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The Five-Year Rule for Roth IRAs: What You Need to Know

Many of you may be aware of the Roth IRA and the value this tool can provide to a retirement strategy. Roth IRAs are very powerful tools that can provide tax-free growth and income for savers who meet the IRS’s qualifications. 

In order to ensure Roth IRA withdrawals are completely tax-free, you must abide by the five-year rule which applies to three situations:

  • Withdrawing earnings 
  • Conversions
  • Inheriting a Roth IRA

Five-Year Rule for Withdrawals

To withdraw earnings tax-free, the IRS requires the Roth IRA owner to attain age 59 ½ (or have a qualifying exception) and have the Roth account opened for five years since the first contribution. Keep in mind we are referring to earnings. Contributions can be withdrawn anytime and tax-free because you’ve already paid tax on this money. 

The five-year period begins on January 1st of the tax year of your first contribution. Roth IRA contributions can be made up to the tax filing deadline. For example, if you made a Roth contribution for 2022, you had until April 18, 2023 to make your contribution. If you made your contribution in 2023 for last year, your initial start date, for the purposes of the five-year rule, would be January 1, 2022. 

If you withdraw funds prior to 59 ½ (or without exception) and you haven’t met the five-year requirement, the earnings are subject to income tax and a 10% penalty (assessed by the IRS – states may also assess a penalty). If you withdraw funds after 59 ½ (or qualifying exception) and haven’t met the five-year requirement, you won’t owe a penalty, but earnings will be taxable. 

Five-Year Rule for Conversions

The second five-year rule applies to funds converted from a Traditional IRA to a Roth IRA or a Traditional 401(k) to a Roth IRA. As a reminder, a conversion allows anyone, regardless of income, to transfer or roll over funds to a Roth IRA. The transfer or rollover amount is subject to ordinary income tax. Each transaction has a separate five-year waiting period. 

Unlike the start date for Roth contributions, conversions must take place by December 31st of the tax year. For example, if you do a conversion in 2023, the start date of your 5-year window is January 1st, 2023. 

If you’re under age 59 ½ and take a distribution before the five requirement is met, you’ll pay a 10% penalty in addition to taxes on the Roth IRA earnings, unless you qualify for an exception. If you’re over 59 ½ and haven’t met the five-year requirement, earnings could be taxed but won’t be penalized. 

Five-Year Rule for Roth IRA Beneficiaries

For Roth IRA beneficiaries, distributions will not be penalized, as the IRS considers death as an exception. However, if a beneficiary takes a distribution from an inherited Roth IRA and the account was not held for at least five years by the original owner, the earnings will be subject to tax. The Roth IRA start date is not when the beneficiary inherited the account. Beneficiaries use the deceased Roth IRA owner’s start date. Also, if an inherited Roth IRA contains any converted funds, the five-year requirement must be met as well. 

So, there you have it, the five-year rule trio. This may seem like a lot of information, but luckily having our team in your corner means we will help make sure you don’t ever have to worry about paying an unwanted tax bill. Roth IRAs are an important part of many retirement and legacy planning strategies. By taking advantage of them and making sure to follow the rules, the benefits can last multiple lifetimes.  

 ~ Diana Sailler