Here’s When The Roth IRA 5-Year Rule Could Cost You Money

SmartAsset: Understanding the Roth IRA 5-Year Rule

The Roth IRA five-year rule will not allow you to withdraw tax-free earnings from your account until five years after your first contribution unless you meet certain conditions. In most cases, however, you can withdraw contributions tax-free since you paid taxes on them before you contributed. Here’s how it works. A financial advisor could help you optimize your retirement investments to minimize your tax liability.

What Is the Roth IRA 5-Year Rule?

The Roth individual retirement account (IRA) is a retirement savings vehicle that allows you to make withdrawals tax-free if you follow the rules. The Roth IRA 5-year rule says that it takes five years to become vested in a Roth IRA account. This means that you can’t withdraw any of the earnings from your contributions to the IRA tax-free until five years have passed since January 1 of the tax year in which you first contributed to the account. Your earnings would be made up of dividends, capital gains, interest and any other type of returns you’ve received on the financial assets in the Roth IRA.

If you do withdraw any of your earnings before the end of the five-year vesting period, you must pay income taxes and a penalty on them. If your marginal tax rate is, for example, 24% and you withdraw your earnings before the end of five years, you would not only pay 24% on your earnings but also have to pay a 10% penalty. That means you would have to pay a total of 34% on your earnings.

Since you have already paid taxes on money contributed to a Roth IRA, you can withdraw your contributions at any time and at any age. For traditional IRAs, you have to wait to make contribution withdrawals until you are age 59 1/2 or incur both income taxes and a 10% penalty. You would incur both the penalty and income taxes on a withdrawal of the earnings on a Roth IRA unless you abide by the five-year rule and are 59 1/2.

Conversion of a Traditional IRA to a Roth IRA

There is a second five-year rule that applies when you convert a traditional IRA to a Roth IRA. When you convert a traditional IRA to a Roth IRA, you pay taxes. The question is whether you pay the 10% penalty. Every time you make a conversion, you create a new five-year period. To avoid the penalty, you cannot withdraw the earnings on your contributions until after the five-year period, which begins January 1 on the year you first contributed to the IRA, has passed.

If you have made more than one conversion, the oldest conversion will be withdrawn first. When making Roth IRA withdrawals, contributions are withdrawn first, conversions second and earnings last.

Inherited IRAs

There is also a five-year rule for inherited Roth IRAs. The beneficiary must liquidate the entire value of the IRA by December 31 of the tax year containing the five year anniversary of the original owner’s death. You are not required to take the required minimum distributions (RMDs) during the five years. If the inherited Roth IRA has existed for more than five years, all withdrawals are tax-free including both contributions and earnings. If it has not existed for more than five years, then earnings are taxable when withdrawn but contributions are not.

In the past, beneficiaries of an inherited IRA could stretch out their withdrawals. Beginning in 2020, according to the SECURE Act, non-spousal beneficiaries must take 100% of the distributions within a 10-year period. There are certain classes of people, such as minor children and spouses, who can transfer the IRA to their name and defer their distributions. Check with your tax accountant to see if you qualify.

A Special Consideration for Inherited Roth IRAs

For the Roth IRA, the IRS has allowed special consideration for inherited Roth IRAs. Instead of withdrawing according to the five-year rule, they allow you to opt to withdraw based on your life expectancy. Consult your tax accountant.

Roth IRA Exceptions to the Five-Year Rule

You can qualify for an exception to the five-year rule if you withdraw $10,000 for your first home purchase. You may also qualify for an exception if you are disabled or if you inherit the Roth IRA after your death. Here are five additional exceptions available to you:

The use of the funds to cover unreimbursed medical expenses if they exceed 10% of your adjusted gross income.
You are unemployed and can’t afford health insurance premiums.
You need to cover qualified higher education expenses for either you or a family member.
The IRS has placed a tax levy on you.
You agree to accept equal periodic payments for five years or until you are 59 1/2, whichever comes last.

After you become age 59 1/2, you can withdraw funds from the Roth IRA at any time if you’ve met the five-year rule. If you have not met the five-year rule, you can withdraw your contributions tax-free but not your earnings. You do not have to pay a penalty in this case.

Bottom Line

The Roth IRA five-year rule imposes a penalty on withdrawals from your account made before five years of your first contribution. But, if you qualify, the IRS has made exceptions to this rule. In either case, if you are unfamiliar with the five-year rule and other potential tax penalties, you should consider working with a financial expert.

Tools for Retirement Planning

The Roth IRA five-year rule is sufficiently complex that you may find it best to consult a financial advisor who specializes in tax planning. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Look at the SmartAsset retirement tax calculator to determine where you’d like to live during retirement to reduce your tax liability.
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