There are rules for Roth IRAs—which offer tax-free withdrawals of both contributions and earnings upon retirement—that are designed to prevent abuse. The most frequently mentioned one is the Roth IRA 5 year rule.
Most discussions center around two 5 year rules—one that deals with earnings withdrawn from a regular Roth IRA and a second concerning conversions of a traditional IRA to a Roth IRA. But there is a third Roth IRA 5 year rule for beneficiaries of an inherited Roth IRA that is also important to know about.
Before reviewing the 5 year rules, there are three basic guidelines for the withdrawal of funds from a Roth IRA that you need to keep in mind:
- At age 59½ you may withdraw both contributions and earnings with no penalty, provided your Roth IRA has been open for at least 5 tax years.
- If you are under 59½, you can withdraw contributions with no penalty.
- Exemptions allow you to withdraw funds before the age of 59½ with no penalty. These exemptions include a first-time home purchase, college expenses and several others.
The use of the term “tax years” above with regard to 5 year rules means that the clock starts ticking January 1 of the tax year when the first contribution was made. For example, a Roth IRA contribution made on April 15, 2018 counts as if it were made on Jan. 1, 2017. In this case, you could begin withdrawing funds without penalty on Jan. 1, 2022—not April 15, 2023.
Rule One: Contributions to a Regular Roth IRA
The first Roth IRA 5 year rule is used to determine if the earnings (interest) from your regular Roth IRA are tax-free. To be tax-free, the earnings must be withdrawn:
- On or after the date on which you turn 59½; after the original IRA owner dies (if you are a beneficiary); or for a qualified first-time home purchase.
- At least 5 tax years after the first contribution to any Roth IRA you own.
The second bullet raises an important point: The 5 year clock starts with your first contribution to any Roth IRA—not necessarily the one from which you are withdrawing funds. The clock rule also applies to conversions from a traditional IRA to a Roth IRA. (Rollovers from one Roth IRA to another do not reset the 5 year clock.)
Once you satisfy the 5 year requirement for a single Roth IRA, you’re done. Any subsequent Roth IRA is considered held for 5 years.
Rule Two: Roth Conversions
The second Roth IRA 5 year rule determines whether distribution of principal from the conversion of a traditional IRA to a Roth IRA is penalty free. (You pay taxes upon conversion.) As with contributions, the 5 year rule for Roth conversions uses tax years but the conversion must occur by Dec. 31 of the year in which the conversion occurs.
Each conversion has its own 5 year period, but IRS rules stipulate that the oldest conversions are withdrawn first. The order of withdrawals for Roth IRAs are contributions first, followed by conversions and then earnings. If you are under age 59½ and take a distribution within 5 years of the conversion, you will pay a 10% penalty unless you qualify for an exception.
Rule Three: For Beneficiaries
Since death is an exception, when a Roth IRA owner dies, beneficiaries who take a distribution will not pay a penalty—no matter whether the distribution is principal or earnings (interest).
Death does not, however, eliminate the 5 tax-year rule for earnings to be tax-free. If you, as a beneficiary, take a distribution from an inherited Roth IRA that was not held for 5 tax years, the earnings will be subject to tax.
Thanks to the withdrawal order mentioned under Rule #2, you may owe no taxes since earnings are the last part of the IRA to be distributed.
As a beneficiary of a Roth IRA you have the option to withdraw funds as a required minimum distribution (RMD) over your life expectancy. You may also withdraw funds by Dec. 31 of the fifth year following the year the original IRA owner died.
With the 5 year withdrawal option you have the flexibility of taking a distribution each year or a lump sum at any point before the Dec. 31 date mentioned above. Be aware, however, that if you fail to empty the IRA by Dec. 31 of that fifth year you face a 50% penalty of the amount left in the account.
It’s always wise to seek advice from a trusted financial adviser before withdrawing funds, converting from one type of IRA to another or beginning the process of taking a distribution from an inherited IRA.