As most investors are well aware of there are several rules that you must abide by when you contribute to a Roth IRA as well as when you conduct a Roth IRA withdrawal. One rule that investors often do not realize is that there is a requirement to own your Roth IRA for five years in order to withdrawal earnings tax free during retirement. But, like always, there are several things to consider avoiding being penalized by the five year rule with Roth IRA withdrawals.
What is the Five Year Rule?
An investor can withdraw his or her contributions to a Roth IRA at any time without tax or penalty. But, that is not the same case for any earnings or interest that you have earned on your Roth IRA investment. In order to withdraw your earnings from a Roth IRA tax and penalty free, not only must you be over 59 ½ years-old but your initial contributions must also have been made to your Roth IRA five years before the date when you start withdrawing funds. If you did not start contributing in your Roth IRA five years before your withdrawal, your earnings would not be considered a qualified distribution from your Roth IRA because of its violation of the five year rule.
How Is The Five Years Calculated?
The five year rule for your Roth IRA earnings starts on January 1st of the year you make your first contribution. That is when your clock starts. Because you can make a Roth IRA contribution up to April 15th of the next year, your five years technically would not have to be five calendar years. The clock for earnings could count as having started on January 1st as long as you designated contributions up until April 15th for the previous tax year.
For example, if you made a Roth IRA contribution in February 2002 and designated it for the 2001 tax year, you would have to wait until January 1st, 2006 in order to withdraw your Roth IRA earnings tax free. Of course this assumes that you are over 59 ½ years-old at that time so it is a fully qualified withdrawal from your Roth IRA. If you practice dollar cost averaging in your Roth IRA or invest periodically, your five year clock does not restart with every investment.
Instead the clock only starts with regular Roth IRA contributions in the very beginning with the first contribution ever to be placed into the Roth. However, this is not the case with a Roth IRA conversion; the five year rule clock restarts with every conversion with the amount and date it was converted.
What Happens If You Violate The Five Year Rule?
There are many exceptions that allow you to withdraw earnings from your Roth IRA tax free before you reach the age of 59 ½ such as a first time home purchase, transferred to your estate after death, in the event of a severe disability, and other reasons. But, none of those exemptions save you from having to abide by the five year rule for Roth IRA withdrawals.
Even if you make a withdrawal because of one of the exemptions listed above, your distribution will still not be a fully qualified Roth IRA withdrawal if the withdrawal was made before the five year rule is met. A withdrawal that is made before the five year time frame is complete will trigger a 10% penalty for an early withdrawal much like it would had you withdrawn the money prior to turning 59½ years-old as well as the requirement to pay taxes on the earnings too.
This can seriously erode 40% or more of your investment depending on which tax bracket you are in at the time of withdrawal. In some cases, a large enough withdrawal can even put you into a higher tax bracket further penalizing you. The five year rule for Roth IRA withdrawals is not something to be taken lightly. It can have serious repercussions on your earnings if you are penalized. Understanding the requirements of the five year rule for Roth IRA withdrawals is critical to keep from being penalized.