What is the 'Five-Year Rule'

The five-year rule for inherited Individual Retirement Accounts (IRA)s allows beneficiaries to make distributions within five years after the death of the original account holder. The rule applies if the death of the original owner was before age 70.5. However, by December 31st of the fifth year after the passing of the originator, beneficiaries must distribute all assets out of the account.

BREAKING DOWN 'Five-Year Rule'

 

The five-year rule applies to one of several options that beneficiaries have when it comes to making distributions from an inherited IRA. Recipients are required to take annual allocations from the account to avoid penalty. The required minimum distribution (RMD) is a sliding scale, set on the age of the recipient. 

A SEP-IRA and a Simple IRA are classified as a traditional IRA when they are inherited. Roth IRAs will remain Roth IRAs. Taxes will be due for distributions from a traditional IRA, but untaxed for most distributions from a Roth IRA. 

The five-year rule gives beneficiaries a window of opportunity when they may withdraw funds without tax. By the end of the five-year window, the recipient must move all funds from the inherited account. The inheritance of the fund must occur before the originator would have reached age 70.5. The seventy and one-half age is when a majority of people begin making required minimum distributions. 

Five-Year Rule for Traditional IRAs

Based on the five year rule, a recipient may take distributions from an inherited traditional IRA at any time, but must entirely liquidate assets by December 31 of the fifth year after the original account holder became deceased. The beneficiary must take annual RMD, or they will face a penalty. Normally distributions from a traditional IRAs are taxable because contributions are tax-deferred.

Under the 5-year rule, the beneficiary will not face the 10% withdrawal penalty on any distribution, even if made it before they are age 59.5. The age fifty-nine and one-half is typically the age at which an IRA account holder may make penalty-free distributions. 

The new owner of the IRA may roll all funds over into another account under their name or cash it out. Within the 5-year window, recipients may continue to contribute to the inherited IRA account. When those five years are up, however, the beneficiary would have to withdrawal all assets. 

Five-Year Rule for Roth IRAs 

Roth IRAs have a series of rules that mandate a five-year waiting period. These rules deal with the withdrawal of earnings and contributions by the owner. A Roth IRA is also subject to a five-year inheritance rule, and the beneficiary must take annual RMD, or they will face a penalty.

If the beneficiary is taking distributions from an inherited Roth IRA, which has existed for longer than 5-years, all distributions will be tax-free. Further, the tax-free distribution may be made up of earnings or principal.

For beneficiaries of a fund that is less than 5-years old, withdrawals of earning are taxable, but the principal remains untaxed.

For example, let's say the original account holder died before reaching age 70.5, but it had been only three years since they made their first Roth IRA contribution. In this scenario, the beneficiary would need to wait two additional years before they could withdraw earnings on the Roth IRA investments without incurring taxes. This stipulation can raise some serious issues because, under the five-year rule, all assets must be removed from an inherited IRA within five years after the original account holder's death. 

Beneficiaries must explore all the options they have when it comes to taking distributions from an inherited Roth IRA and choosing the one that best suits their situation.

RELATED TERMS
  1. Roth IRA

    A Roth IRA is an individual retirement plan that bears many similarities ...
  2. Traditional IRA

    An individual retirement account allows individuals to direct ...
  3. Stretch IRA

    A stretch IRA is an estate planning strategy that extends the ...
  4. IRA Plan

    An IRA plan is an investment account individuals may establish ...
  5. Deferred Account

    A deferred account postpones tax liabilities until a future date.
  6. Guardian IRA

    A Guardian IRA is an Individual Retirement Account held in the ...
Related Articles
  1. Managing Wealth

    Managing Inherited IRAs: Distributions and Taxes

    If you have inherited an IRA account you don’t need to turn it over to the estate, regardless of what the will says.
  2. Retirement

    The Potential Benefits of a Roth IRA

    No one knows when taxes will increase. With a Roth IRA, future distributions are tax-free.
  3. Retirement

    Are You Too Old to Benefit from Opening a Roth IRA?

    You may not be too old to open a Roth IRA. Roth IRAs can offer significant retirement income security and tax advantages, even for older workers.
  4. Financial Advisor

    Top Estate Planning Tips for 401(k)s and IRAs

    Here's how to avoid estate planning pitfalls when it comes to leaving IRA and 401(k) assets to heirs.
  5. Retirement

    Roth vs. Traditional IRA: Which Is Right For You?

    To answer this question, you need to consider several of the factors we outline here.
  6. Retirement

    Why a Roth IRA May Be the Better Choice

    Both traditional and Roth IRAs are good for funding retirement, but here's why the Roth is better.
  7. Retirement

    What's the Tax Hit on an IRA Withdrawal?

    How much taxes you'll pay on IRA withdrawals depends on a variety of factors. Use this guide to plan ahead.
  8. Retirement

    6 Reasons Not to Recharacterize Your Roth IRA

    If you're thinking of recharacterizing your Roth IRA into a traditional IRA account, here are six compelling reasons why you should reconsider.
  9. Financial Advisor

    Why Roth IRA Investors Tend to be More Aggressive

    New data from the Investment Company Institute highlights the differences between Roth and IRA holders.
  10. Retirement

    Traditional or Roth IRA: What's the Difference?

    Traditional IRAs and Roth IRAs have similarities and differences investors need to know.
Trading Center