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Roth IRA: Early Withdrawals & Tax-Free Income - YouTube
Channel: Approach Financial
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A Roth IRA is a really flexible and powerful retirement savings tool that
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can help you get tax free income in retirement, and it can help
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you pre pay your taxes if you think that's the right thing to
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do. But if you're not entirely clear on what happens when you take
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money out of those accounts, that's what we're going to talk about here,
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so we'll figure out if you can get tax free income,
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or what happens when you take early withdrawals from a Roth. As a
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quick refresher, the question is, "do you want to pay taxes on the
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seed that you plant or on the tree that eventually grows?"
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and that's an analogy for your Roth IRA. When you pay taxes on
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the seed, you're paying taxes on the investment that you put into the
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account up front, and the idea is that you won't pay taxes on
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the eventual tree or the amount that it grows to. Ideally,
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over many years, your investment will grow to be quite a bit bigger,
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and you can take that money back out, you have a pool of
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funds to draw from tax free in retirement[again, if all goes well].
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There are three factors that can help you figure out if you're going
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to pay taxes on a Roth withdrawal or an early withdrawal.
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One is the type of money you're taking out, so. Those regular contributions
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that you put in, if you're making the $6000 or $7000 per year
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contribution, those are your regular contributions, and you can take those
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back out of the account at any time without taxes and penalties.
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That's what makes a Roth really flexible. There may also be some earnings
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in your account, so that's a different type that would be on top
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of the contributions you put in, and that's where we may potentially have
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some taxes... We're going to get into that in a minute.
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Your age is also important. So the question is, are you over or
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under the age 59.5? And then we also want to know,
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have you had your Roth account open for at least five years before
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you take that distribution? So let's go through those types of money,
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again, we have the regular contributions, and just... Here's a visual representation
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of it. Let's say you put in 6000,
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this is just one year's worth of contributions, for example, and over some
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period of time, it gained $600 of earnings or 10%...
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Well, that's $6000 you could pull from... It's kind of like pulling from
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the bottom of your stack there, and you would not owe taxes or
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penalties on that, in fact, the IRS sets an order of withdrawals,
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and that says that that money is going to come out first,
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and again, it's tax free and penalty free money. Next, we have the
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earnings or any growth on your contributions, and that's where we need to
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pay attention to your age and the amount of time you've had your
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Roth account. One other type of money or bucket of money you might
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have is conversion money. So if you converted a pre tax IRA or
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a portion of your pre tax IRA to Roth, so that it would
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be ideally tax free later, that is a little bit different money type,
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and we're going to talk about how that works, but each conversion is
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treated separately. So if you've been doing partial Roth conversions, doing
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a little bit each year, then each of those is going to be
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treated separately with its own five year rule, and you might wonder about
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Roth 401k or Roth 403b savings. How do those fit into all this?
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Well, what usually happens is clients, at least typically move that money
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into a Roth IRA. They don't always do that, you don't necessarily have
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to... And there are some pros and cons. I've got videos that discuss
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that, but if you decide to take control of the money,
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maybe you can get more investment options, maybe you can get lower expenses,
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you can move the Roth 401k into your Roth IRA and then take
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your distributions from there. If you're going to go that route,
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it's a good idea to open up a Roth IRA if you don't
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already have one, and that way you can start the five year clock
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ticking so that when you do roll the money in, the account has
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been open for five years. It's important to not only open a Roth,
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but also fund it. So you can do that with a low cost
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investment provider or something, where you can just make a small contribution,
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if that's all you qualify for. Either way you want to get that
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clock ticking. We're getting a little complicated here, so the thing to
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know is that if you just want to make it easy,
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the way to get those tax free withdrawals from a Roth is to
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satisfy two requirements. One is that you're over age 59.5, and number two
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is that you have had the Roth open for at least five years
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before you take that withdrawal. You don't always have to do that,
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but that's the easiest way to just get the tax free withdrawals and
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satisfy the requirements. Now, let's look more closely at your age because
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this is a really important thing to potentially avoid taxes and or penalties.
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So there's a lot packed into this slide here. I'm going to include
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a link or two in the description that help you make more sense
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of this so that you can dig into these details yourself later and
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double and triple check everything. When you're over age 59 and a half,
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and again, you've had your account open for at least five years,
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then you can take those earnings out. Not only the contributions,
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but the earnings on top of it. You can take that money out
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without taxes and penalties, that's what's called a qualified distribution,
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but if you don't meet that five year rule requirement, then you may
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have to pay income tax on the distribution, or at least on the
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earnings portion of the distribution. So there's not a 10% penalty tax,
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but there may be income tax when you're under age 59 and a
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half, but you have met the five year rule, you're going to pay
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income taxes potentially on that earnings portion. And if you haven't met
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that five year requirement, then you can have income tax plus an additional
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10% penalty tax. Like I said, this can get really complicated with a
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couple of different moving parts. You've got your age and then a five
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year rule, and you've got these potential exceptions that can help you avoid
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some taxation. A few of those exceptions are listed here. The important
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thing to do is look them up and make sure you know what
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they are and stay current on all of these rules, and then communicate
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that to your CPA or your tax preparer. So if you do take
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an early withdrawal, they know that you can potentially get an exception
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applied and reduce the amount you owe. Now, let's touch on conversions.
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Again, if you have taken pre tax money in a traditional IRA,
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for example, and converted that over to Roth type money, there are separate
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five year rules for that, and there's a separate rule for each conversion.
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The reasoning behind this is that the IRS doesn't want people to use
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Roth conversions as a way to get around the early withdrawal penalties on
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their pre tax money. So if you had money in a pre tax
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account and you're under age 59 and half, you might say "Well,
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gee, I can just convert that money, pay the taxes on it,
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and then pull it out of my converted Roth, and I don't have
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to pay an early withdrawal penalty." The IRS apparently caught on to that,
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and so when you are under age 59.5, you can still potentially pay
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a 10% early withdrawal penalty even on the amount you convert,
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so you pay taxes on it, you might think it's free and clear,
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but you might still owe a 10% penalty tax on that.
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So just be very careful. Another question that comes up is often,
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What if they change the rules? So I go ahead and pre pay
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my taxes thinking that I'll get a benefit in the future,
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hoping that that will work out, but what if they pull the rug
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out from under me and decide to tax those distributions?
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Anything is possible. What I would say is it's just really hard to
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predict future, and trying to get too fancy is often something that can
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backfire for people. There are several ways that lawmakers could raise revenue
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for the Treasury, and maybe there's a value added tax, or a consumption
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tax that's similar to a sales tax that you might pay locally.
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So you don't necessarily want to just assume that the only way they
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do that is by taxing your Roth. There's some research out there that
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shows what would happen if they did decide to try and tax those
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earnings. So we can say, out of all of the available revenue sources,
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if the IRS was to start taxing the earnings from Roth accounts,
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how much would that be? And what you can see is that that
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slice is actually a really small piece. That doesn't mean it's nothing.
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So it certainly could be attractive for taxation, but the political price
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that lawmakers might have to pay if they decided to go down that
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road could be steep, and the pay off is not necessarily huge.
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So the question is, will they do that or not? Obviously,
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we don't know anything is possible, but at least at this time,
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it doesn't look like a huge risk to reward thing for lawmakers.
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But again, those balances could grow substantially over the years, making
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it a more attractive source of funds. Just remember the benefits of Roth,
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and that is that if all goes well, you can potentially pay taxes
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at a lower rate today, and I've got some videos that discuss the
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math behind that if you want to look into it, and it's not
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just your federal income tax that matters with Roth versus pre tax type
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retirement accounts, you can also just minimize your income, which can help
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your tax return, which might cause you to not have to pay taxes
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on your Social Security income, it could keep your healthcare expenses low.
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So there are a number of benefits, if this all goes well.
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So if this has been helpful for you, please leave a quick thumbs
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up. That helps to get the word out to other people,
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and please subscribe as well, helps you stay up to date on these
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things and again, helps me out just a tiny bit, so...
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Thank you and to take care.
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