Roth IRA 5-Year Birthday Expands Options

One of the shining-star provisions in the 1997 Federal tax act was the creation of the Roth IRA ~~ an attractive alternative to the traditional IRA for retirement savings. An important feature of the Roth IRA is the so-called “5-year holding rule”. Given that the Roth became operative on 1/1/1998, January 1, 2003 marked the 5-year anniversary.

Let’s take a look at some Roth IRA mechanics and, in particular, opportunities that are now available, starting this year, for individuals who made their first contribution in 1998.

Roth Basics
Unlike the traditional IRA, contributions to a Roth are not tax-deductible. But, unlike the traditional IRA, qualified distributions from a Roth are tax-free, Federal and state. That is one of the key advantages to the Roth – tax-free growth and income. While growth in a traditional deductible IRA is tax-deferred, all distributions, including original contributions, are taxed ultimately at ordinary income tax rates.

A Roth distribution is “qualified” if made after a 5-year holding period and one of the following applies: 1) account owner’s age is at least 59-1/2; or 2) distribution is due to death or disability; or 3) distribution is made to a qualified first-time homebuyer.

For any nonqualified distribution from a Roth, the earnings portion is taxed at ordinary rates and is assessed an additional 10% early-withdrawal penalty (on the earnings portion only). Under some circumstances, the 10% penalty is waived for a nonqualified withdrawal but the tax is still owed. Those circumstances include distributions to fund higher education or the account owner’s age is at least 59-1/2. There are a few others.

Finally, Roth contributions, when withdrawn, are not taxed and are not assessed the 10% penalty. That’s because a Roth IRA is funded with after-tax contributions, not pre-tax. Only earnings distributions are potentially subject to tax and penalty. And, distributions are deemed to come from contributions first, and then from earnings. Therefore, no tax or penalty applies to any distribution until withdrawals exceed total contributions.

When does the 5-Year Clock Start?
Once you make your first Roth IRA contribution, the five-year clock starts ticking for all subsequent earnings regardless of when additional contributions are made.

Assume you opened an account in 1998 but didn’t contribute any more money until 2001. You then take out all your contributions and earnings from the account in January 2003. The withdrawal of earnings made from the funds contributed in 2001 qualifies for tax-free treatment the same as the earnings made from your initial 1998 contribution, assuming your age is 59-1/2 or greater.

Additionally, the clock starts on January 1 of the tax year for which your first contribution is made. For example, let’s say you made you first contribution on April 15, 1999 for the 1998 tax year (the latest date for 1998 contributions). The clock would be considered to have started 1/1/1998.

The same policy would apply to a Roth first started, say, by April 15, 2003 for the 2002 tax year. The clock would be considered to have started 1/1/2002.

Example: Age 61, started a Roth IRA in 1998 tax year ~~ When can qualified tax-free earnings withdrawals start? Answer: Immediately, starting January 1, 2003, since the 5-year holding period requirement will be satisfied and the taxpayer is over age 59-1/2.

Example: Age 55, started a Roth IRA in 1998 tax year ~~ When can qualified tax-free earnings withdrawals start? Answer: At age 59-1/2. Earnings withdrawn prior to age 59-1/2 are subject to income tax at ordinary rates plus a 10% penalty.

Example: Age 61, started a Roth IRA in 2000 tax year ~~ When can qualified tax-free earnings withdrawals start? Answer: January 1, 2005, when the 5-year holding period is satisfied. Earnings withdrawn prior to then will be subject to ordinary income tax but will not be subject to a 10% penalty, since the account-owner’s age is at least 59-1/2.

More than One Roth IRA
Let's say in addition to opening a Roth in 1998, you started a separate Roth account in 2001. Do you have to wait until 2006 for tax-free-earning withdrawals from the newer Roth, assuming your age is 59-1/2 or greater?

The answer is no. You can start withdrawing tax-free earnings in 2003 if you are at least 59-1/2. Multiple Roth accounts, even with different custodians, regardless of when each is started, are governed by the date the first Roth IRA was established.

Minimum Required Distributions?
Unlike a traditional IRA, you are not required to start taking distributions at age 70-1/2. When you do take distributions, they can be as small as you like ~~ no minimum amount required. Consequently, you can let the assets continue to grow tax-free and pass the entire account to your heirs, if you wish, instead of being forced to make annual withdrawals.

Withdrawal Strategy
Whether to leave funds in your Roth or withdraw them is something you should discuss with your financial planner and tax professional. Your retirement withdrawal strategy (from taxable accounts vs. traditional IRAs vs. Roth IRAs vs. 401(k)s or other retirement plans) depends on your personal and financial circumstances and current tax laws.

Canandaigua National Bank & Trust is uniquely qualified to work with you as your partner in charting your future financial course.  Whether it be a retirement analysis, retirement plan, or a full comprehensive financial plan, we can help.  For further information, please contact James Terwilliger, CFP®, CERTIFIED FINANCIAL PLANNER™, 585-419-0670 ext 50630 or email jterwilliger@cnbank.com.