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