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  • Writer's pictureW. Scott Hurt, CFP®, CPA

Does The 5-Year Rule For Roth Conversions Mean Retirees Should Think Twice About Doing One?



Roth conversions are a prevalent retirement planning strategy, and for a good reason. In the right situations, they can significantly reduce taxes throughout your retirement and boost the value of your retirement accounts.

Let’s review the benefits and discuss some potential downsides. You may want to download our Roth conversion checklist to work through as you read.


Roth Conversion Refresh


A Roth IRA conversion is when you rollover your money from a traditional tax-deferred account into a Roth IRA. When you do a conversion, you pay income tax on the amount you convert. This strategy enables people in a higher tax-bracket to take advantage of these valuable Roth accounts.

Let’s look at a simple example. If you convert $50,000, you’d include $50,000 in your income that calendar year.

However, the exact calculation can be tricky if you have multiple existing IRAs; here, the pro-rata rule applies!


  • If your IRA balances consist entirely of traditional contributions and earnings (pre-tax), then there’s no concern. However, suppose any amount of any of your IRA balances comes from after-tax contributions (typically because you’ve made a nondeductible contribution to a traditional IRA). In that case, your conversion will be treated as though it came proportionately from your tax-deferred contributions and after-tax contributions.

  • The takeaway is that you can’t just convert your after-tax contributions if you also have a tax-deferred balance.


A big reason you might have after-tax contributions in a traditional IRA is that your income exceeds the limit to directly contribute to a Roth. For 2022, that income limit is $144,000 if you’re single and $214,000 for a couple, although those start to phase out at $129,000 and $204,000, respectively.

Roth IRAs have the same contribution limits as traditional IRAs in the 2022 tax year; $6,000 plus another $1,000 if you’re 50 or older, but they have some unique features:

  • Qualified distributions are tax-free in retirement.

  • Don’t have required minimum distributions RMDs (giving you more options and flexibility).

  • Are great vehicles to pass down wealth to heirs because they can also withdraw funds tax-free.


Roth IRAs can be important accounts for your retirement income and savings strategy.


Roth Conversions And Retirement


Now that you’re all caught up on Roth conversions, what makes them so popular for retirees?


Roth conversions can be beneficial throughout retirement as it helps you build up your tax-free income bucket for retirement savings, leverage lower tax brackets, and help with estate planning and legacy planning (i.e., passing wealth to beneficiaries tax-efficiently).

But Roth conversions aren’t always the best choice. Retirees need to watch out for increasing their tax bracket too much. While that may sound obvious, the nuance is more powerful than you may realize.


A Roth conversion would likely be inefficient if your anticipated future tax rate is lower than your present tax rate. Worse, it could create a domino effect because other retirement expenses are based on your taxable income. If your income goes up because of a Roth conversion, you could end up:

  • Paying more for Medicare premiums via IRMAA.

  • With a larger portion of Social Security benefits subject to taxation.

  • Net investment income tax on gains from taxable investments.

Typically, a Roth conversion makes more sense for early retirees who aren’t claiming Social Security and haven’t started RMDs. They tend to have more flexibility and options to strategically implement Roth conversions because of that income flexibility.

In addition to the retirement stage, you can also consider Roth conversions in a down market. Since the IRS determines your tax bill by the amount you convert, a down market allows you to convert a more significant portion of your tax-deferred savings with a lower tax bill.


What’s The 5-Year Rule (And Why It’s So Misunderstood)


You might be hesitant to do a Roth conversion in retirement because of the five-year rule. However, that may be due to confusion about how the 5-year rule works. In fact, there are actually several different pieces to understand!

Let’s break it down to help clear up the 5-year confusion.

The 5-year rule concerning conversions says that with every conversion, the 5-year clock starts on those specific converted dollars.


If you withdraw the converted dollars before 5 years pass:


  • You are subject to the 10% early withdrawal rules on the conversion

plus

  • You are subject to ordinary income tax and a 10% early withdrawal rule on earnings.


However, if you are 59 ½ or older you can access the conversion amount at any time without the 10% penalty. Also, remember that you can always withdraw the contribution amounts tax-free at any age and any time.


The 5-year rule determines whether you need to consider the 10% early withdrawal penalty on the conversion and whether taxes and early withdrawal penalties apply to the earnings.

Think back to that $50,000 example we mentioned earlier. If you withdraw before 5 years pass, you will incur a 10% early withdrawal penalty if you are under 59 ½.

If the account grows to $55,000 after converting, you would have to wait 5 years and until age 59 ½ before withdrawing the extra $5,000. Otherwise, you’ll have an income tax liability and a 10% penalty on that $5,000 of earnings.

So, yes, the 5-year rule means we’d have to be more cognizant and strategic with the withdrawals, but this doesn’t have to be why Roth conversions won’t work for you.

Roth’s in Real Life: A Case Study


For a more detailed example, consider that you are currently in the 22% Federal Income Tax bracket.

Based on Social Security benefits, a pension, and the amount saved in your 401k and IRA, you anticipate being in the 28% bracket once RMDs start (assuming the TCJA of 2017 sunsets).

In this case, it might make sense for you to convert now and pay taxes while you are in a lower bracket. It could save you thousands of dollars per year throughout your retirement.

If you decide to convert, how likely will you run into a roadblock with the 5-year rule? After all, you don’t want to run into a situation where you must withdraw too soon. It depends on how much you convert and need to withdraw from savings. It’s best to consider this risk and plan accordingly.

However, the IRS treats your withdrawals in the most favorable way, assuming that any money withdrawn comes first from contributions, then conversions, then earnings.

As you can see, proactive tax planning is critical for the health of your retirement strategy.


Sounds like a lot to keep track of? In addition with talking to your CPA, don’t forget to use our Roth conversion checklist and give us a call if you need help seeing where a Roth conversion strategy could fit into your larger financial planning efforts.


 



Scott Hurt, CFP®, CPA

Scott is a fiduciary, fee-only financial advisor at Covenant Wealth Advisors serving clients across the United States. He specializes in helping individuals aged 50 plus create, implement, and protect a personalized financial plan for retirement.


 

Disclosures:


Covenant Wealth Advisors is a registered investment advisor with offices in Richmond and Williamsburg, VA. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital.


The views and opinions expressed in this content are as of the date of the posting, are subject to change based on market and other conditions. This content contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance, and actual results or developments may differ materially from those projected.


Please note that nothing in this content should be construed as an offer to sell or the solicitation of an offer to purchase an interest in any security or separate account.


Nothing is intended to be, and you should not consider anything to be investment, accounting, tax, or legal advice. If you would like accounting, tax, or legal advice, you should consult with your own accountants or attorneys regarding your individual circumstances and needs. No advice may be rendered by Covenant Wealth Advisors unless a client service agreement is in place.

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