While a Roth IRA is an excellent retirement tool, having one entails following a number of rules. For example, you can only contribute $5,500 per year unless you are age 50 or older (when you can then invest up to $6,500 each year).
Another rule of Roth IRAs states that you cannot begin withdrawing earnings from your Roth IRA account until you are 59½ years old, although there are some exceptions to that rule for purchasing your first house or using the money for educational expenses.
Then there’s what’s called the five-year rule: To withdraw earnings from your Roth without owing taxes or penalties—even if you’re already 59½—you have to have had the account for at least five years.
The Rationale for a Five-Year Wait
Roth IRAs are a type of retirement account. Using them for anything other than saving and investing for retirement tends to defeat their purpose. Instituting a rule that investors had to wait at least five years before withdrawing their earnings reinforces the principle that Roth IRAs are designed for long-term investing and should not be used like a savings account.
Even though investors can withdraw earnings without penalty for home purchases and education expenses, Roth IRAs were not designed to be used as an emergency fund. The politicians who founded the Roth thought that the five-year wait would help deter people from misusing it.
Contributions vs. Earnings
One important point before we go any further: The five-year rule only limits when you can withdraw your earnings from your Roth IRA. That means the interest, dividends and any other income your Roth investments have earned.
The original contributions you made, on the other hand, came from your after-tax money. You did not get a tax deduction when you deposited them into your Roth. Therefore, says the IRS, you can withdraw your contributions at any time (and at any age) you want, without any penalty or taxes.
When you withdraw money, the IRS starts by classifying the first amounts as your contributions, until you take out more than you’ve contributed. (Click here for a detailed description of how calculating withdrawals works.)
What Happens If You Withdraw Before Five Years?
There are two types of distributions that are defined by the Internal Revenue Service (IRS) when it comes to Roth IRAs. You can either have a qualified distribution or an unqualified distribution. A qualified distribution is a legal distribution that either was withdrawn from your Roth IRA after reaching the age of 59½ or meets the qualification for an exemption to the distribution rules for items such as your first home purchase.
However, if you withdraw your earnings before they have been invested for five years, whether you are over the age of 59½ or not, your withdrawal will be deemed as an unqualified distribution by the IRS. Unqualified distributions of your earnings from a Roth IRA are subject to taxes at your current ordinary income tax rate, plus a 10 percent penalty. This can be a quite devastating additional tax: If you were in the 28% tax bracket, you would see 38% of your Roth IRA’s earnings evaporate in taxes and penalties because you withdrew the earnings before five years had passed. (Learn more about Roth IRA taxes)
Not following Roth IRA withdrawal rules can result in having to pay taxes and penalties. (Find out about the most important Roth IRA rules so you don’t make a mistake.)