The Trio of 5-Year Rules
One of the much-touted boons of the Roth IRA is your ability — at least, relative to other retirement accounts—to withdraw funds from it when you wish and at the rate you wish. But when it comes to tax-advantaged vehicles, the Internal Revenue Service (IRS) never makes anything simple.
True, direct contributions to a Roth can be withdrawn anytime, without tears (or taxes). Withdrawals of other sorts of funds, however, are more restricted: Access to them is subject to a waiting period, known as the five-year rule.
- Though relatively less restrictive than other accounts, Roth IRAs do impose a waiting period on certain withdrawals, known as the five-year rule.
- The five-year rule applies in three situations: if you withdraw account earnings, if you convert a traditional IRA to a Roth, and if a beneficiary inherits a Roth IRA.
- Failure to follow the five-year rule can result in paying income taxes on earnings withdrawals and a 10% penalty, too.
On March 17, 2021, the Internal Revenue Service (IRS) announced that the federal income tax filing due date for all taxpayers for the 2020 tax year will be automatically extended from April 15, 2021, to May 17, 2021. This pushes other tax-related deadlines back as well; for example, the deadline to make IRA contributions is usually April 15, but taxpayers will have extra time this year.
Taxpayers impacted by the 2021 winter storms in Texas will have until June 15, 2021, to file various individual and business tax returns, make tax payments, and make 2020 IRA contributions. (The IRS's extension for victims of the 2021 winter storms was announced on Feb. 22, 2021.)
The five-year rule applies in three situations:
- You withdraw earnings from your Roth IRA.
- You convert a traditional IRA to a Roth IRA.
- You inherit a Roth IRA.
You need to understand the five-year rule—or rather, the trio of five-year rules—to ensure that withdrawals from your Roth don't trigger income taxes and tax penalties (generally, 10% of the sum taken out).
Roth IRA Withdrawal Basics
As you know, Roths are funded with after-tax contributions (meaning you get no tax deduction for making them at the time), which is why no tax is due on the money when you withdraw it. Before reviewing the five-year rules, here's a quick recap of the Roth regulations regarding distributions (IRS-speak for withdrawals) in general:
- You can always withdraw contributions from a Roth IRA with no penalty at any age.
- At age 59½, you can withdraw both contributions and earnings with no penalty, provided your Roth IRA has been open for at least five tax years.
"Tax years," with regard to five-year rules, means that the clock starts ticking Jan. 1 of the tax year when the first contribution was made. A Roth IRA contribution for 2019, for instance, can be any time up to July 15, 2020, for example, but it counts as if it were made on Jan. 1, 2019. In this case, you could begin withdrawing funds without penalty on Jan. 1, 2024—not April 15, 2025.
A withdrawal that is tax- and penalty-free is called a qualified distribution. A withdrawal that incurs taxes or penalties is called a non-qualified distribution. Failing to understand the difference between the two and withdrawing earnings too early is one of the most common Roth IRA mistakes.
In sum, if you take distributions from your Roth IRA earnings before meeting the five-year rule and before age 59½, be prepared to pay income taxes and a 10% penalty on your earnings. For regular account-owners, the five-year rule applies only to Roth IRA earnings and to funds converted from a traditional IRA.
5-Year Rule for Roth IRA Withdrawals
The first Roth IRA five-year rule is used to determine if the earnings (interest) from your Roth IRA are tax-free. To be tax-free, you must withdraw the earnings:
- On or after the date you turn 59½
- At least five tax years after the first contribution to any Roth IRA you own
A note for multiple account-owners: The five-year clock starts with your first contribution to any Roth IRA—not necessarily the one you're withdrawing funds from. Once you satisfy the five-year requirement for one Roth IRA, you're done.
Any subsequent Roth IRA is considered held for five years. Rollovers from one Roth IRA to another do not reset the five-year clock.
5-Year Rule for Roth IRA Conversions
The second five-year rule determines whether the distribution of principal from the conversion of a traditional IRA or a traditional 401(k) to a Roth IRA is penalty-free. (Remember, you're supposed to pay taxes when you convert from the pre-tax-funded account to the Roth.) As with contributions, the five-year rule for Roth conversions uses tax years, but the conversion must occur by Dec. 31 of the calendar year.
For instance, if you converted your traditional IRA to a Roth IRA in Nov. 2019, your five-year period begins Jan. 1, 2019. But if you did it in Feb. 2020, the five-year period begins Jan. 1, 2020. Don't get this mixed up with the extra months' allowance you have to make a direct contribution to your Roth.
Each conversion has its own five-year period. For instance, if you converted your traditional IRA to a Roth IRA in 2018, the five-year period for those converted assets began Jan. 1, 2018. If you later convert other traditional IRA assets to a Roth IRA in 2019, the five-year period for those assets begins Jan. 1, 2019.
It's a bit head-spinning, admittedly. To determine whether you are affected by this five-year rule, you need to consider whether the funds you now want to withdraw include converted assets, and if so, what year those conversions were made. Try to keep this rule-of-thumb in mind: IRS ordering rules stipulate that the oldest conversions are withdrawn first. The order of withdrawals for Roth IRAs are contributions first, followed by conversions, and then earnings.
If you're under 59½ and take a distribution within five years of the conversion, you'll pay a 10% penalty unless you qualify for an exception.
Exceptions to the 5-Year Rule
Under certain conditions, you may withdraw earnings without meeting the five-year rule, regardless of your age. You may use up to $10,000 to pay for your first home or use the money to pay for higher education for yourself or for a spouse, child, or grandchild.
The IRS will also allow you to withdraw funds to pay for health insurance premiums—should you become unemployed—or if you need to reimburse yourself for medical expenses that exceed 10% of your adjusted gross income.
5-Year Rule for Roth IRA Beneficiaries
Death is also an exception. When a Roth IRA owner dies, beneficiaries who inherit the account can take a distribution without incurring a penalty—no matter whether the distribution is principal or earnings.
However, death does not totally get you off the hook of the five-year rule. If you, as a beneficiary, take a distribution from an inherited Roth IRA that wasn't held for five tax years, the earnings will be subject to tax. But thanks to the withdrawal order mentioned above, you still may end up owing no taxes since earnings are the last part of the IRA to be distributed.
Roth IRA beneficiaries, until they are original account owners, have to take required minimum distributions (RMDs) from the IRA. They have a couple of options as to the schedule. Previously, non-spouses inheriting retirement accounts could stretch out disbursements over their lifetime. This provision was known as the stretch IRA. But after the passage of the SECURE Act of 2019, this provision was eliminated. The new rules will require a full payout from the inherited IRA within 10 years of the death of the original account holder. However, this will apply only to the heirs of account holders who die starting in 2020.
With the five-year withdrawal option, you have the flexibility of taking a distribution each year or a lump sum at any point before the Dec. 31 date mentioned above. Be aware, however, that if you fail to fully deplete the IRA by Dec. 31 of that fifth year, you face a 50% penalty of the amount left in the account.
Roth IRA Beneficiaries Under the SECURE Act
The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 changed a key rule for Roth IRA beneficiaries. Previously, anyone who inherited a Roth IRA could choose to take distributions spread out over a lifetime. This was part of a rule referred to as a Stretch IRA. However, under the new law, only a spouse can stretch the Roth IRA out for a lifetime. Any other beneficiary, such as a child, must close out the account within a decade.
Scott Bishop, CPA, PFS, CFP®
STA Wealth Management LLC, Houston, Texas
There's a third 5-year rule that applies to Roth IRA beneficiaries. Named beneficiaries have the option of stretching required minimum distributions (RMDs) from inherited Roth IRAs either over their life expectancy or via the five-year rule. (Under the new SECURE Act, this only applies to beneficiaries who are spouses. All other beneficiaries must cash out in ten years.)
In some rare cases, the Roth IRA documents may specify the 5-year rule. If you elect the five-year option, the inherited Roth IRA proceeds must be distributed by Dec. 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.