Do a Roth rollover? Beware of the 5 year rule

The Roth IRA has been called the “Swiss Army Knife” of personal finance because of its flexibility and the tax-free status of your earnings. That’s why so many retiring workers move to transfer their workplace 401(k) accounts to a Roth account, and why so many financial advisors recommends converting a traditional IRA to a Roth.

The idea is that if you pay income taxes on your retirement money now, especially when many account balances are significantly low, your tax-free Roth earnings will make up the difference and possibly more.

But beware of the 5 year rule.

Below we’ll walk you through the ins and outs of the 5 Year Rule, but consider contacting a vetted financial adviser for free for more help managing a Roth rollover and other retirement needs.

The 5 Year Rule: What You Need to Know

While contributions to a Roth can be withdrawn at any time, you can’t touch earnings unless the account has been open for at least five years. So, if you’re rolling over another retirement account to a Roth IRA in 2023, make sure you won’t need the earnings until at least 2028. If the rollover account is your first Roth IRA or you opened your first Roth less than five years ago years, earnings will be taxed when withdrawn. One break is that even if a Roth that opened more than five years ago closes, it still counts toward the 5-year rule.

And yes, the 5-year rule counts even if you’re over age 59.5—you must meet both requirements or you’ll lose earnings tax relief.

If you’re thinking of converting an individual retirement account to a Roth, it’s even worse. The 5 year rule Roth conversions requires you to wait the full five years before retiring none converted balances (contributions or earnings) regardless of your age.

That doesn’t diminish the appeal of a Roth account for people who want more control over their investments than they get through a workplace. 401(k) or a 403(b) plan, which may be limited to a few mutual funds owned and operated by the plan sponsor, a complete lack of cheaper ETFs, employer matching contributions attached to company stock , as well as no control over the choice of rates charged to your account.

Another reason investors choose a Roth transfer or conversion is when they want to avoid the Required Minimum Distribution Rules (RMDs) that activate at age 72, even in Roth 401(k) accounts. The Roth IRA is exempt from RMD requirements, allowing money you would have been forced to withdraw to continue earning money.

One issue investors face when planning a Roth rollover or conversion is the income limits that apply to contributions if your adjusted gross income (AGI) from your tax return is more than $144,000 for a single taxpayer or $214,000. for joint declarations. With a 401(k) or similar plan, the solution is an exemption called “in-service distribution.” If you’re over 59.5 and still working, you can withdraw or roll over money from your 401(k). Most plans allow these distributions under certain conditions, such as financial hardship, and many also allow distributions for participants age 59.5 and older, but not everyone, so you’ll need to check with your plan sponsor.

For Roth conversions from a traditional IRA, you can get around the income limits with what’s known as backdoor Roth conversion. You may want to do it sooner rather than later since some members of Congress have been working to close the back door loophole since a time ago. If you are doing a Roth conversion, you will also need to be careful with the “pro rata” rule in the first five years, which applies to account conversions that include pre-tax deductible contributions and non-after-tax deductible contributions. A trick that may work in that case is to convert only a small amount during the first five years.

As always, tax and investment strategies can be complex and depend on each individual’s situation, so consult a tax or financial adviser first.

Bottom line

Converting a traditional IRA to a Roth can be advantageous to many in light of the latter’s flexibility and tax-free status of earnings. But while contributions to a Roth IRA can be withdrawn at any time, remember that you can’t touch earnings unless the account has been open for at least five years, even if you’re age 59.5 or older.

Retirement Planning Tips

  • Consider talking to your Financial Advisor about the best ways to manage retirement assets and taxes if you’re considering a Roth conversion. Free SmartAsset Tool connects you with up to three vetted financial advisors serving your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find a counselor who can help you reach your financial goals, start now.

  • A Roth IRA conversion is not the same as an IRA rollover. With a rollover, you’re moving money from one similar retirement account to another. For example, if you leave your job, you may decide roll your traditional 401(k) assets into a traditional IRA. Or you can convert a Roth 401(k) to a Roth IRA. The IRS limits how often you can transfer funds. Generally, you cannot make more than one rollover from the same IRA in a one-year period.

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