What You Need to Know About the Roth IRA 5 Year Rule
Roth IRAs have become more and more popular lately as savers recognize tax-free assets' benefits in retirement. Additionally, these have no required minimum distribution, unlike traditional IRAs and 401(k)s that are subject to required distributions beginning at age 72. Additionally, the flexibility for taking distributions makes Roth IRA accounts a popular choice. However, there are also lesser-known nuances that are important to understand when it comes to Roth IRA accounts, namely the Roth IRA 5 Year Rule.
Most investors will look towards a Roth IRA for long-term benefits as the more growth you have in your account, the more benefit you will recognize – given that these funds will be tax-free at withdrawal. There are two categories of distributions when it comes to Roth accounts.
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The first is qualified, meaning the withdrawal is tax and penalty-free. The second is non-qualified, indicating the withdrawal would be subject to tax or penalties. To avoid non-qualified distributions, it is essential to be sure your distributions fall into the qualified category, or you may be subject to taxes as well as a 10% penalty. Generally, an investor with Roth IRA funds is eligible to take partially qualified distributions at any time from their account. The investor can take out the portion of their account tied to contributions without tax or penalty, regardless of age.
When it comes to the earnings, the qualified status of your distributions gets a bit more complicated. The most simple rule to follow around avoiding the tax and penalty costs associated with non-qualified distributions is based on age. Like a traditional IRA, at age 59 ½ Roth distributions are generally tax and penalty-free from this point on.
What is the Roth IRA 5 Year Rule?
With that said, the Roth IRA does come with specific 5 year rules that can create challenges if you are not aware of them. The 5 year rule specifies that you cannot take out earnings from your Roth IRA tax-free until at least five years after contributing to your Roth IRA.
So, if your first contribution to a Roth IRA was at age 58, you still cannot take out all of your funds after 59 ½ because you will not have satisfied the Roth IRA 5 year rule. You can still access your contributions fully tax and penalty-free but will need to wait until age 63 before your entire account is eligible for qualified distributions.
It is essential to know that this five year clock starts with the first contribution to ANY Roth IRA you might own. So, as long as you have had any Roth IRA account opened for five years when you look to take distributions, you can freely take qualified distributions from any or all of your Roth IRA without concerns around taxes and penalties. The very first contribution to your very first Roth IRA is what starts the clock.
Roth Conversion 5 Year Rule
The second consideration is how the Roth IRA 5 year rule relates to Roth conversions. Many folks closer to retirement have started to convert their traditional IRA accounts to a Roth IRA, allowing them to pay taxes now to create a tax-free vehicle for their future. With Roth conversions specifically, this five year rule applies to each individual Roth conversion event.
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In other words, if you were to convert $20,000 to a Roth IRA in 2021, you would need to wait until 2026 before you would be eligible to take qualified distributions freely. Subsequently, if you converted another $20,000 to a Roth IRA in 2022, you would need to satisfy a new 5-year rule and wait until 2027 before the funds from that particular conversion are eligible for qualified distributions. Not only do conversions apply to each individual event, but the eligibility for qualified distributions also applies to both the contribution and earnings values as compared to the 5-year rule mentioned above, which only applies to the earnings portion.
Exceptions to the Roth IRA 5 Year Rule
Although the Roth IRA may have some short-term rules to consider, there are also a few exceptions to the rule. You may be able to use a specified amount of your Roth account to pay for a first home purchase or higher education funding. There are health-related expenses that may provide exceptions as well. You may reimburse yourself for medical expenses over 10% of your adjusted gross income, or, if you became unemployed, you are allowed to use funds to pay for health insurance premiums.
Roth IRAs are generally used as a vehicle for long-term planning, and these considerations may not impact those who are planning for long-term use. The most considerable benefit of a Roth IRA is the value you can experience in recognizing significant growth over the long term, allowing that growth to be accessed tax-free in the future. That said, life has a funny way of changing without expectations, and it is critical to understand the impact of the 5-year rule on your Roth IRA accounts to avoid unpleasant surprises.