Two 5-year rules are the benchmarks that determine whether distributions from a Roth IRA are subject to income tax and/or the 10% early distribution penalty.
A Roth IRA is funded with amounts that have already been taxed, and earnings are tax-free as long as distributions are ‘qualified.’ If distributions are non-qualified, income taxes could apply; as well as the 10% early distribution penalty for distributions taken before the account owner reaches age 59½.
The responsibility for determining whether a Roth IRA distribution is subject to income tax and/or the 10% early distribution penalty sometimes falls on the Roth IRA owner, who might pass on that responsibility to an advisor. Regardless of who is responsible, one of the two 5-year rules must be applied when making the determination. One 5-year rule is used for qualified distributions, and the other is used for nonqualified distributions. That one that applies depends on whether the distribution is qualified.
The 2 Roth 5-year rules
Determining taxability of a Roth IRA distribution can seem complex. But much of the complexity can be removed by applying the 5-year rules in the following order.
- 5-year rule #1: This is used to determine if a Roth IRA distribution is qualified.
- 5-year rule #2: This is used to determine if the 10% early distribution penalty applies to nonqualified distributions of conversion/rollover amounts.
For both 5-year rules, an individual’s Roth IRAs are aggregated and treated as one Roth IRA. (This does not include inherited Roth IRAs.)
5-year rule #1: Identifying a qualified distribution
In order for a Roth IRA distribution to be qualified, two requirements must be met. These requirements are:
- The distribution must be made at least five years after the Roth IRA owner makes a contribution to the Roth IRA. This includes regular Roth IRA contributions, Roth conversion contributions, and rollover contributions from employer-sponsored retirement plans. And
- The distribution is made under at least one of the following four circumstances:
- The Roth IRA owner is at least age 59½ on the date the distribution is made.
- The distribution is attributable to the Roth IRA owner being disabled (as defined under Tax Code section 72(m)(7)).
- The distribution is used for eligible first-time home buyer expenses. This is subject to a lifetime limit of $10,000.
- The distribution is taken from an inherited Roth IRA by the Roth IRA owner’s beneficiary.
If a Roth IRA distribution satisfies these two requirements, then the entire distribution amount is tax-free and is not subject to the 10% early distribution penalty.
For 5-year rule #1, the clock starts January 1 of the first year for which a contribution is made to any of the individual’s Roth IRAs.
- Example 1: Assume that Susie made her first Roth IRA contribution in March of 2018, for 2017. Her starting clock for 5-year rule #1 begins on January 1, 2017. If the contribution had been made for 2018, then the clock would have started January 1, 2018.
- Example 2: Assume that Karen made her first Roth IRA conversion in April of 2018. However, she had also made a regular Roth IRA contribution to another Roth IRA in June 2010. Her starting clock for 5-year rule #1 begins June 1, 2010.
Tip: Making a Roth IRA contribution or a Roth conversion/rollover—regardless of how small—can get the clock for 5-year rule #1 started.
5-year rule #2: Identifying distribution of taxable conversions subject to the 10% additional tax
Five-year rule #2 is used to determine if non-qualified distributions of taxable rollover/conversion amounts are subject to the 10% early distribution penalty. In order to make this determination, one must ascertain the source of funding from which the distribution is being made, by applying the ‘ordering rules’ to a non-qualified distribution.
Under the ordering rules, distributions are made from the following funding sources in the listed order:
- Level 1: Regular Roth IRA contributions and rollover of basis from designated Roth accounts (DRAs). (DRAs are Roth 401(k)s, Roth 403(b)s, Roth 457(b)s and Roth Thrift Savings Plans, or TSPs.)
- Level 2: Conversions from traditional, SEP and SIMPLE IRAs; and rollover of non-Roth amounts from employer-sponsored retirement plans (qualified plans, such as 401(k) and pension plans, 403(b) plans, Governmental 457(b) plans and TSPs).
These amounts are distributed on a first-in-first-out (FIFO) basis. For this purpose, all conversions and rollovers done in one calendar year count as one conversion/rollover for that year.
Further, taxable conversion/rollover amounts are distributed before nontaxable conversion/rollover amounts.
- Level 3: All earnings, including rollover of earnings included in a rollover of a non-qualified distribution from a DRA.
A distribution of funds from Level 2 is subject to 10% early distribution penalty, unless the Roth IRA owner is at least age 59½ at the time the distribution is made or qualifies for an exception to the penalty. One of the exceptions applies to conversion/rollover amounts that have been in the Roth IRA for at least five years (5-year rule #2).
Table 1 gives a summary of the taxability of a nonqualified Roth IRA distribution under the ordering rules.
For 5-year rule #2, each conversion/rollover done in one year is counted as one conversion/rollover for that year. A separate clock for 5-year rule #2 applies to each year in which a conversion/rollover is done.
Let’s look at an example of how this works.
Let’s say 45-year-old Peter has several Roth IRAs. The total of all Peter’s Roth IRA balances are broken down in Table 2:
Peter, having never taken distributions from any of his Roth IRAs before, decides to take a distribution in 2018.
However, Peter is not eligible for a qualified distribution and the ordering rules must be applied to determine the level from which the assets are distributed—so as to identify any portion that is subject to income tax and/or the 10% early distribution penalty.
Scenario 1: If Peter takes a distribution of $20,000, the amount will be tax-free and penalty-free because that amount will come from Level 1.
Scenario 2: If Peter takes a distribution of $95,000, the distribution would come from sources in the following order:
- First: $20,000 from Level 1. This would be tax-free and penalty-free.
- Second: $35,000 Level 2, year 2010 conversion. This would be tax-free because any income taxes owed would have been paid for the 2010 tax year. This $35,000 would also be exempted from the 10% early distribution penalty, because it would have been in his Roth IRA for at least five years before the distribution occurred.
- Third: $32,000 Level 2, year 2015 conversion, from the taxable conversion portion, because taxable conversion amounts are distributed before nontaxable conversion amounts. This amount would be tax-free because any income taxes owed would have been paid for the 2015 tax year. However, this $32,000 would be subjected to the 10% early distribution penalty, because it would have been less than five years since the amount was converted to the Roth IRA.
- Fourth: $8,000 Level 2, year 2015 conversion, the nontaxable conversion portion. This amount would be tax-free because any income taxes owed would have been paid before the amount was contributed to the traditional IRA. Also, since the conversion of this amount was nontaxable, it would not be subject to the 10% early distribution penalty when distributed from the Roth IRA.
To make it easier to keep track of Roth conversion/rollovers by year, some practitioners recommend separating Roth conversions by year into separate Roth IRAs, until the Roth IRA owner is at least age 59½. Copies of IRS Form 8606, which is used to track basis in IRAs, should be retained along with the Roth IRA owner’s tax records.
Tax treatment of earnings
As noted above, a qualified distribution of earnings is completely tax-free. For nonqualified distributions, any amount attributable to earnings would be subject to income tax. Such an amount would also be subject to the 10% early distribution penalty unless the Roth IRA owner qualifies for an exception.
Using the example of Peter above, his distributions would include earnings to the extent the amount exceeds $95,000.
Source: Jul 2, 2018 / www.horsesmouth.com
The Greeks called it akrasia—so that’s just how long we humans have been failing to follow through on good intentions—and getting filled with regret! Modern science offers three surprisingly effective, evidence-based ways to break the cycle.
In the summer of 1830, Victor Hugo was facing an impossible deadline. Twelve months earlier, the famous French author had made an agreement with his publisher that he would write a new book, to be titled The Hunchback of Notre Dame.
Instead of writing the book, Hugo spent the next year pursuing other projects, entertaining guests, and generally not working on the text. Hugo’s publisher had become frustrated by his repeated procrastination and responded by setting a formidable deadline. The publisher demanded that Hugo finish the book by February of 1831—less than six months away.
Hugo developed a plan to beat his procrastination. According to his wife, he collected all of his clothes, removed them from his chambers, and locked them away. He was left with nothing to wear except a large shawl. Lacking any suitable clothing to go outdoors, Hugo was no longer tempted to leave the house and get distracted. Staying inside and writing was his only option.
The strategy worked. Hugo remained in his study each day and wrote furiously during the fall and winter of 1830. The Hunchback of Notre Dame was published two weeks early on January 14, 1831.
The ancient problem of akrasia
Human beings have been procrastinating for centuries. Even prolific artists like Victor Hugo are not immune to the distractions of daily life. The problem is so timeless, in fact, that ancient Greek philosophers like Socrates and Aristotle developed a word to describe this type of behavior: akrasia.
Akrasia is the state of acting against your better judgment. It is when you do one thing even though you know you should do something else. Loosely translated, you could say that akrasia is procrastination or a lack of self-control. Akrasia is what prevents you from following through on what you set out to do.
Why would Victor Hugo commit to writing a book and then put it off for over a year? Why do we make plans, set deadlines, and commit to goals, but then fail to follow through on them?
Why we make plans, but don’t take action
One explanation for why akrasia rules our lives and procrastination pulls us in has to do with a behavioral economics term called “time inconsistency.” Time inconsistency refers to the tendency of the human brain to value immediate rewards more highly than future rewards.
When you make plans for yourself—like setting a goal to lose weight or write a book or learn a language—you are actually making plans for your future self. You are envisioning what you want your life to be like in the future and when you think about the future it is easy for your brain to see the value in taking actions with long-term benefits.
When the time comes to make a decision, however, you are no longer making a choice for your future self. Now you are in the moment and your brain is thinking about the present self. And researchers have discovered that the present self really likes instant gratification, not long-term payoff. This is one reason why you might go to bed feeling motivated to make a change in your life, but when you wake up you find yourself falling into old patterns. Your brain values long-term benefits when they are in the future, but it values immediate gratification when it comes to the present moment.
This is one reason why the ability to delay gratification is such a great predictor of success in life. Understanding how to resist the pull of instant gratification—at least occasionally, if not consistently—can help you bridge the gap between where you are and where you want to be.
The framework you need to beat procrastination
Here are three ways to overcome akrasia, beat procrastination, and follow through on what you set out to do.
Strategy 1: Design your future actions
When Victor Hugo locked his clothes away so he could focus on writing, he was creating what psychologists refer to as a “commitment device.” Commitment devices are strategies that help improve your behavior by either increasing the obstacles or costs of bad behaviors or reducing the effort required for good behaviors.
You can curb your future eating habits by purchasing food in individual packages rather than in the bulk size. You can stop wasting time on your phone by deleting games or social media apps. You can reduce the likelihood of mindless channel surfing by hiding your T.V. in a closet and only taking it out on big game days. You can voluntarily ask to be added to the banned list at casinos and online gambling sites to prevent future gambling sprees. You can build an emergency fund by setting up an automatic transfer of funds to your savings account. These are commitment devices.
The circumstances differ, but the message is the same: commitment devices can help you design your future actions. Find ways to automate your behavior beforehand rather than relying on willpower in the moment. Be the architect of your future actions, not the victim of them.
Strategy 2: Reduce the friction of starting
The guilt and frustration of procrastinating is usually worse than the pain of doing the work. In the words of Eliezer Yudkowsky, “On a moment-to-moment basis, being in the middle of doing the work is usually less painful than being in the middle of procrastinating.”
So why do we still procrastinate? Because it’s not being in the work that is hard, it’s starting the work. The friction that prevents us from taking action is usually centered around starting the behavior. Once you begin, it’s often less painful to do the work. This is why it is often more important to build the habit of getting started when you’re beginning a new behavior than it is to worry about whether or not you are successful at the new habit.
You have to constantly reduce the size of your habits. Put all of your effort and energy into building a ritual and make it as easy as possible to get started. Don’t worry about the results until you’ve mastered the art of showing up.
Strategy 3: Utilize implementation intentions.
An implementation intention is when you state your intention to implement a particular behavior at a specific time in the future. For example, “I will exercise for at least 30 minutes on [DATE] in [PLACE] at [TIME].”
There are hundreds of successful studies showing how implementation intentions positively impact everything from exercise habits to flu shots. In the flu shot study, researchers looked at a group of 3,272 employees at a Midwestern company and found that employees who wrote down the specific date and time they planned to get their flu shot were significantly more likely to follow through weeks later.
It seems simple to say that scheduling things ahead of time can make a difference, but as I have covered previously, implementation intentions can make you 2x to 3x more likely to perform an action in the future.
Our brains prefer instant rewards to long-term payoffs. It’s simply a consequence of how our minds work. Given this tendency, we often have to resort to crazy strategies to get things done—like Victor Hugo locking up all of his clothes so he could write a book. But I believe it is worth it to spend time building these commitment devices if your goals are important to you.
Aristotle coined the term enkrateia as the antonym of akrasia. While akrasiarefers to our tendency to fall victim to procrastination, enkrateia means to be “in power over oneself.” Designing your future actions, reducing the friction of starting good behaviors, and using implementation intentions are simple steps that you can take to make it easier to live a life of enkrateia rather than one of akrasia.
Source: James Clear, 4/2018
In the last 50 years, women have made unprecedented strides toward equity in work, family, and social settings. Yet when it comes to securing a financially safe retirement, they are still at considerably greater risk than men.
According to the latest research from the Transamerica Center for Retirement Studies::
Factors contributing to women’s risky retirement outlook include: women’s annual income continues to lag behind men’s—which leads to lower lifetime earnings, lower lifetime savings, and reduced Social Security benefits. Women are also more likely than men to take time out of the workforce to care for children and/or aging parents; a high percentage of women work part-time and do not have access to workplace retirement benefits; and women have longer life expectancies and, therefore, greater savings needs.
These 18 facts aim to raise awareness of risks that women face and highlight opportunities regarding how they can improve their retirement outlook:
- Only 12% of women are “very confident” in their ability to fully retire with a comfortable lifestyle.
- 53% of women plan to retire after age 65, or do not plan to retire.
- 54% plan to work after they retire, including 11% who plan to work full-time and 43% part-time.
- Are women being proactive enough to work past age 65? While 63% say they are staying healthy, only 57% are focused on performing well at their current job and 46% are keeping their job skills up-to-date.
- 64% do not have a back-up plan for retirement income if forced into retirement sooner than expected.
- Paying off debt is a financial priority for almost seven in 10 women (68%). Only 51% of women cite saving for retirement as a priority.
- 73% are saving for retirement through a workplace plan and/or outside of work in an IRA, mutual fund, bank account, etc. Women started saving for retirement at age 27 (median).
- 45% expect their primary source of retirement income will be 401(k)/403(b)/IRA and/or other savings and investments, while 30% expect to rely on Social Security.
- 81% of women are concerned that Social Security won’t be there for them when they are ready to retire.
- 47% of Baby Boomer women say they know a great deal or quite a bit about Social Security benefits.
- 66% of women are offered a 401(k) or similar employee-funded plan. However, 28% work part-time so are less likely to have workplace retirement benefits.
- 77% of women who are offered an employee-funded plan participate in the plan and they contribute 7% (median) of their salary to the plan.
- Women believe that they will need to save $500,000 (median) in order to feel financially secure in retirement; among those who estimated their savings needs, 55% say they “guessed.”
- Women’s total household retirement accounts is $42,000 (median).
- Women’s emergency savings is $2,000 (median).
- Just 28% of women are aware of the Saver’s Credit, tax credit for saving for retirement.
- One in three women use a professional financial advisor to help manage their retirement savings and investments.
- Only 26% of women consider their long-term health when making lifestyle decisions.