As most investors are well aware, there are several rules that you must abide by when you contribute to a Roth IRA. There are also rules for Roth IRA withdrawals. One rule that investors often do not realize is that you must have owned your Roth IRA for five years in order to withdraw earnings tax free during retirement. As always, there are several things to consider to avoid being penalized by the five-year rule.
What is the Five-Year Rule for Roth IRA Withdrawals?
An investor can withdraw his or her contributions to a Roth IRA at any time without tax or penalty. But that does not apply to 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 59½ 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 will not be considered a qualified distribution from your Roth IRA because the withdrawal violates the five-year rule.
How Are 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 2018 and designated it for the 2017 tax year, you would have to wait until January 1st, 2022 in order to withdraw your Roth IRA earnings tax free. Of course this assumes that you are over 59½ years-old at that time so it is a fully qualified withdrawal from your Roth IRA. The good news: 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 starts with the very first contribution you ever deposited into the Roth. Note that, this is not the case with a Roth IRA conversion: The five-year–rule clock restarts for 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 withdrawal of earnings from your Roth IRA tax free before you reach the age of 59½. such as a first-time home purchase, developing a severe disability, money transferred to your estate after death, 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 percent penalty for an early withdrawal, just as it would had you withdrawn the money prior to turning age 59½. It will also subject you to the requirement to pay taxes on the earnings you take out.
This combination can seriously erode 40 percent or more of your investment, depending on which tax bracket you are in at the time of withdrawal. A large-enough withdrawal could 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.