The “Trump-era tax cuts” are set to expire in 2026.
In other words, retirement savers only have two more years to take advantage of today’s lower tax rates.
One of the popular strategies to do this is through (aggressive) Roth conversions.
As a result, I’ve had more questions than ever about the wildly confusing “Roth IRA 5-year rule”…
…specifically, as it relates to Roth conversions.
To help simplify this rule, I’m sharing TWO simple questions you can answer to understand how the rule works.
I’m also sharing several real-life examples + my thoughts on what an election year might mean for the Tax Cuts and Jobs Act (TCJA).
Need Tax + Retirement Planning Help?
We specialize in helping people aged 50+ lower taxes, invest smarter, and (safely) create a retirement paycheck.
Our Free Retirement Assessment™ will answer your BIG questions and help you properly evaluate our firm.
Click the banner below to learn more. 👇
How to Listen to Today’s Episode
🎤 Click to Listen via Your Favorite Podcast App
Episode Resources
📫 Join the Stay Wealthy Retirement Newsletter!
- Roth Conversions:
- Stay Wealthy Roth Conversion Series: Part 1 and Part 2
- 5 Reasons NOT to Do a Roth Conversion
- 3 (More) Reasons NOT to Do Roth Conversions
- Roth Conversions Make Sense at Today’s Low Tax Rates
- Roth IRA 5-Year Rule Explanations:
- Tax Cuts and Jobs Act (TCJA)
Episode Transcript
Roth Conversions and the 5-Year Rule (Explained!)
Taylor Schulte: On December 22, 2017, former President Donald Trump signed the Tax Cut and Jobs Act into law.
In short, TCJA as it’s often referred to, reduced taxes for individuals, corporations, and estates.
In addition to many other changes to the tax code, this Act temporarily reduced tax rates at almost all levels of income and shifted the thresholds for several of the income tax brackets.
For example, the 25% federal tax bracket was reduced to 22%, and the 28% bracket was reduced to 24%.
As it stands, the tax bracket changes are set to expire (or sunset) in 2026. In other words, we only have two more years – this year and next year – to take advantage of lower tax rates before they jump back up to prior levels.
One of the popular ways retirees have taken advantage of lower rates is to aggressively pursue Roth conversions before tax rates go up again.
As a result, I’ve had more questions than ever about the “5-year rule,” specifically as it relates to Roth conversions. Podcast listeners and newsletter readers remain wildly confused about this rule, and I don’t blame them. It’s confusing, and often poorly communicated and covered throughout the mainstream media.
Welcome to the Stay Wealthy podcast, I’m your host Taylor Schulte, and today, once and for all, I’m going to set the record straight on the Roth conversion 5-year rule.
I’m also going to share some brief thoughts on the expiration of the Tax Cuts and Jobs Act, with 2024 being an election year.
And given the very understandable confusion around the Roth IRA 5-year rules, I’m sharing a one-page flow chart with all Stay Wealthy newsletter subscribers this week. This flow chart will allow you to quickly determine how the 5-year rule applies to your exact situation.
If you’re not a newsletter subscriber and want a copy of the flow chart, just head to youstaywealthy.com/email. That’s youstaywealthy.com/email. In addition to cheat sheets and resources like this one, I also personally write and send a retirement-focused article every single week. So, if you enjoy this show, I’m confident you’ll also enjoy the weekly email.
Lastly, as always, to grab the show notes for today’s episode, just head over to youstaywealthy.com/213.
In early 2022, I published an in-depth, two-part series on Roth conversions. I also published two episodes on reasons why you might not want to pursue them.
If you missed the episodes or want to listen again, I’ll link to them in today’s show notes for quick access.
Now, while I’m a huge fan of Roth conversions – especially if there’s an opportunity to pursue them while tax rates are low – I like to highlight that this strategy isn’t going to fix a broken retirement plan. For someone who has a healthy plan, Roth conversions are one of many strategies that can potentially reduce the amount a person pays to the IRS between now and end of life. It’s also a way to create more tax diversity and tax-efficiently give to heirs at the end of life if that’s a goal.
At the end of the day, it’s impossible to guarantee the long-term outcome of Roth conversions. We are, after all, making assumptions about the future. They are – or should be – well-informed and educated assumptions, but they’re still assumptions.
So, as you explore this opportunity, or as you evaluate recommendations from financial professionals, please keep this in mind. Roth conversions can be a powerful way to optimize your plan, take control of your tax bill, and avoid leaving the IRS a tip, but they aren’t this magical strategy that will make up for overspending or undersaving.
With that reminder out of the way, let’s dive into the 5-year rule, specifically as it relates to Roth conversions.
First, to ensure everyone is on the same page, just a quick recap of the Roth conversion process. Not a Roth Contribution but a Roth Conversion.
A Roth conversion is the process of transferring (or converting) money that you already have in a pre-tax retirement account (like a Traditional IRA) into an after-tax Roth IRA. Yes, the IRS allows this transfer, but the catch is that you’re required to pay the tax bill on the amount of money that is removed from the Traditional IRA in the tax year the conversion was processed.
So, if I convert and transfer $100k from my Traditional IRA into my Roth IRA in 2024, I have to pay income taxes on that $100k next April when I file my taxes. And that should make sense. Money in your pre-tax IRA has never been taxed, so the IRS wants their share if you are going to move it out of the pre-tax account.
But, naturally, as you consider pursuing a conversion, it’s common to wonder about the rules and restrictions for withdrawing money from your Roth IRA after a Roth conversion has been executed. And this is where the questions and confusion about the Roth IRA 5-year rule begin to surface.
The root of the confusion often lies in the fact that there are two different Roth IRA 5-year rules out there. One for Roth conversions, and one for Roth contributions. Conversions and Contributions are two very different transactions. And journalists, media outlets, and financial influencers often get them twisted and/or fail to clearly spell out the differences between the two.
While the two 5-year rules are intertwined and overlap, I’m strictly focused today on explaining how to interpret them as they relate to Roth conversions. If you want to learn more about each rule independently, or you have a unique scenario, I’ll link to a couple of good articles in the show notes which again can be found by going to youstaywealthy.com/213.
That said, the one rule that affects both Roth IRA contributions and Roth conversions that you do need to take note of is that any earnings inside of your Roth IRA (i.e., the growth of the dollars invested), cannot be withdrawn until age 59 ½ or older without incurring taxes and a penalty. (Yes, there are some unique exceptions out there, but we’ll push those aside for now).
Just know that you can always withdraw your Roth IRA contributions without penalty or tax or any restrictions. Withdrawing dollars from a Roth conversion is where the nuances lie, and that’s what we’re going to zone in on.
So, the 5-year rule as it relates to Roth conversions. It really is pretty simple. You just need to answer two important questions:
1. Do you currently have a Roth IRA that was funded with any dollar amount at least 5 years ago?
2. Are you 59 ½ or older?
If the answer is “yes” to both questions, you don’t have any restrictions or limitations on withdrawing converted dollars from your Roth IRA. In fact, you can withdraw money you’ve converted from a Traditional IRA, you can withdraw prior Roth contributions you’ve made, and you can even withdraw earnings from your Roth IRA, all without any taxes or penalties. You’re in the clear.
For example, if you converted $100,000 to a Roth IRA today, and you answer “yes” to both of those questions, you could withdraw the entire $100k from your Roth IRA tomorrow without any restrictions or penalties. If you decided not to withdraw it right away, and that $100,000 grew to $120,000 over the next year or two, you’re also able to withdraw the $20,000 of growth (or earnings) without restrictions or penalties.
If they exist, you can also withdraw any other prior contributions you’ve made to your Roth IRA when you were younger as well as the associated growth or earnings from those contributions…all without penalty or taxes.
As long as you are over age 59 ½ and have funded a Roth IRA with any dollar amount 5 or more years ago, you don’t have to worry about any tricky withdrawal rules getting in your way.
Now, let’s look at another scenario. Let’s say your answer is “no” to the first question but “yes” to the second question. In other words, you do NOT currently have a Roth IRA that’s open and funded, but you’re over age 59 ½.
In this scenario, if you opened a Roth IRA this year for the very first time in your life, and immediately did a $100,00 Roth conversion, you would need to wait 5 years to withdraw any of the investment growth associated with that $100,000 conversion.
You can withdraw the $100,000 conversion amount at any time, you already paid the tax bill on it, and you’re over age 59 ½, so you can take your converted dollar amount out whenever you want. The IRS doesn’t care.
However, you’ll need to wait 5+ years from the year of your conversion in order to withdraw any of the growth associated with that $100,000 to avoid taxes and penalty.
For example, if the $100,000 conversion is invested in the first Roth IRA you’ve ever opened and funded, and it grows to, let’s say, $120,000, you’ll need to wait 5+ calendar years from the year you did the conversion in order to withdraw the $20,000 of growth in order to avoid ordinary income taxes and a 10% penalty.
Although you are 59 ½ in this conversion example, you need to have a funded Roth IRA at any time in your life for at least 5 years to be able to withdraw the earnings from your conversion penalty and tax-free.
Now, let’s flip it around. Let’s say you answer “yes” to the first question but “no” to the second question. In other words, you opened and contributed to a Roth IRA 5+ years ago, but you’re under age 59 ½.
Since I’m strictly focused on Roth conversions today, I’m going to keep it really simple and say that the Roth IRA was originally funded with $1. In other words, the original contribution started the 5-year clock, but the dollar amount isn’t meaningful or important here.
So, your Roth IRA was opened and funded with $1 five+ years ago, but you’re under age 59 ½. In fact, you are well below 59 ½, you’re 45 years old.
So, you’re 45 years old, and your Roth IRA was opened and funded with $1 five+ years ago.
In this scenario, even though the Roth was opened and funded 5+ years ago, every Roth conversion you do is going to have its own 5-year clock…and that’s because you’re under age 59 ½.
For example, if you do a $50,000 Roth conversion this year at age 45, and decide to take a $25,000 withdrawal from your Roth IRA in three years at age 48, the $25,000 withdrawal will be hit with a 10% early distribution penalty. To avoid the penalty on the withdrawal of the $25,000, you would have needed to wait 5 or more years from the year you did the conversion.
It’s important to note that each subsequent conversion you do in future years will be treated similarly. In other words, if you do another $50,000 Roth conversion next year, at age 46, that conversion will start its own 5-year clock. Each conversion you do under age 59 ½ will have its own 5-year clock.
Again, I kept the example simple by saying that your original contribution you made 5+ years ago was $1. And that’s because the IRS has an order of operations when you go to take withdrawals from a Roth IRA and wanted to isolate the conversion. But in case you’re wondering about the order of operations, here’s how it works:
When you take a withdrawal from a Roth IRA,
-Roth IRA contributions come out first
-Roth conversions come out second
-And finally, earnings or growth on your money in your Roth IRA will come out last.
Remember, you can always withdraw your contributions from a Roth IRA without any restrictions or age limits. For example, if you contribute $5,000 to a Roth IRA, and one day later, or one year later, or even 10 years later, you want that $5,000 contribution back, you can withdraw it without penalty or taxes.
Going back to that last example, if we tweaked the scenario slightly and said that the total amount of contributions you made to your Roth IRA 5+ years ago totaled $25,000 instead of just $1, well, three years after your $50,000 Roth conversion at age 48, you could have taken that $25,000 withdrawal you wanted free in clear. No tax, no penalty. And that’s because of the order of operations I just explained. That $25k withdrawal would have represented your prior contributions, not your recent Roth conversion since contributions will come out first
Now, let’s look at a more unique scenario that sometimes trips people up. Let’s use the same example we just went through, but instead of being age 45, let’s say you’re age 58.
So, you opened and funded a Roth IRA with a meaningless $1 contribution 5+ years ago, and you’re 58 years old. This year, at age 58, you do a $50,000 Roth conversion. Two years later, at age 60, your Roth IRA has grown from $50,000 to $60,000, and you decide to liquidate and cash out your Roth IRA.
Contrary to what many people think, you can do this without any restrictions, taxes, or penalties because you are now able to answer yes to both questions: you have a Roth IRA that has been opened and funded for 5+ years and you’re now over age 59 ½.
This one trips people up because the conversion was done at age 58, and according to the rules, started a 5-year clock. But after you turned 59 1/2, the clock doesn’t matter anymore because you can answer yes to both of the two questions. You funded a Roth IRA 5+ years ago and you’re over age 59 ½.
I recognize that these 5-year rules are wildly confusing. And I think one reason why they’re met with so much confusion is that the “why” behind these rules is rarely discussed. When you understand why they exist, the rules often make more sense.
So, why do they exist? Let’s walk through one final example/scenario based on our two questions to better understand why it exists.
Let’s say I’m 40 years old and I do not have a Roth IRA. In other words, I answer “no” to both of our two questions. I’m under 59 ½ and I don’t have a Roth IRA.
While I don’t have a Roth IRA, I do have a pre-tax Traditional IRA with $100,000 in it. If I wanted to withdraw that $100,000 today, I would have to pay ordinary income taxes on the withdrawal, and I would also have to pay a 10% early withdrawal penalty since I’m not 59 ½.
Now, remember, unlike Roth contributions, anyone, at any age, can do a Roth conversion of any size. So, if the 5-year rule didn’t exist, I would be able to get my hands on that $100,000 of pre-tax money right now without paying the 10% penalty, I could just convert the $100,000 from my Traditional IRA to a Roth IRA and then subsequently withdraw it.
But since the 5-year rule does exist, I can’t do that. I would have to convert the $100,000, dig into my savings to pay income taxes on the $100,000 in the current, and then I’d have to wait 5-years to be able to withdraw the $100,000 converted amount from my Roth IRA penalty-free.
So, yes, I’m still able to access this $100,000 at age 45, well ahead of turning 59 ½, but I had to cut a nice check to the IRS 5 years prior and then sit and wait. That doesn’t really benefit me if I’m in dire need of money and need to raid my retirement accounts. It’s hard to get money into a Roth IRA, and if I’m going to go through all of this effort to do a conversion, pay the tax bill, and wait five years, I’d probably do everything I can in those 5 years to get my finances in order so I don’t have to touch that money.
Once I get money into a Roth IRA, whether it's through a contribution or conversion, I want it to grow tax-free for as long as possible.
To summarize, the 5-year rule exists to prevent someone who is under the age of 59 ½ from accessing pre-tax retirement account dollars without penalty. Thinking about your scenario through that lens and referencing the order of operations on Roth IRA withdrawals should help you arrive at the right answer.
And if there is one key takeaway for everyone here, it’s that you should consider opening and funding a Roth IRA as soon as possible if you think Roth conversions might be something you want to pursue in the future. Opening and funding a Roth IRA with any dollar amount will begin that 5-year clock and help you satisfy question #1 in the two questions that helped drive all of the scenarios.
Ok, before we wrap up today’s episode, I want to briefly discuss the Tax Cuts and Jobs Act and what may lie ahead.
As noted at the top of the show, this law, and the associated tax cuts are set to expire in 2026. By expire, I mean that tax rates, as it stands today, will be going back up. The 22% federal tax bracket will revert back to the 25% and the 24% will revert back to 28%.
Assuming these tax cuts do sunset as planned, retirement savers would be wise to seriously explore roth conversions this year and next year if they aren’t doing so already.
But what if things don’t go as planned? With 2024 being an election year, it’s anyone's guess how things might play out. Republican or Democrat, it’s unlikely that the newly elected president wants to be blamed for higher tax rates – especially if those higher tax rates on individuals cause harm to the economy.
Julio Gonzalez, CEO and Founder of Engineered Tax Services recently warned of a “harsh reality” facing Congres, stating, “We’re in a situation in which many American families and businesses are hanging on by a thread. Letting the non-permanent provisions of the Tax Cuts and Jobs Act expire could be catastrophic to our overall economy and the well-being of many working families.”
In addition to the potential negative impact to our economy, the US government's balance sheet is also at the top of the list for existing and income leaders in Washington DC. Higher tax rates will of course lead to more revenue which might just be what’s required to balance the budget.
So, while the Trump-era tax cuts are currently set to expire in 2026, we truly won’t know what the outcome will be for another year or two.
Given that, what does this mean for retirement savers who are considering aggressive Roth conversions these next two years?
Well, at the end of the day, TCJA or no TCJA, Roth conversions are a bet – a bet on future tax rates. Or, more specifically, a bet on your future tax rates. If your tax rates will be higher in the future than they are today, then the Roth conversion bet will pay off. As Ed Slott wisely put it,
“Roth conversions, I believe, are really just something I call “tax insurance.” You’re insuring against the uncertainty of what future higher tax rates could do in retirement to you.”
Remember, there’s no way around paying taxes on your pre-tax retirement dollars. You can either pay them now on your terms, or wait for the government to tell you when to pay them. And if you don’t pay some or all of the taxes now, your tax liability will just continue to grow. In other words, as your pre-tax IRA gets bigger and bigger so to does the amount you will owe the IRS in the future. You owe the government money – do you want to pay them back on your terms or on their terms?
In addition, depending on your goals, paying taxes on your pre-tax money now and getting the funds into a Roth IRA to grow tax-free might be an important factor in your decision. Because if you don’t do any Roth conversions now, and you wait for the IRS to come knocking on your door in the form of Required Minimum Distributions at age 73 or 75, you won’t have that same opportunity to get money into a Roth IRA.
You cannot satisfy a Required Minimum Distribution by doing a Roth conversion. And once those required distributions begin (at either age 73 or 75), your tax situation is pretty much set in stone. There’s not much you can do once they kick in to manage and reduce taxes in retirement outside of charitable giving and managing your investments tax-efficiently in your taxable brokerage account.
Depending on the size of your pre-tax IRA, those RMDs might also trigger new phantom taxes such as Medicare IRMAA in your 70s and beyond. If IRMAA surcharges kick in as a result of large required minimum distributions, those surcharges are likely to continue until end of life.
So, while we don’t know for sure what will happen with the Tax Cuts and Jobs Act, there are a number of other factors to take into consideration when determining if it makes sense to pursue Roth conversions these next two years and beyond.
Most notably, do you think your tax rate will be higher in the future than it is today and does getting money into a Roth to grow tax-free support other goals you have. What is most important is that you take the time to go through the exercise each and every year (sometimes multiple times per year) to determine if Roth conversions make sense for you and your plan. If you need help, consider leaning on a professional.
My team and I have the capacity to help a handful of new families this year and continue to offer a Free retirement and tax analysis to those who want to properly evaluate our firm. You can go to freeretirementassessment.com to learn more or visit the Stay Wealthy website and click the work with me button.
As always, if we don’t appear to have the right expertise to help – or you aren’t interested in hiring a full-service firm like ours – shoot me an email at podcast@youstaywealthy.com and I’d be happy to help. I read and respond to every email.
Ok, I know we went through a lot today and I hope you found it helpful. Please let me know if you have any questions or if I missed something in this episode that should be clarified.
And don’t forget to join the Stay Wealthy newsletter if you haven’t already. All newsletter readers will receive my freshly updated Roth IRA 5-year rule flowchart so they can easily determine exactly how the rules impact their unique situation.
Once again, to join the newsletter, just head over to youstaywealthy.com/email. I’ll also provide a link directly in your podcast app in the episode description for quick access.
Thank you, as always, for listening and I will see you back here next week.
Episode Disclaimer: This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.