One way or another, Individual Retirement Accounts will be involved in retirement planning these days. Whether you want to roll over a 401(k), time your withdrawals optimally, or make catch-up contributions, your IRA strategy may be one of the key components of your income strategy. However, there is a little-known timing strategy to get more out of a Roth IRA
What is the Roth IRA and When is it Useful?
Roth IRAs are governed by Title 26 §408A of the Internal Revenue Code and allow you to withdraw funds tax-free after a certain age and time period. Roth IRAs are funded with post-tax dollars, so your contributions are still considered income (i.e. you can’t deduct them from your tax return). Compare that to Traditional IRAs, to which contributions are pre-tax (i.e. you can deduct them) but all withdrawals are taxable. You should also be aware that there are limits to how much you can contribute that reset each year.[1]
Traditional IRAs and Roth IRAs are often used together as part of a retirement income strategy. You can throttle distributions between the two to control taxable income and manage your tax brackets over the course of your retirement.
Why Open a Roth at the End of the Year?
Your timing on when you open a Roth IRA matters as you approach your sixties. Early distribution penalties disappear after age 59.5, but there is a unique five-year timing rule that applies only to Roth IRAs. The account needs to be open for at least five tax years if you’d like to withdraw your earnings tax-free. It’s a strange rule, but the investment gains in your Roth are only tax-free if you’ve had the account open for at least five tax-years (though you can withdraw your contributed principal tax and penalty free at any time).
The tax-year rule is key because it ignores the month in which you contribute. For example, if you make your first contribution in 2022 then your first tax-free distribution of earnings comes in 2027. But there is no difference in the eyes of the IRS between contributing on January 1st or December 31st, even though the difference is essentially a year. This means you can shorten the five-tax year period by contributing on a calendar basis in December of 2022 and withdrawing in January of 2027 (as little as three years and two days!)
But, you still need to be at least 59.5 to avoid the early distribution penalty on those earnings. Which means that you need to get a move on and open a Roth IRA if you are approaching age 59.5 and want to avoid taxes on earnings in your early sixties!
How do you know its earnings coming out of the Roth?
Not everyone plans to take distributions within five years of opening a Roth. Even still, the best practice is to open an account early just to start the clock. It doesn’t matter how much you contribute, either. Throw $50 in a Roth to get it going. Put yourself in a position not to have to sweat the small stuff.
However, if you do need to pull funds out within the first few years, how do you know what you’re withdrawing? Is it the earnings or is it the principal you put in there yourself? Fortunately, there is a defined pecking order to what comes out first from a Roth:
Earnings are last on the list. These accounts tend to work best when you delay taking distributions, but if you don’t need to raid your piggy bank and take from the Roth early on you may still avoid taxes by withdrawing just what you put in.
Timing it well
You can also double up at year end if you plan well. Roth contributions can be made as late as your tax filing deadline (April or October with extensions), but Roth conversions must be done on a calendar year basis. You can complete a conversion on December 31st and another on January 1st to split tax years and lessen the hit the conversion will have on your taxable income.
Your IRA strategy may be crucial to your retirement plan, but there is no one right way to do it. Your age, income, objectives, net worth, and even marital status play into the optimal outcome. Your situation is unique and your finances will be too, so if you have questions about whether a Roth IRA can work for you, then sign up for a complimentary review with us today!
[1] https://www.investopedia.com/retirement/roth-vs-traditional-ira-which-is-right-for-you/
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