Here’s when the 5-year Roth IRA rule can cost you money

SmartAsset: Understanding the 5-Year Roth IRA Rule

The five-year Roth IRA rule won’t allow you to withdraw tax-free earnings from your account until five years after your first contribution, unless you meet certain conditions. In most cases, however, you can withdraw contributions tax-free as you paid tax on them before you contributed. That’s how it works. A financial advisor could help you optimize your retirement investments to minimize your tax liability.

What is the 5 Year Roth IRA Rule?

A Roth Individual Retirement Account (IRA) is a retirement savings vehicle that allows you to make tax-free withdrawals if you follow the rules. The 5-year Roth IRA rule says it takes five years to vest a Roth IRA account. This means that you cannot withdraw any of the earnings from your tax-free IRA contributions until five years have passed since January 1 of the tax year in which you first contributed to the account. Your earnings will consist of dividends, capital gains, interest, and any other type of return you received from the financial assets in the Roth IRA.

If you withdraw any of your winnings before the end of the five-year vesting period, you must pay income taxes and a penalty on them. If your marginal tax rate is, for example, 24% and you withdraw your earnings before the end of five years, not only will you pay 24% on your earnings, but you will also have to pay a 10% penalty. This means that you will have to pay a total of 34% of your winnings.

Since you’ve already paid taxes on money contributed to a Roth IRA, you can withdraw your contributions at any time and at any age. For traditional IRAs, you must wait to make withdrawals until you are 59 1/2 years old or incur both income taxes and a 10% penalty. You will incur both the penalty and income tax if you withdraw earnings into a Roth IRA unless you meet the five-year rule and are 59 1/2.

Converting a Traditional IRA to a Roth IRA

SmartAsset: Understanding the 5-Year Roth IRA Rule

SmartAsset: Understanding the 5-Year Roth IRA Rule

There is a second five-year rule that applies when you convert a traditional IRA to a Roth IRA. When you convert a traditional IRA to a Roth IRA, you pay taxes. The question is whether you pay the 10% penalty. Each time you make a conversion, you create a new five-year period. To avoid the penalty, you can’t withdraw earnings from your contributions until after the five-year period has passed, which begins on January 1 of the year you first contributed to the IRA.

If you have made more than one conversion, the oldest conversion will be retired first. When you make Roth IRA withdrawals, contributions are withdrawn first, conversions second, and earnings last.

Inherited IRAs

There is also a five-year rule for inherited Roth IRAs. The beneficiary must liquidate the entire value of the IRA by December 31 of the tax year that includes five years from the original owner’s death. You are not required to take required minimum distributions (RMDs) during the five years. If the inherited Roth IRA exists for more than five years, all withdrawals are tax-free, including both contributions and earnings. If it doesn’t exist for more than five years, then earnings are taxed when withdrawn but contributions are not.

In the past, beneficiaries of an inherited IRA could stretch their withdrawals. Beginning in 2020, under the SECURE Act, non-spousal beneficiaries must receive 100% of distributions within a 10-year period. There are certain classes of people, such as minor children and spouses, who can transfer the IRA into their own name and defer distributions. Check with your tax accountant to see if you qualify.

Special note for inherited Roth IRAs

For the Roth IRA, the IRS has allowed special consideration for inherited Roth IRAs. Instead of withdrawing according to the five-year rule, they allow you to choose to withdraw based on your life expectancy. Consult your tax professional.

Roth IRA Exceptions to the Five-Year Rule

SmartAsset: Understanding the 5-Year Roth IRA Rule

SmartAsset: Understanding the 5-Year Roth IRA Rule

You may qualify for an exception to the five-year rule if you withdraw $10,000 for your first home purchase. You may also qualify for an exemption if you are disabled or if you inherit your Roth IRA after you die. Here are five additional exemptions available to you:

  • Using the funds to cover non-reimbursable medical expenses if they exceed 10% of your adjusted gross income.

  • You are unemployed and cannot afford health insurance premiums.

  • You need to cover required higher education expenses for either you or a family member.

  • The IRS has levied tax on you.

  • You agree to receive equal periodic payments for five years or until you turn 59 1/2, whichever occurs later.

After you turn 59 1/2, you can withdraw money from your Roth IRA at any time if you’ve met the five-year rule. If you haven’t met the five-year rule, you can withdraw your contributions tax-free but not your earnings. You do not need to pay a fine in this case.

Conclusion

The five-year Roth IRA rule imposes a penalty on withdrawals from your account made more than five years after your first contribution. But, if you qualify, the IRS has made exceptions to this rule. In any case, if you are unfamiliar with the five-year rule and other potential tax penalties, you should consider working with a financial expert.

Tools for Retirement Planning

  • The five-year Roth IRA rule is complicated enough that you may find it best to consult a financial advisor who specializes in tax planning. Finding a qualified financial advisor doesn’t have to be difficult. SmartAsset’s free tool matches you with up to three financial advisors serving your area, and you can interview your advisors at no cost to decide who is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

  • See the SmartAsset Retirement Tax Calculator to determine where you’d like to live during retirement to reduce your tax liability.

  • How much money will you need to retire? Find out using the SmartAsset Retirement Calculator.

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