You probably have a number of options to save for retirement, but there's one retirement account you'll want to open right now if you haven't already: a Roth IRA.
The Roth IRA is similar to a traditional IRA, but it has some very important and unique rules to follow. One of those rules is commonly known as the five-year rule, which says you cannot withdraw earnings from your account without penalty if it's been less than five years since opening and funding a Roth IRA. Failure to comply will result in a 10% tax penalty on the earnings in the account.
This rule is in addition to the age requirement that you must be 59 1/2 to withdraw earnings from a Roth IRA -- or a regular IRA, for that matter.
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Traditional vs Roth
Here's a quick primer on a traditional IRA vs a Roth IRA.
When you contribute to a traditional IRA, you get to deduct that contribution from your taxable income that year. You can invest your contributions and you won't pay any taxes on that growth. You'll only pay taxes when you take a distribution from the account. Traditional IRA distributions are taxed like ordinary income.
There are some important rules to know. You're not eligible to receive a tax deduction if your income exceeds a certain amount. In 2023, that amount is $73,000 for a single filer and $116,000 for a married couple filing jointly.
A Roth IRA doesn't provide a tax deduction up front. Instead, you pay taxes on your contribution today, your investments in the account can still grow tax free, and you won't pay any taxes on your distribution.
There are income limits for the Roth IRA as well. Individuals with over $138,000 of income and married couples with over $218,000 will face limits on their contributions. They can, however, contribute the maximum amount to a traditional IRA without receiving a deduction, and then roll those funds over into a Roth IRA, a process commonly known as the backdoor Roth.
In general, a Roth IRA is best for people with a very low tax rate today or people who aren't eligible for a deduction with a traditional IRA.
The five-year rule
Even if you don't plan on using a Roth IRA immediately, you still need to be aware of the five-year rule.
There are a few different five-year rules for Roth IRAs, but the one we're concerned with in this article is about contributions. The five-year rule says it must be at least five years since you contributed to a Roth IRA before you can withdraw earnings from the account. That clock starts in the tax year it was made.
For example, if you open and contribute to a Roth IRA for the tax year 2022 (by April 15, 2023), it's as if you made the contribution on January 1, 2022. That means you can start withdrawing earnings on Jan. 1, 2027 if you need to, provided you also meet the age requirement.
Importantly, the rule allows for contributions to any Roth IRA. It doesn't have to be the one you'll use in the future. You could open a Roth IRA, fund it with a minimal amount, and then forget about it for years, and then you'll never have to worry about the five-year rule.
It's also worth noting the five-year rule specifically applies to withdrawing earnings on your contributions. You're able to withdraw your contributions at any point for any reason (although it's not recommended to withdraw from your retirement savings before retirement).
As mentioned, the five-year rule supersedes the age requirement for withdrawing from the Roth IRA. So, even if you're over that age requirement, you'll still need to wait if you haven't opened and funded a Roth IRA five years ago.
Who's most likely to get tripped up?
The five-year rule is a problem for a couple of types of retirement savers.
First, there are people who start saving for retirement late. If you want to funnel as much money as you can into a tax-protected account late in your career, a Roth IRA is a pretty good option. But if you're retiring within five years of when you open the Roth IRA, you'll have to wait before you can withdraw the earnings from that account.
The second situation is someone who has saved diligently in their Roth 401(k), but never opened a Roth IRA. If they quit their job and retire, they may want to rollover those funds to a Roth IRA. IRAs typically have lower fees and more investment options than a 401(k), so this is a logical thing to do. However, if they've never contributed to a Roth IRA before, they'll reset the clock on the five-year rule and won't be able to tap into the earnings in the account for five years.
The simplest way to avoid the above scenarios is to open a Roth IRA at least five years before you plan to retire, fund it with $1, and then you don't have to worry about it. If you're not eligible to contribute directly, rollover $1 from a traditional IRA to a Roth.
