The 5-Year Rules for Roth IRA’s

Roth IRAsWe constantly see questions regarding the distribution rules for Roth IRAs. Personally, I’ve always thought that the failure to understand these rules prevents many from truly appreciating the benefits of these accounts. Traditional IRAs are easy. Unless we are talking about nondeductible contributions, the money is deductible when contributed and taxable upon withdrawal. There’s also the early distribution penalty that could apply depending on the circumstances.

Roth IRAs have a couple of different rules, including two separate 5-year rules. The easiest way to understand these rules is to remember that a Roth IRA consists of two parts: (1) contributions/conversions and (2) investment gains/losses. This is important because contributions can always be withdrawn at any time, tax and penalty free. The earnings, however, are potentially taxable and could be hit with the early distribution penalty.

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Can You Contribute to a Roth IRA?

Roth IRA contributionNot everyone is eligible to make an annual Roth IRA contribution. We have seen several cases recently of individuals who contributed for many years until they discovered they were not eligible to make any Roth IRA contributions. Here is what you need to know.

First, you must have earned income in order to make a Roth IRA contribution. That means you must perform some type service to have earned income. Passive sources of income generally do not count. As a result, Social Security and payments from any type of retirement plan are not earned income. Rental income is generally not earned income. Investment income and interest income also do not qualify. Disability income will not qualify.

Many people think that if they have after-tax income they can put it into a Roth IRA. This is not true. Gains on the sale of a home or from investments cannot be contributed to an IRA just because they are after-tax funds.

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Spousal IRAs

What are Spousal IRAs & Who Can Contribute to One?

Spousal IRASpousal IRAs are designed to allow a working spouse to make IRA contributions for a spouse who does not have enough earned income to make their own IRA contributions.

There are some key requirements that must be met:

  • The spouses must be legally married and file a joint federal tax return. This includes same-sex couples.
  • The spouse receiving the contribution must have less compensation, or no compensation, than the spouse making the contribution.
  • The IRA account must be held in the name of the spouse for whom the contribution is made. If Gina is the working spouse and the contribution is made for George, then the IRA account must be in George’s name. George has complete control over the IRA account. He can name his own beneficiaries, invest the funds as he wishes, and take withdrawals whenever he wants.

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Happy Anniversary to the Roth IRA!

Happy Birthday Roth IRAHappy Anniversary to the Roth IRA! Celebrating 20 years in 2018.

IRAs started small. The first IRAs created in 1974 had two purposes:

1.  As a retirement savings vehicle for employees not covered by employer retirement plans; and
2.  As an account to hold distributions from employer plans on separation from service

These first IRAs could accept annual contributions not exceeding the lesser of $1,500 or 15% of earned income, only from employees who were not covered by an employer’s qualified retirement plan. Distributions from them were subject to still familiar rules — being taxable income at ordinary rates, with required minimum distributions (RMDs) starting at age 70½, and distributions before age 59½ subject to 10% penalty. They could accept rollovers from company plans.

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5 Easy Steps to a Roth IRA Recharacterization

What is a Roth IRA recharacterization?

Roth IRA recharacterizationIn the simplest of terms, a Roth IRA recharacterization is an “undo.”  It erases a Roth IRA conversion, and the conversion is treated as if it never occurred.

1.  Meet the deadline.   A Roth IRA conversion can be recharacterized until October 15 of the year after the calendar year of conversion. That means that either a January 1, 2017 or a December 31, 2017 conversion can be recharacterized through October 15, 2018. If you miss the October 15 deadline, the only way to get an extension is to go for a private letter ruling from the IRS.

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Is a Roth conversion right for you?

Roth ConversionAre you considering a Roth conversion, but you’re unsure whether or not it’s the right move for you? A Roth IRA provides a great way to help reduce the taxes you’ll pay during retirement, but it can also increase your income during the year that you convert, which could bump you into a higher tax bracket.

When you convert funds to a Roth IRA, your pre-tax funds will be included in your income in the year of the conversion. This will increase your income for the year of the conversion, which may impact deductions, credits, exemptions, phase-outs AMT (alternative minimum tax), the taxation of your Social Security benefits and more.

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The Roth IRA as an Emergency Fund

ROTH IRA Emergency FundA recent Pew Charitable Trusts study released in March came to the scary conclusion that roughly one-third of Americans would have trouble coming up with $2,000 in the event of an emergency. Clearly, this is a problem. Try as one might, emergencies are bound to happen from time to time. Some of them may not have an impact on your finances, but many emergencies will. With that in mind, let’s talk for a moment about the Roth IRA as an Emergency Fund

So what makes the Roth IRA such a great emergency fund? Quite simply, it has the capacity to “check all the boxes” an emergency fund should have, and then some.

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Roth IRA Recharacterization: 11 Things You Need to Know at Tax Time

What is a recharacterization of a rollover or a conversion?

Roth IRA RecharacterizationA recharacterization allows you to “undo” or “reverse” a rollover or conversion to a Roth IRA. You generally tell the trustee of the financial institution holding your Roth IRA to transfer the amount to a traditional IRA (in a trustee-to-trustee or within the same trustee). If you do this by the due date for your tax return (including extensions), you can treat the contribution as made to the traditional IRA for that year (effectively ignoring the Roth IRA contribution).

1.  It is not too late to recharacterize a Roth IRA conversion done in 2016.

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5 Things to Know Before Taking a Roth IRA Distribution

By Sarah Brenner, JD

IRA Analyst


Roth IRA DistributionAre you one of the growing number of savers who has a Roth IRA? If so, there will come a time when you will want to take funds from your account. Here are 5 things that every owner should know before taking a Roth IRA distribution.

1. Your Roth IRAs are treated as one account. Things can get a little tricky if you have more than one Roth IRA. When determining the taxation of a Roth IRA distribution, all of your Roth IRAs are aggregated. What does “aggregated” mean? Well, simply put, this means of your Roth IRAs are considered one account for tax purposes.

Your IRA custodian will report the distribution on Form 1099-R to you and to the IRS. You will be responsible for determining the taxation of your distribution. You will use Form 8606 to report the Roth IRA distribution on your federal tax return.

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Rulings to Remember: The $425K IRA Mistake

Client Should Have Realized CPA Firm’s Tax Deal “To Good to be True”

Robert K and Joan L. Paschall V. Commissioner of Internal Revenue
(No. 2: Nos. 10478-08, 25825-08, Decided July 5, 2011

IRA Mistake results in taxesRobert Paschall, a married resident of California and an MIT graduate, worked for Rockwell International for his entire career until he retired in 1996.  Early in 2000, Paschall paid Grant Thorton, a national accounting firm, $120,000 for advice on his regular IRA that had a value of $1,391,942.  They presented Paschall with a plan, which he accepted, to “restructure” his regular IRA into a Roth IRA – the $425K IRA Mistake.

Under Grant Thorton’s guidance, Paschall rolled his IRA over into a self-directed traditional IRA.  He also opened a self-directed Roth IRA, funding it with $2,000, and created two corporations.  The Roth IRA purchased all the stock of one corporation for $2,000, and the traditional IRA purchased all the stock of the second corporation for close to the traditional IRA’s balance. The second corporation transferred the purchase amount (plus $120,000 paid as consideration in a merger) to the fi rst corporation.  The fi rst corporation then transferred the proceeds ($1,272,802) to the Roth IRA, which then transferred the funds into a second Roth IRA.

He was caught by IRS and got hit with penalties for excess Roth contributions, late filing and negligence penalties for multiple years.  He essentially made a $1.4 million excess contribution to a Roth IRA in a year when the contribution limit was $2,000.  The IRS assessed deficiencies against Paschall and his wife totaling more than $425,000 for tax years 2002 to 2006 for the excise tax on the excess contribution and assessed penalties of more than $103,000 for the same years for failure to file Form 5329.

In 2008, Paschall and his wife petitioned the Tax Court for relief.

What happened?

The Paschalls argued that the statute of limitation barred the assessment of the excise tax for 2002-2004, since they had filed Form 1040 for those years.  The taxpayers also argued that the penalty for Paschall’s failure to fi le Form 5329 should not apply, since his failure to file was due to reasonable cause –specifically, his reliance on the certified public accountant.

The court ruled on July 5, 2011 that the IRS was right and that it was unreasonable for Paschall to rely on the opinion of a tax advisor who was actively involved in the planning of the transaction in question and was tainted by an inherent conflict of interest.

The Paschalls owed income tax on their Roth conversion.  Interest was owed on the late tax. They owed accuracy-related penalties.  They owed failure to file penalties for not filing Form 8606.

The court stated, “Mr. Paschall should have realized that the deal was too good to be true.”  Despite his doubts during the process, Paschall never asked for advice from an independent advisor, the court said.

What you can do

If you have doubts about advice you are receiving, get a second opinion!  IRS holds the tapayer responsible for taxes, interest, and penalties.

Work with someone you trust and don’t fall for “too good to be true.”

Copyright 2016 Ed Slott and Company LLC
Photo credit: 401(K) 2013 via / CC BY-SA