What is the Roth IRA 5-year rule? Important guidelines for withdrawing IRA earnings
Roth IRAs offer significant tax breaks: The money grows tax-free within the account, and you don't owe income taxes when you take it out. But, as with most tax-advantaged vehicles, there are strings attached.
In the case of Roths, it's called the 5-year rule, and it applies to account withdrawals, or distributions as the IRS calls them. If you want to keep your distributions free and clear of taxes and tax penalties, you need to understand its ins and outs.
Technically speaking, three different 5-year rules apply to Roth IRAs. Here's what you need to know about each.
1. The 5-year rule for withdrawing earnings
First, a quick Roth refresher. Roth IRAs are individual retirement accounts that you fund with after-tax dollars. That means you don't get a tax deduction for contributions when you make them, but then you don't incur taxes on distributions when you take them (the opposite of the way traditional IRAs work).
At least, that's the general rule. But a key thing you need to know about withdrawing money from a Roth IRA is that there's a difference between taking out contributions you made to the account and taking out the account earnings — that is, any interest, capital gains, or other income generated by your investments.
You can withdraw sums equal to your contributions from a Roth IRA any time, tax- and penalty-free. But earnings are more complicated.
The 5-year rule imposes a waiting period on them. It states the Roth IRA has to be at least five years old before you can withdraw any of its earnings. Even then, you may have to pay taxes and/or penalties (generally 10% of the distributed sum) depending on your age and how long you've held the account.
Roth IRA withdrawals if you're under 59½
Since the IRS wants you to save Roth IRA funds for your retirement, it frowns on you withdrawing them too early. It defines "too early" as age 59½. In general, if you're younger than that, you will have to pay income taxes and the 10% early withdrawal penalty on any earnings you pull out of the account.
However, there are exceptions. They include:
Let's say you do meet one of these exceptions. Here's where the 5-year rule really comes into play.
Roth IRA withdrawals if you're 59½ or older
If you've passed the magic age of 59½, things loosen up considerably. But not completely.
If you have had your Roth IRA for more than five years, you can withdraw earnings from your account for any reason without paying taxes or penalties.
If you've had the account for less than five years, the earnings portion of the withdrawal is taxable, but you don't have to pay penalties.
2. The 5-year rule for converting a Traditional IRA to a Roth IRA
The second 5-year rule applies only to funds that are part of a Roth conversion. A Roth conversion is when you roll over money from a Traditional IRA into a Roth IRA. You must pay income taxes on the rolled-over, or "converted," amount in the year you do the Roth conversion. That's why people usually only do a Roth conversion if:
The 5-year rule on Roth conversions requires you to wait five years before withdrawing any converted balances — contributions or earnings — regardless of your age. If you take money out before the five years is up, you'll have to pay a 10% penalty when you file your tax return.
One bright spot: The clock starts ticking on the first day of the year you do the conversion, no matter what date the conversion actually happened. For example, you could execute the conversion on Dec. 15, 2020, and the five years would be up on Jan. 1, 2025.
3. The 5-year rule for inherited Roth IRAs
The final 5-year rule applies to inherited Roth IRAs. Roth IRA beneficiaries can withdraw contributions from an inherited Roth account at any time (in fact, they're required to). But to withdraw earnings tax-free, the account must have been open for at least five years when the original account-holder died.
If the account hasn't been open that long, there are a few options:
The financial takeaway
Roth IRAs can be an excellent source of tax-free income, but it's important to understand the nuances of the withdrawal rules — particularly the 5-year rule — in all its permutations. Flouting the rule can be costly, especially if you're under 59½. So plan carefully — otherwise, you can wind up owing avoidable taxes and penalties.
This article was written by Janet Berry-Johnson from Business Insider and was legally licensed through the Industry Dive publisher network. Please direct all licensing questions to firstname.lastname@example.org.
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