What is the five-year waiting rule for Roth IRAs?
There are two five-year waiting periods that apply to Roth IRAs. However, in both cases, the waiting period for a Roth IRA begins on the first day of the applicable calendar year. How this rule applies to you depends on the circumstances.
To clarify, let's look at the rule in detail:
- For the five-year waiting period to determine whether a Roth IRA distribution is qualified (that is, tax and penalty free), the five-year period begins the first day of the first year for which any of your Roth IRAs were funded. For instance, if you converted your Traditional IRA to a Roth IRA in November 1998, your five-year period begins January 1, 1998. Or, if you made a regular contribution to your Roth IRA for 1998, which could occur any time between January 1, 1998, and April 15, 1999, your five-year period begins January 1, 1998. If you establish other Roth IRAs after that first Roth IRA, your five-year period for those new Roth IRAs still begins January 1, 1998, regardless of when those new Roth IRAs are established. A qualified distribution from your Roth IRA is tax and penalty free and there is only one five-year waiting period, which begins with your first Roth IRA. If your Roth IRA distribution is qualified, you need not be concerned with the other five-year period.
- The other five-year waiting period applies only if the distribution is non-qualified. For this purpose, there is a separate five-year period for each Roth IRA conversion, and each one begins the first day of the year in which the conversion was made. For instance, if you converted your Traditional IRA to a Roth IRA in 1998, the five-year period for those converted assets begins January 1, 1998. If you later convert other Traditional IRA assets to a Roth IRA in 2003, the five-year period for those assets begins January 1, 2003. To determine whether you are affected by this five-year rule, you need to consider whether the distribution being made from your Roth IRA includes Roth conversion assets and, if so, what year those conversions were made. For this purpose, the ordering rules must be used.
This question was answered by Denise Appleby
With a Roth IRA, you can always take out contributions penalty free, and are never taxable as you didn't get a tax deduction going when making the contribution. But earnings must meet the 5 year rule to be considered a "qualified distribution" and thus tax free. If you meet the 5 year rule and are under 59 1/2, there is still a 10% penalty on earnings. To be penalty free and tax free on earnings, you must meet the 5 year rule and be over 59 1/2. There are, however, a few special circumstances to avoid the 10% penalty under 59 1/2, such as first home purchase (up to $10,000) or disability. Again, contributions can be taken out at any time.
A common misconception is that the 5 years starts ticking when you make the first contribution. Not true. It is the tax year applicable to the contribution. So, if you make a contribution on April 15th (tax day) for the previous tax year, then the contribution starts ticking on January 1st of the applicable (previous) tax year. So, you really get an extra 1 year and 3 months bonus. Even if you have multiple Roth IRA accounts at different brokerage firms, the clock starts ticking on all of the Roths when the first contribution is made, even if you are dollar cost averaging or opened and funded another Roth later.
Conversions from a Traditional IRA to a Roth have slightly different 5 year rules. With a Conversion, the 5 year rule begins January 1st in the year of conversion regardless of the actual conversion date for EACH conversion (if more than one). Thus, each conversion stands on its own and begins on January 1st in the year of conversion. But if you meet the 5 year rule, then there are no penalties or tax for withdrawal of earnings if you are over 59 1/2. If under 59 1/2, the 10% penalties apply unless, again, you meet special circumstances stated above.
I know this can be a little confusing, but the whole idea for Roths was have the earnings tax free for retirement because you didn't receive a tax deduction when you made contributions. But because contributions can be taken out whenever you like, and the rules apply only to the earnings or growth, it makes Roth IRAs a fairly flexible vehicle especially as far as retirement account are concerned.
Hope this is clearer than mud. I tried to make it as simple as I could but had to keep enough detail as to be thorough. Best of Luck, Dan Stewart CFA®
The purpose of the 5-year rule on Roth contributions is most likely to require that tax-free growth for “retirement” purposes be done for the long-term, meaning at least 5 years (other requirements apply too). Which given the meaning of “long-term,” is not unreasonable.
The 5-year rule for Roth contributions is the 2nd part of a two-part test for a qualified distribution. The distribution must meet the Roth contribution 5-year rule, or “nonexclusion period” rule, under IRC Section 408A(d)(2)(B).
The 5-year rule states that five TAX YEARS must pass from when the first contribution is made to the owner’s Roth IRA (NOT SPECIFIC Roth ACCOUNT), until a qualified distribution can be made.
Actually, 3 years 8 months, not 5 years:
- Based on tax years, this means that a contribution to a Roth IRA as late as April 15 of 2017 will still count as a contribution for the 2016 tax year (it is the same as if made January 1, 2016), which means the first year of a potential qualified distribution would be 2021-- the five years that passed would have been 2016, 2017, 2018, 2019, and 2020. This means that a “5-year” qualified distribution could actually be made after less than 3 years and 8 months, as a contribution on April 15 of 2017 (made in 2017 but for 2016) would allow for tax-free distributions as early as January 1st of 2021.
The second 5-year rule applies not to new Roth contributions, but to Roth conversions from traditional pre-tax retirement accounts, and determines whether Roth conversion principal will be penalty-free.
To meet the 5-year rule for Roth conversions, again, the measuring period is five tax years -- (Treasury Regulation 1.408A-6, Q&A-5(b)).
Unlike the 5-year rule for contributions:
- Each conversion amount has its own 5-year time period (Treasury Regulation 1.408A-6, Q&A-5(c)); as a result, with multiple conversions, there may be multiple different 5-year periods at once.
When withdrawals occur from conversion amounts, they are on a first-in, first-out basis under IRC Section 408A(d)(4)(B)(ii)(II)
- Oldest conversions are withdrawn first, and the most recent conversions are withdrawn last.
- Ordering rules from Roth IRAs
- After-tax contributions first,
- Conversions second, and
- Earnings third.
- Ordering rules from Roth IRAs
Checkout this Sona video on Roth IRAs:
Mark Struthers CFA, CFP®
In order to recieve distributions from our Roth IRA of the appreciated amounts tax free, you must have owned the Roth IRA for at least 5 years. If you take such distributions prior to 5 years, you will suffer the 10% penalty and ordinary income tax on the appreciated portion of the distribution. However, if within the 5 years your funds within the Roth IRA do down, you can cash out the full amount of the Roth IRA and recognize the loss against your ordinary income currently and fully.
The short answer is you must wait 5 years to withdraw money from a Roth IRA to avoid taxes and penalties. This would be a qualified distribution. The longer answer is per the IRS website, 'A qualified distribution is any payment or distribution from your Roth IRA that meets the following requirements:'
1 - It is made after the 5-year period, beginning with the first taxable year for which a contribution was made to a Roth IRA set up for your benefit, and
2 - The payment or distribution is: