The Roth IRA 5-Year Rule(s) Explained
Tim explains the often confusing Roth IRA 5-year rule in detail, including the 5-year contribution rule and the 5-year conversion rule.
The 5-year rule associated with Roth IRA accounts can often confuse those getting ready to withdraw money from their accounts for retirement or implement Roth conversions to lower their lifetime tax liabilities.
It is confusing! And it’s often poorly communicated and covered throughout the media, and financial influencers usually don’t clarify the rules very well, and sometimes even other financial professionals get it wrong. But today, I’m going to set the record straight.
I’m going to discuss the Roth IRA 5-year rule - actually rules, plural - because there are actually two different 5-year rules, and this is often where most of the confusion comes from. There is a 5-year “contribution” rule and a 5-year “conversion” rule.
I recently made a video discussing, in detail, the difference between a Roth IRA contribution and a Roth IRA conversion, so check that out if have more questions.
As a quick refresher, Roth contributions and Roth conversions are two very different transactions.
- A Roth contribution has limits on how much you can contribute and income thresholds you have to be under in order to contribute.
- But anyone, at any age, can do a Roth IRA conversion, of any size, from a pre-tax retirement account (like a traditional IRA) to an after-tax Roth IRA - there are no limits. But you will have to pay ordinary income taxes on the converted amount in the year it was converted.
To start, I want to frame this discussion by asking the “why” behind these rules. Because when we consider why they exist, the rules often make more sense.
5-Year Roth Contribution Rule
First, the 5-year contribution rule. In order to have a tax-free “qualified” distribution from a Roth IRA, two requirements must be satisfied.
- First, the distribution must be made after one of the following: the IRA owner turns 59 ½ (this one is the most common); or after death of the original IRA owner; or after becoming totally disabled; or for qualified first-time homebuyer expenses up to a $10,000 limit.
- Second, the distribution must meet the Roth contribution 5-year waiting period.
This 5-year period applies across the board to any and all of an individual’s Roth IRAs. And it starts with an individual’s first contribution or conversion that is deposited to any Roth IRA. And it does not restart if a Roth IRA is ever closed out. So, let’s call this the “5-Year Forever Rule” to help you remember it’s forever.
Once a person makes their first Roth IRA contribution or Roth IRA conversion, then their starting date for the “5-Year Forever Rule” is locked in. This is true even if all the Roth IRA funds are distributed at some point and they start a new Roth IRA later.
Quick note: The 5-year holding period begins on January 1 of the year for the first contribution or conversion to any Roth IRA. So, it may actually be less than a full five years.
I also want to remind you, that you can always withdraw your contributions from a Roth IRA without any restrictions or age limits because you’ve already paid taxes on it.
For example, if you contribute $6,000 to a Roth IRA, and one day later, or 6 months later, or 15 years later, you want that $6,000 contribution back, you can always withdraw it without penalty or taxes.
Why the 5-year Roth Contribution Rule Exists
So, back the “why.” To get something, we have to give something, and in this case, we’re getting the opportunity for tax-free growth for our retirement.
In order to get this, we have to be willing to wait at least five years after our Roth IRA has been opened, and we generally have to wait until we’re at least 59 ½.
But, if we think about getting all the growth in a Roth IRA tax-free after it’s qualified, this seems like a reasonable price to pay.
5-Year Roth Conversion Rule
Now, let’s discuss the 5-year rule for Roth conversions.
Let's try to keep this simple: you will need to answer two questions to know if you’re good to go, and if your Roth IRA is qualified:
- Has your Roth IRA been open and funded for at least 5 years?
- Are you 59 ½ or older?
If you answered “yes” to both questions, then you do not have any restrictions or limitations on withdrawing any money from your Roth IRA. You can withdraw money you’ve converted, you can withdraw contributions, and you can withdraw earnings, all without any taxes or penalties. You are good to go, and the benefits of a qualified Roth account are yours! So, nice work.
Roth Conversion During First 5 Years
Over age 59.5
Now, what if you do NOT currently have a Roth IRA that is open and funded, but you’re over age 59 ½. Well, if for the first time, you opened a Roth IRA this year, and did a $100,000 Roth conversion, you would need to wait 5 years to withdraw any of the earnings or growth associated with that $100,000 conversion tax-free.
But you could still withdraw the $100,000 conversion amount at any time, because you already paid taxes on that amount, and you’re over age 59 ½, so you can take your converted dollar amount out whenever you want with no tax or penalty.
However, you’ll need to wait 5 years after the year of your conversion in order to withdraw any of the growth or earnings associated with that $100,000 to avoid taxes. But you are over 59 ½, so there would be no 10% penalty if you took it before the 5 years is up, just taxes on the growth.
For example, let’s say the $100,000 conversion, that went into the first Roth IRA you have ever funded, grows to $150,000. Well, you will need to wait at least 5 years from the year you did the conversion in order to withdraw the $50,000 of growth tax-free. Because again, even though you are 59 ½, you have not had a Roth IRA opened and funded for at least 5 years.
Under age 59.5
It’s important to note, that if you are under 59 ½, every Roth conversion you do is going to have its own 5-year clock. So, how does that work?
Well, let’s say you opened and funded a Roth IRA over 5 years ago, but you’re under age 59 ½. Let’s say when you’re 40 and you do a $100,000 Roth conversion, and then decide to withdraw $50,000 from this conversion amount three years later, at age 43. That $50,000 withdrawal will be hit with a 10% early distribution penalty. Because to avoid this penalty, you would have needed to wait 5 or more years from the year you did the conversion.
And each subsequent conversion you do in future years will be treated the same. So, if you do another $100,000 Roth conversion next year, at age 41, that conversion will start its own 5-year clock.
Now, on to the next confusing situation.
Roth Conversion After First 5 Years
Let’s say you opened and funded a Roth IRA over 5 years ago, and now you’re 57, and you do a $100,000 Roth conversion. And three years later, at age 60, that $100,000 Roth IRA conversion has grown from $100,000 to $150,000, and you decide to cash out.
Well, you can, and you won't have any restrictions, taxes, or penalties because you are now able to answer yes to both questions:
- You have a Roth IRA that has been opened and funded for 5+ years
- You’re now over age 59 ½
This one confuses people because they forget that once they are 59.5, the 5-year conversion rule no longer applies, and the 5-year contribution rule has already been satisfied.
Why the 5-year Roth Conversion Rule Exists
Now, back to the “why.” Why does the 5-year conversion rule exist in addition to the 5-year contribution rule?
Well, let’s revisit that 40-year-old. Let’s say you’re 40 and you do not have a Roth IRA.
But you do have a tax-deferred traditional IRA with $100,000 in it. Now, let’s say you have an emergency, and you want to withdraw that $100,000 today. You would have to pay ordinary income taxes and you would get hit with the 10% early withdrawal penalty since you’re under 59 ½.
So, if the 5-year conversion rule did not exist, you would be able to convert $100,000 of your pre-tax money right now, and then withdraw it, without paying the 10% penalty. The IRS doesn’t want you to have this loophole.
They made the 5-year conversion rule so you can’t do that. You would have to convert the $100,000, pay income taxes on the $100,000, and then wait 5-years to be able to withdraw that $100,000, penalty-free.
You could still be able to access this $100,000 at age 45 (5 years later), much younger than 59 ½, but you would have had to pay Uncle Sam his share, and then sit and wait.
So, the 5-year conversion rule exists to prevent someone who is under the age of 59 ½ from accessing pre-tax retirement account dollars without penalty, at least for 5 years.
Bottom line
You may have noticed from other videos, I’m a huge fan of Roth conversions – especially now since our tax rates are historically low – and we can potentially reduce lifetime tax liabilities for clients as well as their heirs or legacy.
If you think retirement, tax planning and/or Roth conversions might be something you want down the road, and I hope they are, you should consider opening and funding a Roth IRA as soon as possible to get the 5-year forever rule taken care of.
A CERTIFIED financial planner™ professional can help you plan for your retirement. Schedule a call today so we can talk about your situation.