Established in 1997, the Roth individual retirement account has long been a favored option for retirement savings due to its promise of tax-free withdrawals in retirement. To make the most of this type of account, it’s essential to pay close attention to the details. “Roth IRAs have specific five-year rules that can create challenges if you are not aware of them,” says Brandon Steele, a certified financial planner and co-founder of Mainsail Financial Group in Bellevue, Washington. To avoid paying fees or penalties, you’ll want to follow the time-sensitive guidelines.
Keep in mind that the Roth IRA five-year rule:
— Applies to investment earnings, not initial contributions.
— Could trigger taxes and penalties on early withdrawals of investment earnings.
— Applies to all account owners, regardless of age.
[Read: How to Open a Roth IRA.]
What Is the Roth IRA 5-Year Rule?
After opening and contributing to a Roth IRA, you’ll need to wait five years to begin tax-free withdrawals of investment earnings. “The very first contribution to your very first Roth IRA is what starts the clock,” Steele says. Once you open a Roth IRA and the five-year rule begins, the waiting period can be applied to other accounts.
After five years have passed, you’ll still need to meet certain requirements to be eligible to withdraw earnings without penalty. To qualify for tax-free withdrawals, you’ll also need to be 59 1/2 or older. “If your first contribution to a Roth IRA was at age 58, you still cannot take out all of your funds after 59 1/2 because you will not have satisfied the five-year rule,” Steele says. In this case, you will need to wait until age 63 for the account to be eligible for qualified distributions.
The five-year time frame is calculated based on tax years. The IRS determines a tax year as running from Jan. 1 to Dec. 31. The deadline for contributions coincides with the deadline for filing taxes. If you fund a Roth IRA in April 2021 for the calendar year of 2020, the five-year rule starts as of Jan. 1, 2020. You could begin withdrawing earnings from the account on or after Jan. 1, 2025.
If you want to withdraw funds before the account is 5 years old, aim to distribute contributions to the account instead of investment earnings. “Money contributed to a Roth can be withdrawn at any time regardless of age without tax or penalty,” says Ben Soccodato, a certified financial planner at Barnum Financial Group in Elmsford, New York. If you put $5,000 into a Roth IRA and want to take it out two months later, you can do so without tax or penalty if you meet the other qualifying requirements for withdrawals. However, the earnings would need to remain in the account until the account is 5 years old to avoid taxes and penalties.
The 5-Year Rule for Roth IRA Conversions
The rules are slightly different for Roth IRA conversions. “As opposed to waiting five years after your initial contribution to any Roth IRA, each conversion has its own five-year waiting period,” says Rafael Rubio, president of Stable Retirement Planners in Southfield, Michigan. If you convert $20,000 to a Roth IRA in 2021, you’ll need to wait until 2026 to be eligible to take qualified distributions. If you convert another $20,000 to a Roth IRA in 2022, you’ll need to fulfill another five-year rule and wait until 2027 to make qualified distributions.
The 5-Year Rule for Inherited Roth IRAs
Inherited Roth IRAs are subject to the five-year rule as well. “All owners of inherited Roth IRA assets will want to check the date of the original contribution, conversion or rollover to make sure they are not met with a surprise tax bill come tax time,” says Brent Weiss, co-founder of Facet Wealth in Baltimore. If you are not the spouse of the account owner and you inherit a Roth IRA, the SECURE Act has established that you will generally need to withdraw the funds within a decade. If you are the spouse, you can stretch out withdrawals over your lifetime.
Consequences for Breaking the 5-Year Rule
If you take a distribution from a Roth IRA that is fewer than 5 years old, the portion of the withdrawal that comes from investment earnings could be subject to income tax and an early withdrawal penalty. The amount you’ll pay in penalties and taxes will depend on your age, income and how long you have held the account.
If you’re under 59 1/2 years old and have held the account for less than five years, you can expect to pay a 10% penalty and also income taxes on earnings distributed from the account. If you are over 59 1/2 years old and have held the account for less than five years, you won’t need to pay a penalty on the earnings, but the amount will be subject to income taxes.
Exceptions to the 5-Year Rule
There are several times when you may be able to make early withdrawals from a Roth IRA without paying a penalty. For instance, you might be able to use up to $10,000 in earnings from the account to pay for a first home. You could qualify to use earnings to cover higher education expenses for yourself or your spouse, child or grandchild. “There are health-related expenses that may provide exceptions,” Steele says. “You may reimburse yourself for medical expenses that are over 10% of your adjusted gross income.” If you are unemployed, you might be eligible to use funds to pay for health insurance premiums. There are also exceptions if you become permanently disabled.
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Update 03/10/21: This story was published at an earlier date and has been updated with new information.