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In 2021, more people than ever are considering converting their traditional IRA into a Roth IRA. However, though eager to do so, many hesitate because they are confused about what is known as the "five-year rule." If you are one of the many who needs answers to your five-year rule questions, here is the Roth IRA five-year rule explained in easy to understand terms.

Future Distributions

When you have a Roth IRA, future distributions are considered to be tax-free if they are "qualified distributions." However, for a distribution to be qualified, it must meet the five-year rule. Yet once you think you have this part of your Roth IRA understood, there may be more confusion ahead.

One Rule or Two?

In reality, the five-year rule confuses so many people because there are two five-year rules. While the first determines if a Roth IRA distribution will be tax-free, the second determines if a distribution that is taken before you turn age 59 -1/2 will avoid the early distribution tax of 10%. Fortunately, after speaking to your CPA about these rules, you are likely to find out you won't have to worry about either one.

Income Taxes and the Five-Year Rule

Since the first five-year rule will determine if your Roth IRA distribution will qualify to be income-tax free, you'll definitely want to discuss this in detail with your CPA. For the distribution to be qualified, it must pass two tests. First, five tax years must have passed since you made your initial contribution to your Roth IRA. But according to Treasury Department regulations, this rule is very broad, thus allowing contributions to be both direct and converted amounts.

When speaking to your CPA, you will come to realize this rule is not applied separately to each Roth IRA or Roth IRA conversion, nor does the five-year period hit the reset button when one Roth IRA is rolled over to another. Rather, everything is aggregated into one five-year period. Thus, once the five-year rule is satisfied for one Roth IRA, you've met this criteria for life.

Test Number Two

Once you've passed the first test for qualified distributions, it's time for test number two. For the distribution to be qualified to be tax-free, it must have been made on or after you turned 59 - 1/2, the IRA owner died and the distribution was therefore made to a beneficiary or estate, or it was for first-time homebuyer expenses of up to $10,000. To be in the clear for a tax-free distribution, you need to meet criteria from both tests. For example, if you are 59 - 1/2 or older and have had your Roth IRA for at least five years, you'll have a qualified distribution that is tax-free.

The 10% Penalty

Now that you know about the first five-year rule regarding qualified distributions, it's time to move on to the second five-year rule that focuses on the 10% penalty. Since this can have a major impact as to how much money you may actually receive from a distribution, make sure you have discussed this in detail with your CPA. In essence, you won't incur this penalty if a minimum of five tax years have come and gone since the Roth IRA principal was converted. However, this rule will apply to each IRA conversion, meaning you'll need to track the amount of principal year after year if doing multiple conversions.

A Rule Negates A Rule

As you discuss this with your CPA, one thing you'll come to find out is that one rule negates another rule in regards to the 10% penalty. For most people who convert a traditional IRA to a Roth IRA, the 10% penalty doesn't apply if you are at least 59 -1/2 years old.

Is a Five-Year Rule Really a Five-Year Rule?

This question is answered by both yes and no. In reality, a five-year rule does not focus on calendar years or even a 12-month period. Rather, it is centered upon tax years or taxable years. Under the federal tax code, that means a tax year starts on January 1. Thus, since you can make a tax year 2021 contribution to a Roth IRA through April 15, 2022 or convert an IRA as late as December 31, 2021, your five-year period may actually end well before an actual five years have passed.

Exceptions to the Rule

As with most rules of any type, these too have exceptions. For example, both a traditional and Roth IRA may forgo the 10% early distribution penalty if the money goes to first-time homebuyer expenses, payment of unreimbursed medical expenses, or if a series of equal and substantial distributions have taken place.

Why None of it Will Likely Matter

Ultimately, most of the various aspects of the five-year rule likely won't apply to you and your individual financial situation. Since the second rule does not apply to people who are at least 59 - 1/2, you probably won't have to worry about this rule. Also, the first five-year rule may not apply due to what are known as IRA ordering rules.

In a Roth IRA, you will have the principal and the earnings on the principal. When you take a distribution that is less than the full value of the IRA, ordering rules dictate principal is considered to be distributed first. Once all principal is distributed, earnings are then considered to be distributed. The beauty of this is that distributions of principal for a Roth IRA have already had taxes paid on them, and thus are no longer taxable.

Beneficiaries Have No Worries

Finally, beneficiaries of your Roth IRA won't have to worry about the five-year rules, since these complex rules only apply to the original owner of the Roth IRA.

As you have realized by now, there are many different things at play when it comes to the five-year rules and a Roth IRA. To get a full understanding of how they apply to your situation, consult with your CPA.

In what most of us would call a normal world, bankruptcies are filed each day. However, during these times when more and more people are dealing with the financial fallout associated with COVID-19, it is estimated that numerous individuals and businesses will be filing for bankruptcy in the months and years ahead. Since the bankruptcy process is complex, confusing and will have a significant impact on a person's finances and particularly their credit, it is a decision that should be made only after careful thought, and as a last resort. If this is something you are considering, you should know the key differences between Chapter 7, Chapter 11, and Chapter 13 bankruptcies.

Repayment Plans

When most people start considering bankruptcy, they assume the process will involve a repayment plan where they will have to repay their creditors. However, that is not always part of the plan. If an individual or qualifying business such as an LLC, partnership, or corporation that has assets that can be liquidated files Chapter 7, no repayment plan is required. However, you will be required to liquidate or sell all nonexempt assets so that the money gained can be used to repay creditors. However, Chapter 11 and Chapter 13 bankruptcies do have repayment plans as part of the agreement, with the majority of plans extending three to five years.

Secured and Unsecured Debts

In most bankruptcy filings, individuals and businesses have an assortment of secured and unsecured debts. While secured debts are a bit harder to eliminate even through bankruptcy, unsecured debts such as credit cards or medical bills are mostly, if not completely, eliminated once Chapter 7 proceedings begin. Yet, when filing Chapter 11, unsecured debts are dealt with separately and are never included with other debts. Instead, repayment of all debts is determined by what is in the best interest of the creditors, not the individual or business filing bankruptcy.

Chapter 11 and Businesses

While Chapter 7 and Chapter 13 are bankruptcies most often used by individuals, Chapter 11 is generally reserved for businesses seeking reorganization of their finances. Though used mainly by large corporations, it can also be beneficial to small business owners. Considered the most complicated of the three bankruptcy processes, Chapter 11 should always have experienced attorneys and CPAs guiding you through each step of the way. Once Chapter 11 is filed, a business has up to 18 months to create and submit a reorganization plan that will restructure its debts so that all creditors can be repaid.

Stopping Collection Actions

When individuals get in over their heads financially and cannot pay their bills, they know all too well just how aggressive collection agencies can be when trying to obtain payments for unpaid bills. In many cases, collection agencies will use wage garnishments and other drastic measures to obtain the necessary funds. However, once Chapter 7 or 13 bankruptcy is filed, all collection actions against the individual must immediately stop. In addition, filing Chapter 13 can potentially save your home from foreclosure. Though you must continue to pay your mortgage during this time or risk having your lender start foreclosure proceedings in court, having filed Chapter 13 can give you extra time needed to try and make sure you don't lose your home.

Is Chapter 7 or 13 Best for You?

As for whether you should file Chapter 7 or Chapter 13 bankruptcy, this will depend on many factors. In most instances, Chapter 7 will be best if you own little or no property, have a low income level, have debt that is mostly unsecured, and do not have the financial resources needed to commit to a repayment plan. However, if you have student loans, income taxes that are unpaid, or court-ordered support obligations such as alimony or child support, Chapter 13 is usually recommended, since debts of this nature will not be eligible for discharge. Consult with your CPA and bankruptcy attorney for individual recommendations tailored to your situation.

Negotiations with Creditors

If you are concerned about having to negotiate with creditors to make sure your debts are repaid, the good news is that this will not be part of the process if you decide to file Chapter 7 bankruptcy. However, should you need to file Chapter 11 or 13, it will be imperative you have a skilled bankruptcy attorney on your side who can advise you concerning the negotiations and act on your behalf with creditors. Unfortunately, most creditors are not concerned about your financial situation, but instead simply want all or most of their money as fast as possible. Therefore, make sure the repayment plan eventually submitted to the court is one you are comfortable with and know will work for you and your finances in the short and long-term.

Impact on Your Credit Score

Though there are many differences between these three types of bankruptcy plans, one area where they are all the same is the impact they have on your credit score. In almost all cases, expect your credit score to drop 100-200 points immediately upon filing bankruptcy. Also, once a bankruptcy is on your credit report, it may stay there as long as 10 years. 

Bankruptcy and the Pandemic

Under the CARES Act passed by Congress to provide financial relief to individuals and businesses during the pandemic, some changes have been made to bankruptcy filings. For example, if you file Chapter 11, filing requirements and costs have been reduced, and the debt threshold has been increased to make this a viable option for more businesses. In addition, if you file Chapter 7 or 13 bankruptcy, any government stimulus payments received are not included in income calculations. Finally, if you can prove the pandemic has caused you tremendous financial hardship, repayment plans may be modified or extended.

Due to the many complexities associated with each of these three types of bankruptcy, never assume you will be able to navigate the process by yourself. Instead, if you need help organizing and analyzing your financial situation to determine whether or not bankruptcy should be considered, consult soon with an experienced and knowledgeable CPA for advice on how to proceed.

Dear Valued Clients,

As everyone knows, the COVID-19 virus has caused a major and unprecedented disruption in our communities. Our top priority is meeting deadlines for our clients and providing them with  the information and support that they need.  We are working extremely hard to make sure the highest level of service that you are accustomed to receiving from us stays steady, even during the crisis. There is plentiful information that is circulating online but concerning taxes and deadlines; we wanted to share some of the important items directly our clients:

• The deadline to file tax returns has been extended. Returns and extensions are now due on July 15, 2020, rather than April 15, 2020. No interest or penalties will accrue on taxes owed until after this date.
• If you owe state taxes, some states still have the April 15, 2020 deadline. Check with your state’s tax department to find out if they have decided to follow the Federal government’s extension.
• The “90 day” deferral period refers to the payment of taxes – both for 2019 taxes that would normally be due with extensions or filed returns, and 1st Quarter estimates for 2020 for individuals and corporations.

* This deferral removes any interest and late payment penalties associated with these payments that would otherwise be due until July 15, 2020, and includes self-employment taxes paid as part of an individual tax return (Form 1040).

* The maximum deferral for individuals is limited to $1 million, and for corporations, the cap is $10 million. If your total tax bill exceeds those amounts, we will recommend payments to the extent it exceeds those maximums.

While this gives individuals, corporations, and accounting professionals much-needed relief, those who believe they will be entitled to a refund are still urged to file on time. Many families are dealing with a loss of income, and the IRS has indicated an expedited processing to get the money back to you.

We stand ready to either prepare or extend your income tax returns in the same manner as always. Like many businesses, we are working to remain ‘open.”   Please don’t hesitate to reach out by phone or email so we can discuss timely and strategic delivery of our services.

As always, we very much value your business and will continue to be your trusted partner through these uncertain times.