The Roth IRA is a great type of retirement account which offers significant tax advantages for many people. A Roth IRA lets you contribute after-tax dollars, and then in retirement you can withdraw those contributions and all of your investment earnings tax-free.
But of course, since the IRS controls how you make your contributions and withdrawals, you know there are going to be some confusing rules involved.
In this article we are going to cover the Roth IRA 5-year rule. The rule dictates when you can withdraw funds from your Roth IRA account. This rule is applied in three different ways which we will detail in this article.
Roth IRA Distribution Basics
Before getting into the specifics of the 5-year rule, we need to review some basic requirements which must be met in order for your Roth IRA withdrawal to be tax-free and penalty-free. Since the whole point of a Roth IRA is for the money to be tax-free when you withdraw it, these conditions are important to know.
- If you are at least 59 ½ years old, you can withdraw both your Roth IRA contributions and earnings penalty free (provided that you have met the 5-year rule that we will define later)
- If you are younger than 59 ½ and you satisfy the criteria for certain IRS exceptions, you can withdraw funds from Roth IRA without a penalty. These exception categories include: first-time home buyers, disabled individuals, death of the account holder, and other exceptions.
- Regardless of your age, you can always withdraw your Roth IRA contributions without a penalty since you have already paid your income tax on your contributions.
THERE ARE 3 GENERAL SITUATIONS REQUIRING YOU TO FOLLOW A 5-YEAR RULE
SUTUATION #1 – Withdrawal of investment earnings from your Roth IRA.
In order for you to be able to withdraw your Roth IRA earnings (interest or investment returns) without a penalty, two conditions must be met:
- You must be at least 59 ½ years old or meet one of the IRS exceptions.
- Five years must have elapsed since you made your first Roth IRA contribution.
Now a few notes about the 5 year rule:
- The clock on the 5-year rule starts running on January 1st of the tax year in which you made your first contribution to any Roth IRA (the tax year runs from January 1st to April 15th of the next calendar year). So for example: if you opened a Roth IRA and made your first contribution in March of 2015 and designated it as a 2014 contribution, then your 5-year waiting period would start on January 1st of 2014.
- Once you have satisfied the 5-year rule for any Roth IRA, the IRS considers the 5-year rule satisfied for any other Roth IRA you open after that.
- IMPORTANT NOTE: the 5-year rule applies to withdrawal of earnings only, not your contributions. With a Roth IRA you can always withdraw your contributions at any time without penalty since you’ve already paid your income tax on that money.
If you do not satisfy the 5-year rule you may be required to pay a 10% penalty and income tax on the earnings that were withdrawn.
SITUATION #2 – Withdrawal of funds from a Roth IRA conversion.
If you convert a traditional IRA to a Roth IRA, there is another 5-year rule that takes effect. Like the 5-year rule described above, the clock on the 5 year period for making withdrawals from conversions is started on January 1st of the tax year in which the conversion is made.
There is an important catch when it comes to taking distributions from a Roth IRA conversion: A separate 5-year waiting period applies to each and every conversion you make.
So for example, let’s say you converted some money from your traditional IRA to a Roth IRA in the 2010 tax year, and then you made another conversion in the 2011 tax year. You would be able to take distributions, without taxes or penalties, from the first conversion starting in 2015, and you can take distributions from the second conversion no earlier than 2016.
If you do not satisfy the 5-year rule for a conversion, you may be required to pay a 10% penalty and income tax on the funds that were withdrawn.
SITUATION #3 – If you are the beneficiary of a Roth IRA.
As noted above, death of the Roth IRA account holder is one of the IRS exceptions, so if you inherit a Roth IRA, you won’t be required to pay penalties or taxes on the withdrawals you take from the account.
However, the two 5-year rules above still apply to an inherited Roth IRA.
- Five years must have elapsed since the deceased individual first funded a Roth IRA in order for earnings to be withdrawn.
- If the funds to be withdrawn are the result of a conversion, five years must elapse between the conversion and the withdrawal of those funds.
Before you start worrying too much about whether or not you will have to pay penalties and taxes for breaking the 5- year rule, consider the order in which funds are withdrawn from a Roth IRA:
- First, your contributions are withdrawn
- Next, your conversions are withdrawn
- Finally, your earnings are withdrawn last
Therefore, you don’t need to worry about satisfying the 5-year rule until you’ve withdrawn all of your contributions.
As you can see, these rules can be complicated and confusing, so always be sure to consult with a tax expert prior to taking distributions from a Roth IRA.