Roth IRAs are one of the greatest tools given to us by the tax code. Roth IRAs provide the potential for tax free growth and distributions, and unlike Traditional IRAs they have no Required Minimum Distribution (RMD) requirement. However, as with most parts of our tax code there are several nuances and caveats to be aware of. One such rule for Roth IRAs is the 5-year rule, and as we discuss in this post, there are multiple 5-year rules. However, while it is important to be aware of and understand this rule to take full advantage of all that Roth IRAs have to offer, it does not change the special place that Roth IRAs have in our heart and should not for you either.
Before we begin going down the rabbit hole, know this: Roth IRA contributions/principal can always be withdrawn tax and penalty free, and contributions are always the first dollars to come out of a Roth IRA. Therefore, you have to take distributions in excess of your contributions before the 5-year rule is applicable. Because basis can be withdrawn tax free at any time, we recommend that you file IRS Form 8606 with your tax return so that you have a running inventory of your Roth IRA basis. In addition, you can save the annual statements and IRS Form 5498s to create your inventory.
5-Year Rule for Earnings
We often say that Roth IRA distributions are tax-free. That is true as long as it is either:
- A return of your contributions/principal
Or
- A distribution of growth/earnings (these are dollars after you have pulled your contributions/principal out) that are made after 59 ½ (or death, becoming totally disabled, or for first-time home purchase), and satisfy the 5-year rule.
- Therefore, you could essentially have contributed/opened a Roth IRA at 60, and if you withdraw all of the amount you contributed (that has already been taxed) plus the earnings by age 63, the earning/growth would be taxable at your ordinary income rate or marginal tax bracket. However, you are not subject to a 10% penalty because the funds were not accessed prior to 59 ½. If in the same example with the taxpayer accessing the funds prior to 59 ½, the earnings would be subject to taxes and a 10% penalty.
The 5-year rule for distributions of growth/earnings says that 5 tax years must have passed since you made a contribution to any Roth IRA for the distribution of earnings to be tax free. It doesn’t matter if you are pulling from a Roth IRA that only has been open for 1 year as long as at some point, 5 tax years ago, you opened and funded a Roth IRA at any amount. Roth IRAs are aggregated for this test rather than looked at independently. Once you have satisfied the 5 year test, you’ve satisfied it for good for all of your contributory Roth IRAs
Fun Fact: You could even close your Roth IRAs and as long as you had reached the 5 years, you could open a new Roth IRA and any earnings (assuming you are over 59 ½) are tax free.
5 Tax Years vs 5 Calendar Years:
IRA and Roth IRA contributions can be made over a 15 ½ month period. For example, 2021 IRA contributions can be made from January 1 of 2021 through April 15 of 2022. Any contribution made to an IRA during that 15 ½ month period is effective January 1, 2021. Essentially, a contribution made to a Roth IRA on December 31, 2021 has already satisfied one year of the five-year requirement.
Employer Plans:
Individual Retirement Accounts and Employer Sponsored Retirement Plans such as a Roth 401(k) or Roth TSP have their own 5-year clock and must be individually satisfied. Satisfying the 5-year requirement on a Roth IRA doesn’t satisfy the 5-year requirement on Roth TSP.,
Planning Note: If you have a Roth TSP or Roth 401(k), consider opening a Roth IRA. Assuming your Roth 401(k) or Roth TSP is transferred to a Roth IRA at retirement, it is imperative that you’ve already satisfied the 5 year Roth IRA requirement if you plan on taking immediate distributions from this account. If the Roth IRA 5 year test hasn’t been satisfied you can still access your principal tax free and penalty free while waiting for the 5 year and 59.5 requirements to be satisfied for the earnings to become tax free.
IRA to Roth IRA Conversions Principal 5 Year Rule (or 59.5)
We’re big believers in tactically converting IRAs to Roth IRAs. Roth conversions are irrevocable and there are a host of financial planning considerations that should be discussed prior to implementation. One rule to be aware of is a separate 5-year rule for conversions. This rule applies to the principal (the amount you convert and pay taxes on). Although contribution principal is accessed tax free and penalty free, that is not always the case with Roth Conversion principal.
Conversion principal can be withdrawn penalty free (it has already been taxed) after 5 years have passed from the time you converted it or if you have reached age 59 ½ (or death, totally disabled, or first-time home purchase). Unlike Roth contributions, each conversion has its own 5-year clock. For example, a conversion in 2020 would be satisfied in 2025, and a conversion in 2021 would be satisfied in 2026.
If you have reached age 59 ½, your conversion principal can be withdrawn penalty free at any time and there is no 5-year rule. However, the earnings associated with that specific conversion must also satisfy the aggregate 5-year rule discussed earlier.
Why does this rule even exist? If it did not exist, and we wanted to take early distributions from an IRA and avoid the 10% penalty, a conversion would be a very easy work around. Convert the money, pay the tax, and avoid the 10% penalty. While this rule does not completely prevent doing that kind of planning, it does make it a little more difficult. And of course, since normal IRA and Roth IRA distributions are not subject to a 10% penalty once over 59 ½, you can basically skip this test if that is your situation.
Key Take Aways
- It’s easy to get confused with these rules and there is a lot of misinformation out there. You can count on our advisors to give you accurate and useful information and to incorporate it appropriately into your financial plan.
- Establish and fund a Roth IRA yesterday and get the 5-year clock on earnings started!
- Distributions from Roth IRAs are in this order:
- Contributions (tax and penalty free)
- Conversion principal that was taxable at conversion
- Conversion principal that was nontaxable at conversion
- Earnings (tax free if 5 year forever rule and over 59 ½ are met)