth. And if it went up then we kept it in the Roth because they could afford the higher taxes because they had so much growth tax free. If it didn’t go up, we just re-characterized it backed into the IRA and no harm no foul.
Joe: Just remember when you’re converting- let’s say you convert $50,000. Look at the shares of what you’re converting. You know what I mean? Because now you’re converting shares of stocks depending on if you want to buy mutual funds, index funds or individual stocks. It doesn’t necessarily matter. But that share price is a lot lower so you’re able to convert. When you convert those share prices are going to go up. So I would pay more attention to how many shares am I converting versus the price. Because it could still go down. We don’t know what the heck’s going to happen in the overall markets. But you have X amount of shares in the overall Roth and let’s say over the next year or two years, do you believe that that’s going to be higher? Then I would absolutely do conversions.
Al: And I think what you said right off the bat is the key. If you believe the market’s going to recover and which we’re generally in that camp. But there’s no guarantees. No guarantees at all. But if you believe that then that this is a fantastic strategy.
Joe: Second question from Kenny. “I’m holding funds in my brokerage account for the purpose of dividend income for those funds that took a large hit but I still intend to hold. Is it beneficial to sell my shares, wait 5 minutes and repurchase them? Will this allow me to write out the losses on my 2020 taxes?” Another good tax strategy, Kenny. But you’ve got to wait more than 5 minutes.
Al: The IRS is onto ya.
Joe: Yes. You could sell those, take the loss, but there’s something that’s called a wash sale rule. You’re going to have to wait 31 days to repurchase those shares or repurchase that particular company or stock or mutual fund. However let’s say if you have let’s say large cap growth fund or something like that and it’s down you could sell that and buy a total U.S. market fund. So it’s similar but it’s not identical. You got to be very careful with those because the IRS scrutinizes. I mean if it’s pretty close they might still call it a wash sale rule. So it’s gonna be a little bit different but it still can be in the same kind of family.
Al: And the 31 days- the rule is this, you have to wait 30 days before you buy the next stock. Which means the 31st day you can actually buy that stock. Now something else that trips people up and it’s really not very clear in the tax code is if you- some people want to sell in their non-qualified account, get the loss and then they rebuy it in their retirement account. So there they have same same. Can’t do that. You can’t do that.
Joe: No. Still wash sale rule.
Al: Still wash sale rule. So although IRS has a hard time catching that to be honest but you’re not supposed to do that. So don’t try that one.
Joe: So you can’t wait 5 minutes, you’ve got to wait a month, 30 days. So I like where your head’s at Kenny.
Al: Yeah. Wonderful. By the way, those losses, those as are capital losses so those go against capital gains. It’s not an ordinary loss. So if you don’t have any other capital gains, then you’ll only get to take $3000 and the rest you carry over to next year and the carryover is indefinite. So some people think they got $50,000 stock loss and they can write it off against their salary and you can’t. It’s a different kind of a loss.
Joe: But think of it like this Kenny, so let’s say you’re taking that loss and then you’re repurchasing something else. You sell some dividend paying stocks and then you’re buying like a high dividend ETF, whatever. But when you sell other investments to create income when you retire those hopefully will be at a gain as the market recovers. So those gains will offset the losses that you occurred today. So let’s say you’re not retiring for 5 years and you have a $50,000 loss, $100,000, whatever it is that like Al said, that will continue to go indefinitely until you use it all up. So if you’re retiring in 5 years you can take those losses. They’ll take $3000 of that loss each year right against ordinary income. But now you have a larger loss that will offset against capital gains. So you could create a tax free income from this. So you’re doing a conversion. Market’s down 30%, do the conversion. So when that recovers, all of that money is going to come to a tax free, start doing some tax-loss harvesting in your other accounts, create those losses there. And then when the market recovers and you start taking dollars from that those losses will offset future gains. That’s going to be tax free. So all of this works if the market recovers. If it doesn’t you’re-
Al: That’s a different story.
Joe: That would be a bad story for all of us. So he’s got a few additional comments. “I had recently asked if I should ignore the Roth 401(k) because my state, Illinois, does not tax individual retirement accounts. I’ve subsequently learned that this also applies to Roth conversions. So yes, it’s beneficial for me to perform a Roth conversion.” Well thanks for the comment Kenny. Wasn’t Kenny saying I would never do it?
Al: You would never do it because the-
Joe: -the state tax-
Al: -the 401(k) is tax free in Illinois, at least for the state tax?
Joe: Right. If you take distributions from 401(k).
Al: So why would you do the conversion? But now he’s telling us that if you do a Roth conversion in Illinois that’s tax free as well. How about that? Like it.
Joe: Granite City. “Also, recently John had inquired about performing a Roth-” who’s John?
Andi: Keep reading. You’ll remember this.
Joe: Okay. “Also recently John-” I mean are we now like all friends?
Al: Yeah. Of course.
Joe: Is that what’s going on here? Got it.
Al: It’s a Kumbaya.
Andi: It’s a YMYW community.
Joe: Got it. Got it. “Also, recently John had inquired about performing the Roth conversion on behalf of his wife. You informed him he cannot do so. However if John’s wife were to perform a Roth conversion, John could pay the tax on behalf of her? Absolutely happy late Valentine’s Day, John.”
Andi: You were saying about how the Roth conversion for her would be good for a Valentine’s Day gift.
Joe: Oh I love it.
Al: How about that?
Joe: “Thanks again for all the great information. Investors need relevant, current information in regards to strategy and in situations like the past three weeks. I can’t just sit and wait for Robert Kiyosaki’s next book. I need YMYW.”
Al: And we do it weekly. It’s not once a year.
Joe: All right Kenny. Hopefully that helps. I like where you’re at. I think it’s time to make lemonade out of lemons. When the market is scary and there’s some turmoil and you see these point drops of 1000, 2000. I mean what the hell is going on with that?
Al: Strange times. But as you say Joe, regardless of the market there are strategies. And Kenny, you’ve identified a couple really good ones. Doing your Roth conversions now, getting the future growth, the recovery in the Roth, wonderful. Tax-loss harvesting. Absolutely. Everyone should be looking at that right now. By the way, tax-loss harvesting, you can’t get too much. It’s not like you have to just get enough to cover your gains this year. Get as much as you can, because it carries over for the rest of your life.
Joe: Yes. So and then when you know your tax strategy is down just don’t look at your statement for a while. Say I’ve done my tax planning. I got the strategy in line. I’m retiring not today. I’m retiring in a couple of years from now. Or if you are retired today and you don’t necessarily have a strategy to create the income, now you have to start tweaking some stuff. Because if you’re all in equities and now you start taking dollars and selling stocks in times like this. This is why retirement income strategies are very important. So that’s what we preach here on YMYW.
Mea Culpa: Apologies to Josh at Heritage Wealth Planning
Joe: Alan, I got an issue an apology.
Joe: We had a listener write in.
Andi: Darrell from Ohio.
Joe: Darrell. Our good friend Darrell, his other brother Darrell. Right? Is that the right Darrell?
Andi: Larry, Darrell and Darrell.
Joe: Larry, Darrell and Darrell.
Al: I do remember that.
Joe: And he said some about a colleague of ours or things like that from-
Andi: A peer.
Joe: -a peer. From Heritage Wealth Planning. And there’s this- I don’t want to- I always put my foot my mouth. There is another firm that’s Heritage. Maybe I got confused. I don’t know Josh and he did this YouTube video about it.
Al: About us.
Joe: I thought was awesome.
Al: It was great.
Joe: Can you play some?
Josh: “Whoa! Did the Your Money, Your Wealth® guys, Big Al and Joe, just say they don’t care for me? What? Man! Man, guys. Why would you do that to old Josh? I didn’t do anything to you.”
Joe: You’re right Josh and I apologize. I find your content very good, amusing and on point.
Al: And I would say after watching your YouTube video where you’re kind of dissing me about my knowledge of-
Joe: Yeah, you don’t know anything about-
Al: -about taxes. Apparently not.
Joe: You are an idiot and I’m a jerk.
Al: Yeah, that’s what I got from that YouTube.
Joe: Which is pretty true.
Al: I probably Josh, I probably know a couple more things than you give me credit for. But nevertheless I don’t know everything. But anyway- so I think we tried to answer the question on pretty limited information, is what I recall. But watching your YouTube video, I think I agreed with a lot of what you said. Except I sort of disagreed with some of your asset classes in the Roth versus the trust account versus the IRA. But basically I agreed with most of the rest of it.
Joe: Al’s giving him a critique.
Al: Well he just critiqued me so I’m going to critique him back.
Andi: This is gonna go on forever.
Al: I know. It’s all cool.
Andi: Josh, thank you for the video.
Joe: Yes. And check him out. Where can they find him?
Andi: They can find him on YouTube. Just search for Heritage Wealth Planning.
Joe: All right. Heritage Wealth Planning. So again, please accept our apologies Josh. Keep up the good work. Keep fighting the good fight.
Al: Yeah. Agreed.
Thanks to all the commenters on Josh’s YMYW YouTube video – unfortunately our compliance department doesn’t allow us to have comments on our YouTube channel, but that doesn’t mean you can’t subscribe on YouTube, listen to the podcast there, learn from our financial advisors, and catch new episodes of the Your Money, Your Wealth® TV show – season 6 will be getting underway very soon! Speaking of learning from our financial advisors, one of our heaviest hitters – he loves it when I call him that – our Director of Research, Brian Perry, CFP®, CFA, has done a comprehensive video guide on bear markets – what they are, the history and statistics of previous bear markets and their recoveries, the relationship between bear markets and recessions, and more on bear market investing strategies. Watch the entire video guide in the podcast show notes. Click the link in the description of today’s episode in your podcast app, or if you’re on a desktop computer, visit YourMoneyYourWealth.com and click “Listen to podcasts” to get there. Now, by popular demand, let’s go over those Roth withdrawal 5 year clocks again…
5-Year Clock on Roth IRA Withdrawals – part 1
Joe: Tom from Phoenix. He goes “Hi. Got the following from Ed Slott and I’m more confused. I listen to your podcasts and thought that I understood that each Roth conversion had its own 5-year rule. The way I read this is that only the first conversion would satisfy the 5-year rule for withdrawals. Thanks.” All right. 5-year clock.
Al: This is complicated.
Joe: So the first conversion would satisfy the 5-year clock on a conversion. If you’re over 59 and a half.
Al: Now see that’s the key that everyone misses.
Joe: There’s two 5-year clocks. There’s three. There’s actually three 5-year clocks.
Al: I agree with that.
Joe: So there is a 5-year clock on contributions. So if all of you that have a Roth IRA- we’re getting more 5-year clock questions than ever before.
Al: Yeah. Because it’s confusing.
Joe: So let’s do this one more time. Ready Al?
Joe: Look hopefully I can simplify the hell out of this.
Al: Dazzle me and then I’ll try to help translate. If you go too deep.
Joe: Contributions. If I make a Roth IRA contribution- so I put money into a Roth. The money grows tax free. I have full access to the contribution at any time, any age. There is no 5-year clock on the contribution. We all agree with that?
Joe: So don’t worry about it. If you want to make a contribution the money is available to you the next day. No harm no foul.
Al: Not the growth.
Joe: Not the growth.
Al: But the basis. You put in $4000 into your Roth IRA. You can pull it out the next day. Even at age 25.
Joe: Yep. Now that $4000 grows to $40,000.
Al: It went up 10 times.
Joe: It went 10 times.
Al: Really good investment.
Joe: Really good investment. So you have to wait 5 years or 59 and a half. Which ever is longer, to have access to the growth of a Roth IRA contribution.
Al: Okay. So I’m 25 years old. I put $4000 in. I hit it big. I got a 10-bagger. Stock went up 10 times. You like that term?
Joe: A big 10-bagger.
Al: 10-bagger. $40,000. So I can pull the $4000 out next year or next week, doesn’t matter. But I got to wait till 59 and a half to take all that growth. Because it’s the longer of 5 years or 59 and a half.
Joe: Correct. We are on the same page?
Joe: Okay. All right.
Andi: You haven’t confused anybody yet.
Joe: Now let’s go into conversions. Let’s talk about after 59 and a half. So we’re older than 59 and a half. So I’m going to convert and I do not have a Roth IRA. There’s never been a Roth IRA established.
Al: No contribution. No conversion. No Roth IRA at all.
Joe: At all. I convert. I have to wait 5 years for the earnings. I have full access to the converted amount-
Al: – immediately.
Joe: – immediately. So it’s just like a contribution.
Al: So I convert $30,000. You’re saying the next day I can pull out $30,000.
Al: No problem.
Joe: If you’re over 59 and a half.
Al: Right. So my one day investment went up 10 times.
Al: It’s a 10-bagger. So that’s worth $300,000. I got to wait 5 years to pull that extra $200,000 whatever thousand.
Joe: So you’re 59 and a half you will have to wait till you’re 64 and a half. To have access to the earnings, if you have never established a Roth IRA before, ever.
Al: So what if I did a $1 Roth contribution when I was 20.
Joe: OK. So then you do a conversion after 59 and a half, your 5-year clock is satisfied.
Al: So I can pull out my extra $270,000.
Joe: Yes. You have full access to all dollars. You have a Roth IRA that you’ve established over 5 years. It was a contribution. 59 and a half, you do a conversion. The next day, 10-bagger. It’s up X. You have access to all of your money, because of the first contribution that you’ve made. You already had a Roth established. The 5-year clock is satisfied.
Al: So it’s like everybody should have at least $1 in a Roth just to start the 5-year clock.
Joe: Yes. Here’s the massive confusion. That all makes sense. Doesn’t that all make sense?
Joe: OK. So now here’s the biggest twist. So here’s the third 5-year clock. Is if you convert money from a retirement account prior to 59 and a half, then each conversion you have has its own 5-year clock until you reach the age 59 and a half.
Al: Yes and that’s right along lines with when you’re penalized on taking money out or not.
Joe: So if you think about it, if I pull money out of an IRA prior to 59 and a half and spend it, what happens?
Al: Got to pay tax and a 10% penalty.
Joe: 10% penalty. Pay taxes on the dollars. So if I do a conversion under 59 and a half, I pay tax but I avoid that penalty. Because I put it in a retirement account. But what the IRS is saying to us is that you have to hold that money in until you turn 59 and a half or 5 years. Because people were taking the money out the next day to avoid that 10% penalty.
Al: So I needed $20,000 to buy a car. So I converted $20,000 from my IRA to my Roth. And then the next day I pulled that out, I pay tax on the $20,000, I get it. But there’s no penalty out of a Roth.
Joe: You avoided the 10% penalty from the feds and whatever from those state of California.
Al: But the IRS said no, you can’t do that.
Joe: The first year- first couple years- I forget when they put that law in. So under 59 and a half, just remember each conversion has its own 5-year clock until you turn 59 and a half. And if you think about it they’re just trying for people to screw the system. For lack of a better word.
Al: Trying find a loophole?
Al: Is that a better way to say it?
Andi: All right, I’m going gonna screw this whole thing up and throw a wrench into it. I have a question. If somebody opens a Roth when they’re 20 and then closes it?
Joe: It’s fine.
Andi: So it doesn’t matter.
Joe: Doesn’t matter. You already had the Roth.
Andi: So the 5-year clock has been running even if you close it.
Joe: And I’m not giving advice here. And do not quote me on this. Because I’m not a tax expert. Please consult your tax adviser. If your IRS agent-
Al: -your friendly IRS agent that you see every other Saturday? I’m not 100% sure on that.
Joe: I’m 95%. I’m 95%. If you can have proof that you had a Roth IRA established- even though it was closed, it was established, in my humble personal- this is opinion.
Al: Yeah. It’s just your opinion.
Joe: I’m not going to go- I’m not going to go to it-
Al: Don’t take it to the bank.
Joe: I’m not gonna go to court and stand up for ya here.
Al: Judge, here’s my thought. I thought that’s how it worked.
Joe: I’m just a podcast guy. So I don’t know. Was that clear enough do you think? Was that better?
Andi: I hope so.
Al: I thought that was the clearest you’ve ever been on that-
Andi: I’m looking at what Ed Slott said and it seems to jive with what you guys said, so-
Al: Well we didn’t have to read Ed Slott. We know exactly what the problem is. Joe has talked about this in every class he ever teaches. And you’ve had people come up to you say ‘you’re wrong.’ It’s like ‘I’m not wrong.’ There’s a different rule when you’re under 59 and a half and over 59 and a half.
Joe: It gets confusing because- but then if you just think logically if I have a retirement account and I take the money out prior to 59 and a half, you get a 10% penalty. So if you think- if I’m doing a conversion prior to 59 and a half, they want me to hold onto the money. I don’t have access to the principal until I’m turned 59 and a half.
Al: That’s the whole point. They don’t want you pulling your retirement money out early. They want it to be for retirement.
Joe: And if it’s a conversion- because some people will say well you know what. I already paid the tax on it. It’s in a Roth, whatever, let me pull it out and buy whatever. And so- it’s just trying to hold on and get the 5 years. After 5 years, hopefully you’ve found funds in another area.
Al: But I mean you think about the reason why a contribution- you can put your contribution in- in my example of $4000 dollars and then you pull it out the next day you’re not penalized. You already paid taxes on that and there is no possibility of a penalty. Right?
Andi: Yeah. Because it’s your money.
Al: It’s your money. That’s different when you do a conversion and you’re under 59 and a half, you basically could avoid the penalty if they didn’t have this 5-year clock rule for each conversion.
Joe: So each Roth IRA conversion under 59 and a half has its own 5-year clock until you turn 59 and a half. And then it doesn’t matter because you’re not avoiding the 10% penalty anymore because you’re over 59 and a half. So it’s like you know you get questions- ‘man, I’ve been doing conversions each year. I’ve got to go back and track all that? And how do I- And I separate account-‘ I’m like ‘how old are you?’ ’60.’ Who cares? Don’t worry about it.
Al: You’re old enough.
Joe: You’re fine. You’re an old man.
Al: Is that what you say?
Joe: No. no. If they’re young-
Al: You think it though.
Joe: If they’re 80. That’s when you’re getting older.
Al: That’s when you get older.
5-Year Clock on Roth IRA Withdrawals – part 2
Joe: I’m going to answer another question here Alan. From our good friend Rob who works in Hollywood. “Hey, as always love your show, Andi, Joe and Big Al. But very important, just found out something about Roth conversions that I’ve never heard you guys bring up about the 5-year rule.” Don’t we talk about the 5-year rule often?
Al: Every other week.
Joe: It’s like Rob, what the hell are ya doing?
Al: How much more is there to talk about?
Joe: I don’t know. “I saw that there were actually three 5-year rules and one of them is that when you do a Roth conversion, not contribution, the 5 year waiting period doesn’t start from the first time you open the Roth. But rather every time you convert. That conversion has to wait 5 years on its own. This is not the same as the 5-year rule for contributions directly to a Roth, which starts from the calendar year that you first contributed. No matter how many Roth contribution amounts that you have.”
Andi: “Accounts that you have.”
Joe: “How come this rule has never been mentioned by you guys? It makes a huge difference in when I want to do with my traditional IRA money from year to year.” God, Rob is like angry.
Al: He’s a little mad we didn’t bring it up.
Joe: “Or how much that I may want to do with each conversion. The third 5- year rule had to do with inheriting a Roth IRA and have to wait for the deceased 5 years. Correct me if I’m wrong, but I read this on Nerd Wallet.”
Andi: We covered this in podcast 255.
Al: Go ahead, give him a little summary. You’re really good at these 5-year rules.
Joe: Rob, we would never let you down, my friend. Yes. There’s 2 things you have to consider, if you’re under 59 and a half or over 59 and a half. If you’re under 59 and a half, each conversion has its own 5-year clock until you reach age 59 and a half. Is that clear?
Al: Yeah. Sort of. It’s the 5-year clock is for the basis part. You can pull that out before age 59 and a half. But the earnings you gotta wait till 59 and a half.
Joe: No. Wrong. Each conversion has its own 5-year clock. If you convert an IRA to a Roth IRA under 59 and a half, each conversion has a 5-year clock for you to touch the money.
Al: Isn’t that what I just said?
Joe: No. You said you could take the conversion out but not the earnings.
Al: Yeah. After the 5 years, for each conversion.
Joe: After the 5 years.
Al: Didn’t I say that?
Joe: No, I thought you said something else.
Al: Roll back the tape.
Joe: So Rob, I think we’ve talked on this podcast many a times. Yeah. And I think his strategy is to convert to Roth IRAs. But I don’t think he’s planning on retiring under 59 and a half. And so if that’s the case then don’t worry about it. You’re getting too much in the weeds. Because they don’t want people to avoid the 10% penalty.
Al: So if you are going to retire before 59 and a half it’s a great strategy. Because then if you have a lot of these Roth conversions that now you can pull out with no penalty. Because otherwise if you kept them in the IRA-
Joe: But then you’re paying a 10% penalty on the earnings.
Al: Yeah, if you pull it all out.
Joe: So, we’re on totally opposite pages here. It’s an awful strategy if you’re planning on retiring before 59 and a half.
Joe: The whole purpose of a Roth IRA is tax free growth. Not to short cut the IRS by converting, waiting 5 years and taking your principle out.
Al: What if you’re going to retire at 40? And so you start doing this at age 30-
Joe: I can’t. I’m going to retire right now. This show sucks.
Al: You start doing this at age 30. So by age 35 and certainly by age 40, you have 5 different conversions.
Joe: What if they don’t have any money? What are you converting? And now you’re 40 and you’re going to live until 100. On your conversion amount?
Al: Yeah but see- apparently we’re not on the same wave length. What I’m suggesting is if you need that money- if you leave it in the IRA and don’t convert. Then if you pull it out age 40 you’re going to pay taxes and penalty. Joe: OK.
Al: If you’ve been converting it periodically over time, at age 40 you can pull out that conversion amount as long as it’s been in there 5 years without at least paying the penalty.
Joe: No I’m with you.
Al: Otherwise you do a 72T election and that’s your only choice of getting money out of the IRA without a penalty.
Joe: I agree. However-
Al: You have a however?
Joe: I believe- but this is for retirement planning not for like if I’m in a jam. Get a loan. Don’t take it from the Roth. Especially the Roth conversion that you did at age 35 or 40. But you’re talking about retiring at 40.
Al: That’s right. That’s the only reason you’d want to do this. Otherwise, who cares? I agree with that.
Joe: Because after 59 and a half, each conversion has its own 5-year clock is off the table. It doesn’t matter. Because if you did one conversion and then you did multiple conversions and then you turn 59 and a half and you’re like I did this conversion at age 58 I can’t touch it until I’m 63. That’s not true. You can touch you that 59 and a half because they if you were under 59 and a half. But once you’re over 59 and a half year it’s all fair game.
Al: I agree with that.
Joe: All right.
5-Year Clock on Roth IRA Withdrawals – part 3
Joe: We got Ricky. Ricky is calling in from Alabama. “Great and entertaining show each week. In Alabama, but a big season ticket holder for LSU.” What the hell are you doing?
Al: That’s the wrong state.
Joe: I’m a University of Florida grad, Ricky. So I might just end this question right now. So he’s like playing both sides here. You know? Alabama but a big LSU Tigers fan. “Now on Roth conversion. Let’s presume that I conversion is done in 2021, 2022 and 2023 to not jump tax brackets. What can I withdraw in 2026? Just the money in earnings from 2021? Or any amount? Thanks.” Ricky. Great question. So this is kind of the 5-year clock rule again is what he’s getting at. One piece of information that we would need Ricky, is how old you are. If you are over fifty nine and a half and you have never done a Roth IRA conversion or contribution, 2021 would start your 5-year clock for all future conversions and contributions. If you are under fifty nine and a half, then each of your conversions would have its own 5-year clock until you reach fifty nine and a half. And then you would only be allowed to take the conversion amount out; not the earnings until you turn fifty nine and a half.
Al: Clear as mud.
Joe: Does that make sense?
Andi: It gets clearer every time you do it.
Joe: See that’s it.
Andi: Practice makes perfect.
Joe: That’s a gator right there. That’s a Florida gator education.
Al: See that’s I think one of the big keys, are you over 59 and a half or under? Because they’re different rules.
Joe: Right. Because you gotta take- it’s like a schematic.
Al: You do. Because then there’s different contribution rules versus conversion rules.
Joe: So let’s say Ricky did a Roth IRA contribution 5 years ago and he’s over 59 and a half and he does a conver- or maybe he’s 57. How about that? So he does one in 2021 when he’s 57, 2022 when he’s 58, 2023 when he’s 59. So then he’s just gotta wait till he’s 59 and a half. And then all of it’s all good.
Al: On the conversion part.
Joe: No. Because he’s over 59 and a half. It’s been 5 years. And so everything is available.
Al: Oh, I thought the first one was at 57. You’re saying he had one already.
Joe: If he had a Roth IRA contribution already.
Al: Okay. Got it.
Joe: Got it?
Al: Just to clarify. OK. Now it’s clear. To me. Fairly.
Joe: Hopefully that helps Ricky.
If you missed it, you can catch the episode that started it all, #255, Breaking Down the Confusing 5-Year Roth Clock Rules, in the podcast show notes – or just search for it in your podcast app. We’ll have a handy cheat sheet on these 5 year withdrawal rules very shortly, so if you’re visual like me and need to see it all broken down on paper, subscribe to the podcast newsletter and you’ll be notified as soon as it’s available. If you still have questions, I don’t blame you! Click the Ask Joe and Al On Air banner to send in an email or a voice message, and the fellas will answer right here on the show. How do you get to previous episodes, subscribe to the newsletter, and send in questions? The podcast show notes is where it’s at. Click the link in the description of today’s episode in your podcast app, or visit YourMoneyYourWealth.com and click “Listen to podcasts” to see show notes from every episode.
I Didn’t Track Roth IRA Contributions and Withdrew Money. Now What?
Joe: So let’s go to Joan from Tierrasanta.
Joan: ”Andi, Joe and Big Al. You are all great and make my day. This is Joan from Tierrasanta here in San Diego. Love your show. Never thought I would write in. But we are in a pickle.”
Joe: Oh boy. Don’t like to be in a pickle.
Al: It’s an emergency.
Joe: Oh boy.
Al: You should have read this one first.
Joan: ”So we have a Roth IRA and ended up pulling out some of the money. We are younger than 55. I’m married. So it’s the 2 of us. Husband, me. We have owned the Roth IRA more than 5 years. And we have never pulled that money before. And we did withdraw a lump sum.”
Joe: Okay, a couple of things. We already went through the 5-year clock. So contributions are 100% available. No questions asked. 5 years does mean nothing because they’re 55. So you make contributions. It’s 5 years or 59 and a half, whichever is longer. But if they are contributions she has full access to them.
Joan: ”We assumed too late that the investment company knew how much we had contributed over the years. They don’t. I think it’s because we rolled it from one investment company to another and closed the first account. When we call the first people they had no record of the account. Now I read online that the IRS is notified about Roth contributions.”
Joe: That’s form 5906, I believe? 5928?
Al: Maybe, I forget.
Joe: 5498. So close.
Al: You were close.
Joe: I know.
Joan: “I also read we’re responsible for tracking them ourselves. Crap. And before you ask, the old tax returns I have show nothing. Including zero old forms stashed in the old folders from the investment company. So do we have to pay not only the income tax but also the 10% penalty for this entire withdrawal? We know some was the initial contributions. Can we guess? What proof does the IRS accept or require? And can the IRS tell us how much we contributed? Your show is wonderful. Keep up the great work. And I really look forward to hearing your reply. Thanks. Bye.”
Joe: All right Joan. It’s not as bad as you might think but I don’t know how big of a lump sum you took.
Al: Yeah true.
Joe: And how long they have been contributing to Roth IRA.
Al: Yeah. So let me give you Joan- here’s my thoughts as a CPA is take your best guess. You said you know some contributions. Just start a little Excel spreadsheet or something of year by year put down first of all what you know. And so that’s a for sure thing.
Joe: First of all, it’s not going to be on your tax return now because you never took a deduction.
Al: No and actually the custodians don’t necessarily have to keep track of that anyway. So let’s not throw them too much under the bus. But the thing is the years that you probably put some contributions in and you’re not sure, just make your best guess and go with that. Here I’ll give you a little tip. Hopefully the IRS isn’t listening. They don’t have a lot of resources to check this stuff. So don’t go crazy. I mean really try to do this as accurately as you can and have reasons why you came up with the dollar amounts that you came up with. And then once you’ve done you that analysis put it in a drawer somewhere and that’s your number. And then as you add more contributions to it keep track of that.
Joe: Because it’s FIFO tax treatment, first in first out. So let’s just assume Joan you took out $30,000 but you’ve been making Roth IRA contributions since 1997 and they started out at $1600 and they went to $2000. Then they went to $2500. Then they went to $3000, $3500, $5000, so on. And so you add up all of your contributions over the years and you’re like you know what. We probably put in about $30,000 of contributions and we have growth here because we pulled $30,000 out, the account balance is about $60,000 because it doubled over the last let’s say 20 years and so on. And so from there the $30,000 that you pulled out would match your contributions. So taxes owed would be zero. If let’s say that you figured out your contributions was $20,000. Well then you would have to pay tax and penalties on the $10,000. So it’s not going to be on the entire amount. You need to figure out roughly- if it’s a lump sum- the Roth IRAs hasn’t been around for 50 years so you can only put a couple of dollars in. If you said you converted a bunch too then it could get a little bit more complex. But hopefully that helps because I don’t think it’s going to be as bad as she thinks.
Al: Yeah and a lot of people don’t really know it FIFO tax treatment is but basically it just means your contributions that come out tax free, you get those first. And so whatever the earnings and growth is that comes out second so all your contributions come out first. And so that’s a perfect example- you took out $30,000 and you determine your contributions were $20,000. So the first $20,000 is tax free. It’s only that extra difference, the growth since you’re not 59 and a half, that’s taxed and penalized.
Joe: Right. So when you do your taxes you would say all $20,000 was basis, tax free. $10,000, pay taxes and penalties on.
Al: Now some people put in let’s say $6000 a year for 3 years. They got $18,000 in; it’s grown to $20,000. They have some kind of financial emergency, they pull out $15,000. That whole $15,000 is tax free, penalty free, because it’s less than your basis.
Joe: The original basis. There you go, Joan.
Roth IRA Rollover Consequences
Joe: Chidam. I remember him. Gave us a terrible review, said we sucked.
Andi: And then took it back.
Joe: He was like “oh my bad.”
Al: “I was thinking of another show.”
Joe: Because we like to read the negative reviews. We giggle too much and we got annoying.
Al: We do. Especially you. My voice is awful. It’s so bad. I try to switch it up every now and again. I try to go a little bit deeper.
Al: That’s better. I like that. That matches mine. So I all the time people come up to me and you got a great-good radio voice. You get that?
Joe: Never. Never.
Andi: Does anybody tell you guys you have faces for radio?
Al: Yes, all the time.
Joe: That’s a good one, Andi. Never heard that one before.
Al: We used to say that- we used to say that until we started doing the TV show. Then I guess we upgraded somehow. We wore makeup. No lipstick though.
Joe: He’s calling in from Louisville, Kentucky. Well we found that out from in the area code. So-
Andi: We ask people for their phone number on the form and so I go based on the area code.
Joe: No we’re not going to call you. We would just like to know where you’re from. That’s kind of the rules of our show that we’d like to know. Then we could talk about- gets people in the mood. Because when I start reading the question they’re going to be thinking about like Kentucky bourbon. That’s what I’m thinking about right now.
Al: I’m thinking about a baseball bat.
Andi: That’s what I was thinking too. And I’m not even into sports.
Al: Louisville Slugger.
Joe: Huh. OK well that shows you kind of our differences.
Al: I know what you think about.
Joe: Got it. “Joe and Al. I’m a regular listener of your podcast. You both combined with Andi make it very interesting and informational. Good job. My question is about after tax contributions. My wife’s employer allows for after tax 401(k) contributions. This is separate from Roth 401(k) which I’m aware of. My plan is to contribute to after tax 401(k) and roll this over to a Roth IRA when she eventually leaves the employer. Employer does not allow in-service rollover at this point. Since she already has some traditional IRAs as of now, will there be any consequences like the pro-rata rule for a Backdoor Roth? Do existing IRA balance affect my plan after tax 401(k) roll over to Roth? Please educate me on this great show every Tuesday. Kudos to you and the team.” Well thank you Chidam. No there’s no pro-rata rules because they’re two separate accounts. You got an IRA that’s under one tax law; you got section 401(k) which is under something completely different.
Al: But that is confusing. So any IRA needs to be aggregated as if it were one IRA. But that rule does not count when it’s a 401(k) or a 403(b), for example.
Joe: You could have multiple 401(k) accounts with multiple after-tax contributions in it and there’s no pro-rata rule.
Al: Correct. Agreed. It’s only in the IRA world.
Joe: Correct. And I would double check the in-service because most cases Chidam, after-tax dollars are always- not always. What’s-
Andi: Usually. Commonly.
Joe: Often available. Maybe she doesn’t have access to the full amount but the after tax dollars are often available to put into a Roth.
Al: And the sooner that she can do it the better, because then all the future growth in the Roth is tax free.
Joe: So for those of you that have after tax contributions in a 401(K) plan or have the ability to put after tax contributions into a 401(k) plan our advice is always to take a look and potentially encourage for individuals to do that. Because then you could take those after tax contributions and directly convert those into a Roth like Chidam is asking us.
Al: What do they call that? A mega Roth?
Joe: That’s a big big ass back door. It’s a barn door. It’s a barn.
Al: It’s a barn door. Okay.
Joe: Yes. It’s a barn door conversion. Not a backdoor, a barn door. A barn door Roth. So yeah, double check that because- so she could put money after tax, those dollars in the 401(k) plan. And then you convert those directly into the Roth. So you could put up to around $50,000 into a defined contribution plan so she could do a Roth IRA or Roth 401(k) up to the max. And then she could put double that just about of after tax contributions, take the after tax contributions and convert them. Or if the plan truly doesn’t allow an in-service distribution on those after tax dollars, which I’ve never seen but never I’ve never practiced in Kentucky, so I’m not sure what employers she works at. But it’s a great strategy. He listens to a lot of podcasts because I think he got us confused with some other.
Joe: Has to. Hopefully- the pressure was on because I want to- hopefully he gives a nice comment.
Al: I wouldn’t hold your breath right now.
Thank you Chidam and everyone else for listening today and every week, we appreciate the fact that you keep coming back to laugh with us and hopefully learn a little something along the way. We’ve got plenty of derails at the very end of today’s episode whether you love ‘em, hate ‘em, Joe kinda likes that anyway.
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