The Roth IRA 5-Year Rule: Ensure that Your Withdrawals Are Tax-Free
Saving for retirement helps you make sure your future self can live a comfortable lifestyle. You have many options to save the money you need for retirement.
A Roth IRA is an essential tool that many people use to put away money for retirement. These accounts have several tax benefits that make them popular.
That said:
There's a catch.
It's called the 5-year rule, which may surprise some people that didn’t fully read up on these accounts before using them. It can cause headaches and cost you money if you don’t carefully plan around it.
Here’s what you need to know about the Roth IRA 5-year rule and how it works.
The Roth IRA 5-Year Rule
The Roth IRA 5-year rule does not allow you to withdraw earnings tax-free until five (5) years have passed since the first contribution to any Roth IRA.
Important to note:
- The rule considers "tax years" rather than the date an event actually occurred
- The rule applies regardless of your age
For example, a contribution made for your 2020 Roth IRA will meet the 5-year requirement on January 1, 2025.
This applies even if your first contribution to your 2020 Roth IRA is made in 2021 before the tax deadline.
In reality, this means the five-year rule generally requires you to hold a Roth IRA for less than five years unless your first contribution was on the first day of a year.
The 5-year rule also starts counting time from your first contribution to any Roth IRA. It isn’t the particular Roth IRA you want to withdraw from if you have multiple Roth IRA accounts.
Here are three instances when the Roth IRA 5-year rule applies and how it works in each instance.
1. Withdrawing funds in retirement
The primary way that most people encounter this rule is by withdrawing funds from their accounts after age 59 and ½.
Because you withdraw funds after age 59 and ½, the withdrawal is generally penalty-free.
The withdrawal is also tax-free if you’ve held open your Roth IRA for at least five years.
If you haven’t, you have to pay taxes on the earnings.
This can be an issue if you’ve contributed to a traditional IRA your whole life but decide to contribute to a Roth IRA shortly before retirement.
You’ll need to wait until the Roth IRA account has been open for five tax years to avoid the taxes on earnings from the account.
2. Conversion to a Roth IRA
The 5-year rule also applies in other ways.
In particular, there is a 5-year rule regarding funds converted from traditional retirement accounts to a Roth IRA.
These funds may have been converted from an IRA or a 401(k).
This 5-year rule determines whether the initial amount you transferred to the Roth IRA, called the principal, can be withdrawn penalty-free or not.
Unlike the first 5-year rule discussed above, each conversion starts its own 5-year rule period.
If you withdraw funds from the conversion before the 5-year period is met and you’re under age 59 and 1/2, you have to pay a 10% early withdrawal penalty on the amount withdrawn.
This may be an issue if you end up doing tax planning shortly before retirement.
If you decide to convert a traditional retirement account to a Roth IRA, be sure you understand this 5-year rule. By doing so, you can plan withdrawals from the converted Roth IRA to avoid these penalties.
3. Inherited Roth IRAs
The last five-year rule application occurs when a Roth IRA is inherited.
A person that inherits the account must make sure the Roth IRA has been open for at least five tax years to withdraw earnings from the account tax-free.
Thankfully, withdrawals from an inherited IRA should be penalty-free.
In reality, this rule follows the same guidelines as the first 5-year rule.
The key difference is the 5-year period starts from when the original owner opened the account, not when you inherited it.
Inherited Roth IRAs also must follow other rules.
If you’ve recently inherited a Roth IRA, consult an expert for advice specific to your situation.
How Roth IRAs Work
Before diving into the 5-year rule and how it works, it helps to understand the basics of a Roth IRA.
Taxation in general
Roth IRAs are an attractive tool to use for your retirement savings due to their tax benefits.
You don’t get a tax break for the contributions you make to these accounts. The earnings in the account grow without any immediate income tax impact, too.
The real benefit is the taxation when you withdraw the money in retirement.
As long as your withdrawals are after age 59 and ½, you can withdraw money penalty-free in most cases.
If you meet the 5-year rule, withdrawals are generally both tax and penalty-free.
Some exceptions also exist that may allow you to get to some of the money early, too.
Contribution limits
The standard contribution limit for a Roth IRA is $6,000 in 2022.
If you’re age 50 or older, you get an additional $1,000 catch-up contribution.
In this case, you can contribute up to $7,000 for the 2022 tax year.
Your Roth IRA contributions may be limited, though. The IRS limits your contributions based on your adjusted gross income (AGI) and your filing status.
If your AGI exceeds the limits for your filing status, your contribution limit is reduced.
Eventually, the contribution limit will reach zero as your AGI climbs above a set amount.
Contribution deadlines
Roth IRA contributions may be made until your usual tax return deadline.
For 2022 contributions, the deadline is April 15, 2023.
If you extend your tax-return deadline, it does not extend the Roth IRA contribution deadline.
Roth IRA Withdrawal Exceptions to Know
A few exceptions can help you withdraw money from a Roth IRA before age 59 and ½.
Depending on your circumstances, these exceptions may allow you to make tax-free distributions, penalty-free distributions, or both.
In particular, qualified distributions can be made tax and penalty-free.
To be a qualified distribution, you must have met the 5-year rule.
Contribution withdrawals
Contributions to a Roth IRA have already been taxed.
For this reason, any withdrawal of contributions from a Roth IRA is both tax and penalty-free.
However, earnings withdrawn may face taxes and penalties.
First-time home purchase
A first-time home purchase is an exception that may count earnings as a qualified distribution.
As long as you only withdraw up to $10,000 for a first-time home purchase, the withdrawal is penalty-free.
The key:
This being a qualified distribution is meeting the 5-year rule.
In this case, it is tax and penalty-free.
A first-time home purchase isn’t as restrictive as it sounds.
As long as you and your spouse haven’t owned a home for the last two years, buying a house should count as a first-time purchase.
Disability
If your doctor certifies that your disability is permanent, continuous, or likely to lead to death, you may qualify for penalty-free withdrawals.
A disability may also count as a qualified distribution if you meet the 5-year rule.
Meeting both conditions means your distributions would be tax and penalty-free.
Death
As mentioned above, when a person dies, their account gets passed on to beneficiaries.
Beneficiaries may withdraw money from a Roth IRA penalty-free.
The death of a Roth IRA owner would result in a qualified distribution if the original owner met the 5-year rule.
This results in both tax and penalty-free withdrawals.
Other exceptions
Other exceptions exist that allow you to withdraw money from your account before age 59 and ½.
Unfortunately, the five-year rule can’t help you avoid income taxes on the following exceptions.
You can only avoid early withdrawal penalties on the following:
- Substantially equal payments under rule 72(t)
- Qualified education expenses at a qualifying educational institution
- Health insurance premiums while unemployed
- Unreimbursed medical expenses exceeding 7.5% of your AGI
- Up to $5,000 in the year after birth or adoption of a child
- Certain other specific circumstances
Consult an Expert
Retirement planning is a highly complex topic when you consider all aspects of the task.
Understanding the 5-year rule for Roth IRAs is relatively simple on its own. Even so, understanding the impacts on your financial plan may be more complex.
If you want help understanding Roth IRAs on their own or within the bigger picture of your whole retirement plan, a financial advisor may help.
In particular, a fiduciary fee-only financial advisor may be the best bet.
These advisors charge you directly for their advice. They don’t accept commissions, which could cause a conflict of interest.
They can help you make a plan for withdrawing earnings from your Roth IRA.
Depending on your circumstances, they may be able to help you find a way to withdraw them without paying taxes or penalties.
They may also advise whether Roth conversions may help you save taxes on your overall retirement withdrawal strategy.
These advisors can even look at other solutions that may work better for you.
