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Ask Millionacres -- How Does the Roth IRA "5-Year Rule" Work

May 25, 2020 by Matt Frankel, CFP
Q: A recent article of yours stated that a REIT could be bought within a Roth IRA and if the IRA has been open for at least five years and you're at least age 59 1/2, you can withdraw from the account tax-free. Is the five years from the time the investment was bought, or five years from Roth IRA open date? For example, if I've had a Roth IRA for 20 years and open a REIT, after three years, can I receive dividends from the REIT tax free?" -- Richard

A: Hi Richard,

Here's the short answer. The "five-year rule" for Roth IRA tax-free withdrawals of investment earnings means that five years must have passed since your first contribution to the account.

In other words, the date when you filled out the paperwork to open the account doesn't matter, nor does the date that each individual investment held in the account was purchased. The only thing that matters when determining whether your Roth IRA satisfies the five-year requirement is how much time has passed since you first put money into the account.

For example, let's say that you opened a Roth IRA on January 1, 2020, by contributing $100, and you are turning 60 this year. Even if you wait to deposit any additional money or make no investments within the account for several years, your account will be eligible for tax-free withdrawals after January 1, 2025. If you specifically want to own real estate investment trusts, or REITs to generate tax-free income, you can choose to withdraw any REIT dividends you receive after this date, regardless of the date you purchase your REIT investments.

To sum it up, the answer to your question is yes. If you've had a Roth IRA for 20 years since your original contribution was made and invested in a REIT three years ago, you can withdraw the dividends paid by the REIT tax-free.

With all of that in mind, there is one caveat that could allow you to withdraw from your Roth IRA tax-free even sooner. When you contribute to a Roth IRA, you are free to withdraw your original contributions tax- and penalty-free at any time, no matter how old you are or how long your account has been open. You just can't touch any money that represents investment earnings until the five-year window passes.

So, let's say you put $5,000 into a newly opened Roth IRA and buy a REIT that yields 5% per year, or $250. You can actually withdraw this $250 per year from your account starting right away, even if you aren't over 59 1/2 years old. As long as your cumulative withdrawals remain less than $5,000, your withdrawals can be treated as a return of your original contributions. In fact, the IRS stipulates that Roth IRA withdrawals are treated as contributions first and are only treated as earnings (and therefore would be subject to the five-year rule) after all of your contributions have been withdrawn.

In short, until your withdrawals exceed the total amount you've contributed to your Roth IRA over the years, you don't even have to worry about satisfying the five-year rule.

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