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. Inherited IRA

    An inherited IRA is an account that is opened when an individual ...
  2. IRA Asset Will

    An IRA asset will is a document specifiying how the assets in ...
  3. Beneficiary

    A beneficiary is any person who gains an advantage and/or profits ...
  4. Traditional IRA

    An individual retirement account allows individuals to direct ...
  5. Roth IRA Conversion

    A Roth IRA Conversion is a movement of assets from a Traditional, ...
  6. IRS Publication 590: Individual ...

    IRS Publication 590: Individual Retirement Arrangements (IRAs) ...
Related Articles
  1. Financial Advisor

    How to Help Clients Manage Roth IRA Distributions

    Here's how the five-year rule works with Roth IRAs and what to consider for clients.
  2. Retirement

    Tips for Properly Aggregating IRA Accounts

    When it comes to IRAs, there are times when they can be combined, or aggregated, and times when they can't. Here are some basic rules to follow.
  3. 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.
  4. Retirement

    Inheriting an IRA: Tax Rules You Should Know

    Don’t get hit with a 50% penalty because you don’t know the required minimum distribution (RMD) rules for IRA beneficiaries.
  5. Retirement

    The Potential Benefits of a Roth IRA

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

    Am I 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.
  7. Financial Advisor

    Avoid These 4 Roth IRA Mistakes in Estate Planning

    Beneficiaries will not be able to maximize their tax savings with a Roth IRA unless it is passed down in a certain manner.
  8. Retirement

    11 Things You May Not Know About Your IRA

    These little-known features will help you get the most out of your retirement savings.
  9. Retirement

    How Advisors Can Protect Inherited IRAs

    A new Supreme Court ruling has some financial advisors rushing to set up trusts to help protect inherited IRAs. Is that necessary?
  10. 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.
Trading Center