Should I open a Roth IRA before I retire?
Q: A colleague told me to open a Roth IRA before I retire, otherwise my Roth 401(k) will be taxed if I use any of it five years from now. Is that true and if so how do I do that if my income is too high to open a Roth? I’ve been funding this for 10 years, so the amount in it isn’t small.
–Seth in Taos
A.: Seth, there are some five-year rules that apply to Roth accounts. I’m only going to address two of them today. If you plan to just let the Roth grow, these rules can become irrelevant.
The first five-year rule applies to Roth 401(k) accounts. It states that income is taxable if it is distributed before the age of 59 or if the account has not existed for at least five years. You did not state your age, but as you have been contributing for 10 years, profit distributions would only be taxable if made before you turned 59.
It is important to note that contributions are not taxed and in the event of a distribution, contributions are distributed first. Because contributions were made with after-tax monies, these distributions would be received tax-free.
A similar five-year clock applies separately to Roth IRAs. If the Roth IRA that would receive the rollover is your first Roth IRA account or it has been less than five years since you opened your first Roth IRA account (even if that account no longer exists), the returns are subject to in the case of distribution, the 5-year period has elapsed.
What I suspect your colleague is referring to is that by opening a Roth IRA now, when your Roth 401(k) is transferred to a Roth IRA, you have already started that five year clock. Again, contributions come out first, so you still have tax-free access to some funds even if the Roth IRA was your first Roth IRA.
You may be wondering, if you’ve met the five-year 401(k) rule, why would you transfer the funds to a Roth IRA? The two most common reasons are better investment opportunities and avoiding required minimum distributions (RMD). Unless you are still working and eligible for a delay, you will be subject to RMD at age 72 in the Roth 401(k) accounts. There is no RMD on your individual Roth IRA.
If you view the RMD as an unnecessary annoyance, chances are your intent is to let the Roth account grow, so turning it into a Roth IRA subject to the five-year income rule may not matter.
How to put money into a Roth IRA to start this watch if your income is too high to contribute (adjusted gross income over $144,000 for an individual, $214,000 for joint applicants in 2022) are the two most common methods: “in-service distribution” or converting IRA funds into Roth IRAs. An in-service distribution allows individuals over the age of 59½ to access or roll over 401(k) funds prior to retirement. Check your plan documents to see if your plan includes such a provision.
The conversion can be from existing IRA money or a new IRA via a “backdoor Roth IRA”. Last year, a bill to get rid of the backdoor option was popular but not passed. The term “back door Roth” can also conjure up fears of the infamous “share rule”. However, you can avoid a high tax burden at the beginning of the five-year clock by converting a small amount. I saw one made for only $1.
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Dan Moisand is a financial planner at Moisand Fitzgerald Tamayo serving clients nationwide from offices in Orlando, Melbourne and Tampa, Florida. His comments are for informational purposes only and do not replace personal advice. Let your advisor advise you on what is best for you. Some reader questions have been edited to aid in the presentation of the topic.