What Is the 5-Year Rule?

Generally speaking, the 5-year rule concerns the withdrawal of funds from an IRA. However, several different types of 5-year rules actually exist. Two apply specifically to Roth IRAs: a waiting period before funds can be withdrawn. Another relates to the distribution schedule of funds from inherited IRAs, either Roth or traditional ones.

Key Takeaways

  • The 5-year rule deals with withdrawals from IRAs.
  • One set of 5-year rules applies to Roth IRAs, dictating a waiting period before earnings or converted funds can be withdrawn from the account.
  • Another 5-year rule applies to inherited IRAs, both traditional and Roths. It mandates that non-spousal beneficiaries take distributions on a 5-year schedule.

How the 5-Year Rule Works

Contributions to a Roth IRA can be distributed to the original account holder at any time. However, to withdraw earnings from your Roth without owing taxes or penalties you have to be 59½ years old and the account has to be five years old. Even if you’re already 59½, you have to have established and held the Roth for at least five years. That, in a nutshell, is the 5-year rule for Roths.

The 5-year rule only limits when you can withdraw your earnings from your Roth IRA. That means the interest, dividends, capital gains, and any other income your Roth investments have accumulated. (Contributions are not limited because they came from your after-tax money—you did not get a deduction when you deposited them into your Roth. Therefore, says the IRS, you can withdraw your contributions at any time and at any age you want, without any penalty or taxes.)

The 5-year clock starts ticking with your first contribution to any Roth IRA—not necessarily the one you’re withdrawing funds from. The clock rule also applies to conversions from a traditional IRA to a Roth IRA.

The second 5-year rule determines whether the distribution of principal from the conversion of a traditional IRA to a Roth IRA is penalty-free. (You pay taxes upon conversion.)

Each conversion has its own five-year period, but IRS rules stipulate the oldest conversions are withdrawn first. The order of withdrawals for Roth IRAs are contributions first, followed by conversions, and then earnings.

If you break the 5-year rule by withdrawing earnings or converted funds from a Roth too soon, your withdrawal will be deemed as an unqualified distribution by the IRS. Unqualified distributions are subject to taxes at your current ordinary income tax rate, plus a 10% penalty. This can be a quite devastating additional tax: If you were in the 24% tax bracket, you would see 34% of your Roth IRA’s earnings evaporate in taxes and penalties because you withdrew the earnings before five years had passed.

Inherited IRAs vs. Traditional IRAs vs. Roth IRAs

Inherited IRAs

The 5-year rule applies to one of several options that beneficiaries have when it comes to taking distributions from an inherited IRA. Whether it's a traditional IRA or a Roth IRA, heirs are required to take annual allocations from the account, known as required minimum distributions (RMD).

If the owner had already begun receiving required minimum distributions at the time of death, the beneficiary must continue to receive the distributions as calculated or submit a new schedule based on their own life expectancy. If the owner had not yet chosen an RMD schedule or had not turned 72, the beneficiary of the IRA has a 5-year window to withdraw the funds, which would then be subject to income taxes.

This rule applies to non-spousal beneficiaries. Spouses have more flexibility; they can transfer the existing IRA into their name and defer distributions until they reach RMD-age.

A SEP-IRA and a Simple IRA are classified as a traditional IRA when they are inherited. Roth IRAs will remain Roth IRAs.

The 5-year rule gives beneficiaries a window of opportunity when they may withdraw funds without tax. By December 31st of the fifth year, the end of the five-year window, the recipient must have removed all funds from the inherited account.

Traditional IRAs

Under the 5-year rule, the beneficiary will not face the usual 10% withdrawal penalty on any distribution, even if make it before they are 59½. Income taxes will be due, however, on the funds, at the beneficiary's regular tax rate.

The new owner of the IRA may roll all funds over into another account under their name or cash it out in a lump sum, or do a combination. Within the five-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.

Roth IRAs 

Roth IRA is also subject to a five-year inheritance rule. The beneficiary must liquidate the entire value of the inherited IRA by December 31 of the year containing the fifth anniversary of the owner’s death.

Notably, no RMDs are required during the five-year period. For example, Ron dies in 2021, leaving his Roth IRA to his daughter Ramona. If she opts for the five-year payout, she must distribute all assets by December 31, 2026.

If the beneficiary is taking distributions from an inherited Roth IRA that has existed for longer than five 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 hasn't met that five-year mark, withdrawals of earnings are taxable, but the principal remains untaxed.

Example of the 5-Year Rule

For example, let's say the original IRA account holder died before reaching age 70½ but had only established the account three years ago. 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 5-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. In the above example, the beneficiary might want to opt for distributions based on his life expectancy instead of using the five-year plan.

Special Considerations

Roth IRAs are a type of retirement account. Using them for anything other than saving and investing for retirement tends to defeat their purpose. Instituting a rule that investors had to wait at least five years before withdrawing their earnings reinforces the principle that Roth IRAs are designed for long-term investing and should not be considered a savings account with benefits—the sexy tax-free growth. The legislators who founded the Roth thought that the five-year wait would help deter people from misusing it.

As for the inherited IRAs, the five-year schedule is kind of a compromise from the IRS. It understands that IRAs wouldn't be very popular if they couldn't be bequeathed; if passing them on created a tax burden for beneficiaries. At the same time, these heirs weren't the ones who funded the account, and the IRS doesn't want to miss out on any tax revenue it's owed, especially on the traditional IRAs. Hence, the mandate that funds be withdrawn, according to either the five-year plan or one based on the beneficiary's life expectancy.