What You Should Know About the Surprisingly Complex Roth IRA Five-Year Rule
The Roth IRA is a unique retirement savings tool. While there is no upfront tax break with a Roth IRA, it grants you tax-free management of your income and gains as long as you retain your investments within the account. Roth IRAs are also flexible, which allows for better access to your funds than traditional retirement accounts. However, the five-year rule—which is actually a set of rules—dictates the penalty and tax-free eligibility of your Roth IRA withdrawals. Here are the rules investors need to be aware of.
Your First Contribution
In order to avoid taxes on distribution from your Roth IRA, you must wait five years after your first contribution to withdraw your earnings tax-free. The five-year period begins on the first day of the tax year for which you made a contribution to any Roth IRA, not necessarily the specific Roth IRA account you’re withdrawing from. For example, if you put money into a Roth IRA for the first time in early 2020 but contributed it toward the 2019 tax year, then the five-year waiting period will end on January 1, 2024.
Because the money you contributed to the Roth IRA was an after-tax contribution, if you withdraw funds before the five-year period, only the growth of the account is potentially subject to income tax.
One more point to make note of in regards to the five-year rule: This rule supersedes the one that states you must be 59 ½ in order to withdraw from a Roth IRA without incurring taxes and penalties. This means that even if you meet the age requirement when you withdraw, you still must have made your first contribution at least five years prior in order to avoid being taxed. You won’t owe a 10% penalty fee for early withdrawals, but you’ll still owe tax on any withdrawals above the amount contributed.
- Penalty for breaking this rule: You will be required to pay taxes on the earnings portion of the withdrawals. However, Roth IRA withdrawals give preference to contributions before earnings. Therefore, if you have enough cumulative contributions to cover the amount you wish to withdrawal before the five-year mark of your first contribution, you may be able to make the withdrawal tax-free.
Roth Conversions
There is an additional five-year rule that was established in order to prevent people from using Roth conversions to gain penalty-free access to their traditional retirement accounts. This rule, therefore, applies to those who convert other kinds of retirement accounts, such as a 401(k), into Roth IRAs. This rule starts on Jan. 1 of the year in which you do the conversion. As a result, if you convert in, say, Nov. 2021, you will only need to wait a bit longer than four years (Jan. 2026) before taking withdrawals.
However, unlike the first-contribution five-year rule, this rule applies individually to each Roth conversion you do. All new conversions start their own five-year clock, and you’ll need to account for multiple conversions to be sure you don’t withdraw too much money too soon.
It’s important to note that if you’re using the backdoor Roth IRA strategy (i.e., contribute to a traditional IRA then immediately convert the account to a Roth IRA), this five-year rule will treat your “Roth contributions” as conversions, and you can’t withdraw them for five years without penalty.
- Penalty for breaking this rule: You will be required to pay a 10% penalty on any withdrawals, including withdrawals of the amount you initially converted (this is on top of the taxes you already paid on that amount). However, if you are over age 59 ½, the age exception will apply, and you can immediately take withdrawals penalty-free.
Inherited IRAs
First, inherited IRAs are also subject to the first-contribution five-year rule. Therefore, if the original owner’s initial contribution was less than five years before you inherited the account, the earnings are subject to taxes.
If you inherit a Roth IRA from someone who is not your spouse, you have a couple of options. The first is to spread out distributions from the inherited IRA up to 10 years, taking required minimum distributions (RMDs) based on your life expectancy each year (if the account owner lived beyond the RMD age, this is your only option.). The second option is to take lump-sum distributions. If you choose this option, you are obliged to exhaust the account by Dec. 31 of the fifth year succeeding the death of the original owner. While you can take distributions of any amount up to that date, you are required to withdraw 100% of the funds by the end of the fifth year.
- Penalty for breaking this rule: If you don’t withdraw 100% of funds from an inherited IRA by the end of the fifth year after the owner’s death, the remaining balance is subject to a 50% penalty.
