Roth IRA Owners Beware of the 5-Year Rule
KEY TAKEAWAYS
The 5-year rule stipulates that you must wait to withdraw earnings tax-free until it has been at least 5 years since you first contributed to a Roth IRA account.
Roth 401(k) plans do not count towards the 5-year rule with IRAs.
Those who have not met the 5-year rule and are under the age of 59 ½, withdrawing funds from a Roth conversion will trigger a 10% IRS penalty on the entire converted amount and income taxes are owed on any earnings.
Inherited Roth IRAs are also subject to the 5-year rule and are based on how long the original owner established the Roth IRA.
As you prepare for retirement, a Roth IRA can be a wonderful way to build and grow your nest egg. The tax-free benefits previously discussed in our article, Why Choose a Roth IRA, are a major reason why investors gravitate towards owning a Roth IRA. However, the IRS is not in the habit of letting money just come and go willy-nilly, especially when it comes to tax-favored investment vehicles. Therefore, the Roth IRA has strict rules around contributions and withdrawals. This article focuses on one element of the withdrawal rules – the Roth IRA 5-year rule.
There are 4 key situations to understand when it comes to the 5-year rule:
Withdrawal of earnings
Rolling over a Roth 401(k) to a Roth IRA
Converting a traditional IRA to a Roth IRA
Inheriting a Roth IRA
The point of understanding these rules is to avoid paying unnecessary taxes or penalties to the IRS. If you aren’t careful, the resulting condition is a sad face.
WITHDRAWAL OF EARNINGS
The 5-year rule stipulates that you must wait to withdraw earnings tax-free until it has been at least 5 years since you first contributed to a Roth IRA account. This applies regardless of age – even if you are older than 59 ½, which is the age when retirees are eligible to withdraw money from their Roth IRA without incurring a 10% IRS penalty. Put another way, if the Roth IRA owner is younger than 59 ½, they may withdraw the original principal without paying an IRS penalty, however, the earnings portion that is taken out is subject to regular income taxes and a 10% IRS penalty.
Of note, the 5-year waiting timeline begins January 1st of the year you made your first contribution. Therefore, if you contributed to your Roth IRA on December 1st, 2022, you are permitted to count the entire year towards the 5-year rule. In fact, you have until April 15th of 2023 to make a prior year contribution to your Roth IRA and have it count towards the 5-year rule.
Let’s say you are 58 years old, and you contributed $7,000 to your Roth IRA on April 15, 2023 – your 5-year waiting period ends on January 1st, 2027 because the 5-year clock started January 1st, 2022. On or after 1/1/2027, you are permitted to withdraw both the principal and earnings without any taxes or penalties. Any withdrawals that include earnings occurring before January 1st, 2027, are subject to both taxes and a penalty. There are a few exceptions that allow you to avoid the penalty that will be covered in an upcoming blog article about withdrawals from Roth IRAs.
Another wrinkle applies to investors with multiple Roth IRAs. In this situation the 5-year clock starts ticking once the first Roth IRA is established. Once you have satisfied the 5-year rule for one Roth IRA, you have satisfied it for any additional Roth IRAs that you may open later.
ROLLING OVER A ROTH 401(K) TO A ROTH IRA
The 5-year rule must also be met in situations when you own a Roth 401(k), terminate employment, and decide that you want to rollover your Roth 401(k) to a brand-new Roth IRA. Unfortunately, the period of time that you owned your Roth 401(k) does not count towards the 5-year waiting period. On the other hand, you do not have to wait if you rolled your Roth 401(k) into an existing Roth IRA that you established more than 5-years ago.
CONVERTING A TRADITIONAL IRA TO A ROTH IRA
For those that have not met the 5-year rule and are under the age of 59 ½, withdrawing funds from a Roth conversion will trigger a 10% IRS penalty on the entire converted amount and you pay income taxes on any earnings. For those over 59 ½ the earnings are taxable. Regardless of age, this can be a very costly mistake when making substantial Roth conversions. To get more information about Roth conversions, check out Roth Conversions – When It Makes Sense and When It Does Not.
Income taxes are paid when converting a traditional IRA to a Roth IRA during the calendar year the conversion was executed. Also, in such instances the 5-year waiting period begins during the calendar year that the conversion took place. In other words, if you converted $20,000 in March 2020, the 5-year period begins January of 2020. This is not to be confused with how Roth contributions are able to take advantage of the tax year and get an extra 4 months to squeeze it in because of the April 15 deadline.
What can get messy with Roth conversions is that each conversion has its own 5-year period. For example, if you converted $100,000 to a Roth in 2020, that has its own 5 year waiting period that ends December 31st, 2024. Now say you converted another $50,000 in 2022 – that 5-year waiting period ends December 31st, 2026.
Given that there are different ways to get money into a Roth IRA and the varying timing of conversions, the IRS has ordering rules that determine what gets taken out first. When it comes to conversions, the oldest conversions are to be withdrawn prior to subsequent conversions. Untangling this a bit further, the order of withdrawals for Roth IRAs are contributions first, followed by conversions, and then earnings come out last.
INHERITING A ROTH IRA
Inheriting a Roth IRA may seem straightforward at first glance because the distributions are free from income taxes. This is true if the Roth IRA of the decedent was opened 5 or more years prior to their death. However, if the deceased owner of the Roth IRA did not satisfy the 5-year rule – either because the Roth IRA was recently opened or there was a recent Roth conversion – then the beneficiary must finish out the remaining years not yet satisfied within the 5-year rule. Otherwise, the earnings or converted amount are subject to taxes.
Due to the withdrawal ordering rules taxes can sometimes be avoided. The challenge is that the SECURE Act and rules around required minimum distributions (RMDs) have evolved to where non-spouse beneficiaries are forced to distribute the entire inherited Roth IRA within 10 years of the account owner’s death.
Alternatively, spouses can continue using the previous stretch rule that allowed the beneficiary to take distributions based on their own life expectancy rate. Other exceptions that allow for the Roth IRA stretch include:
You are a minor child of the original owner.
You are chronically ill or disabled in accordance with IRS definitions.
The original Roth IRA owner was less than 10 years older than you.
You inherited the Roth IRA prior to 2020 (before the SECURE Act took effect).
ADDITIONAL RESOURCES
To get more information and examples about the distribution rules from Roth IRAs, you may refer to chapter 2 of IRS Publication 590-B. In addition, if would like a better understanding of the ins and outs of various Roth planning techniques, we have an entire page dedicated to it called Roth Strategies.
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