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

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.