roth ira 5 years

roth ira 5 years

What is the five-year waiting rule for Roth IRAs?

There are two five-year waiting periods that apply to Roth IRAs. However, in both cases, the waiting period for a Roth IRA begins on the first day of the applicable calendar year. How this rule applies to you depends on the circumstances.

To clarify, let's look at the rule in detail:

  1. For the five-year waiting period to determine whether a Roth IRA distribution is qualified (that is, tax and penalty free), the five-year period begins the first day of the first year for which any of your Roth IRAs were funded. For instance, if you converted your Traditional IRA to a Roth IRA in November 1998, your five-year period begins January 1, 1998. Or, if you made a regular contribution to your Roth IRA for 1998, which could occur any time between January 1, 1998, and April 15, 1999, your five-year period begins January 1, 1998. If you establish other Roth IRAs after that first Roth IRA, your five-year period for those new Roth IRAs still begins January 1, 1998, regardless of when those new Roth IRAs are established. A qualified distribution from your Roth IRA is tax and penalty free and there is only one five-year waiting period, which begins with your first Roth IRA. If your Roth IRA distribution is qualified, you need not be concerned with the other five-year period.
  2. The other five-year waiting period applies only if the distribution is non-qualified. For this purpose, there is a separate five-year period for each Roth IRA conversion, and each one begins the first day of the year in which the conversion was made. For instance, if you converted your Traditional IRA to a Roth IRA in 1998, the five-year period for those converted assets begins January 1, 1998. If you later convert other Traditional IRA assets to a Roth IRA in 2003, the five-year period for those assets begins January 1, 2003. To determine whether you are affected by this five-year rule, you need to consider whether the distribution being made from your Roth IRA includes Roth conversion assets and, if so, what year those conversions were made. For this purpose, the ordering rules must be used.

This question was answered by Denise Appleby

There are actually three different five-year rules for Roth IRAs. You need to understand each of them to maximize the benefits of your Roth IRA.

1. Five-Year Rule for Penalty-Free Distributions of Converted Funds

If you convert your traditional IRA to a Roth IRA, any pre-tax funds in the traditional IRA that you convert are taxable to you in the year of the conversion. No matter what age you are when you convert, the 10% early distribution penalty does not apply. If you then take a distribution of the converted funds from your Roth IRA, that distribution will always be tax-free. This makes sense because you already paid taxes when you converted your Traditional IRA. However, if you are under age 59 ½ and take a distribution within five years of your conversion, your distribution will be subject to the 10% early distribution penalty, unless an exception such as disability applies. This rule was put in place to close a loophole in the rules, where traditional IRA owners, under age 59 ½, would have been able to convert to Roth IRA and then take a Roth IRA distribution to evade the early distribution penalty that would have applied if they took the distribution directly from their traditional IRA.

The five-year period starts January 1 of the year you convert, regardless of the date of the actual conversion. It applies separately to each conversion you do, if you do more than one. After-tax dollars converted from a traditional IRA are never subject to the penalty. If you are over age 59 ½, no worries, you can access converted funds in your Roth IRA whenever you want without penalty.

2. Five-Year Rule for Tax-Free Distributions of Earnings

A big reason why many people have a Roth IRA is the opportunity for tax-free earnings. You will want to be sure, therefore, that you understand the rules to achieve this benefit. For earnings to be distributed tax-free from a Roth, there must be a qualified distribution. To be a qualified distribution, the distribution must be taken from the Roth IRA after age 59 ½, disability, death, or be used to purchase a first home. In addition, the distribution must be taken after a five-year period is satisfied. The five-year period begins January 1 of the year of your first Roth IRA conversion or of the year for which you make your first Roth IRA contribution. It may be less than five actual years. The

3. Five-Year Rule for Beneficiaries

The third five-year rule that applies to Roth IRAs will affect you if you are a beneficiary. Under the rules, named beneficiaries, not those who inherit through the estate of the deceased Roth owner, have the options of stretching RMDs (required minimum distributions) from inherited Roth IRAs over their life expectancy or using the five-year rule. The five-year rule for beneficiaries is often misunderstood. Under the law, all named Roth IRA beneficiaries have the choice to use the five-year rule, but are never mandated to do so. Some Roth IRA documents may require the five-year rule, but that is relatively rare.

What must you do if you elect the five-year rule? The Roth IRA you inherited must be distributed by December 31 of the fifth year following the year of the IRA owner’s death. Within the five-year period there is complete flexibility. You can take a lump sum or take a distribution each year. You just need to be sure the Roth IRA is emptied by the end of the five-year period or you will face a 50% penalty on the amount not taken in that year. That is a hefty penalty for a Roth IRA distribution, which most likely would not be taxable.

What Is the Roth IRA 5 Year Rule?

The Roth IRA 5 year rule is a rule that is designed to keep the money in a Roth IRA account for at least five years. This rule penalizes you if money out of your Roth IRA before five years. For most people, this is not an issue because they start the account earlier in life and they have to wait until the age of 59 1/2 before they can access the account. However, if you are getting close to retirement and you start up a Roth IRA, this rule could affect you.

If you are 58 when you start the account, you would have to wait until the age of 63 to have access to the money, because you are required to wait five years. Usually, retirement accounts have a 59 1/2 age cutoff, but if you open an IRA later in life, the age cutoff does not apply.

Keep in mind that the rule only applies to the amount of money that you earn from investment returns. With a Roth IRA, you can always take out the principle that you have put into the account at anytime. The money that you put into the Roth IRA was already deducted, so you do not have to pay a tax penalty.

FAQs Regarding Roth IRA Withdrawals

Understanding how a Roth IRA withdrawals work can help you avoid any problems or penalties in the future. Roth IRAs represent a way to take advantage of tax benefits and save for your retirement. However, you need to .

Making Roth IRA withdrawals is the ultimate goal of every Roth investor. We all want to get to the point where we can start enjoying the fruits of our labor. However, there are some rules and regulations that you .

Distribution Rules for the Inherited Roth IRA

When an individual dies prior to withdrawing funds from a Roth IRA, the beneficiary will be subject to new distribution rules. Essentially, the beneficiary will receive similar benefits as the contributor would have .

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Understanding The Two 5-Year Rules For Roth IRA Contributions And Conversions

January 1, 2014 07:01 am 74 Comments CATEGORY: Taxes

While Roth IRAs are very popular as a retirement savings vehicle due to their tax-free growth treatment, they also have several unique rules associated with them to ensure that their favorable tax status is not abused. In particular, there are two different 5-year rules associated with Roth accounts to prevent them from being taken advantage of; the first 5-year rule applies to Roth contributions and determines whether earnings will be tax-free, while the second 5-year rule applies to Roth conversions and determines whether conversion principal will be penalty-free.

Each of the 5-year rules are measured from the beginning of the tax year for which they apply, which means in reality tax-free earnings or penalty-free conversion principal may be accessible in less than 5 years in certain circumstances. And because the Roth rules aggregate all accounts together for the purposes of determining the tax treatment of various distributions, it’s necessary to track the various 5-year rules and the amounts they’re associated with, regardless of whether they are held separately or mingled together into a single account.

Ultimately, being able to effectively navigate the various Roth 5-year rules creates several planning opportunities as well. For some, taking advantage of the Roth conversion 5-year rule is a way for those well under age 59 1/2 to tap their IRA funds “early” without an early withdrawal penalty. For others, the reality is that the Roth conversion 5-year rule is a moot point anyway, because they already meet another exception to the early withdrawal penalty (e.g., already being over age 59 1/2). However, in all cases, the 5-year rule for contributions must be met before any Roth earnings can actually be tapped tax-free; fortunately, though, because any first-time contribution or conversion can start the clock, clients who are concerned about the 5-year rule can make a contribution to a Roth (or to a traditional IRA and then convert it) to start the time window now, and ensure they’ll never need to worry about it in the future!

5-Year Rule For Roth Contributions

The 5-year rule for Roth contributions is used to determine whether a withdrawal of growth will be tax-free as a “qualified distribution” from a Roth IRA (which is not automatic, just because growth is tax-deferred along the way).

In order to be a tax-free qualified distribution from a Roth IRA, two requirements must be satisfied. First, under IRC Section 408A(d)(2)(A), the distribution must be made either: on/after the date the IRA owner turns 59 1/2; after death of the IRA owner (i.e., to the estate or a beneficiary); after becoming totally disabled (under the Social Security definition of “total disability”); or for qualified first-time homebuyer expenses (up to a $10,000 limit and subject to other limitations). The second requirement, in addition to meeting one of the preceding tests, is that the distribution must meet the Roth contribution 5-year rule (also known as the “nonexclusion period” under IRC Section 408A(d)(2)(B)).

The 5-year rule essentially states that five tax years must pass from when the first contribution is made to (any) Roth IRA, until a qualified distribution can be made. Because the measurement is based on tax years, this means that a contribution (not just a rollover, but an actual new contribution) to a Roth IRA as late as April 15 of 2014 will still count as a contribution for the 2013 tax year (in essence, it counts as though the contribution was made January 1st of 2013), which means the first year of a potential qualified distribution would be 2018 (because the five years that passed would have been 2013, 2014, 2015, 2016, and 2017). Notably, this means that a “5-year” qualified distribution could actually be made after less than 3 years and 8 months, as a contribution on April 14 of 2014 (made in 2014 but for 2013) would allow for tax-free distributions as early as January 1st of 2018.

Notably, under Treasury Regulation 1.408A-6, Q&A-2, for the purposes of this 5-year rule the clock starts the first time any money is funded into any Roth IRA, whether by contribution or conversion. There is not a new 5-year clock for each Roth contribution, nor for each Roth account that is held. All Roth IRAs (but not Roth 401(k)s) are aggregated together to determine whether the 5-year rule is met for any/all of them (which indirectly means that rollovers from one Roth IRA to another do not change or reset the 5-year requirement). In the case of rollovers from a Roth 401(k), any years in the Roth 401(k) are not added to the years for the Roth IRA; thus, if the individual did not otherwise have a Roth IRA already, the rollover from a Roth 401(k) begins a new 5-year period, even if the Roth 401(k) itself had already satisfied the 5-year requirement (per Treasury Regulation 1.408A-10, Q&A-4(a)).

The fact that the 5-year requirements are aggregated across IRAs effectively means that once the 5-year rule has been satisfied once for a taxpayer (i.e., if you’ve already had a Roth for at least 5 tax years), it’s been satisfied for good; in turn, this means that recent contributions may actually be eligible for withdrawal as a qualified distribution even if they’ve been in the account for less than 5 years, as long as the taxpayer overall has met the 5-year requirement with respect to any Roth IRA.

Bear in mind, though, that regardless of whether the 5-year rule is met, for the distribution to be qualified, it must still also satisfy the first part of the test (a distribution made after 59 1/2, death, disability, or under the first-time homebuyer rules).

5-Year Rule For Designated Roth Accounts Under A 401(k) Or Other Employer Retirement Plan

In the case of a Designated Roth Account under a 401(k) or other employer retirement plan, the 5-year rule again applies to determine eligibility for a qualified distribution. However, under Treasury Regulation 1.402A-1, Q&A-4(b), the 5-year rule for an employer retirement plan is counted separately from the 5-year rule for any/all Roth IRAs. Thus, even if the 5-year rule has already been satisfied for qualified distributions from a Roth IRA, a Roth 401(k) still has to satisfy its own 5-year period.

In addition, each employer plan is subject to its own 5-year rule, in the event that someone has multiple Roth accounts under multiple employer retirement plans. Although if one Roth employer retirement plan is directly rolled into another – e.g., if the balance of one Roth 401(k) is rolled into another Roth 401(k) – then again under Treasury Regulation 1.402A-1, Q&A-4, the 5-year period is based on whichever plan has been around longer (the original plan or the new one being rolled in to). Thus, once a designated Roth account under an employer retirement plan has satisfied the 5-year rule, it can continue to be satisfied with a new designated Roth account as long as the ‘old’ funds are rolled into the new plan. And if a “new” plan has already satisfied the rule, any old Roth employer plans rolled in will have already satisfied the rule as well.

On the other hand, when a designated Roth account from an employer retirement plan is rolled into a Roth IRA, the years in the Roth employer plan do not count towards the Roth IRA. Instead, under Treasury Regulation 1.408A-10, Q&A-4(a), for a Roth IRA it’s the original 5-year rule for the Roth IRA that counts. And if there was no existing Roth IRA and the rollover from the Roth 401(k) creates the account for the first time, that starts a new 5-year clock for the IRA, even if the ‘old’ Roth 401(k) had satisfied its own 5-year rule. Again, any years in the Roth 401(k) (or other Roth employer retirement plan) do not carry over and get tacked onto the Roth IRA.

The Second 5-Year Rule, For Roth Conversions

As the name implies, the second 5-year rule applies not to (new) Roth contributions, but to Roth conversions from traditional pre-tax retirement accounts, and determines whether Roth conversion principal will be penalty-free.

To meet the 5-year rule for Roth conversions, again the measuring period is five tax years, which essentially means any Roth conversion is deemed to have occurred as of January 1st of that year (Treasury Regulation 1.408A-6, Q&A-5(b)). Notably, since conversions must occur by December 31st in a given year, their 5-year period will always start in the calendar year in which the conversion occurs; for instance, any conversion between January 1st and December 31st of 2013 will count as a 2013 conversion, but anything in 2014 will count as a 2014 conversion (by contrast, a new contribution as late as April 15th of 2014 could still be counted towards the 2013 tax year).

Unlike the 5-year rule for contributions, in the case of conversions, each conversion amount has its own 5-year time period (Treasury Regulation 1.408A-6, Q&A-5(c)), and thus with multiple conversions there may be multiple different 5-year periods underway at once. When withdrawals occur from conversion amounts, they are deemed to be withdrawal on a first-in, first-out basis under IRC Section 408A(d)(4)(B)(ii)(II), which effectively means the oldest conversions (most likely to have finished their 5-year requirement) are withdrawn first, and the most recent conversions are withdrawn last. (Overall, the ordering rules from Roth IRAs stipulate that withdrawals are after-tax contributions first, conversions second, and earnings third.)

The purpose of the 5-year rule on Roth contributions is relatively straightforward – to require that tax-free growth for retirement purposes be done for the long-term, which means the account must be maintained for at least 5 years (in addition to meeting one of the other requirements).

To understand the purpose of the 5-year rule for Roth conversions, an example of what would occur if it wasn’t there might help.

Example 1. Jeremy is 40 years old and would like to tap the $50,000 of funds in his traditional IRA. If he takes a withdrawal now, he will be subject to ordinary income, and a 10% early withdrawal penalty. If Jeremy converts his IRA to a Roth IRA, he will also be required to report the amount as ordinary income; however, he can now take a withdrawal of his “after-tax” principal from his Roth IRA (the conversion amount) without an early withdrawal penalty. The end result: Jeremy could entirely circumvent the IRA early withdrawal penalty by simply doing a Roth conversion first and taking the money thereafter, so the 5-year conversion rule is designed to prevent this!

Example 2. Continuing the prior example, if Jeremy completes his conversion and waits 5 years, he will be eligible to withdraw his Roth conversion principal without any early withdrawal penalty; this is true because he has met the 5-year requirement for conversions, even though he would only be age 45 at the time. Thus, while the 5-year conversion rule prevents individuals from outright dodging the early withdrawal penalty from their IRAs, it does allow them to potentially gain access to their IRAs prior to age 59 1/2, albeit with a 5-year waiting period! (Though notably, any gains on Jeremy’s conversion would still be taxable, as even if he has met the 5-year requirement for conversions and contributions, he has not met the 59 1/2, deceased, or disabled requirement to receive tax-free qualified distributions from his Roth IRA.)

Accordingly, it’s also worth noting that because the 5-year rule for Roth conversions merely leaves the withdrawal of conversion principal potentially subject to the early withdrawal penalty, any other exceptions to the early withdrawal penalty can still shelter the Roth conversion amount from the penalty. Thus, withdrawals within 5 years of conversion by someone who is already over age 59 1/2 are not subject to the early withdrawal penalty, regardless of the 5-year conversion rule, simply because being over age 59 1/2 itself is an exception to the penalty!

Roth Strategies To Manage The 5-Year Rules

Because of the different purposes of the 5-year rules, effective techniques for managing and planning around them are different as well.

In the case of the 5-year rule on Roth contributions, the easiest way to manage the rule is simply to start the clock as early as possible, since any first amounts placed into a Roth IRA start the clock. For many, they have already started (or entirely satisfied) their 5-year requirement with prior Roth contributions. For those who have never chosen to make a Roth contribution – or perhaps couldn’t, due to the income limitations – an alternative is to do a conversion from a traditional IRA to start the clock; even just a modest $100 conversion is enough to open the time window. For those who have no IRA funds to convert, they can even create an IRA just for the purposes of doing a conversion, as there are no income limits on traditional IRA contributions (the income limits only determine whether the contribution will be deductible or not). However, those looking to do a (nondeductible) traditional IRA contribution and subsequent Roth conversion may wish to wait a year to avoid the risk of the step transaction doctrine.

In addition, it’s notable that because distributions are deemed to come from principal first and earnings second, even withdrawals from a Roth contribution within the 5-year time window will not necessarily trigger any income taxation, unless the total distributions exceed all prior contributions. However, it’s also important to bear in mind that even if the withdrawal is principal and not subject to ordinary income taxation, if it is a conversion amount within the 5-year time window, the withdrawal may be subject to early withdrawal penalties even if it is not otherwise taxable. On the other hand, as noted earlier, if the individual is otherwise exempt from the early withdrawal penalty (e.g., by being over age 59 1/2), the withdrawal of conversion principal is penalty-free (over 59 1/2) and tax-free (as it was already taxed at conversion). Thus, for those who are already over age 59 1/2 (or totally disabled), the Roth conversion 5-year rule is essentially a moot point, and only the 5-year rule for contributions remains relevant.

Another notable situation where the rules may overlap is after the death of a Roth IRA owner. As death is an exception to the early withdrawal penalty, any beneficiaries taking distributions from a Roth IRA will always enjoy penalty-free treatment (regardless of whether it’s principal or earnings, and regardless of whether the 5-year rule for conversions has been met or not). On the other hand, death does not eliminate the 5-year contribution rule for earnings to be tax-free! Thus, beneficiaries taking withdrawals from a recently opened Roth IRA (if there were no other Roth accounts to start the 5-year clock) may find that the earnings are still taxable until the 5-year time window has passed from when the original Roth owner established the account; on the other hand, because of the favorable ordering rules, beneficiaries taking RMDs will be tapping tax-free and penalty-free principal anyway, so this issue would generally only apply if the beneficiaries were liquidating most/all of the Roth IRA shortly after inheriting it (and before the original 5-year contribution time window had been satisfied).

For convenience purposes, because the Roth rules aggregate together all Roth accounts under IRC Section 408A(d)(4)(A), there is no need to keep Roth contributions and conversions in separate accounts, or to otherwise try to separate out multiple types of contributions. The aforementioned ordering rules (principal first, then conversions on a FIFO basis, then earnings) apply in the aggregate across all accounts. So at the most, accounts should only be kept separate if it is necessary/helpful for tracking and accounting (though notably, conversions should be kept separate if there is an expectation they might be recharacterized and there is a desire to just recharacterize the specific gains/losses and assets associated with that particular conversion).

The bottom line, though, is simply this: it’s important to remember that there are two separate 5-year rules, each with their own requirements and stipulations. The Roth conversion 5-year rule is about accessing penalty-free conversion principal (and is irrelevant if the individual already meets one of the other exceptions to the early withdrawal penalty), while the Roth contribution 5-year rule is about accessing tax-free Roth earnings (which are assumed to be extracted last, anyway).

Homebuyers, education, disability, etc. exceptions aside, if you are less than 59.5 years old but make a withdrawal of earnings from a Roth IRA account that's been open for more than 5 years, do you also pay the 10% penalty on top of the taxes?

In other words, does the amount of time that the account has been open matter at all if withdrawals are made before age 59.5?

Yes, there are taxes and penalty on that withdrawal of earnings.

For a withdrawal to be a "qualified distribution", both of the conditions must be true: 1) Roth IRA must be open for at least 5 years, and 2) the person must be age 59.5 or meet one of the other exceptions. Failing to meet both conditions, it is a "non-qualified distribution". And a non-qualified distribution of the earnings part of the money (which would only happen if all the contribution has already been withdrawn) is subject to both tax and penalty. See Figure 2-1 in Publication 590-B for a flow-chart that describes whether a withdrawal from Roth IRA is a qualified distribution or not.

Traditional or Roth IRA…5 years from retirement

Due to some events that I’ve shared here before where I had to decrease my work last year due to a health issue (now fixed. ), my wife and I actually qualify for either/or a traditional IRA or Roth IRA for 2016, $6500 each (in addition to 43k that I’ve already put in 401k). I’ll probably work part time for another 5 years or so and currently have about 1.6m in tax deferred and 1.6m in taxable accounts, net worth around 4m. I’m in my late 50’s.

I’ve thought about contributing this money to a Roth to help pay for ultimate RMD’s (but then I already have some taxable money) and for never pay tax on them again reasons and traditional for the immediate tax savings. Can’t decide.

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