The Roth IRA 5-Year Rule Explained

On the 49th episode of the Retirement Explained show, I’m talking about the five-year Roth IRA rule that is often confusing and overlooked.

The Roth IRA is a really great investment account to have, but the five-year rule can be tricky to navigate and it’s very important to get it right…like most things, if you do it wrong, there are penalties!

Whether you’re a DIY’er or work with a financial advisor, this is a great episode that I think you’ll enjoy.

What is the Roth IRA Five-Year Rule

After making a contribution to your Roth IRA, you have to wait five years before you can take tax-free withdrawals on the investment earnings. Typically, with Traditional IRA withdrawals, it’s all good once you reach 59.5 years old; you can begin taking penalty-free withdrawals, but with a Roth IRA, there’s the extra layer of the five-year rule to consider.

The time frame is based on the calendar year, which is a good thing. For instance, the IRS allows you to make your 2020 Roth contribution on April 14th (for instance), but begin your five-year waiting period as of January 1st, 2020.

How The Five-Year Rule Affects Roth IRA Conversions

Roth IRA conversations are a sneaky way of moving your money from qualified investment accounts that are subject to income tax upon withdrawal (think Traditional IRA/401k accounts) into non-qualified investment accounts that are allowed to grow tax-free (think Roth IRA).

This can also come in handy if you’re income is too high and you’re not allowed to make a direct Roth IRA contribution, you can use the Roth IRA conversion strategy to make a back-door Roth contribution.

The five-year rule affects Roth IRA conversations because, unlike the initial funding of the Roth IRA (the five-year clock starts and stops five years after the account is initially funded), each conversion you do in your Roth will have its own five-year waiting period.

Inherited Roth IRAs and the Five-Year Rule

If you inherit a Roth IRA, it is subject to the five-year rule. Make sure to check and see if the account is still within the five-year period before taking withdrawals!

What Happens If You Break the Five-Year Rule

The consequences of breaking the five-year rule depend on how old you are. If you’re younger than 59.5, then you can expect to pay a 10% penalty as well as income tax on the earnings. If you’re older than 59.5, you won’t have to pay the 10% penalty, but you’ll have to deal with the taxes on the investment earnings.

I want to clarify that it’s taxes on the investment earnings only. If you’re in a 20% tax bracket and you take a withdrawal of $1000 and only $300 of that $1000 is earnings, you’ll pay 20% tax on the $300 only, for example.

Make sure to talk to a qualified tax professional about your situation, the above example is only for illustrative purposes only.

Exceptions to the Five-Year Rule

If you have a qualified expense, you can avoid the 10 percent penalty even if you haven’t satisfied the five-year rule, but remember, you’ll still be dealing with taxes on the investment earnings.

Which things qualify as a penalty-free withdrawal, you ask?

First time home purchase
Certain educational expenses
Disability or death
Certain medical expenses
Birth or adoption
Health insurance
Period payments
Involuntary distribution
Reservist distributions

For more information on this list, reach out and I’ll be happy to talk to you!

-Brian