Roth’s options have always been a popular savings choice for younger investors, but with the new IRA inheritance rules that started in 2020 and the possibility of higher tax rates looming in the future, investing in a Roth has become even more popular.
While Roth IRA’s may be a great choice when they fit, don’t let current enthusiasm trick you into thinking that a Roth is always the answer. Roth IRA’s and 401(k)’s are actually some of the most complicated investment vehicles out there due to the underlying rules associated with these types of accounts.
The most sinister of these rules is the 5-year rule for withdrawals. This rule is confusing because there are about 4 different 5-year rules. These apply to different types of contributions or conversions that can be deposited in a Roth IRA or 401(k).
For example, contributing to a Roth IRA starts your own personal 5-year Roth clock. Once five years has passed from that contribution and you’ve met a qualifying event like turning 59 1/2, you can take your contributions and earnings out of any Roth IRA you have tax free no matter when you opened it or made those contributions. However, conversions, that go into that same Roth IRA each get their own 5-year clock before each individual conversion’s earnings can be withdrawn. And furthermore, neither of these clocks have anything to do with what’s going on in your Roth 401(k) if you have one.
The second most confusing Roth rule is the withdrawal ordering rules. The money you put into a Roth is meticulously categorized so the IRS can force you to keep track of all these crazy clocks going on. And if you take the money out, there is an order that the funds are withdrawn in that is set in tax code stone. That’s not terrible news in itself but the twist is that these orders are very different for Roth IRA’s and Roth 401(k)s.
The combination of the 5-year and ordering rules dictates if the IRS has any need to penalize and or tax some or all of your withdrawal. And there are other rules to look out for as well.
On the other hand, Roth options can be very simple if used as intended and withdrawals are only made when the proper conditions are met.
As you can see, even the friendly and popular Roth has some skeletons in its closet. As with any investment, be sure to set proper expectations and understand the purpose of your investment ahead of time to help avoid unwelcome surprises down the road. And when in doubt, don’t hesitate to contact your financial professional for guidance.