Hi there. I'm struggling understand the optimizer's thinking w/r/t spending down my Roth accounts in early retirement.
My understanding that, under age 59 1/2, only previous contributions can be accessed tax-free. However, Pralana seems to be proposing to drain the entire account in the first few years of my retirement, before I or my spouse reach 59 1/2. I think this would be a major tax hit but I don't see any income tax liability in those early years.
My understanding is that these funds would be taxed at withdrawal as regular income (well, at least the gains) but I don't see my income going up or taxes being withheld for these amounts. Am I missing something? Or is my understanding of the taxability not correct? And is it this also subject to an early withdrawal penalty? It's a big chunk of money - $670,000 liquidated over four years.
As a picture is worth 1000 words, attached are some pics (and comments/questions) that might help to explain it better.
Thanks for any ideas or pointers.
From the bogleheads.org wiki, you can always withdraw your contributions without tax or penalty. You can also withdraw conversions amounts that were made more than 5 years prior without tax or penalty. The rules change again once you reach 59.5 but haven't had your Roth for 5 years and then finally once you are over 59.5 and have had the Roth for 5 years, you can do what you want.
https://www.bogleheads.org/wiki/Roth_IR
Quoting from there:
The amounts you withdraw from a Roth IRA are considered to come out of the account in the following order of categories, each with its own tax consequences:[14]
- Regular contributions
- Taxable portion of first conversion (portion that was taxed at time of conversion)
- Nontaxable portion of first conversion
- Each subsequent conversion, in chronological order, with the taxable portion coming out first for each conversion
- Earnings (any increase in value occurring inside the Roth IRA)[15][16]
The tax treatment is summarized in the following table, from information supplied by KAWill (Fairmark). A "Qualified" distribution incurs no federal tax or penalty.
| Withdrawal | Treatment | Under age 59½ | Over age 59½ | ||
| Five year conversion holding period not met | Five year conversion holding period met | Less than five years since opening first Roth IRA | Five years or more since opening first Roth IRA | ||
| Contributions | Tax | No | No | No | Qualified |
| Penalty | No | No | No | ||
| Conversions, taxable portion | Tax | No | No | No | |
| Penalty | Yes | No | No | ||
| Conversions, nontaxable portion | Tax | No | No | No | |
| Penalty | No | No | No | ||
| Earnings | Tax | Yes | Yes | Yes | |
| Penalty | Yes | Yes | No | ||
Pralana doesn't know if what you contributed vs. converted, nor does it know when you did the conversions. Note that unless you are doing something with a big payoff like squeezing in to get an ACA subsidy, it's usually not a good plan to use your Roth early. That money is the best protected from taxes, you'd like to keep it around.
Withdraws from Roth's continue to be hard to follow. Thumb nail: for Roth conversions, there is no penalty if you are over 59 1/2, no matter when you converted it. Starting a new Roth or Roth 401K, the 5 year rule starts with the very first Roth you opened up (additional Roths do not reset the 5 years), must wait 5 years, and be over 59 1/2.
From Ed Slott https://irahelp.com/roth-iras-and-5-year-rules/
Roth IRAs have a couple of different rules, including two separate 5-year rules. The easiest way to understand these rules is to remember that a Roth IRA consists of two parts: (1) contributions/conversions and (2) investment gains/losses. This is important because contributions can always be withdrawn at any time, tax and penalty free. The earnings, however, are potentially taxable and could be hit with the early distribution penalty.
The Ordering Rules
Before jumping into the two 5-year rules and their examples, it’s important to understand the ordering rules for Roth IRA distributions. Thankfully, the IRS created the rules in a way that looks to benefit taxpayers. That is because the first dollars withdrawn are considered basis (contributions), which is always tax and penalty-free. If the distribution exceeds the Roth IRA basis, the excess is considered coming from converted funds, if any have taken place. With conversions, we use the oldest conversion first, thereby increasing the chance that the holding period (described below) has been met. Finally, any amount left over after the application of the first two tiers is considered earnings.
Conversion Rule
The first 5-year rule only applies to conversions and even then, only if the individual is under age 59 ½. It was adopted to prevent taxpayers from skirting the 10% early distribution penalty. For example, let’s say I have a traditional IRA and am under age 59 ½. If I take a distribution from this account, I pay taxes and trigger the 10% early distribution penalty. However, conversions do not trigger the 10% penalty. Thus, if this 5-year rule didn’t exist, I could convert all, or a portion of the traditional IRA to a Roth IRA, pay tax on the conversion, and then immediately take a distribution from the newly converted Roth IRA without triggering the penalty.
As a result, converted amounts are subject to the 10% early distribution penalty unless they were held for 5-years or the taxpayer is at least age 59 ½. Each conversion is subject to its own, separate, 5-year holding period.
Example: Melanie converts $50,000 to a Roth IRA in 2012 and another $60,000 to the same Roth account in 2014. She has not made any other contributions or conversions to the account. In 2018, at the age of 50, she takes an $80,000 distribution. Assuming no other exception to the 10% penalty applies, Melanie will owe the early distribution penalty on $30,000 (i.e., $3,000 tax). Under the ordering rules, $50,000 of the distribution is applied to her 2012 conversion, which has met its 5-year holding period. However, the remaining $30,000 is applied towards her 2014 conversion, which has not satisfied the 5-year rule. Thus, even though her withdrawal isn’t subject to income taxes, part of it will be subject to the 10% early distribution penalty.
Qualified Distribution Rule
The second 5-year rule mainly applies to earnings and determines whether a distribution is qualified, and therefore is tax and penalty free. A qualified distribution is one that paid after the 5-year holding period and:
- After the Roth IRA owner reaches age 59 ½;
- After the Roth IRA owner is totally and permanently disabled;
- To a beneficiary after the Roth IRA owner’s death; or
- To a Roth IRA owner for a first-home acquisition ($10,000 lifetime limit)
Unlike the conversion rule, this 5-year rule only applies once and is not separately tracked for every contribution or its earnings. Therefore, the 5-year period begins running as soon as the first dollar is contributed, converted, or rolled into any Roth IRA.
Example: Francisco contributed $5,000 to his Roth IRA in 2010 and 2011. He then converted another $10,000 in 2012. The account has produced $5,000 in earnings, giving Francisco a $25,000 balance. In March of 2018, Francisco decides to withdraw the entire balance. At the time of distribution, Francisco is 43 years old. What happens?
- He’s met the 5-year rule for qualified distribution and the separate 5-year rule for conversions. However, he’s not yet 59 ½, so unless any of the other conditions apply, the distribution will not be qualified.
- The first $10,00 is a return of basis and therefore isn’t taxable.
- The second $10,000 is a return of converted funds and also isn’t taxable and is not subject to the early distribution penalty.
- The last $5,000 is the earnings and those would be subject to both income tax and the early distribution penalty.
In the end, Roth IRAs provide numerous benefits, and historically low tax rates make them more attractive than ever. But like any transaction, make sure you understand the rules, and any potential pitfalls before taking the plunge.
Thanks for the info. I understand the rules and realize it's not a great idea to empty a roth. But Pralana really likes to take out this money first when I use Analyze | optimize Withdrawal priorities. The difference in outcome over the plan life is several hundred thousand dollars for the Roth vs. proportional withdrawals.
However, I also suspect this isn't really correct becuase it seems like Pralana isn't assessing any tax or penalty to this (pre-59.5) withdrawal, even when it drains the entire account (!)
I also looked again at the initial account balances page. I notice that Pralana doesn't ask about the Roth account makeup, so it doesn't know if the funds are from return of contributions or growth. But it DOES know my age at the time of withdrawal, so I would think it would/should assess the penalty for early withdrawl of earnings. (And I also wonder if it did then would that be enough for the optimizer to stop prioritizing the Roth account in the first place?)
Bottom line - should I assume that Pralana's current pre-59.5 Roth spenddown behavior is not really accurate and/or a good idea? Sure seems that way.
@ricke Thanks. The table is very helpful, and confirms my suspicion that the withdrawals of earnings from a Roth would be taxable and penalty-able for me before age 59.5.
However, it seems like Pralana is not assessing the tax and penalty, which are due only on the growth, because it doesn't know the breakdown of earnings vs. growth in the overall account. (But it could in theory ask in the initial setup, right?)
Correct, it doesn't know your history and since there is a 5 year clock for each conversion involved, plus a 5 year clock on the account, plus the rules change again at 59.5, the water is too deep for Pralana to wade into.
The order of withdrawal optimizer is considering hundreds of combinations already, and the calculation grows factorially when you add another type of account taxation to add. So adding even one more type of account (say Roth with non-qualified earnings) jumps the math into the tens of thousands of combinations. And with the real level of complexity, with all the Roth clocks running, it would take approximately forever to run.
I think you are right that it's not a realistic plan. Perhaps you can approximate a better plan by modeling the portion of the Roth with non-qualified earnings as an HSA. HSAs are not considered in the withdrawal optimization routine. While it seems obvious that you shouldn't use the non-qualified money, you can test to be sure by telling it you are doing a Non-Qualifying HSA withdrawal during that time.
I'll attach a handy reference flowchart on whether Roth withdrawals are penalty free.
@ricke Thanks. I'll try this option and will see what happens.
As predicted - big difference in the outcome when making a 529 account for the value of the account growth in the roth, and leaving only the contributrions in the roth itself. Pralana now not so eager to drain the roth account at the beginning of my plan.
