One significant advantage of a Roth IRA is that these accounts do not have required minimum distributions. That means you are not forced take out a certain amount each year so these funds can remain in the Roth IRA, earning tax-free. If you do decide to withdraw funds from your Roth IRA, there are rules to follow to avoid taxes and penalties. Because there's no tax deduction for Roth contributions, you can retrieve that money at any time free of taxes and penalties, regardless of age.
But for earnings to be tax- and penalty-free, you have to pass a couple of tests. And you must have had one Roth open for at least five years. The clock for that five years starts on January 1 of the year that you make the conversion. You could make the conversion late in a year, meaning you only have to wait closer to four years before you can touch earnings without penalty.
Each conversion has its own five-year holding period. So if a young account owner does one conversion in and a second conversion in , the amount from the first conversion can be withdrawn penalty-free starting in and the amount from the second starting in The rules for determining the source of money coming out of a Roth work in the taxpayer's favor. The first money out is considered contributed amounts, so it's tax- and penalty-free.
Once contributions are depleted, you dip into converted amounts if any. Only after you have cashed out all converted amounts do you get to the earnings. In essence, this account can act as an emergency fund and could be used to pay off significant unexpected medical bills or cover the cost of a child's education.
But it's best to only tap into these funds if it's absolutely necessary. And if you must withdraw any money from a Roth IRA before retirement, you should limit it to contributions and avoid taking out any earnings. If you withdraw the earnings, then you could face taxes and penalties.
But that process is now prohibited by the Tax Cuts and Jobs Act of However, you can still recharacterize all or part of an annual contribution, plus earnings. You might do this if you make a contribution to a Roth IRA then later discover that you earn too much to be eligible for the contribution, for instance. You can recharacterize that contribution to a traditional IRA since those accounts have no income limits. The change would need to be completed by the tax-filing deadline of that year.
The recharacterization is nontaxable but you will need to include it when filing your taxes. Unlike traditional IRAs—which you must begin to tap at age 72—Roth IRAs have no minimum distribution requirements for the original owner. So, if you don't need the money, it can grow in the tax shelter until your death. This is true for spousal heirs as well. A spouse who inherits your Roth IRA is never required to make withdrawals.
Those who inherited an IRA — either a traditional or Roth — after that cutoff must now withdraw the money within a decade. There are a few exceptions to this, including if the heir is disabled, a minor child of the original owner or less than a decade younger than the original owner. However, keep in mind that these withdrawals are tax-free. That means if you wait until the tenth year to withdraw all of the funds, you will benefit from almost 11 years of tax-free growth.
The tax advantages are some of the greatest benefits offered by a Roth IRA. Investing involves risk including loss of principal. This information is presented for educational purposes only and is not a recommendation to buy or sell a specific security or engage in a particular strategy. Acorns does not provide legal or tax advice. Nancy Mann Jackson writes regularly about personal finance and business.
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