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
The 5-year rule applies to the Roth distribution. Although a Roth IRA is touted for its tax-free withdrawal, it’s not entirely true for one must abide by the IRS rule. Only qualified distributions from the Roth is free from federal income taxes, and you guessed it, any non-qualified distributions may be penalized with income tax, 10% penalty tax, or both.
Then, you may wonder what counts as qualified distributions for a Roth. Two requirements: 1) The distribution must be made after the 5-tax-year period beginning with the first tax year for which a contribution was made. That includes the contributory Roth or a converted Roth. If you happen to have multiple Roth IRAs, the clock starts with the very first one you made.
For example, you made your first Roth IRA contribution on 4/15/16 for the year 2015. Even though you literally deposited the check in 2016, your clock for the Roth started as if you made the contribution on 1/1/15.The 5-year period ends on 12/31/2019. Thus, any distributions in 2020 or later have satisfied the 5-year requirement. Furthermore, because of the aggregation rule, if you open another Roth later, say 2017, the 5-year period ends at 12/31/2019 for that new Roth as well.
2) The second requirement is that the distribution must be made after one of the four “triggering events”: a) owner has attained age 59 ½, b) death, thus the distribution is paid to the beneficiary, c) owner’s disability, and e) pay the qualified first-home homebuyer expenses. Qualified first-time homebuyer expenses include acquisition costs of a first home (paid within 120 days of the distribution) for the owner, spouse, any child, grandchild, or ancestor of the owner or spouse. Keep in mind though, this exception has a $10K lifetime limit per Roth IRA participant.
Distributions that do not satisfy both requirements are referred to as non-qualified distributions. Even the prefix with “non-" may dampen your spirit somewhat, the tax treatment of non-qualified distributions from a Roth is still quite favorable. The law allows the withdrawal of the owner’s Roth contributions (or converted contributions) first without any income tax consequences. Once all contributions have been withdrawn, any additional amounts (i.e. earnings from the investments) withdrawn are subject to both income tax and the 10% penalty tax. However, all of the exceptions to the premature distributions apply to a traditional IRA such as medical expenses, medical insurance premiums while unemployed, substantially equal periodical payments, and higher education expenses will also apply to distributions from the Roth IRA.
Lastly, there is a special tax rule to the Roth IRA that was created with a conversion. Under this rule, the 10% penalty tax applies to any distributions from a converted IRA made within the 5-year period, starting with the first day of the tax year in which the conversion took place. The reason for this rule is curb individuals who use the Roth conversion as a way to avoid the 10% early withdrawal penalty tax. Best!
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®
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: