A divorce can throw a curveball into retirement income planning even for the most financially savvy client. When two spouses divide retirement plans in a divorce, it's critical to pay close attention to the details.
Roth IRAs can be particularly valuable to a client's future retirement income planning because, most of the time, withdrawals are taken tax-free, so they won't increase the client's future taxable income. It's not at all uncommon for clients to transfer these valuable Roth IRA assets to a former spouse in a divorce. After all, the bulk of a client's assets may be tied up in retirement savings accounts.
It's important to remember that many clients simply look at Roth IRAs as a tax-free source of income, and they might not understand the nitty-gritty rules. One critical issue that clients may overlook when transferring Roth assets pursuant to a divorce settlement is the so-called "five-year rule" that applies to distributions from Roth IRAs.
What Is the Five-Year Rule?
Typically, all withdrawals from a Roth IRA are taken on a tax-free basis. That includes both contributions, which the account owner paid taxes on before they were contributed, as well as earnings on those contributions.
However, the distribution must be a "qualified distribution" for the earnings on after-tax contributions to receive tax-free treatment. A distribution is only "qualified" if it is taken after the five-year period beginning with the first tax year that the owner opened the Roth IRA and made a contribution to the account. This is known as the "five-year rule."
Distributions that are taken within five years of the date the account is opened will be subject to ordinary income tax to the extent that those distributions represent earnings on after-tax contributions.
In other words, the contributions themselves will not be subject to tax a second time. The distribution could, of course, be subject to the 10% early withdrawal penalty if the client is not yet 59 ½ (unless another exception to the penalty applies).
