Dicussion Forum Topic: 5-Year Clock
By Jeffery Levine, IRA Technical Expert
Follow Me on Twitter: @IRAGuru4EdSlott
For years now, Financial Advisors, CPAs and taxpayers just like you have realized the incredible benefit that Roth IRAs can provide. After-tax money (money you did not take a deduction on) can be invested and can grow tax deferred for years. Later, that money, along with all the earnings, can be withdrawn tax-free!
Of course, like most benefits afforded to you by the tax code, Roth IRAs are subject to a variety of rules and restrictions. One of these rules is commonly known as the "5 year clock."
So what exactly is this infamous clock? In order for all Roth IRA distributions (contributions and their earnings) to be withdrawn tax and penalty-free, you must be 59 ½ AND you must have held a Roth IRA for least 5 years.
But why does this 5 year rule exist? Well, believe it or not, our government doesn't always trust us! They think we might say we are putting the money away for retirement when we are really using the account as a way to avoid taxes. For example, say you are 60 years old and invested $6,000 in a Roth IRA at the market lows in February this year. Now that account is worth $10,000. If it wasn't for the 5-year rule you could just take out the entire $10,000 now tax-free. But, since the 5-year clock hasn't been reached, only your initial $6,000 would be tax free (getting your own money back). The $4,000 of gain would still be taxed at ordinary income rates, plus, if you were under age 59 ½, you would also be hit with a 10% early withdrawal penalty on that $4,000.
It’s not all bad, though. Roth IRA contributions can be made up until April 15th 2010 for the 2009 tax year – and even if you make the contribution on that last day (April 15th), if the contribution is made for the 2009 tax year, your 5-year clock will actually have started January 1, 2009 – in effect, a 4-year clock!
More good news? The Roth IRA clock is for all of your Roth IRAs. If you later open a new Roth IRA, or rollover or transfer the first Roth IRA to a new institution, the original 5-year clock applies. In fact, you could have as little as one penny in a Roth account now, but your clock would still be ticking.
The Roth IRA is truly one of the biggest benefits of the tax code, but only if you follow all the rules. Think of it this way though - You may have to work 25, 30, or even 40 years to get your gold watch when you retire, but the IRS gives you your “golden clock” after only 5 years. Not so bad!
Remember, this is only one of the many Roth IRA rules. If you have a specific question, it’s best to consult with a knowledgeable advisor first to make sure you are aware of all the rules.
Got more questions?? Want to see what other people are asking? Check out the Ed Slott and Company IRA Discussion Forum.
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