Recs

22

The 2 Toughest Roth IRA Rules, Explained

Source: StockMonkeys.com via Flickr.

Roth IRAs are among the most useful tools you can use to save for retirement. In addition to the trait all IRAs share -- that is, letting you enjoy tax-deferred growth on the investments within your retirement account throughout your career -- a Roth IRA has the added benefit of letting you take distributions after you retire without having to worry about paying taxes during retirement. But two Roth IRA rules put limitations on your ability to get tax-free treatment for your investment income, as well as your right to take money out of your account without having to pay onerous penalties. Let's take a look at these two Roth IRA rules to learn how you need to manage your retirement account in order to avoid nasty surprises.

Roth IRA Rule No. 1: Waiting five years after you contribute

The first five-year rule deals with when you can withdraw money from your Roth IRA and have it treated as a qualified distribution for tax purposes. In the simplest terms, you must have had money in a Roth IRA for at least five years before any withdrawals qualify for favorable tax treatment.

Source: StockMonkeys.com via Flickr.

The whole point of a Roth IRA is to avoid taxes on distributions, as you don't get an upfront deduction for your contributions as you would with a traditional IRA. So complying with this rule is important, because otherwise, you'll end up having to pay income tax on the earnings from your Roth investments. In addition, if you're not at least age 59-1/2 and you don't qualify for one of the penalty exceptions, you'll also pay a 10% penalty. By contrast, qualified distributions are tax-free and penalty-free.

For the purposes of the rule, the five-year clock starts on Jan. 1 of the tax year in which you make your initial Roth IRA contribution. Because you have until April 15 of the year following any given tax year to make a Roth contribution, in some cases, the five-year rule actually requires holding your assets within the Roth for less than four years. For instance, if you opened your first Roth IRA on April 15, 2014 and designated that contribution for the 2013 tax year, then the five-year period would expire on Jan. 1, 2018.

Interestingly, this five-year rule only applies to your first Roth IRA contribution. Future contributions don't start a new clock running, and once that initial five-year period passes, you don't have to worry about this rule any longer.

Moreover, there are ways around the five-year rule, at least to a limited extent. You can still withdraw your original contribution (but not any capital gains) out of your Roth IRA without having to pay tax or penalties, even if the five-year period hasn't passed.

Roth IRA Rule No. 2: Waiting five years after a Roth conversion

A completely separate five-year rule applies when you convert money in a traditional IRA to a Roth IRA. Here, the rule says that until five years has passed after the conversion, you have to pay the 10% penalty if you withdraw money from the converted Roth and don't qualify for the usual penalty exceptions.

This rule works differently from the first Roth IRA rule in that a new five-year period starts for every Roth conversion you make. But the point of the rule is to prevent you from using Roth conversions to avoid a penalty that would apply to traditional IRA withdrawals. Without this rule, you could convert money to the Roth and then immediately withdraw it without paying the 10% penalty, because converted amounts are generally treated as tax-free when distributed because you included them in taxable income and paid tax at the time of the Roth conversion. This rule closes that loophole.

Source: Zack McCarthy via Flickr.

The five-year period starts running on Jan. 1 of the year of conversion, so, depending on when the conversion takes place during the year, the actual waiting period can be as little as four years and a day. If you turn age 59-1/2 during the five-year period, then the penalty no longer applies after that date, even if the five years haven't elapsed.

Stay on top of the rules
Roth IRAs are valuable for your retirement planning, but keeping track of the Roth IRA rules can be tricky. By knowing the basics, you can avoid making big mistakes that can cost you in extra taxes and penalties.

How to get more income during retirement
Roth IRAs play a key role in your financial security, but they're not the only way to boost your retirement income. In our brand-new free report, our retirement experts give their insight on a simple strategy to take advantage of a little-known IRS rule that can help ensure a more comfortable retirement for you and your family. Click here to get your copy today.


Read/Post Comments (11) | Recommend This Article (22)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 13, 2014, at 3:09 PM, yardomd wrote:

    Roth IRA isa great tax efficient instrument. Everybody should have one.

    You don't have to draw from it until you are age 72.

    Meantime it grows at 20% per year with BRK/B shares, (or more, in a self directed portfolio).

  • Report this Comment On August 13, 2014, at 7:01 PM, CaptGene wrote:

    And what happens if you roll your existing IRA into your ROTH? Can I now withdraw funds cooking for years or is my entire account untouchable for another 5 years, unless I'm willing to pay the taxes?

  • Report this Comment On August 13, 2014, at 7:24 PM, Alexander68 wrote:

    CaptGene:

    "A completely separate five-year rule applies when you convert money in a traditional IRA to a Roth IRA. Here, the rule says that until five years has passed after the conversion, you have to pay the 10% penalty if you withdraw money from the converted Roth and don't qualify for the usual penalty exceptions."

    You pay the taxes when you make the conversion to a Roth. Until the 5 year period passes, any withdrawals would be subject to a 10% penalty. Any withdrawals from gains would also be subject to tax.

    BUT: once you are 59 1/2, the penalty no longer applies.

  • Report this Comment On August 13, 2014, at 9:01 PM, 123spot wrote:

    Excellent! I have had a Roth for years and the finer points on withdrawal that you covered were new and very helpful to me. Thank you. Spot

  • Report this Comment On August 13, 2014, at 9:21 PM, bobspeldbackwrds wrote:

    Yardomd, you never have to make withdrawals from a Roth IRA. There is no RMD requirement with Roth IRAs. With traditional IRAs you are required to begin taking withdrawals at age 70 and a half.

  • Report this Comment On August 13, 2014, at 11:06 PM, GomerWumphf wrote:

    How does it work for an inherited Roth IRA that is less than 5 years old? Are RMDs required before the 5 year period is over?

  • Report this Comment On August 13, 2014, at 11:49 PM, dl66 wrote:

    Really a question: still not clear from comments above. If you are past 59 1/2 and have a Roth IRA and a Rollover IRA which you are gradually converting to Roth, how does the 5 year waiting period work?

    Can you withdraw funds that have been contributed or rolled over at least five years ago -- without any penalty or tax? Do I only have to be sure that I don't touch the conversions I made in the past 5 years? (I'm not really planning to withdraw any funds, but want to know that if I needed to -- I could withdraw "older" Roth money without paying anything.)

    Thanks for the article and for the discussion.

  • Report this Comment On August 14, 2014, at 12:57 AM, kankemike wrote:

    When did brk/b earn 20% in a year?

  • Report this Comment On August 15, 2014, at 12:36 PM, drborst wrote:

    Maybe this is off topic, but is this pretty much the same for a workplace sponsored Roth retirement plan?

    DRB

  • Report this Comment On August 16, 2014, at 5:02 PM, dragonmonkey wrote:

    I have BRK/B shares...sucks that I somehow missed those 20% returns every year.

  • Report this Comment On August 17, 2014, at 10:05 AM, Becker2011 wrote:

    Somehow I would have imagined explaining investing in MLPs within a Roth IRA would have qualified as one of the "2 toughest rules"

    I know it comes down to opinions in regards to UBIT with what you should do, but since there are a lot of arguments for both sides I would think that fleshing out that would create a pretty solid article.

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 3068241, ~/Articles/ArticleHandler.aspx, 10/2/2014 8:48:39 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

Today's Market

updated 11 hours ago Sponsored by:
DOW 16,804.71 -238.19 0.00%
S&P 500 1,946.16 -26.13 0.00%
NASD 4,422.09 -71.31 0.00%

Create My Watchlist

Go to My Watchlist

You don't seem to be following any stocks yet!

Better investing starts with a watchlist. Now you can create a personalized watchlist and get immediate access to the personalized information you need to make successful investing decisions.

Data delayed up to 5 minutes


Advertisement