The beauty of a Roth IRA is the tax-free income it generates for retirement because these types of saving vehicles use after-tax contributions. When the time comes to withdraw your funds, you don't have to pay income tax on the money. There are rules put into place by the Internal Revenue Service (IRS) that apply to Roth IRA accounts, like two five-year waiting periods.
In both cases, the waiting period for a Roth IRA begins on the first day of the applicable calendar year, but how this rule applies to you depends on the circumstances.
Roth IRA Waiting Period: Rule #1
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 2019, your five-year period begins January 1, 2019. Or, if you made a regular contribution to your Roth IRA for 2019, which could occur any time between January 1, 2019, and April 15, 2020, your five-year period begins January 1, 2019.
If you establish other Roth IRAs after that first Roth IRA, your five-year period for those new Roth IRAs still begins January 1, 2019, 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.
Roth IRA Waiting Period: Rule #2
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 2008, the five-year period for those converted assets begins January 1, 2008. If you later convert other Traditional IRA assets to a Roth IRA in 2013, 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 is 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. At age 59 1/2, provided you met the five-year rule, you can take contributions out tax and penalty free.
If you don't meet the five-year rule, be prepared to owe both taxes and most likely a 10% penalty on any earnings you withdraw. There are certain conditions under which you may withdraw earning funds without meeting the five-year rule. You can use up to $10,000 to pay for your first home, or use the money to pay for higher education, for yourself, spouse, child or grandchildren.
The IRS will also allow you to withdraw funds to pay for health insurance premiums, if you become unemployed, or if you need to reimburse yourself for medical expenses that exceed 10% of your adjusted gross income.
Roth IRA Contributions vs. Earnings
It is important to note that these rules apply to Roth IRA earnings. As per the IRS, you may remove your contributions to a Roth IRA at any time (even before age 59.5), without paying taxes or penalties. If you withdraw funds from your Roth IRA earnings before meeting the five-year-old and before age 59.5, be prepared to pay taxes and penalties on your earnings.
Scott Bishop, CPA, PFS, CFP®
STA Wealth Management, LLC, Houston, TX
There’s a third five-year rule that applies to Roth IRA beneficiaries. Named beneficiaries have the option of stretching RMDs (required minimum distributions) from inherited Roth IRAs either over their life expectancy or via the five-year rule.
In some rare cases, the Roth IRA documents may specify the five-year rule. If you elect the five-year option, the inherited Roth IRA proceeds must be distributed by December 31 of the fifth year following the year of the original owner’s death. Within the five-year period, you have complete flexibility in the distributions: You can take a lump sum or make withdrawals each year. You just need to be sure the Roth IRA is emptied by the end of the five-year period or you will face a 50% penalty on the amount not taken in that year.