The Trio of 5-Year Rules
One of the much-touted boons of the Roth individual retirement account (IRA) is your ability–at least, relative to other retirement accounts–to withdraw funds from it when you wish and at the rate you wish. But when it comes to tax-advantaged vehicles, the Internal Revenue Service (IRS) never makes anything simple.
True, direct contributions to a Roth can be withdrawn anytime, without tears (or taxes). Withdrawals of other sorts of funds, however, are more restricted: Access to them is subject to a waiting period, known as the five-year rule.
The five-year rule applies in three situations:
You withdraw earnings from your Roth IRA.
You convert a traditional IRA to a Roth IRA.
You inherit a Roth IRA.
You need to understand the five-year rule–or rather, the trio of five-year rules–to ensure that withdrawals from your Roth don’t trigger income taxes and tax penalties (generally, 10% of the sum taken out).
Roth IRA Withdrawal Basics
Roth IRAs are funded with after-tax contributions (meaning that you get no tax deduction for making them at the time), which is why no tax is due on the money when you withdraw it. Before reviewing the five-year rules, here’s a quick recap of the Roth regulations regarding distributions (IRS-speak for withdrawals) in general:
You can always withdraw contributions from a Roth IRA with no penalty at any age.At age 59 1/2 , you can withdraw both contributions and earnings with no penalty, provided that your Roth IRA has been open for at least five tax years.
Start Date of 5-Year Rule
“Tax years,” with regard to five-year rules, means that the clock starts ticking on Jan. 1 of the tax year when the first contribution was made. Typically, you can make an IRA contribution by April 15 or the tax filing deadline of the next year, and it can count for the prior tax year.
For example, a Roth IRA contribution for the 2021 tax year can be made up to April 18, 2022, meaning that it can count as a 2021 contribution (the tax deadline was pushed up to April 18 for most people due to the Emancipation Day federal holiday).
As a result, a 2021 contribution made up to April 18, 2022, would count as if it were made on Jan. 1, 2021. In calculating the five-year rule, you could begin withdrawing funds without penalty on Jan. 1, 2026–not April 18, 2027.
A withdrawal that is tax- and penalty-free is called a qualified distribution. A withdrawal that incurs taxes or penalties is called a non-qualified distribution. Failing to understand the difference between the two and withdrawing earnings too early is one of the most common Roth IRA mistakes.
In sum, if you take distributions from your Roth IRA earnings before meeting the five-year rule and before age 59 1/2 , be prepared to pay income taxes and a 10% penalty on your earnings. For regular account owners, the five-year rule applies only to Roth IRA earnings and to funds converted from a traditional IRA.
5-Year Rule for Roth IRA Withdrawals
The first Roth IRA five-year rule is used to determine if the earnings (interest) from your Roth IRA are tax free. To be tax free, you must withdraw the earnings:
On or after the date when you turn age 59 1/2 At least five tax years after the first contribution to any Roth IRA that you own
A note for multiple account owners: The five-year clock starts with your first contribution to any Roth IRA–not necessarily the one from which you’re withdrawing funds. Once you satisfy the five-year requirement for one Roth IRA, you’re done.
Any subsequent Roth IRA is considered held for five years. Rollovers from one Roth IRA to another do not reset the five-year clock.
5-Year Rule for Roth IRA Conversions
The second five-year rule determines whether the distribution of principal from the conversion of a traditional IRA or a traditional 401(k) to a Roth IRA is penalty free. (Remember, you’re supposed to pay taxes when you convert from the pretax-funded account to the Roth.) As with contributions, the five-year rule for Roth conversions uses tax years, but the conversion must occur by Dec. 31 of the calendar year.
For instance, if you converted your traditional IRA to a Roth IRA in November 2019, your five-year period begins Jan. 1, 2019. But if you did it in February 2020, the five-year period begins Jan. 1, 2020. Don’t get this mixed up with the extra months’ allowance you have to make a direct contribution to your Roth.
Each conversion has its own five-year period. For instance, if you converted your traditional IRA to a Roth IRA in 2018, the five-year period for those converted assets began Jan. 1, 2018. If you later convert other traditional IRA assets to a Roth IRA in 2019, the five-year period for those assets begins Jan. 1, 2019.
This can be confusing. To determine whether you are affected by this five-year rule, you need to consider whether the funds you now want to withdraw include converted assets, and if so, what year those conversions were made. Try to keep this rule of thumb in mind: IRS ordering rules stipulate that the oldest conversions are withdrawn first. The order of withdrawals for Roth IRAs are contributions first, followed by conversions, and then earnings.
If you’re under age 59 1/2 and take a distribution within five years of the conversion, you’ll pay a 10% penalty unless you qualify for an exception.
Exceptions to the 5-Year Rule
Under certain conditions, you may withdraw earnings without meeting the five-year rule, regardless of your age. You may use up to $10,000 to pay for your first home or use the money to pay for higher education for yourself or for a spouse, child, or grandchild.
The IRS will also allow you to withdraw funds to pay for health insurance premiums–should you become unemployed–or if you need to reimburse yourself for medical expenses that exceed 10% of your adjusted gross income (AGI).
5-Year Rule for Roth IRA Beneficiaries
Death is also an exception. When a Roth IRA owner dies, beneficiaries who inherit the account have to take required minimum distributions (RMDs) from it. However, they can take these distributions without incurring a penalty–no matter whether the distribution is principal or earnings or what their own age is.
However, death does not totally get you off the hook of the five-year rule. If you, as a beneficiary, take a distribution from an inherited Roth IRA that wasn’t held for five tax years, then the earnings will be subject to tax. But thanks to the withdrawal ordering rules mentioned above, you still may end up owing no taxes since earnings are considered the last part of the IRA to be distributed.
Avoid a 50% Penalty
There’s another five-year rule that applies to Roth IRA beneficiaries. Named beneficiaries have the option of stretching required minimum distributions (RMDs) from inherited Roth IRAs over five years. In some rare cases, the Roth IRA documents may specify the five-year rule.
If you elect the five-year option, the inherited Roth IRA proceeds must be distributed by Dec. 31 of the fifth year following the year of the original owner’s death. Within the five-year period, you have complete flexibility in the distributions: You can take a lump sum or make withdrawals each year. You just need to be sure the Roth IRA is emptied by the end of the five-year period or you will face a 50% penalty on the amount not taken in that year.
—Scott Bishop, certified financial planner and CPA, Avidian Wealth Solutions
Roth IRA Beneficiaries Under the SECURE Act
The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 changed a key rule for Roth IRA beneficiaries. Previously, anyone who inherited a Roth IRA could choose to create something called a stretch IRA and take distributions from it based on their own life expectancy rate.
But after the passage of the SECURE Act, this provision was eliminated. Unless they are spouses of the deceased, Roth IRA beneficiaries are now required to withdraw all funds within 10 years of the original account holder’s death. Only an inheriting spouse can stretch the Roth IRA distributions out for a lifetime. Any other beneficiary, such as a child, must close out the account within a decade.
The SECURE Act’s rules apply only to the heirs of account holders who die after Jan. 1, 2020.
What Is the 5-Year Rule for Roth Individual Retirement Accounts (IRAs)?
The Roth individual retirement account (IRA) five-year rule applies in three situations:
You withdraw earnings from your Roth IRA.You convert a traditional IRA to a Roth IRA.You inherit a Roth IRA.
In general, the five-year rule states that if you withdraw money from a Roth IRA that has been in the account for less than five years, you will have to pay taxes on it and a 10% penalty.
Can You Take Money Out of a Roth IRA Before 5 Years?
The Roth IRA five-year rule says you cannot withdraw earnings tax free until it’s been at least five years since you first contributed to a Roth IRA account. This rule applies to everyone who contributes to a Roth IRA, whether they’re 59 1/2 or 105 years old.
Does the 5-Year Rule Apply to Roth Conversions After Age 59 1/2 ?
Yes. Even if you’re over age 59 1/2 when you withdraw, some of your withdrawals could get included in taxable income, thanks to the five-year rule. You won’t owe the 10% penalty in that case, but you’ll still owe tax on any withdrawals above the amount contributed.
The Bottom Line
Though Roth IRAs are generally quite flexible when it comes to withdrawals, and much more so than other retirement accounts, IRS rules impose a waiting period on certain withdrawals, known as the five-year rule.
The five-year rule applies in three situations: if you withdraw account earnings, if you convert a traditional IRA to a Roth, or if a beneficiary inherits a Roth IRA. You need to understand the five-year rule in all three cases, because failure to follow the five-year rule can result in paying income taxes on earnings withdrawals and a 10% penalty.