What's the 5-year rule for Roth IRA?

If you are looking to eliminate taxes on retirement income, you should consider opening a Roth IRA. This retirement account is funded with after-tax dollars so that you can take tax-free distributions once you reach retirement age. However, there are certain IRS rules that determine who can contribute, when you can withdraw funds, and how much money can be converted to Roth IRA. 

The 5-year rule for Roth distributions states that you must wait five tax years after the first contribution to take distributions without paying taxes and penalties. If you make a Roth Conversion, you must wait five years from the year of Roth conversion to withdraw funds tax-free. The 5-year rule for inherited IRAs requires beneficiaries to take the full payout by the end of the fifth year from the date of the account owner’s death.

The Roth IRA 5-Year Rule

A Roth IRA is a preferred retirement account for most retirement savers. It allows retirement savers to pay income taxes when making contributions so that retirement distributions will be free of any tax liabilities. However, you must understand the 5-year rule for Roth IRA beforehand.

The 5-year rule for Roth IRA requires account holders to wait five years from the year of the first contribution or Roth conversion to withdrawal funds tax-free. The clock starts counting from January 1 of the tax year when you made the first Roth IRA contribution. As long as you meet the 5-year rule and you are above age 59 ½, any distributions you take from the Roth IRA are considered qualified. Hence, there will be no income taxes or penalties on the distribution.

The 5-Year Rule for Roth IRA Withdrawals

If you have a Roth IRA, you must wait five years from the tax year when you made the first contribution to take tax-free distributions of your investment earnings.

The 5-year period is calculated in tax years, and it starts on January 1 of the year you made the first contribution. The deadline for making contributions follows the same timelines as the deadline for paying income taxes. For example, if you made the first contribution in February 2022, the contribution will be counted as if it was made on January 1, 2021. The 5-year period will run from January 1, 2021, to January 1, 2026.

Once the 5 years have elapsed and you are 59 ½ or older, you qualify to make tax-free withdrawals. If you opened the Roth IRA account at 57, you won’t qualify to take tax-free distributions of your earnings at 59 ½. You must wait until you reach 62 to take a distribution without paying taxes or penalties. However, you could withdraw your contributions tax-free at 59 ½. Only the investment earnings will be taxed when you withdraw money at age 59 ½. If you have more than one Roth IRA, the 5-year rule applies to all the Roth IRAs as an aggregate, and not the separate Roth IRA.

5-Year Rule for Inherited IRAs

If you are the beneficiary of an inherited IRA, you must consider the 5-year rule for taking distributions. You must take distributions from the inherited Roth IRA over the five years from the date of death of the account owner as long as you empty the Roth IRA account by the end of the fifth anniversary of the account owner’s death. The 5-year rule also applies if the deceased owner held the account for less than 5 years, and you want to withdraw investment earnings.

For example, if you inherited the account on May 1, 2021, and the original account owner made the first contribution on February 1, 2020, you will have to wait until the 5-year period ends to take tax-free distributions of earnings. In this case, the 5-year period starts on January 1, 2019, to January 1, 2024. Therefore, you will have to wait until January 1, 2024, to start taking tax-free distributions on any earnings.

5-Year Rule for Roth Conversions

The 5-year rule applies when you rollover other qualified retirement accounts into Roth IRAs. This rule requires that when you take distributions converted from other types of retirement accounts such as traditional 401(k) to Roth IRA, you must wait 5 years to take tax-free distributions.

The 5-year period for Roth conversions starts counting from January 1 of the year when you converted your retirement account into a Roth IRA. Therefore, if you make a Roth conversion on September 1, 2021, it will be counted as if the conversion happened on January 1, 2021. Therefore, you will wait until January 1, 2026, to take distributions without paying taxes and penalties.

If you do multiple Roth conversions in a year, each conversion is subject to the 5-year rule. Therefore, if you convert $20,000 in April 2021 and $44,000 in March 2022, you will need to wait until January 1, 2026, to withdrawal the $20,000 from the first conversion, and January 1, 2027, to withdraw the $44,000 from the second conversion.