Follow these rules to avoid penalties
- Five-year rules apply to withdrawals, conversions, and beneficiaries.
- If you don’t follow the rules, you could owe a penalty.
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. The 5-year rule applies in three situations:
- You withdraw earnings from your Roth IRA.
- You convert a traditional IRA to a Roth IRA.
- A beneficiary inherits a Roth IRA.
Roth IRA Withdrawal Basics
Before reviewing the 5-year rules, there are a few basic guidelines to keep in mind when you withdraw money from a Roth IRA:
- At age 59 ½, you can withdraw both contributions and earnings with no penalty, provided your Roth IRA has been open for at least five tax years.
- If you’re under 59 ½, you can withdraw contributions with no penalty.
- Exemptions allow you to withdraw funds before the age of 59 ½ with no penalty. These exemptions include first-time home purchases, college expenses, and several others.
The use of the term “tax years” with regard to 5-year rules means that the clock starts ticking Jan. 1 of the tax year when the first contribution was made. A Roth IRA contribution for 2019 can be made on April 15, 2020, for example, but it counts as if it were made on Jan. 1, 2019. In this case, you could begin withdrawing funds without penalty on Jan. 1, 2024—not April 15, 2025.
Rule One: Roth IRA Withdrawals
The first Roth IRA 5-year rule is used to determine if the earnings (interest) from your Roth IRA are tax-free. To be tax-free, you must withdraw the earnings:
- On or after the date you turn 59 ½, after the original IRA owner dies (if you are a beneficiary), or for a qualified first-time home purchase.
- At least five 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 you’re withdrawing funds from. 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 one Roth IRA, you’re done. Any subsequent Roth IRA is considered held for five years.
Rule Two: Roth Conversions
The second 5-year rule determines whether the 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 the conversion happens.
Each conversion has its own 5-year period, but IRS rules stipulate the oldest conversions are withdrawn first. The order of withdrawals for Roth IRAs are contributions first, followed by conversions, and then earnings. If you’re under age 59 ½ and take a distribution within five years of the conversion, you’ll 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 won’t pay a penalty—no matter whether the distribution is principal or earnings (interest).
Death does not, however, eliminate the five tax-year rule for earnings to be tax-free. If you, as a beneficiary, take a distribution from an inherited Roth IRA that wasn’t held for five tax years, the earnings will be subject to tax.
Thanks to the withdrawal order mentioned under Rule Two, you may owe no taxes since earnings are the last part of the IRA to be distributed.
As a Roth IRA beneficiary, 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 advisor before withdrawing funds, converting from one type of IRA to another, or beginning the process of taking a distribution from an inherited IRA.