Retirement Answers

Jacob: 00:00

Hey everybody, and welcome back to another episode of Retirement Answers. My name is Jacob Duke, I help people just like you who are thinking about retirement or who already are retired, plan out a successful retirement so that you can live comfortably and live confidently. So today is July 4, and I wanted to wish you a happy July 4 and also extend a sense of gratitude and appreciation and send a big thank you out to those who are either active or former military. Thank you so much for your service to this country. Thank you for the price that you've paid to allow us to have our freedoms and do the things that we enjoy doing on a daily basis.

Jacob: 00:33

So what you've done does not go unnoticed. So today I wanted to just go through a few different questions that I've gotten recently and answer those for you. And if these are questions that you've had, hopefully this is helpful for you. If you have questions that you would like to have answered here on the show, please email me at jacob. Dukeappliedcapital dot com.

Jacob: 00:51

And that is where I can receive your question and then also answer them here on the show. So if you want that to happen, go ahead and email me there, and I'd be happy to answer your questions here on Retirement Answers. So the first question that I wanted to go over together is one that I got recently, and it's around the idea of Roth conversions. And the question is, I have IRA accounts, and I'm curious if I can start doing conversions on those before I turn 59.5. And the reason for this question is, is most people know that whenever they have an IRA or a Roth IRA, they're unable to take at least a portion of that money out of that account before 59.5, because you would be taking it out early before you turn the appropriate age.

Jacob: 01:28

And so whenever it comes to conversions, there is sometimes a little bit of confusion there because there are a few different five year rules, whether it be on contributions, but then also on conversions. And so the answer to this question of, can I convert money to Roth IRAs before 59.5 is yes, you can convert money from a traditional IRA to a Roth IRA before fifty nine and a half, because conversions are not considered distributions? You're not actually taking money out of an IRA account. You're just moving it from one IRA account to another. Now I do wanna make one important point here.

Jacob: 02:02

If you're gonna be doing a Roth conversion before 59.5, it's probably a wise decision to pay the associated taxes with cash that would be at your bank account, as opposed to withholding the taxes out of your IRA to pay the taxes for the conversion. The reason is, is anytime you do a conversion before 59.5, and you're withholding the taxes from your IRA account to pay those taxes on the conversion with, you are gonna pay a 10% penalty on top of the taxes that you would be withholding. So the tax withholding is considered a distribution from your account. So if you're before that age 59.5, you would owe the additional 10% early distribution penalty because of that. So if you're doing a Roth conversion before 59.5, I would encourage you to pay the taxes with cash as opposed to withholding that from your IRA.

Jacob: 02:51

Now, you're 59.5, you can withhold the taxes from your IRA. Once again, this is still potentially a benefit for you to do the Roth conversion, but ultimately the best way to do a Roth conversion at any point is to do the conversion and then pay the taxes out of cash and let all of the converted amount stay in the IRAs or Roth IRAs so that you can grow that money faster tax free as opposed to make up a whole or a difference if you are withholding the taxes out of the conversion amount. So I hope that's helpful whenever thinking about Roth conversions before 59 and 0.5. So thank you so much for that question. That's a really good one.

Jacob: 03:23

All right, the next question I have for us says that I'm 61 years old. I've made after tax contributions to my four zero one k. And just to be clear, this is different from Roth contributions to a four zero one k. These are after tax monies that are in a traditional four zero one k. Then this four zero one k allows in service withdrawals.

Jacob: 03:41

If I wanna transfer the entire after tax dollar amount to a Roth IRA and its earnings to a traditional IRA, does the pro rata rule apply to this distribution? I also have a significant amount of pre tax money remaining in the four zero one ks. So this is a really interesting question, and it's one that is very confusing most of the time. And whenever we think about money that is in a four zero one ks, we think about typically a Roth four zero one ks or a traditional four zero one ks. Well, within a traditional four zero one ks, you can contribute after tax dollars to that traditional side, which means you've already paid the tax on it, and typically the money in the traditional four zero one ks is pre tax money.

Jacob: 04:18

So, you can co mingle these types of dollars within a four zero one ks plan. Now, this is not something that everyone does, but just know that it is a possibility. And sometimes I run into this issue with some clients. And the issue is whenever we decide to roll over or transfer out of the four zero one ks to an IRA or a Roth IRA in the future. So any distribution that you take from an employer plan will be treated as a pro rata distribution.

Jacob: 04:42

Now, a distribution can be split and go to more than one destination. So the way that this works is you would need to designate any pre tax amount to go directly to your IRA, your traditional IRA, and then you can designate any after tax amounts to go to your Roth IRA. So the after tax money is not Roth money within the four zero one ks, but whenever you take a rollover or a distribution, you can say, I want that after tax money to go to my Roth IRA account. Now, many employers will do only one direct transfer, so you end up with the after tax money being sent directly to you, and then you have sixty days from the date you receive the funds to complete the rollover by depositing those after tax dollars into your Roth IRA. So that's what's called a sixty day rollover.

Jacob: 05:23

Now now you're not limited to this particular scenario, like you have to do it this way. You can split up your distribution any way you want. And for example, you can send all of the dollars to your IRA or send some of the after tax money to your Roth. But I will warn you that whenever you have pre tax and after tax dollars in your four zero one k, remember, this is not Roth money. That's the hard part to remember.

Jacob: 05:43

Whenever you have that co mingling of dollars, whenever you do a rollover, that's your opportunity to separate these two types of money. Right? You have pre tax and after tax, so you would want the pre tax money to go in your traditional IRA, and you would want your post tax money to go into the Roth IRA. Whenever you have an IRA, let's say you have Basis, which is called after tax dollars, let's say you have that Basis in your IRA, you run into the issue of having to distribute money out of that IRA whenever you take a distribution pro rata, meaning whatever portion of after tax dollars as a percentage of your account is in your IRA, anytime you take a distribution from that account, you would have to take that percentage of after tax dollars on that distribution. So for example, let's say you had $100,000 in your IRA, and 10,000 of that was post tax money, meaning it's already been taxed.

Jacob: 06:32

So you have 90,000 pre tax and 10,000 post tax. That's 10% of your overall account balance. Anytime you take a distribution from your IRA account, let's say you take $10,000 out of your IRA account, you don't get to pick whether or not you pulled the pre tax or after tax, you just have to take that pro rata, meaning 10% of your $10,000 distribution is always gonna be your after tax money, and the other 90% is gonna be pre tax money. The hard part is, is you have to know how much pre tax and post tax money you have in it. So you have to keep up with the accounting yourself, because if you don't keep up with the accounting, then you don't know how much post tax money you have.

Jacob: 07:09

Therefore you may not be able to claim that you don't owe taxes on that money whenever you take it out. So whenever you have post tax money in the account, you have to know where did it come from, because you can make non deductible contributions to an IRA and you can roll over after tax dollars from your work four zero one ks into your IRA. But regardless of how the after tax money arrived, you must know that the pro rata rule dictates that a person cannot cherry pick only the basis from an IRA or subsequently withdraw or do a Roth conversion do with just those after tax dollars. You have to take all dollars out pro rata. So keeping up with your basis, if you have after tax money, finding a way to separate those two things, pretax and after tax, especially if the money is still in a four zero one ks becomes very important and understanding how much tax you will or will not owe on distributions from those commingled funds in the future.

Jacob: 07:59

So the one takeaway that I want you to hear from this question is, if you have money in a four zero one ks, before you do any rollovers or transfers out, I want you to check with the custodian or the plan provider and say, do I have any after tax money in this account? Remember, tax is not Roth within a four zero one ks, they're two separate things. So ask that question if you have no after tax, you don't have anything to worry about. If you do have after tax, it's important that you distribute or roll over those funds appropriately, as I mentioned earlier. So that's a really complicated question.

Jacob: 08:31

I don't know if I made it more confusing or if I cleared it up, but that's something that maybe if you have questions about that, feel free to email me and I can have a more in-depth conversation and personal conversation with you on your specific situation. Because like I said, this is a confusing topic whenever we talk about commingled funds, pre tax, after tax, and then obviously having basis in an IRA. Okay. The third and final question for today's episode has to do with Inherited Roth IRAs and whether or not those are gonna be taxed and kind of how that works. So the question is, am I correct to assume that if I leave my Roth IRA to my two adult children, they will have to take all that money out by year ten, and they will have no taxes to pay on it because it's a Roth.

Jacob: 09:12

They can take out some money each year if they want to, but they have the option to leave it all in for the ten years if they if they want to as well. Okay, this is a great question, and it's something that's gonna apply to most people because most people have a Roth IRA, and one day whenever they pass away, they will leave that to someone who is younger than them if they're not a spouse. So the answer to that is assuming that you've had that Roth IRA for five years, then yes. Your children, they can inherit that money, the entire account, and it will be available immediately tax free. However, they cannot leave that money in the Roth IRA forever, meaning they will have to take a distribution, it's just a matter of when.

Jacob: 09:46

They can take as much or as little as they want each year, but they will have to have that account emptied by the end of the tenth year after your death. So going back to the SECURE Act, there were a few rule changes in terms of how beneficiary IRAs worked. And so no matter what, if you're a non designated beneficiary, meaning you're not a spouse pretty much, meaning there's a few different categories of people that are considered designated beneficiaries, they receive special treatment when it comes to inherited IRAs as a beneficiary. But if you're a non designated beneficiary, which children are, you have to take out all money that you received from an IRA or a Roth IRA, you have to have that all taken out by the end of the tenth year. So for a Roth IRA, the rule is slightly different because you can elect to not take that money out until all of it at once at the end of the tenth year.

Jacob: 10:36

Remember, you're not being taxed on that money, that is gonna be tax free to you, but you've allowed that money to grow tax free for ten years after your parents had passed away to continue compounding and growing tax free. On the other end of the spectrum, the traditional IRA, that money has that same ten year window, but you are required to take one tenth out every year for the ten years. And then ultimately, after those ten years, you will have no dollars left in your inherited IRA. You have paid tax on it to take the money out, and you will do whatever you want to do with that money. So slightly different rules, but for this specific question, will my children owe taxes on the Roth IRAs whenever they receive it as an inheritance one day?

Jacob: 11:14

No. And then will they have to take all that money out at some point? Yes. By the end of the ten year window after your passing. So hopefully that's helpful as you think about your estate planning and some of the different questions around taxes for beneficiaries one day.

Jacob: 11:27

Once again, thanks so much for tuning in to this week's episode of Retirement Answers. If you have questions, feel free to reach out to me at my email that I stated earlier. And other than that, I hope you have a great July 4 and look forward to talking with you again next week.