Here’s When The Roth IRA 5-Year Rule Could Cost You Money

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SmartAsset: Understanding the Roth IRA 5-Year Rule

The Roth five-year IRA rule doesn’t allow you to withdraw tax-free income from your account until five years after your initial contribution, unless you meet certain conditions. In most cases, however, you can withdraw contributions tax-free, as you paid tax on them before you contributed. This is how it works. A financial advisor can help you optimize your retirement investments to minimize your tax liability.

What is the Roth IRA 5-Year Rule?

The Roth Individual Retirement Account (IRA) is a retirement savings vehicle that allows you to withdraw tax-free if you follow the rules. The Roth IRA rule of 5 years says it takes five years to be established in a Roth IRA account. This means that you cannot withdraw any of the income from your contributions to the IRA tax-free until five years have passed since January 1 of the tax year in which you first contributed to the account. Your income would consist of dividends, capital gains, interest and any other type of return you received on the financial assets in the Roth IRA.

If you withdraw your earnings before the end of the five-year vesting period, you will have to pay income tax and a penalty. For example, if your marginal tax rate is 24% and you withdraw your earnings before the end of five years, not only will you pay 24% on your earnings, but you will also have to pay a 10% penalty. That means you would have to pay a total of 34% on your earnings.

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Since you have already paid taxes on money contributed to a Roth IRA, you can withdraw your contributions at any time and at any age. For traditional IRAs, you must wait to make contributions until you are 59 1/2 or pay both income tax and a 10% penalty. You would pay both the penalty and income tax when withdrawing the income on a Roth IRA unless you adhere to the five-year rule and are 59 1/2.

Conversion from a Traditional IRA to a Roth IRA

SmartAsset: Understanding the Roth IRA 5-Year Rule

SmartAsset: Understanding the Roth IRA 5-Year Rule

There is a second five-year rule that applies when you convert a traditional IRA to a Roth IRA. When you convert a traditional IRA to a Roth IRA, you pay taxes. The question is whether you will pay the 10% fine. Every time you make a conversion, you create a new five-year period. To avoid the penalty, you cannot withdraw the income from your contributions until after the five-year period, which begins on January 1 of the year in which you first contributed to the IRA, has expired.

If you’ve made more than one conversion, the oldest conversion will be revoked first. When making Roth IRA withdrawals, contributions are withdrawn first, conversions second, and earnings last.

Hereditary IRAs

There is also a five-year rule for inherited Roth IRAs. The beneficiary must settle the full value of the IRA by December 31 of the tax year that includes the five-year anniversary of the original owner’s death. You are not required to take the required minimum benefits (RMDs) during the five years. If the inherited Roth IRA has been in existence for more than five years, all withdrawals are tax-free, including both contributions and income. If it has not been in existence for more than five years, income is taxable when withdrawn, but premiums are not.

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In the past, beneficiaries of an inherited IRA were able to renew their withdrawals. As of 2020, under SECURE law, non-spouse beneficiaries must receive 100% of benefits within a 10-year period. There are certain groups of people, such as minor children and spouses, who can put the IRA in their name and defer their benefits. Check with your tax advisor if you qualify.

A Special Consideration for Hereditary Roth IRAs

For the Roth IRA, the IRS has allowed special consideration for inherited Roth IRAs. Instead of canceling according to the five-year rule, you can choose to unsubscribe based on your life expectancy. Consult your tax accountant.

Roth IRA Exceptions to the Five-Year Rule

SmartAsset: Understanding the Roth IRA 5-Year Rule

SmartAsset: Understanding the Roth IRA 5-Year Rule

You may qualify for an exception to the five-year rule if you withdraw $10,000 toward your first home purchase. You may also qualify for an exception if you are disabled or if you inherit the Roth IRA upon your death. Here are five additional exceptions available to you:

  • Using the funds to cover non-reimbursed medical expenses if they exceed 10% of your adjusted gross income.

  • You are unemployed and cannot pay a health insurance premium.

  • You must cover the costs of higher education for yourself or for a family member.

  • The tax authorities have imposed a tax on you.

  • You agree to accept equal periodic payments for five years or until you are 59 1/2, whichever comes later.

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After you turn 59 1/2, you can withdraw money from the Roth IRA at any time if you meet the five-year rule. If you do not meet the five-year rule, you can withdraw your premium tax-free, but not your earnings. You do not have to pay a fine in this case.

Bottom Line

The Roth five-year IRA rule imposes a penalty for withdrawals from your account made before five years after your initial contribution. But if you qualify, the IRS has made exceptions to this rule. In either case, if you’re unfamiliar with the five-year rule and other potential tax penalties, consider working with a financial expert.

Retirement Planning Tools

  • The Roth five-year IRA rule is so complicated that it may be best to consult a financial advisor who specializes in tax planning. Finding a qualified financial advisor doesn’t have to be difficult. SmartAsset’s free tool matches you with up to three financial advisors serving your area, and you can interview your advisors at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

  • Look at the SmartAsset retirement tax calculator to determine where you want to live during your retirement to reduce your tax liability.

  • How much money do you need to retire? Find out with the help of the SmartAsset pension calculator.

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