Things to Know About the Roth IRA 5-Year Rule

Launched in 1997, a Roth IRA is a tax-advantaged Individual Retirement Account wherein you contribute after-tax dollars to make tax-free withdrawals later dependent on meeting certain conditions. Herein, your contributions and the earnings on those contributions grow tax-free. However, you must be 59.5 years of age and have held your Roth IRA account for a period of five years to be able to make tax-free withdrawals. One of the primary benefits of opening a Roth IRA account is that it is an ideal investment for individuals who expect to be in a higher tax bracket in retirement. It is also helpful when it comes to reducing your taxability.

If you wish to avoid incurring a penalty, you must adhere to the Roth IRA 5-year rule. The guidelines are time-sensitive and strictly enforced by the Internal Revenue Service (IRS). If you wish to gain a thorough understanding of the Roth IRA 5-year rule, consult with a professional financial advisor who can advise you on the same.

In this article, we will discuss the 5-year rule of Roth IRA in detail:

What is meant by the 5-year rule of Roth IRA?

As per the Roth IRA 5-year withdrawal rule, you must wait at least five years after opening your account before you can make any tax-free withdrawals from your account. This period begins from the date you make your first initial contribution towards your Roth IRA account.

That said, you need to fulfill certain requirements even after completing a five-year holding period. To make tax-free withdrawals from your Roth IRA account, you must be 59.5 years of age or older. Suppose, you open your Roth IRA account at the age of 57. To make a tax-free withdrawal, you need to first hold the account for five years meaning you can make a withdrawal at age 62 without having to pay any taxes.

Additionally, you must understand that there are certain rules associated with the Roth IRA 5-year rule, the foremost being that it follows the US tax-year system (from 1^st January to 31^st December). The additional rules are:

• The five-year rule only applies to your earnings, interest, dividends, capital gains, or any other income your investments have accumulated. You can withdraw your contributions made to the Roth IRA account at any time without incurring a penalty.
• You may have to shell out different taxes and penalties in the event of making an early withdrawal.

Does the Roth IRA 5-year rule have any exceptions?

As stated above, the Roth IRA 5-year rule does not apply to your contributions and you can withdraw them before completing a five-year holding period without incurring any taxes or penalties. This rule does not apply to any income accrued from your Roth investments. That said, there are certain exceptions where you can withdraw from your Roth account without having to pay a penalty.

These are:

• You can withdraw up to $10,000 from your Roth account if you are either buying or building a home for the first time.
• You can cover the college tuition costs for yourself, your spouse, kid, or grandchild.
• You can get any medical expenses reimbursed if they make up for more than 10% of your adjusted gross income along with any other health-related expenses.
• You can pay your health insurance premiums if at the time you are unemployed.
• If you have become permanently disabled, you may be allowed further consideration.

What is meant by the Roth IRA conversion 5-year rule?

The rules differ slightly when it comes to Roth IRA conversions. Herein, each conversion has a separate five-year waiting period. Let’s say you converted $25,000 to a Roth IRA in 2019, this means that you cannot make a qualified withdrawal until 2024. If you made a further conversion of another $25,000 in 2020, you will have to wait a further five years i.e. until 2025 to make a qualifying distribution.

Does the 5-year rule apply for inherited Roth IRAs too?

Yes, it does. If you have inherited a Roth IRA, you must find out the date of the initial contribution, conversion, or rollover. This would save you from the unpleasant surprise of having to make an unexpected tax payment in the coming tax year. In addition, as per the SECURE Act, if you inherit a Roth IRA and are not the account owner's spouse, you must withdraw all the deposited funds within a period of ten years from the date of inheritance. However, if you are the spouse, you have the freedom to spread out the withdrawals across your lifetime. Doing so would allow you to space out your withdrawals efficiently as well as avoid paying any taxes or penalties on the withdrawn money.

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Are there any repercussions if you break the Roth IRA 5-year rule?

Simply stated, if you make a withdrawal from a Roth IRA account that was opened less than five years ago, only the part withdrawn from your investment earnings may be taxed and subject to an early withdrawal penalty. The tax and penalty amount are dependent upon your age, income, and ownership period of the account. Typically, the IRS levies a 10% penalty on early withdrawals.

What happens to non-qualified distributions in a Roth IRA?

Here, a non-qualified distribution refers to a distribution that does not meet the criteria set by the IRS for a qualified distribution i.e. the account owner must be 59.5 years of age and the account should be at least five years old. Non-qualified distributions may be subject to tax and a 10% early withdrawal penalty. Here, the penalty and tax are levied on the earnings and not the contributions.

There are certain exceptions to this rule, such as:

• To pay unreimbursed medical expenses: You can use your Roth IRA distribution for paying any unreimbursed medical expenses that exceed 7.5% of your adjusted gross income (AGI) for 2021 and prior tax years.
• To pay for medical insurance: If you have lost your job and become unemployed, you can use your Roth IRA distribution to pay for medical insurance.
• To pay qualified higher-education expenses: If you use your distribution for paying your or your dependent’s qualified higher education expenses such as tuition, fees, books, supplies, and equipment needed to enroll in the college.
• To pay for childbirth or adoption expenses: You can use your Roth IRA distribution for paying any expenses related to childbirth or adoption provided they do not exceed $5,000 and are made within one year of the said event.
• If you are suffering from a mental or physical disability: You can make a tax-and-penalty-free Roth IRA withdrawal if you have a severe physical or mental disability that prevents you from working. To qualify for this exemption, you must show medical proof ascertaining the same.

To conclude

The Roth IRA 5-year rule is a mandatory prerequisite for making a tax-free withdrawal later in retirement. It is advised that you carefully understand all the aspects discussed here to avoid attracting any penalties on your Roth IRA earnings. That said you can withdraw your contributions even before reaching the age of 59.5 or having ownership of your Roth IRA account for 5 years. The Roth IRA 5-year rule is only applicable to your Roth investment earnings. Ensure that you go through all the terms and conditions at the time of opening your Roth IRA account or converting your 401(k) or traditional IRA account to a Roth IRA account.

If you want to understand the Roth IRA 5-year rule effectively to make tax-free withdrawals in retirement and how a Roth IRA might fit in a suitable financial plan for your financial needs, use the free advisor match service to connect with 1-3 financial advisors based on your financial requirements. All you need to do is answer a few simple questions about yourself and the match tool will find advisors that match your financial needs.