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A tax freight train is bearing down on your retirement. To protect yourself, you'll have to harness The Power of Zero.
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Hello. David McKnight here. Welcome to The Power of Zero show. Grateful that you're with us. I'm the best-selling author of The Power of Zero, Look Before You LIRP, and the most recent addition to our Power of Zero library is The Volatility Shield. Last week, we began a discussion about 15 different things that you need to know about Roth IRAs and today, we are going to continue that discussion.
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Obscure thing about Roth IRAs, obscure little detail number nine, you cannot take an RMD from an IRA and turn that magically into a conversion. You have to take that money and now you have to deposit it somewhere. You can't count it as a conversion, you can't say, “Okay, I turned 70 1/2, I've got $1 million. My RMD that year is $36,500,” you can't go to the IRS and say, “I want to take this money and put it into my Roth conversion account.” You cannot take that money and make it into a Roth conversion.
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Now, really the ideal scenario is to preemptively convert all your IRAs to Roth so that you're never in a position where you've got so much money coming out of these IRAs by way of RMDs that you are pining to put it into a Roth IRA account. You need to do so much more preemptive planning. You cannot take that money and put it into a Roth conversion. You can, however, take that money, deposit it into your savings account, for example, and then write a check out to your traditional Roth IRAs. For example, of that $36,500, I could take that $36,500 RMD, deposit it into a checking account, and then take $14,000 out of that $36,500 and write checks to fund my traditional Roth IRA—$7,000 for me if I'm age 50 or older, $7,000 for my spouse if she is age 50 or over.
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Important rule number 10, Roth conversions—and I've got a bone to pick with the IRS about this—Roth conversions have to be done by December 31st. To avoid coming up against a hard deadline, you probably need to begin these things some time in November. Here's my bone that I have to pick with the IRS, it's pretty tough to figure out what your income levels are in November or early December. You might not have accounted for bonuses, if you are self-employed, you maybe don't know exactly what your modified adjusted gross income is going to be in November or December of that year. What the IRS is asking us to do is say, “If you're going to do a Roth conversion, do it before December 31st before you truly understand the tax implications of said Roth conversion.” You have to be mindful of that if you're planning on doing Roth conversions, and by the way, I'm obviously a huge fan of Roth conversions, especially with taxes at historical lows, taxes being on sale. I feel like 2026 are roll-around, we’ll look back on the year 2019 and say, “Why did we not take advantage of tax rates while they were historically low?”
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I'm a big fan of Roth conversions, I just wish that the Roth conversions followed rule number 11, which we're about to talk about. With traditional Roth IRAs, you have the ability to make up your mind about whether you'll do a Roth IRA by April 15th of the following year. I think the IRS is on to something here, they're saying, “Hey, people don't even know if they have the ability to do a Roth IRA until they've done their taxes. They're not going to know what their modified adjusted gross income is until they've actually done their taxes.” This is the rule that I wish they would adopt for the Roth conversion because this leads into obscure rule number 12 with the new tax cuts, they actually did away with what we call a Roth recharacterization.
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Rule number 12 is you cannot recharacterize a Roth conversion any more. It used to be back in the day, 2017 and prior, you could do a Roth conversion and then if the market tanked, it went way down, you said, “Hey, look, I just paid a lot of taxes, now my Roth IRA, my Roth conversion is not worth that much anymore, I'm going to undo it, I'm going to put it back into the IRA, let the money recover a little bit, and then maybe do the Roth conversion the next year.” You had that flexibility, guess what, those days are long gone, you can no longer recharacterize your Roth IRA. If wishes were fishes, I wish that the IRS would say, “We're no longer going to let you do the Roth recharacterization, but we're going to give you until April 15th of the following year to make up your mind as to whether you want to do the Roth conversion,” but that's not what they've done, we have to deal with the hand that we've been dealt. But it's important to recognize that you have until December 31st to make up your mind on the Roth conversion, you have up until April 15th of the following tax year to figure out if you want to do a traditional Roth IRA.
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All right, here is obscure detail number 13, Roth IRAs do not have required minimum distributions during your lifetime because you've already paid the tax, it's tax-free, what would be the point of having them make you take required minimum distributions from your Roth IRA? If you die and that Roth IRA goes to your spouse, your spouse does not have to take RMDs on your Roth IRA which is great, you can just take that money at your leisure. However—and here's point number 13—if you die and that money goes to a non-spouse beneficiary, you do have to take required minimum distributions. Let's say I died, my Roth IRA went to my son, my son would have to take distributions on that Roth IRA. I think that the rationale here is they don't want you to just let that money grow and compound in a tax-free account for the rest of that young person's really long life, they would rather him take the distribution. If he doesn't want to spend it, where's that money going to go? It's going to go into his taxable bucket and it's going to be taxed in the least efficient way possible. Most efficient for the IRS, least efficient for my son, so he's going to be forced to pay taxes on that money at some point in time if he doesn't spend it.
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That's something that you need to be aware of. Keep in mind that a lot of this is potentially going to change when the SECURE Act, which is almost certainly going to be signed in the law some time this year, IRAs and Roth IRA’s rules are going to change where you could be forced to take distributions on these things over 10 years, you won't be able to stretch these things out over a lifetime, you could be forced to take these things over a 10-year period which will be especially devastating if you are taking distributions in an inherited IRA because all that money gets piled on top of all your other earned income and it gets taxed at your highest marginal tax bracket at a period in time when tax rates are likely to be much higher than they are today. That is a little-known detail number 13 with Roth IRAs.
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Number 14—14 and 15 can be a source of confusion for a lot of different people but let's lay all that confusion to rest—Roth IRAs have a five-year rule. Upfront, let's be clear that whatever you contribute to a Roth IRA, you can take out whenever you want. A lot of people use the Roth IRA as an emergency fund because you can put the money in and you can take the money out. You can put the money back in so long as you do so within 60 days of having distributed that money. I'm not a huge fan of using my Roth IRA as an emergency fund because if you take the money out and you can't put it back within that 60-day window, then the window closes forever and you will no longer have the ability to experience the benefit of that Roth IRA contribution and its compounded growth over the rest of your life. It's important to recognize that you can put the money in, you can take it out as long as you put it back within 60 days, it's a very, very flexible emergency fund type of account.
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Now, what is the five-year rule with the Roth IRA? The five-year rule with the Roth IRA says essentially that you cannot touch the growth on your Roth IRA contributions until 5 years have passed or until you're 59 1/2, whichever is later. For example, if you start your Roth IRA at 58, even if you hit 59 1/2, you're not going to be able to touch those earnings until 5 years have passed. By the way, if you make your first contribution when you're 58 in May of that year, the date that they're going to use is January 1st of that year. So in theory, you could touch the growth on that money in less than 5 years. If you did it at the very end of the year, you could do it in four years and one day. It's the January 1st of the year in which you make the contribution. It's important to recognize, most people who do Roth IRAs are starting them when they're relatively young so they're not going to have to worry about not being able to touch the growth when they're 59 1/2 because they will have had the Roth IRA in place for a very, very long time.
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Fifteen, this is the final one that we'll talk about. What is the Roth conversion five-year rule? This can be confusing for a lot of people so let's dig into this. Let me lay out a scenario for you, let's say you've got $1 million in your IRA, you're in a pickle, and you say, “I want to be able to access this money without penalty prior to 59 1/2.” You hatch up this idea in your brain that you will convert that money to a Roth IRA, you will pay the tax—but you’re going to have to pay the tax anyway—but you think that by doing so, you will avoid a 10% penalty because Roth IRAs don't have penalties in that instance. Guess what, the IRS is one step ahead of you. The IRS says that there is a 5-year rule for a conversion, meaning, let's say you convert $100,000 in a given year, you cannot touch that conversion for 5 full years. This is designed to prevent you from pulling a quick one on the IRS where you convert it to a Roth IRA and say, “Hey, it's after-tax dollars, I'm just going to take the money out.” If you do it within five years, you will get a penalty.
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Now, what are the implications of this? If somebody is 40 and they decide to do a Roth conversion that year, 5 years later, when they're 45, they can take that money out tax-free—they already paid the tax—and penalty-free. This is conceivably a way to get money out of your IRA pre 59 1/2 without penalty, you just have to have the discipline to wait the 5 years to be able to pull it off. A lot of people don't realize you can actually be younger than 59 1/2, take the money out penalty-free so long as you wait 5 years. Once you hit 59 1/2, there's no more 5-year rule. The 5-year rule for Roth conversions only affects people that are younger than 59 1/2. Why? Because once you're 59 1/2, you can get that money tax-free and penalty-free anyway so what's the point of giving you a 5-year rule if you're already 59 1/2 and you could have gotten the money tax-free and penalty-free anyway. That's the five-year rule.
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There are two five-year rules, so in summary five-year rule for the Roth IRA says that you can't touch the growth on your contributions and your traditional Roth IRA until 5 years have passed or until age 59 1/2, whichever is later. Then the 5-year rule for the Roth conversion says that if you're younger than 59 1/2, and you make a conversion, you can't touch the growth on that conversion for that matter for at least 5 years. But once 5 years is up, you can touch it without penalty even if you're younger than 59 1/2.
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That's the show. Thank you for being with us. Of course, if you want to subscribe to our show, please do so, you can get our show now in probably a dozen different formats from Spotify to iTunes to YouTube, Pandora, so on and so forth. Please subscribe, you'll get an email letting you know that a new episode is out. If you are looking for help with this type of planning, please go to davidmcknight.com, we have lots of resources to be able to help you and help you navigate all of these different rules and all of these different pitfalls on your way to the 0% tax bracket. Of course, if you would like to check out my new book, The Volatility Shield, please do so at Amazon. If you want to buy it in bulk, you can go to thevolatilityshield.com. Thank you for being on the show today and we will look forward to talking to you next week.
