The Roth IRA is often vaunted for its preferential tax treatment and flexibility. However, there are a few key rules that any Roth IRA owner (or potential owner) needs to know.

A Roth IRA Refresher

A Roth IRA is an indvidual retirement account funded with after-tax contributions. This means you get no tax deduction at the time of making contributions, but there is no tax due on distributions when you take them (the opposite of a traditional IRA). In addition to being tax-advantaged, Roth IRAs are highly flexible compared traditional retirement accounts as they allow you to withdraw your contributions at any time and at any age.

The Three Five-Year Rules

The IRS makes it easy to withdraw direct contributions, but when it comes to withdrawing other funds, the process isn’t so simple. These three scenarios require you to jump through some extra hoops to withdraw your money.

Withdrawing earnings from your Roth IRA

The first five-year rule states that you must wait five years from the time you made your first contribution to your Roth IRA to withdraw your earnings tax-free. The initial contribution can still be withdrawn when you want and at the rate you want, but any growth is potentially subject to income tax.

To meet the Roth IRA five-year rule and start taking tax-free distributions:

  • You must be at least 59 ½ years of age.
  • You must wait at least five years after the first contribution on any Roth IRA you own. You do not need to wait another five years whenever you roll over your IRA.

What happens if you’re over 59 ½ (the age you can usually begin withdrawing without taxes and penalties) but haven’t waited five years since your first contribution? You wouldn’t face penalties, but your withdrawals could be included as taxable income.

The Penalty: If you withdraw early and you are not 59 ½, you’ll have to pay a 10% penalty. However, there are a number of exemptions. You won’t face a penalty if you use the withdrawal to, for instance, pay for qualified education expenses, qualified expenses related to a birth or adoption, or a first-time home purchase (up to $10,000).

Converting from a Traditional IRA to Roth IRA

If you convert a traditional IRA to a Roth IRA, the five-year rule requires you to leave the converted funds in your account for at least five years. Unlike the contribution rule, this rule doesn’t allow you to make a conversion before the tax deadline of one year and have it count towards the previous tax year. In this case, all conversions must be completed by December 31st, and the clock starts ticking on January 1st of that same year.

For example, if you made a Roth conversion on December 27th, 2020, your five-year period starts on January 1st, 2020. If you made the conversion on January 15th, 2021, your five-year period starts January 1st, 2021. This means that those who convert later in the year only need to wait a bit more than four years.

It’s important to note that each Roth conversion comes with its own five-year waiting period. If you make multiple conversions, you may have different five-year periods underway at the same time, so you need to be careful to ensure you’re not withdrawing money too soon.

The Penalty: If you’re under age 59 ½ and you withdraw within five years after the conversion, you’ll need to pay a 10% penalty on any withdrawals. Anyone above that age qualified for an age exception and can make withdrawals without any penalties.

Inheritance of a Roth IRA

If you’re a beneficiary of a Roth IRA, you must withdraw required minimum distributions (RMDs) from the inherited account. You can do this at any time without incurring any penalties, but to withdraw tax-free, at least five years must have passed since the original owner’s initial contribution. If you withdraw early, the earnings may be taxed.

Roth IRA beneficiaries are subject to an additional five-year rule regarding the two options you have for withdrawing funds. You can spread out distributions up to 10 years and take minimum required distributions based on your life expectancy, or you can take lump sums in any amount. In the latter case, the Roth IRA’s funds must be completely emptied by December 31st of the fifth year after the death of the original owner.

The Penalty: If a beneficiary fails to withdraw all of the funds from the Roth IRA within five years, they’ll face a hefty 50% penalty on the remaining balance.

Are you thinking of converting to a Roth IRA, or do you have questions about your current account? We’re here to provide the answers you need. Reach out to us to learn more about what our comprehensive financial planning services can do for you.