One of the great things (maybe the greatest thing) about having a Roth IRA is your ability to withdraw money from it without having to pay taxes. However, as is the case with most things concerning the IRS, there are some rules you must follow if you want to reap the benefits of such an amazing perk. And one of the most important is the 5-year rule.
The 5-year rule for Roth IRAs essentially just means you have to wait five years from a certain point in time (we’ll get into the specifics later) before you can take those tax-/penalty-free distributions. Often, people taking distributions from their Roth IRAs are already complying with the 5-year rule without even knowing it. But there are three situations in which it’s important to adhere to the 5-year rule, otherwise those withdrawals may be subject to income tax and incur a 10% penalty:
- Withdrawing earnings from your Roth IRA
- Withdrawing conversions from your Roth IRA
- Inheriting a Roth IRA
A Quick Refresher on Roth IRA Distributions
As we previously mentioned, the great thing about Roth IRAs is your ability to withdraw money from them without having to pay taxes. This is because the account was already filled with after-tax contributions, so that would be like paying taxes twice for one sum of money.
Additionally, you can withdraw money from the principal of your IRA (the money from your after-tax contributions) at any time. There’s no magical age you need to reach or threshold you need to cross before you can start taking distributions—as long as you’re only withdrawing from your contributions. Once you start pulling from other sources, that’s when the 5-year rule comes into play.
Withdrawing Earnings from a Roth IRA
It’s important here to note the word “earnings.” Withdrawing from the principal of your Roth IRA is tax-free, but like just about any other type of savings or retirement account, Roth IRAs accrue interest and grow over time.
Another point of emphasis is the IRS’s Roth ordering rules. When it comes to your Roth IRA, the IRS stipulates that the money you withdraw should first come from your own contributions, then from conversions, and finally from earnings.
With all that in mind, when withdrawing earnings from your Roth IRA, you must wait at least five tax years after your first contribution into the IRA or that withdrawal may be taxed as regular income and/or incur a penalty of 10% of the withdrawal amount. Additionally, you must be at least 59 ½ to withdraw earnings from your Roth IRA or the same consequences apply.
Yet another point of emphasis with the 5-year rule is the mention of “tax years,” which differ from calendar years. With tax years, your deadline for contributions follow the same deadlines as your income taxes. For example, in 2020, you had until July 15 to make a contribution to your Roth IRA, but that contribution counted for 2019—the same way you had until July 15, 2020 to file your income taxes for 2019. So, if you made your first Roth IRA contribution on July 15, 2020, it counted as if it was made on January 1, 2019, and you only need to wait until January 1, 2024 to withdraw earnings from that account tax-/penalty-free.
It should also be noted that the 5-year rule stipulates that you must wait five tax years after your first Roth IRA contribution. If you have multiple Roth IRAs, in the eyes of the IRS, they all count as one. So, if you opened one and started contributing to it five or more years ago, and now you suddenly open a second one and start contributing to it, you don’t need to wait another five years to withdraw from the second account’s earnings. In the eyes of the IRS, you’ve already passed the five-year waiting period.
Withdrawing Conversions from a Roth IRA
The 5-year rule also comes into play when you’re withdrawing Roth IRA conversions. If you’re taking distributions from funds that you previously converted from a Traditional IRA or Traditional 401(k) into your Roth IRA, then you must again wait five years to avoid paying taxes/penalties on those distributions.
However, unlike withdrawing from earnings, the calendar works a little different when withdrawing conversions. This time around, the 5-year rule follows more traditional calendar-year rules. This means that if you make a Roth conversion on December 17, 2020, it will be counted as if it was made on January 1, 2020. If you make a conversion on March 3, 2021, it will be counted as if it was made on January 1, 2021. Essentially, any conversions made inside a calendar year will be counted as if they were made on January 1 of that same year. So, to avoid penalties and taxes from your December 17, 2020 conversion, you must wait until January 1, 2025 to take a distribution from those funds.
It’s also important to note that each Roth IRA conversion is subject to the 5-year rule. That means if you make a conversion on December 17, 2020 and a second one on March 3, 2021, you must wait until January 1, 2025 to withdraw funds from the first conversion, and you must wait until January 1, 2026 to withdraw funds from the second conversion. This is yet another big distinction between withdrawing earned funds and withdrawing converted funds.
Although, one similarity between the two is that, once again, you must be at least 59 ½ to take a distribution from converted funds or you will be subject to income tax and/or a penalty of 10% of the distribution.
Inheriting a Roth IRA
Typically, beneficiaries of an inherited Roth IRA can take distributions—whether the funds are coming from contributions, conversions, or earnings—at any time without fear of taxes or penalties. However, the 5-year rule may still rear its head if the original account owner did not hold the Roth IRA for more than five tax years and the funds you’re withdrawing are coming from earnings. This means that if you inherit a Roth IRA on October 28, 2020, but the first contribution was only made on April 2, 2019, then you must wait until January 1, 2023 before you can take tax-free distributions on any earnings from the account. But this only applies to earnings on the account, and since the aforementioned IRS Roth ordering rules favor contributions and conversions over earnings, this may end up being a moot point.
Additionally, beneficiaries of Roth IRAs must be aware of the recent rule changes that came with the SECURE Act. Previously, beneficiaries needed to start taking required minimum distributions (RMDs) upon inheritance of qualified accounts like IRAs, Roth IRAs or 401(k)s. These RMDs could potentially be stretched out over your lifetime. But with passage of the SECURE Act, there are no longer RMDs for inherited IRAs and Roth IRAs, although, beneficiaries of these types of accounts must now withdraw the full amount of the account within 10 years. Spouses are exempt from this rule and can still stretch out RMDs across their lifetime. Because of this sped-up timeline, it’s possible the 5-year rule could be more of an issue for you now than it would have been in previous years, so make sure you consult a financial advisor on how best to take your RMDs. With a Roth IRA, you may even want to defer withdrawal until the tenth year to benefit from 10 more years of tax-free growth.
Exceptions to the 5-Year Rule
There are certain situations in which the 5-year rule for Roth IRAs can be ignored. You may take tax-free distributions from your Roth IRA at any time, at any age, and from any source (contributions, conversions or earnings) for any one of the following reasons:
- Making a down payment on your first house (withdrawal amount capped at $10,000)
- Paying for higher education for yourself, your spouse, your children or your grandchildren (withdrawal amount capped at $10,000)
- Paying for health insurance premiums
- If you become unemployed
- Paying for medical expenses that exceed 10% of your adjusted gross income (AGI)
It’s also worth reiterating that since the IRS’s Roth ordering rules stipulate that funds for distributions should be taken from contributions to the principal, conversions, and then earnings, in that order, it’s entirely possible that you can avoid the 5-year rule altogether. As long as you make enough after-tax contributions to cover your withdrawals, you won’t have anything to worry about.
If you have any additional questions regarding Roth IRAs or the 5-year rule, don’t hesitate to consult your financial advisor.
ChFC®, Series 7 Securities Registration,1 Series 66 Advisory Registration, † Insurance License Brent has been advising Wealth Enhancement Group clients since 2007. As a believer in the power of teamwork, Brent often leverages the vast knowledge and resources of Wealth Enhancement Group to provide great service and smart strategies to his clients. Specializing in values-driven planning and retirement income planning, he takes pride in his ability to listen...Read More