What Is the 5-Year Rule?

Generally speaking, the 5-year rule concerns the withdrawal of funds from an Individual Retirement Account (IRA). However, several different types of 5-year rules actually exist. Two apply specifically to Roth IRAs and the waiting period before funds can be withdrawn.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 Individual Retirement Accounts (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  • One set of 5-year rules applies to Roth IRAs, dictating a waiting period before earnings or converted funds can be withdrawn from the account.
  • To withdraw earnings from a Roth IRA without owing taxes or penalties, you must be at least 59½ years old and have held the account for at least five tax years.

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 at least 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 tax 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. Thus, 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 Each conversion has its own five-year period, but IRS rules stipulate the oldest conversions are withdrawn first.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 IRA 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 large 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).

Beneficiaries who inherit an IRA can take distributions of either contributions or earnings without a penalty. However, this distribution may trigger a taxable event. Whether you'll need to pay taxes on your distribution depends upon the type of IRA you inherit and your relationship to the deceased.

For example, if you inherit a Roth IRA and take a distribution, any earnings or interest on the contribution will be subject to tax if the IRA wasn't held for five tax years by the original owner.

With the passage of the SECURE Act, starting in 2020, non-spousal beneficiaries of an IRA must withdraw all funds from the account within 10 years of the original owner's death. Before passage of the SECURE Act, beneficiaries could stretch out the distribution period and delay paying taxes on distributions, an estate planning strategy known as a stretch IRA. Spouses, however, under the SECURE Act have more flexibility; they can transfer the existing IRA into their name and defer distributions until they reach RMD-age.

SEP IRAs and Simple IRAs are classified as traditional IRAs when they are inherited. Roth IRAs will remain Roth IRAs.

Traditional IRAs

Under the 5-year rule, the beneficiary of a traditional IRA 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 

A 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 Dec. 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 their 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 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 a compromise from the IRS. It understands that IRAs wouldn't be very popular if they couldn't be bequeathed and 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 traditional IRAs. Hence, the IRS mandates that funds be withdrawn according to either the five-year plan or one based on the beneficiary's life expectancy.