The five-year rule for Roth IRAs is a rule that includes several technical rules, and it requires you to wait at least five years before withdrawing investment earnings to avoid penalties.
How Does the Five-Year Rule Work?
The five-year rule refers to three different rules that apply to IRA distributions. It applies in the following three situations:
1. You are withdrawing funds from a Roth IRA account.
2. You are converting a traditional retirement account into a Roth IRA.
3. You have inherited an IRA from someone who has passed away.
The five-year rule works differently in each of these three cases.
The Five-Year Rule for Roth IRA Withdrawals
The five-year rule for withdrawing from a Roth IRA requires you to wait five years after opening your account to withdraw investment earnings. Otherwise, taxes and penalties will apply, although there are some exceptions that we will cover.
When you fund a Roth IRA account, you do not receive a pre-tax deduction on your contribution. However, you can withdraw money from the account without paying taxes or penalties if you wait until you are 59 and a half years old and have kept the account for at least five years.
Suppose you opened a Roth IRA when you were 57, and you are now 61. You contributed $5,000 annually for four consecutive years. Let’s assume your account value is now $30,000, consisting of $20,000 from your contributions, plus $10,000 in investment earnings.
If you decide to withdraw $25,000 from your account, the first $20,000 will be completely tax and penalty-free because it is your contribution amount. The tax authority considers the money you withdraw first from a Roth IRA account to be contributions. Earnings are only withdrawn after the contributions have been exhausted.
In this case, because you have not yet met the five-year rule, you will owe income taxes on $5,000 of earnings. However, because you have surpassed the age of 59 and a half, you will avoid paying the 10% early withdrawal penalty. If you wait one more year to withdraw the $5,000, you will completely avoid any tax bill as you will have met the five-year rule requirements.
There are some exceptions to the five-year rule. For example, you can avoid the 10% penalty if you become disabled or withdraw up to $10,000 of earnings for what the tax authority considers a first-time home purchase, even if you have had the account for less than five years. However, you will still owe income taxes on the distribution in these cases. Once you have held the account for five years, you will avoid both the 10% penalty and taxes in either case.
Note: The five-year countdown starts on January 1 of the year you made your first contribution to any Roth IRA, even if the account you are withdrawing from is not the same account. For example, if you made your first contribution to a Roth IRA in June 2021 and opened another account in January 2023, you would have met the five-year rule requirements on January 1, 2026.
The Five-Year Rule for Converting Roth IRAs
The second five-year rule applies to Roth IRA conversions. When you transfer funds from a traditional IRA or 401(k) account to a Roth IRA, you pay income taxes at the time of the conversion. To qualify for a tax-free distribution, you must keep the funds in the account for at least five years or face a 10% penalty. An additional 10% penalty may apply if you withdraw the funds before age 59 and a half.
Suppose
You are ineligible to contribute directly to a Roth IRA because your income exceeds the limits, which are $144,000 for single filers and $214,000 for married couples filing jointly in 2022. ($153,000 for single filers and $228,000 for married couples in 2023.) If this is the case, you can choose to use the backdoor Roth IRA – an alternative solution that allows you to fund a traditional IRA and then convert the funds to a Roth IRA.
Under the five-year IRA rule, you will need to:
– wait at least five years to make tax-free withdrawals on your conversions.
– be at least 59 and a half years old before withdrawing your money.
Otherwise, unless you qualify for an exception, you will pay income taxes and a 10% early withdrawal penalty. The penalty will apply to the total amount withdrawn early, rather than just the amount you contributed.
The five-year IRA rule applies to each conversion. So, if you converted $5,000 to a Roth IRA in 2020 and another $5,000 in 2021, you will have to wait until at least 2025 to withdraw the first $5,000 and until 2026 to withdraw the next $5,000.
The Five-Year Rule for Inherited IRAs
The final five-year rule applies when you inherit a Roth IRA. As a beneficiary, you must take the required minimum distributions (RMDs). If the account was not held for five years by the original owner, you will need to wait until the end of the fifth year, or the earnings will be taxable. (However, since the tax authority considers that the first withdrawals you make may have been from contributions, not earnings, you may not owe anything.)
If you inherited an IRA from someone who died on or after January 1, 2020, SECURE Act rules will apply. This means that unless the deceased was your spouse, you are required to withdraw all funds from the Roth IRA within 10 years of the original account owner’s death. If you are a spousal beneficiary, you can create an inherited IRA and take distributions based on your life expectancy. However, children and other beneficiaries must liquidate the account within ten years.
There is another type of five-year rule that applies to how distributions are taken from an inherited IRA. You can take distributions at any time during the five years after the original owner’s death. However, you must withdraw the entire balance by December 31 of the fifth anniversary of their death. You can do this gradually or in a lump sum.
The penalty for failing to take any required distribution from the IRA by the deadline is up to 50% of the amount that should have been withdrawn.
Frequently Asked Questions (FAQs)
Can I withdraw my money from a Roth IRA after five years?
You can withdraw your contributions from a Roth IRA at any time without paying taxes or penalties. However, if you withdraw earnings before you have had the account for five years and before you are 59 and a half, you will have to pay taxes and a 10% penalty.
Why are there five-year rules for Roth IRA withdrawals?
The IRS imposes penalties on early withdrawals from Roth IRAs and other retirement accounts because it wants to discourage individuals from using tax-advantaged retirement funds for purposes other than normal retirement.
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Sources:
IRS. “Publication 590-B (2020), Distributions from Individual Retirement Arrangements (IRAs).”
IRS. “Publication 590-B (2020), Distributions from Individual Retirement Arrangements (IRAs): What Are Qualified Distributions?”
IRS.
“Publication 590-B, Distributions from Individual Retirement Arrangements (IRAs).”
IRS. “Publication 590-A, Contributions to Individual Retirement Arrangements (IRAs).”
IRS. “Amount of Roth IRA Contributions That You Can Make For 2022.”
IRS. “Amount of Roth IRA Contributions That You Can Make For 2023.”
Congress.gov. “H.R.1994 – Setting Every Community Up for Retirement Enhancement Act of 2019.”
IRS. “Retirement Plan and IRA Required Minimum Distributions FAQs.”
Source: https://www.thebalancemoney.com/what-is-the-roth-ira-five-year-rule-5192052
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