Roth IRAs have become a popular way for taxpayers to save for retirement because of their tax-free distributions and the fact that savers can withdraw the principal they contribute without paying taxes or penalties. However, these accounts have several rules you must follow in order to benefit from their tax-free status.
Most Roth IRA owners know they must be at least 59-1/2 years old and must have had a Roth account open for at least five years if they want to make a tax- and penalty-free withdrawal. But the rules surrounding Roth IRA distributions are more complicated than that. Roth IRAs have two separate sets of five-year rules that specify when money can be withdrawn without taxation. One set of rules applies to the earnings that are generated from Roth IRA contributions, while the other set is used to determine whether Roth IRA conversion balances will be penalized. The time limit for both sets of rules begins on Jan. 1 of the year in which the contributions or conversions are made, which means the wait time for tax-free distributions may actually be less than five year in some cases. The two sets of rules also aggregate all your Roth accounts (if you have more than one) for the purpose of determining the taxability or penalization of your contributions and conversions, even if these are done in separate accounts.
Roth contribution rules
The five-year rule as it applies to Roth contributions requires any distribution that is made to meet two criteria. In order to be counted as a qualified tax-free distribution, the withdrawal must meet a number of requirements.
First, let's go over the circumstances in which funds can be withdrawn from a Roth IRA without taxes or penalties being assessed:
- You're aged 59-1/2 or older
- You're completely disabled
- You're using the withdrawal to pay for 1) your first home; 2) qualified higher-education expenses; 3) out-of-pocket medical expenses that exceed 7.5% of your adjusted gross income; or 4) health insurance premiums if you're unemployed
- You have passed away and the distribution is going to your beneficiary or your estate
No matter the circumstances, the Roth owner must have had a Roth account open for at least five tax years prior to the distribution. However, because this time period is measured in tax years, it's technically possible to take a qualified distribution from a Roth IRA after just three years and eight months.
Roth IRA contributions for a given tax year can be made up until the tax filing deadline, which is typically on April 15 of the following calendar year. So if, for example, you made a contribution on April 14 of 2014 for the 2013 tax year, then the clock starts on Jan. 1 of 2013 for the purpose of this requirement. This means you could take qualified distributions starting in 2018, because that would be five tax years after your first contribution was made, though only three years and eight months had actually passed.
The clock on this five-year rule begins as soon as any contribution or conversion is made, and it does not reset for every subsequent contribution. Once the five-year test has been met, it is permanently satisfied. However, those who roll money from a Roth 401(k) into a Roth IRA must still satisfy the five-year rule, even if they contributed to their Roth 401(k) for five years before rolling it over. The five-year rule for Roth IRAs does not apply to Roth 401(k)s; rollovers from these plans must satisfy a separate five-year rule.
Roth conversion rules
As with the contribution rules, the Roth conversion five-year window is measured in tax years, meaning that any conversion that occurs within a given tax year is considered to have occurred on Jan. 1 of that calendar year. However, before the principal in a conversion can be withdrawn without penalty, each conversion must satisfy its own separate five-year window. Withdrawals from a Roth conversion account may still be tax-free before age 59-1/2 if the conversion account owner has contributed at least as much to a Roth IRA as the amount that is withdrawn. But if the distribution is made within the five-year time window, then the early-withdrawal penalty will apply.
Distributions from Roth conversion accounts are taxed on a first-in, first-out basis, where the oldest conversion balance is considered to be withdrawn first. The overall order in which all Roth IRA money is taxed specifies that contribution amounts are withdrawn first, then conversion balances in the order that they occurred, and then finally earnings.
Don't let the fine print scare you away
In many cases, Roth IRA owners who are at least age 59-1/2 and have had a Roth account open for at least five years don't have to worry about the taxation of their distributions. If you do not have a Roth IRA open at this point but would like to be able to take tax-free distributions in retirement, then open a Roth IRA and make a contribution as soon as possible in order to start the clock now. Those who have converted traditional IRAs or qualified plans to Roth IRAs may have more complicated rules to follow. For more information on Roth IRA distributions, check out the IRS' Publication 575 and Publication 590 or consult your tax or financial advisor.