One of the main benefits of Roth IRAs is the investor’s ability to withdraw funds whenever and at whatever rate they want. But, like anything related to tax-advantaged vehicles, things are never that simple. Although direct contributions to a Roth IRA can be withdrawn at any time, other types of funds are more restricted.
In fact, most of them are subject to a waiting period, usually referred to as the five-year rule. To ensure that withdrawals from a Roth IRA won’t bring about any penalties or income taxes, investors need to understand this rule.
What Is the 5-Year Rule?
The five-year rule stipulates that before an investor can withdraw the earnings tax-free, five years must have passed since the tax year of the first contribution. This rule applies in three specific situations:
● The withdrawal of funds.
● The conversion of a traditional IRA to a Roth IRA.
● The inheritance of a Roth IRA.
It’s important to note that the five-year clock starts ticking on January 1st of the year of the first contribution. Additionally, Roth IRA conversions have a separate five-year clock. And while inherited Roth IRAs have their own clock as well, it starts when the original owner made its first contribution, not when the person inherited it.
Withdrawals
As previously mentioned, the Roth IRA five-year rule is used to determine if someone’s earnings from their account are tax-free. In order to be tax-free, the owner of the account needs to withdraw their earnings:
● On the day or after the date they turn 59 ½
● Five tax years or more after the first contribution to their Roth IRA
For those who own multiple Roth IRAs, the five-year clock starts ticking with the first contribution to any account. In other words, once an account has a contribution older than five years, an investor can withdraw funds from any of his accounts. Additionally, rollovers from one Roth IRA to another don’t reset the five-year counter.
Conversions
Another essential aspect of the five-year rule is that it helps determine if the distribution of principal from the conversion of a 401(k) or a traditional IRA to a Roth IRA is penalty-free. Like with withdrawals, the five-year rule for conversions uses tax years. However, the conversion must occur by December 31st of the calendar year.
For instance, if someone converted to a Roth IRA in November 2020, their five-year period began on January 1st, 2020. However, if they did the conversion in February 2021, the five-year period began on January 1st, 2021. Account owners need to be careful not to mix this up with the extra months’ allowance they have to make a direct contribution to their Roth.
Furthermore, each conversion has its waiting period. For example, if an investor switched to a Roth IRA in 2020, their five-year started on January 1st, 2020. If they later decided to convert other IRA assets to a Roth IRA in 2021, the five-year period for those began on January 1st, 2021.
All of this might indeed sound very convoluted. But what account owners need to know is that withdrawing converted assets is not always a good idea. As a result, investors need to consider the five-year rule before withdrawing. It’s also important to note that the oldest conversions are withdrawn first, according to the IRS ordering rules. Generally speaking, Roth IRA withdrawals follow a specific order: contributions, conversions, and earnings.
Beneficiaries
Last but not least, the five-year rule applies to those who have inherited a Roth IRA. If a Roth IRA owner dies, those who inherited the account will have to take required minimum distributions from it. And while inheritance could seem like a loophole to the five-year rule — it isn’t.
Unfortunately, death does not get anyone off the hook of the five-year rule. If a beneficiary takes a distribution from the inherited Roth IRA that wasn’t held for five tax years, they will have to pay taxes on the earnings. However, a beneficiary might still end up owing no taxes, as the earnings are last on the Roth IRA withdrawals order. On a related note, we have another article tackling what income is not taxable in Pennsylvania.
The Bottom Line
Ultimately, knowing all about the five-year rule is a must, especially for those who want to make the most out of their Roth IRA. Not only does it help owners avoid penalty fees, but it also ensures that their withdrawals stay tax-free. And though its intricacies might seem extremely hard to understand fully, they are an essential part of Roth IRAs.
But even those who don’t want to spend their time researching Roth IRAs can take advantage of them with the help of a professional financial advisor. The Kelley Financial Group makes sure that all of its clients are fully informed and educated about any rules, policies, and fees that might affect their investments, such as if one has to report Roth IRA on their tax return.
Disclosure: A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earning prior to age 59 ½ or prior to the account being opened 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply. Traditional IRA account owners have considerations to make before performing a Roth IRA Conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take required minimum distribution (RMD) in the year you convert you must do so before converting to a Roth IRA.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
This material was prepared for The Kelley Financial Group.