Motley Fool Hidden Gems Investing - Your Roth Won’t Be Tax-Free If You Break These Rules

Starting point is 00:00:00 The rules that make your Roth tax-free and the Social Security time bomb ticks louder. You're listening to the Saturday Personal Finance Edition of the Motley Fool Hidden Gems Investing Podcast. I'm Robert Brokamp, and for this week's main segment, I outline the sometimes complex rules you must follow to ensure the distributions from your Roth accounts are tax-free. But first up, let's turn to some news from this past week, starting with the release of the latest Social Security trustees report on Tuesday. And well, folks, the news isn't good. The Social Security Retirement Trust Fund is now projected to run dry in late 2032,

Starting point is 00:00:38 one quarter earlier than last year's estimate, and a full year ahead of where projections stood just a couple of years ago. The primary culprits behind the accelerated timeline are lower birth rates, reduced immigration, and the revenue impact of the One Big Beautiful Bill passed last summer, which reduced how much Social Security benefits are taxed. When recipients pay taxes on benefits, that money goes back into the trust fund. But now fewer beneficiaries are actually paying taxes on benefits, which is good for them, but not for the program's financial health. When the trust fund is depleted, the program will only be able to pay about 78% of scheduled retirement benefits from incoming payroll tax revenue. So the program isn't bankrupt, as some people might suggest,

Starting point is 00:01:16 but that is still a significant reduction in benefits. Meanwhile, Medicare's hospital insurance trust fund is also now projected to be depleted a quarter earlier in 2033. So stress test your retirement plan and make sure it'll still be okay if Social Security gets a 20 to 25% haircut. Also, keep in mind that this is an election year, and any U.S. senators elected this cycle will probably have a say in how Social Security gets fixed. The solution will probably be a combination of higher taxes, benefit cuts, and gradually increasing eligibility ages, either for everyone or just for higher income Americans. So you might want to make sure where the candidates stand on this issue before casting your vote. For our next newsy item, we turn to an article from the Wall

Starting point is 00:01:56 Street Journal's Sharon Turlep with the headline, Americans are keeping their cars longer than ever and remaking the auto industry. According to the article, the average vehicle on U.S. roads is now approximately 13 years old, a historic high and a 10% increase from a decade ago. And while the trend toward older vehicles has been building for 15 years, it has accelerated sharply in recent years, as new car prices have climbed to an average of roughly $50,000, up about $10,000 from the start of the decade. High interest rates compound the sticker shock, and economic uncertainty is pushing even drivers who could theoretically afford a new car to hold off. Drivers are also keeping their cars longer because they're still in good shape.

Starting point is 00:02:34 Advances in engineering, materials, and safety technology mean that today's cars genuinely last longer. So keeping an older vehicle running is a more viable strategy than it once was. Automakers and dealers, long focused exclusively on new car sales, are now pivoting toward the service and repair business. Ford, for example, is now running an ad campaign not to sell new cars, but to persuade existing owners to bring their vehicles into dealerships for maintenance. Service and repair now accounts for roughly half of the average dealership's gross profit, making it far more lucrative than selling cars.

Starting point is 00:03:05 And I'll just add that keeping your car running for another year or few could be a significant boost to your bottom line. Yes, you may pay more in repairs, but according to Experian, as of the end of 2025, the average monthly payment was $767 for a new car and $537 for a used car. So unless you're shelling out $6,000, $9,000 a year in maintenance, you'll come out ahead by sticking with your current vehicle. And now for the number of the week, which is 12%. That is how much growth in investment prices has inflated the earnings of companies in the S&P 500, according to Bao-Lian Wang, a finance professor at the University of Florida. As Dr. Wang wrote in his substack, the S&P 500 posted annualized

Starting point is 00:03:47 earnings growth of 28% in Q1 2026, well above the five-year historical average of 16%. But beneath that number lies a significant structural distortion. A substantial portion of that reported growth didn't come from actual business operations. Instead, it flowed from an accounting standard that requires companies to mark the fair value of their equity investments to market every quarter, routing any unrealized gains, including paper profits from private startup uparounds, directly through the income statement under the other income and expenses line. The practical effect here is twofold. First, investors and analysts who benchmark valuations against gap earnings may be drawing conclusions from figures that are partly illusory

Starting point is 00:04:28 and unlikely to recur. Second, the same accounting rules work in reverse. A down round in the private venture market or a broader pullback in investment prices could translate directly into reported losses, even if the underlying businesses remain healthy. Next up, how to keep your Roth tax-free when Motley Fool Hidden Gems Investing continues. Stop wasting your nights on a mattress that doesn't get you. Experience the most comfortable mattress in the world. The Sleep Number smart bed. At the touch of a button, you can personalize your comfort. Choose firmer or softer. Adjust cooler to warmer. And right now, save up to $2,500 during our massive Labor Day event. Hurry into your local Sleep Number store today because we have your

Starting point is 00:05:22 number. Tax rates are as low as they've been in decades, yet due to ballooning government deficits and increasingly underfunded entitlements, as I mentioned previously in this episode, it's reasonable to have a hedge against higher tax rates in the future. One way to protect the retirement from higher taxes is to have at least some money in Roth accounts. With the Roth, the contributions aren't tax deductible, but withdrawals are tax-free as long as you follow the rules. And I throw in that phrase about the rules because they can get rather complicated, and I generally don't get into the nitty-gritty because most long-term investors will satisfy the requirements. This episode, however, is all about those rules. So if you have or are

Starting point is 00:06:00 considering a Roth account, here's what you need to know. We'll start by pointing out that there are two ways that Uncle Sam can grab your Roth gains. First, of course, is taxes. Running a file of the rules can make your gains, but not the contributions, taxable at your ordinary income tax rate, otherwise known as your tax bracket. And the second way is penalties. This is another set of rules that could make your gains or conversions, but not contributions, subject to a 10% penalty. The key to avoiding the taxes and penalties? Well, don't touch the investment growth in the account until withdrawing it would be considered a qualified distribution.

Starting point is 00:06:33 Very generally, a withdrawal is considered qualified if the account has been open for five tax years and the account holder is 59 and a half years old. But there are many exceptions depending on the type of Roth. Some exceptions could allow you to withdraw at least some money sooner, tax and penalty free. Others might require that you have to leave the money in there longer. So let's break this down into the three keys to keeping Uncle Sam from grabbing your Roth-produced

Starting point is 00:06:58 profits. The first key, contributions are always tax and penalty free. To be able to contribute to a Roth account, you first have to earn money from doing a job, then you have to pay income taxes on that money. What's left over can be contributed to the Roth, subject to annual limits. Because you pay income taxes on the money before it goes into the Roth, contributions are considered after tax money. And generally speaking, Uncle Sam taxes money only once. Thus, the money you contribute to a Roth account will come out free of taxes and penalties, regardless of your age and how long the account has been open. However, there are important differences between a Roth IRA and Roth employer accounts such as a Roth 401k in terms of what comes out of an account first. So with the

Starting point is 00:07:39 Roth IRA, the first money to come out is the money you contributed. So let's look at an example. Let's say you're 45 years old and you contribute $7,500 to a new Roth IRA. A year later, it has grown to $8,500. You can withdraw the $7,500 contribution and not worry about any immediate consequences. But if you took out the earnings, in other words, the amount above $7,500 in this example, you'd likely owe taxes and a 10% penalty on that amount. With a Roth 401k, withdrawals are a proportional mix of contributions and earnings with any taxes and penalties being assessed against the earnings only. So again, assume the same particulars as in the previous example, the contributions account for 88.2% of the account value. In other words, 7,500 of the 8,500,

Starting point is 00:08:26 thus 88.2% of a distribution would be considered a return of your contribution and not taxed or penalized, while the rest would be considered earnings and maybe taxed and penalized. All right, let's move on to the second key. And this is the important one, obey the five-year rules. So generally, you must have had a Roth account open for five years for withdrawals of the earnings to be considered qualified. But five years in IRS time is different than five years in normal time. The clock begins ticking on January 1st of the year the account is considered open, regardless of the date you actually sent in the money. Because you have until the tax filing deadline, usually April 15th, of the year following any

Starting point is 00:09:05 given tax year to contribute to a Roth IRA, the five-year rule actually could require that you hold your assets within the Roth IRA for less than four years. So let's look at an example. Let's say you opened your first Roth IRA on April 15, 2022, and made a contribution that counted toward the 2021 tax year. Then the effective start date is January 1, 2021, and thus your five years are up on January 1, 2026. And if that isn't confusing enough, each type of Roth account has its own twist to the five-year rule. So let's consider what I would call contributory Roth IRA. So there's a situation where you're putting new cash into a Roth IRA. The five-year clock starts the year you open your very first Roth IRA, and that clock applies to all Roth IRA accounts open

Starting point is 00:09:50 thereafter, not including conversions. This also means that if you're 57, when you contribute to your very first Roth IRA, you have to wait until your 60s to access the earnings without paying taxes, though after 59 and a half, the 10% penalty won't apply. Now let's look at what I would call contributory Roth 401k. So you're putting in new money to a Roth 401k. Each account has its own five-year clock. So if you open a Roth 401k with one employer when you were 54, and then switch jobs and open another one at age 58, the assets in your first Roth 401k can be distributed tax-free after age 59 and a half, but you'll have to wait until you're 60s to tap the assets in the second without taxes. Though you might be able to get around that by rolling over the account to a

Starting point is 00:10:35 Roth IRA that's been open for five years, which brings us to Roth rollovers. If you roll over a Roth 401k to an existing Roth IRA, the five-year clock for that IRA is what's used to satisfy the rule. But what if you don't have any existing Roth IRAs and you have to open a new one in order to receive the roller from a 401k? That starts a whole new five-year clock, even if the Roth 401k had been open for several years. Now let's move on to Roth conversions. If a distribution of a converted amount is done within five years of the conversion and the owner is younger than 59 and a half, the distribution will trigger a 10% penalty. Each conversion receives its own five-year clock. However, once the account owner reaches 59 and a half, the 10% penalty will no longer apply to

Starting point is 00:11:23 converted amounts, even if it's been less than five years since the conversion. Now let's move on to inherited Roths. Beneficiaries inherit the decedent's five-year status. So if the decedent satisfied the five-year rule, distributions are generally tax-free to the beneficiary. If not, the earnings portion may be taxable until the five-year period is met. Keep in mind that there is no 10% early distribution penalty on inherited retirement accounts. And a final note on the five-year rules, each member of a married couple has their own clocks. So for example, if your spouse has had a Roth IRA for a decade, but you open your first one this year, you have to wait the five years. And now we move on to key number three,

Starting point is 00:12:02 know when early withdrawals are exempt from penalties. So there are many ways to get around the 10% early distribution penalty. Some apply just to IRAs, some apply to just qualified employer sponsored accounts like 401ks, and still others apply to both. And just note that even though the IRS might allow an exception for employer plans, your employer might not. So check with your plan provider. And while this episode is nominally about Roth accounts, these exceptions also apply to traditional accounts. So some of the most common exceptions to the 10% early withdrawal penalty include qualified higher education expenses, up to $5,000 of qualified birth or adoption expenses, up to $10,000 of qualified expenses related to purchasing your

Starting point is 00:12:42 first home, and paying for health insurance when unemployed. But there are many, many more. And again, let me repeat, some exceptions apply to just IRAs, whereas others just to employer accounts. For example, the higher ed exception applies just to IRAs, but I know of someone who thought it applied to employer accounts, took out a bunch of money from her 403b to pay her daughter's college bills, and owed the 10% penalty. Workers who are covered by a simplified employee pension, otherwise known as a SEP, or a simple IRA, should take particular care to know the rules because these types of accounts are kind of a hybrid of employer-sponsored plans and IRAs. When it comes to exceptions to the 10% penalty, they're most often considered IRAs, but you should

Starting point is 00:13:23 confirm with an expert before making a withdrawal because the rules can be kind of quirky. For example, withdrawals from a simple IRA within the first two years of participation can incur a 25% penalty instead of 10%. The best source of updated information about all this is the IRS website. It has a whole page devoted to these exceptions. And permit me to repeat the word updated. The rules change and following guidance based on outdated articles you find on the internet is not an excuse that the IRS probably will consider valid. Finally, if you're considering any of the aforementioned exceptions, please, please, please make sure to read up on all the details. Not following the rules, which sometimes can get pretty complex,

Starting point is 00:14:01 can result in the 10% penalty being assessed. it's time to get it done fools and with the summer soon upon us gas price is still high and as i discussed earlier most of us trying to get our cars last longer i have a suggestion for you spend more time on your bike perhaps even using it to run short errands if your community has decent enough trails and roads i say this in light of a recent study published in the journal Frontiers in Sports and Active Living. The study synthesized the findings of 87 other studies about cycling across 19 countries. The authors found, quote, positive impacts of bicycling on well-being, including improved mood, reduced depressive symptoms, increased social connection,

Starting point is 00:14:45 and enhanced cognitive function, end of quote. You'll find plenty of other studies demonstrating the health benefits of biking, including a stronger immune system and even a longer life expectancy. A 2024 study found that people who regularly bike are significantly less likely to have arthritis and experience pain in their knees by age 65 compared to people who don't bike. As I've discussed on the show before, the evidence is clear that healthier people as a group tend to be wealthier for a whole host of reasons. So do your body and bank account some good by getting some exercise. And cycling is a great way to do it. Now I will acknowledge that a good bike isn't cheap. I paid $1,000 for my used Cat Trike Trail recumbent trike in 2010.

Starting point is 00:15:24 And that was a lot of money to me back then. But if I bought it today, it would cost more than $3,000. And I'm still riding my bike 16 years later, putting 900 miles on it so far this year. And it's one of the reasons why I weigh about 30 pounds less than I did in 2010. So for me, my bike has been a great investment in both my health and my happiness. And on that note, it's time to close out this episode. Thank you so much for spending part of your weekend with us. and thanks to Bart Shannon, the engineer for this episode.

Starting point is 00:15:51 As always, people on the program may have interests in the investments they talk about, and The Motley Fool may have formal recommendations for or against. So don't buy or sell investments based solely on what you hear. All personal finance content follows Motley Fool editorial standards

Starting point is 00:16:03 and is not approved by advertisers. Advertisements are sponsored content and provided for informational purposes only. To see our full advertising disclosure, please check out our show notes. I'm Robert Brokamp. Fool on, everybody. We'll be right back.

Motley Fool Hidden Gems Investing - Your Roth Won’t Be Tax-Free If You Break These Rules

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