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Slott Report Mailbag: I Am Confused About the Roth IRA 5-Year Rules!

So, another consumer is confused about the Roth IRA 5-year rules. Who isn't (they are confusing)? We devote an entire pamphlet to it on our online store and have written more than our fair share on the subject on this website since its inception. And still (rightfully so), the Roth IRA 5-year rules are confusing and continue to trip up consumers and less-informed financial advisors.

This week's Slott Report Mailbag includes an answer to a question on those rules, as well as an inquiry on spousal beneficiary rules and the differences between an IRAs and fixed annuities. As always, we stress the importance of working with a competent, educated financial advisor to keep your retirement nest egg safe and secure. Find one in your area at this link.


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I have a qualified Roth 401(k) that I have to withdraw from my company retirement plan when I turn 65 in a few weeks. I had met the 5-year rule on contributions and earnings for the Roth 401(k), it's deemed "qualified" by the plan, but I now find that if I roll it over to a Roth IRA, the clock starts over. I don't understand this quirk that I found reading through the IRS guide. It wasn't mentioned in the plan details or by my financial planner. I thought I had earned access to this money already. I also had planned to continue to contribute to the Roth IRA by converting funds from my traditional 401(k) each year. What are my options?

Because your distribution from the Roth 401(k) is qualified (tax-free), those funds go into your Roth IRAs as basis. That basis can be withdrawn anytime without tax or penalty. There’s no 5-year clock that applies to those rollover funds in this example, but a 5-year clock will apply to earnings on those funds. If the earnings are withdrawn from the Roth IRA within five years, they will be taxable.



Just trying to help my mother and save her some money. My father passed away, leaving her some properties and a couple of retirement accounts. She is named as beneficiary on all accounts.

What we would like to do is place the money from the CD we closed out, about 25,000, and two IRA’, about 80,000 each, into her IRA just so it is easier to manage. Can we do this all at once without penalties?


Your mother, as a spouse beneficiary of your late father’s IRA, can rollover or transfer the IRA funds to her own IRA. Any non-IRA money she inherited, such as a non-IRA CD or proceeds from the sale of non-IRA properties, can never be put into an IRA. If your mom is under age 59 ½ and needs the IRA money to pay bills, she should not roll over or transfer to her own IRA, but instead leave it as a beneficiary IRA. That way, she won’t be hit with the 10% penalty for early distributions. She should speak with a competent advisor before making any decisions.


My husband and I are both retiring in about a month, and we both have government retirement savings accounts. We are bombarded with financial planners wanting us to roll over our TSP (thrift savings plan) and 401(k) plans into lifetime income annuities. Since neither are FDIC protected, which is safer, IRAs or fixed annuities? The more we research on the subject, the more we are confused. Thanks

Please click on the “Find an Advisor” tab on our website to find an Ed Slott trained Elite IRA Advisor in your area. Your decision on the investments of your retirement funds should be based on your individual circumstances and future income needs. For many individuals, the security of an annuity is what is important to them. Be sure you understand all your distribution options and the options available to your beneficiaries, if that is a planning point that is important to you. You also need to understand the costs involved in the annuity. Some annuities cost a lot more than others.

- By Joe Cicchinelli and Jared Trexler

"How is My Annuity Going to Be Taxed?"

“How is my annuity going to be taxed?” It’s a question that's asked frequently, but one that can have several different answers. That's because an annuity can be taxed differently depending on the type of annuity you are receiving distributions from, as well as the type of the account it's in.

annuity taxFirst, let's make sure that we understand annuities generally fall into one of two categories. Either they are in “deferred status” or they have been “annuitized.” With a deferred annuity, you generally still exercise some control over your investment. On the other hand, annuitization is generally an irrevocable election where you essentially turn your money over to an annuity carrier in exchange for a series of payments.

Distributions of deferred annuities (that have not been annuitized) held in non-qualified accounts are taxed on what is known as a LIFO, or last-in, first-out basis. This means that if you have any earnings in your annuity, they are the first dollars considered to be distributed and are taxable as ordinary income. Only after you have exhausted your earnings will you receive distributions of principal - your initial investment in the contract - back tax free.

Example: You purchase a deferred annuity for $100,000 and the value has now grown to $115,000. While still in deferred status, you take a $12,000 distribution. The entire distribution would be taxable as ordinary income because you have not yet exhausted your $15,000 of earnings. If, instead of taking $12,000 you took $18,000, you would have taxable income of $15,000 and a return of basis of $3,000.

Distributions of annuitized annuities purchased with after-tax funds are taxed a little bit differently. Instead of being taxed on a LIFO basis, a portion of principal is returned with distributions. If you’ve annuitized your IRA over a specific number of years (i.e., 20 years), your principal will be distributed to you evenly over those years. If, on the other hand, you’ve annuitized your annuity contract over one or more life expectancies, your principal will be returned to you over the predicted life expectancy. An annuity company will calculate this “exclusion ratio” for you and can tell you how much of your distributions will be taxable and how much will be tax free.

Example: You purchase an annuity for $100,000 that is annuitized over 20 years and guarantees annual payments of $6,500. Each year, $1,500 of your distribution will be tax free and $5,000 ($100,000/20 = $5,000) will be taxable.

What if, on the other hand, you purchase your annuity with traditional IRA or Roth IRA money? Well here’s where people get confused. For the most part, you can throw away everything above, because when an annuity is purchased with retirement account money, distributions from that investment follow the applicable rules for the specific retirement account.

For example, if you purchase an annuity with traditional IRA money and start taking distributions, for tax purposes, it really doesn’t matter whether it’s been annuitized or not. If those distribution checks are going straight to you (i.e., the money is no longer in an IRA), then the entire amount is generally taxable because IRAs are generally funded with pre-tax dollars.

Similarly, if you purchase an annuity in a Roth IRA and begin to take distributions, the tax impact will be determined based on the Roth IRA rules. So, for instance, if you are already age 59 ½ and have owned a Roth IRA for at least 5 years, any distributions from Roth IRA-owned annuities will be considered qualified distributions and will be completely tax free.

- By Jeff Levine and Jared Trexler

Using Post-Nuptial Agreements for Employer Plan Benefits is RISKY

A recent court case highlights how risky it is when a married couple attempts to use a post-nuptial agreement when trying to waive spousal benefits to an employer retirement plan. In the case of Mid-American Pension v. Michael Cox, the court ruled that a surviving wife’s promise to waive her rights to her husband’s 401(k) funds by signing a post-nuptial agreement was invalid because the agreement wasn’t drafted correctly. As a result, she didn’t waive her rights and inherited his 401(k) money after he died, even though her husband wanted his parents to get the money. The interesting part of the case was that the husband and wife were married and divorced to each other twice before.

While the husband was single, he named his parents as the beneficiary of his 401(k) plan where he worked. Sometime later, he and his ex-wife remarried for the third time. Apparently, they both thought that the marriage might not work, so they both signed post-nuptial agreements.

In the post-nuptial agreements, they agreed that if their marriage ended again, they each waived their rights to each other’s property. With respect to her husband’s 401(k) plan, the wife specifically disclaimed all of her rights to it. A little over a year after the remarriage, the husband filed for divorce from her for the third time. Unfortunately though, he died about a week later, before the divorce was finalized.

His parents, who were named as the beneficiaries, and his surviving wife fought over who should get his 401(k) money. The court decided that his wife should get the money as her husband’s surviving spouse, despite the fact that she signed a post-nuptial agreement waiving her rights to his 401(k). Generally, a spouse is entitled to their spouse’s employer retirement plan funds unless they sign a waiver. Basically, if the idea was for her to waive her rights to the plan benefits, she should have signed a form provided by the plan.

Under federal pension law, there are many very strict legal requirements that must be met when a spouse tries to waive his or her rights to the other spouse’s retirement benefits. In this case, those rules weren’t met because the post-nuptial agreement was drafted incorrectly. So because the agreement wasn’t written properly, the soon-to-be-but-not-yet ex-wife got everything.

Whoever drafted the agreement didn’t understand the rules on how a spouse waives his or her rights to retirement plan money. In hindsight, they should have taken the easy route and used the plan’s form.

- By Joe Cicchinelli and Jared Trexler

The Kay Bailey Hutchison Spousal IRA Receives Congressional Agreement

kay bailey hutchison spousal IRAThe Kay Bailey Hutchison Spousal IRA: what a mouthful! We now have this thanks to a bill that was signed into law on July 25, 2013 that renamed the section of the tax code that specifies the spousal IRA contribution limit.

Kay Bailey Hutchison was one of the sponsors of the bill that increased the spousal IRA contribution limit to equal what a working spouse can contribute to an IRA. For 2013, that amount is $5,500, but if you are 50 or older by the end of this year, you can add an additional $1,000 for a total contribution of $6,500. The working spouse’s earnings must equal or exceed the amount of all IRA contributions. If you are turning age 70 ½ this year or are older, you can’t make a contribution to your IRA, even if your spouse is still working (and even if your spouse is under age 70 ½).

Kay Bailey Hutchison did not seek reelection in 2012. Her colleagues in the Senate chose to honor her service and her dedication to women’s issues by renaming this section of the tax code. And, for whatever reason, enough members of Congress could agree on this issue to pass the bill.

Meanwhile, we have a host of  issues that need to be resolved that will impact the well-being of all American citizens and, on these issues, Congress chooses to continue to posture and hold its uncompromising positions. Tax reform has been pushed off to the fall. We have major budget issues, which look like they will never be resolved. There are many, many presidential appointment positions that continually go unfilled because of Congressional actions - not inaction.

But we have the Kay Bailey Hutchison spousal IRA. On that, Congress could agree. Maybe we can build on this.

- By Beverly DeVeny and Jared Trexler


Thursday's Slott Report Mailbag

Consumers: Send in Your Questions to [email protected]

You recently said that a 401(k) distribution would add to your MAGI (modified adjusted gross income) for the purpose of determining if you are subject to the 3.8% healthcare surtax. What about Roth IRA distributions? Would they also count towards your total MAGI income for surtax purposes?


IRA distributions are exempt from the 3.8% surtax, but taxable distributions from IRAs can push income over the threshold amount, causing other investment income to be subject to the surtax. Because Roth IRA distributions are generally tax-free, they don’t count towards your total MAGI.