IRA's A Closer Look

Understand the five-year rule on Roth IRA contributions and payouts.

It determines whether payouts of Roth IRA earnings are tax-free to you. Generally speaking, distributions of earnings from Roth IRAs are tax-free if the owner is at least 59½ at the time of the withdrawal and at least five tax years have passed since the owner first made a contribution into any Roth IRA. The five-year clock starts the first time money is deposited into any Roth IRA that you own, through either a contribution or a conversion from a traditional IRA. The clock doesn’t restart for later Roth payins or for newly opened Roth IRA accounts. Here’s an example. Say you’ve owned a Roth since 2010, and in Jan. 2021, you opened and funded a second Roth IRA. Because you funded your first Roth IRA in 2010, you needn’t wait five years to take money from your second Roth for the earnings to be tax-free, provided you’re at least 59½ at the time of the payout. Note that it’s only the Roth earnings in the account that this five-year rule applies to.

Withholding more federal income tax on IRA RMDs is a popular tax strategy.

Tax withheld at any point in the year is treated as if evenly paid throughout the year. Some retirees rely on this rule to avoid paying estimated taxes and instead have taxes that they expect to owe for the year withheld from an RMD from a traditional IRA. In fact, Kiplinger regularly advises retirees who are falling short on their withholding to have more tax withheld from a year-end distribution from their traditional IRAs. Note that by default, the IRA custodian will withhold 10% of the payout for taxes. So if you want more tax withheld from an IRA payout, you’ll need to request it.

The above strategy doesn’t work as well with Roth IRA conversions, tax advisers tell us. When you convert a traditional IRA to a Roth, the conversion is treated under the income tax rules as a taxable distribution of the IRA funds to you, and the IRA custodian will by default withhold 10% tax from the converted funds. But understand that the 10% tax withheld is also treated as a distribution to you on which you’d have to pay tax, in addition to the funds you’re moving to the Roth. And, if you’re younger than 59½, you’ll be slapped with a 10% penalty, in addition to the regular federal income tax, on the money used to pay the tax bill. That’s why experts say to pay the tax owed on a Roth conversion with non-IRA funds and request that the custodian withhold 0% from the converted IRA funds.

Wondering what IRS agents look for when they audit retirement plans?

Large participant loans are a key examination issue. During an audit, IRS checks how plans handle loans, such as the time allowed for repayment, and what happens on default. Agents ask for copies of signed loan agreements and promissory notes, as well as documentation to substantiate residential loans. Among common plan loan failures: Loan amounts over the statutory cap. Nonresidential loans in which the repayment period exceeds the maximum five years. And loan defaults, in which the participant fails to make the required payments.

Small businesses have many options to help workers save for retirement: SEPs, SIMPLE IRAs, payroll deduction IRAs, profit-sharing plans, 401(k)s and pensions. There is a helpful brochure that compares the employer’s role, contribution limits, eligibility, withdrawals, vesting and other basic operational rules. See IRS Pub. 3998.