I’ve been watching my boys play football for years, and I LOVE watching them, but I still struggle with many of the rules.
Recently, I’ve been trying to figure out punt return vs kick return and when you are supposed to touch the ball vs not touch the ball and just let it roll. Go ahead football aficionados, have your laugh.
No matter how many times my husband explains it, or I ask my football guru friend Tricia what is happening, I can never seem to keep it straight.
I mention this because instances like this help me to remember how my clients might feel when I am spurting out planning concepts and recommendations for them.
One topic area that can be difficult to keep straight, even for us advisors, is the rules surrounding Roth IRAs.
Read on to see how I will now differentiate between a punt and kick return.
When it comes to Roth IRAs, there are TWO ways they can be funded and TWO “5-year rules” that must be differentiated when it comes to distributions from the IRA.
But like the punt and kick return, they may seem like the same thing, but they are not, which is what leads to the confusion.
First, some differences between the two ways a Roth can be funded:
- Contributions are made with after-tax dollars.
- Contribution amounts are limited each year by the IRS.
- If you earn too much (according to the IRS), your contributions may be phased out, or you may not be able to directly contribute to a Roth IRA at all.
- Your CONTRIBUTIONS can be withdrawn at any time, penalty free (but the goal is to keep them in!)
- Conversions are typically made from an IRA. You are converting from a “pre-tax” account to an “after tax” account.
- Conversions are not limited by amounts or income levels. You can convert as much or as little as you want at any time, regardless of how much you earn (this is the rule that allows for the back door Roth strategy)
- Since you are converting pre-tax dollars, you must pay taxes on the amount being converted in the year it is converted.
Now here is where the PUNT RETURN analogy comes in – Don’t touch it, just let it roll.
There are two 5-Year Rules for Roth IRAs.
5-Year Rule #1 – Pertains to Growth only (for both contributions or conversions)
For the GROWTH in your Roth IRA to become what is called a QUALIFIED DISTRIBUTION (tax and penalty free distribution), two conditions must be met:
- 5-Year Rule #1 – the account must have been open for at least 5 tax years (there are favorable rules around when the clock starts on the 5-years). AND
- The IRA owner must be 59.5 or older (or totally disabled; a few other exceptions exist)
Don’t touch it, just let it roll.
5-Year Rule #2 – Pertains to the CONVERSION amounts
The SECOND 5-year rule pertains to whether the amount you converted can be withdrawn penalty free. Unlike Roth CONTRIBUTIONS that can be taken out penalty free at any time, you cannot pull your conversion amounts out before the 5-year clock is up (unless you are 59.5 or older),or you will pay a penalty on the withdrawal.
Don’t touch it, just let it roll.
It’s too much to dive into the specifics on the ”start clock” for the two 5-Year rules, but know that even the start clock rule has rules. But the gist is… Don’t touch it, just let it roll.
Ultimately, the rules for Roth IRAs exist to keep the “spirit of the law” in place to prevent misuse of this type of tax advantaged account.
But when managed effectively, and in the right situations, Roth contributions and conversions can offer great planning opportunities for many clients.