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 on the withdrawals. (If that sounds like a good deal to you, the Fool happens to have a great section where you can learn about IRAs, and figure out which one is right for you.)
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 can 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 tax years before any withdrawals qualify for favorable tax treatment.
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 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) from 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.
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 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.
Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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