What is the Roth IRA 5-Year Rule?

One of the more popular retirement plans in the US, the Roth IRA was first established in 1997. It is a tax-advantaged retirement savings plan which helps millions of Americans save for retirement. The major benefit of opening a Roth IRA account is the ability to make tax-free withdrawals in retirement. In addition, if you own a traditional 401k or IRA account, you can roll over your account to a Roth IRA plan. However, before you do so, it is critical that you understand the Roth IRA 5-year rule and other stipulations concerning Roth IRAs. For further information on how you can effectively use a Roth IRA account for your retirement savings, reach out to a professional financial advisor.

What are the major features of the Roth IRA 5-year rule?

1. To make tax and penalty-free distributions from your Roth IRA account, you must be 59.5 years of age and wait for at least five years from the date of opening your account to make a withdrawal. Do note that this restriction is applicable to your earnings from investments and not the initial contributions made to the account.

• If you make a withdrawal before turning 59.5 but have completed the 5-year period, you will owe taxes on the withdrawn amount.
• If you open a Roth IRA account at 57, you will be able to make tax-free withdrawals at 62 years of age after having completed the five-year period.
  
  

2. The Internal Revenue Service (IRS) levies a 10% penalty on withdrawals if the distribution is made before the completion of five years. That said, if the account owner makes a withdrawal before turning 59.5, the penalty will not be applicable to the said owner. Suppose you convert your traditional IRA to a Roth IRA at 50 years of age. At age 56, you need to take some money out of your account. In this scenario, you will not have to pay a 10% penalty as five tax years have already passed since you first made a contribution to your Roth account. That said, you will have to pay tax on your earnings as you are under 59.5 years of age.

3. All Roth IRA owners have to follow the tax year, i.e., 1st January to 31st December, when making contributions to their accounts.

4. If you have inherited a Roth IRA, you will still have to abide by the five-year rule. Thus, it is advised that you keep a record of any initial contributions made to the account in addition to any other conversions, to avoid incurring taxes on the same. Moreover, if you are not the spouse of the Roth IRA owner, you will have to make a full withdrawal from the account within the next ten years. This rule is applicable in case the beneficiary of a Roth account is not the owner’s spouse as per the SECURE Act. However, if the beneficiary is the account owner’s spouse, then, in that case, the spouse can make withdrawals as per their wishes and the aforesaid rule does not apply to them.

5. As per the Roth IRA divorce 5-year rule, a Roth IRA account can be considered marital property under certain conditions. This occurs when either you need to transfer some funds to your Roth IRA account or you are planning to make a withdrawal from your Roth account before or after the divorce. The ensuing property division laws of the state will be applicable where you reside at the time of divorce.

Suppose both you and your spouse reside in a community property state such as Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin; herein, the Roth IRA assets will be divided equally among the spouses. However, if you live in an equitable distribution state (all states except community property states), the court will take the final call and your Roth IRA assets will be divided in a way that’s fair to both spouses. You can continue contributing to your Roth IRA even after the divorce up to your annual contribution limit.

What are the exceptions to the Roth IRA 5-year rule?

Specifically, the Roth IRA 5-year rule is applicable to the earnings from investments and not the initial contributions. So, if you wish to take out your initial contribution that excludes any investment earnings, you can do so without incurring any penalty. Remember that you must hold your contributions for a period of at least five years to avoid paying any taxes or a penalty. That said, there are certain exceptions to this rule such as:

• If you are a first-time homebuyer, you can make a withdrawal of up to $10,000 without incurring a penalty.
• You can cover your health insurance premiums by making a Roth IRA withdrawal in case you have lost your job.
• If you are disabled.
• If you are having a baby or adopting a child for the first time.
• You can cover qualified education expenses through Roth IRA withdrawals.

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What are the consequences of not adhering to the Roth IRA 5-year rule?

• You will incur an early withdrawal penalty and have to pay tax if you withdraw money from your Roth IRA account before five tax years have passed. The IRS determines the penalty amount after taking into account certain factors such as your age, period of ownership, annual income, etc.


• If you have held your account for less than five years and are younger than 59.5 years of age, you may incur a 10% penalty and be liable to pay taxes on any earnings distributed from your account.


• If you are 59.5 or up but have not held the account for at least five years, you will not have to pay a penalty on the earnings. However, you will have to pay taxes incurred by you on the withdrawn amount.

To conclude

Making an early withdrawal can lead to a potential loss of future earnings, not to mention other financial implications such as payment of penalties and taxes. This makes it a bad idea. However, you still have certain options that can enable you to make the most of your Roth IRA account. But in order to do so, you must adhere to the Roth IRA 5-year rule. This would allow you to make a penalty-free withdrawal in retirement. That said, if you are in a financial crunch, you may first check if you qualify for any of the exceptions to the five-year rule and lower your financial burden.

You may also consult with a professional financial advisor who can explain the Roth IRA 5-year rule, its exceptions, and clear up any doubts regarding the same. 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.