There's no other retirement savings vehicle quite like the Roth IRA. The Roth IRA rewards those willing to accept deferred gratification, as it doesn't give you an upfront tax break but gives you tax-free treatment of your income and gains as long as you keep your investments inside the account. Roth IRAs are also flexible, giving you greater access to your money than traditional retirement accounts.
However, there are a couple of important rules that govern Roth IRAs. In particular, the Five-Year Rules are a set of rules that determine the penalty and tax-free eligibility of your Roth IRA withdrawals.
What is the Roth IRA five-year rule?
There are actually three five-year rules investors need to be aware of.
1. Your first contribution
The first five-year rule states that you must wait five years after your first contribution to a Roth IRA to withdraw your earnings tax free. The five-year period starts on the first day of the tax year for which you made a contribution to any Roth IRA, not necessarily the one you're withdrawing from. So if you contributed to a Roth IRA for the first time in early 2020 but the contribution was for the 2019 tax year, then the five years will end on Jan. 1, 2024.
If you don't meet the five-year rule, that doesn't mean all of your withdrawals will be taxed. You can still withdraw the amounts you contributed without being taxed, because the money you put in was an after-tax contribution. Only the growth of the account is potentially subject to income tax.
However, this rule comes as a shock to some people because it supersedes the well-known rule that you have to wait until age 59 1/2 to take retirement account withdrawals without taxes and penalties. That means that even if you're over 59 1/2 when you withdraw, some of your withdrawal could get included in taxable income thanks to this five-year rule. You won't owe the 10% penalty in that case, but you'll still owe tax on any withdrawals above the amount contributed.
2. Roth conversions
There's also a separate five-year rule that applies only to those who convert other types of retirement accounts into Roth IRAs. Here, the idea of the rule is to prevent people from using Roth conversions to get penalty-free access to their traditional retirement accounts.
This five-year rule also starts the clock on Jan. 1 of the year in which you do the conversion. As a result, those who convert late in the year only have to wait a bit longer than four years before taking withdrawals.
However, this five-year rule is different in that it applies separately to each Roth conversion you do. Each new conversion starts its own five-year clock, and you'll need to account for multiple conversions to make sure you don't take out too much money too soon.
Note that the five-year rule applies equally to Roth conversions for both pre-tax and after-tax funds in a traditional IRA. That means, if you're using the backdoor Roth IRA strategy every year, your "Roth contributions" are really conversions, and you can't withdraw them for five years without penalty.
If you use the mega backdoor Roth IRA and roll over funds from a designated non-Roth after-tax account in a 401(k) into a Roth IRA, the five-year rule only applies to the amount you paid taxes on when you made the conversion. So, if you contributed $10,000 to a non-Roth after-tax 401(k) account, it grew to $12,000, and then you converted it to a Roth IRA, you'd be able to withdraw $10,000 at any point without penalty, but $2,000 is subject to the five-year lockup.
3. Inherited IRAs
If you inherit a Roth IRA from someone other than your spouse, you have a couple ofoptions for withdrawing the funds. You can elect to spread out distributions from the inherited IRA up to 10 years, taking required minimum distributions based on your life expectancy each year. This is the only option if the account owner lived beyond the required minimum distribution age.
The other option is to take lump sum distributions. This second option requires you to deplete the account by Dec. 31 of the fifth year following the death of the original owner. You can take distributions of any amount up to that date, but you must withdraw 100% of the funds by the end of the fifth year.
Inherited IRAs are also subject to the first-contribution five-year rule. So, if it's been less than five years since the owner's initial contribution to a Roth IRA, the earnings are subject to taxes. Keep that in mind if you want to withdraw a lump sum early.
Penalties for breaking the five-year rules
- Your first contribution. Withdrawing funds from a Roth IRA less than five years after your first contribution requires account holders to pay taxes on the earnings portion of the withdrawals. That said, Roth IRA withdrawals prioritize contributions before earnings. That means you may be able to make the withdrawal you need less than five years after your initial contribution but still tax-free if you have enough cumulative contributions to cover the amount.
- Roth conversions. If you withdraw money from a converted Roth IRA within the first five years after the conversion, you'll have to pay the 10% penalty on any withdrawals. That includes withdrawals of the amount you initially converted -- even though you've already paid taxes on that amount. You're still allowed to use other exceptions to the 10% penalty rules in a Roth conversion situation, however. In particular, if you're over age 59 1/2, then the age exception applies, and you can immediately take withdrawals without worrying about the penalty.
- Inherited IRAs. If you fail to withdraw 100% of funds from an inherited IRA by the end of the fifth year following the owner's death, the remaining balance is subject to a 50% penalty.
Exceptions to the five-year rules
Unfortunately, there's no way around establishing a Roth IRA for five years before you can withdraw earnings tax free. However, the IRS does provide a list of exceptions to the five-year rule on Roth conversions and the early withdrawal penalty.
First-time home purchases
Investors can withdraw up to $10,000 from their Roth IRA for a first-time home purchase. The IRS defines a first-time home buyer as anyone who has not owned a principal residence in the last two years. You can also use the funds to help a family member buy their first home.
Qualified higher education expenses
You can use your Roth IRA to pay for higher education expenses for yourself, a spouse, a child, or grandchild. Qualifying expenses include tuition, fees, books, and room and board.
If you lose your job and your health insurance, you can use funds from your Roth IRA to pay for your insurance premiums while you're unemployed. Additionally, if you have unreimbursed medical expenses exceeding 7.5% of your adjusted gross income, you can cover them with funds from Roth conversions without concern for the five-year rule.
Don't let the five-year rules bite you
Even with these rules, Roth IRAs are a great way to save for retirement. All it takes is a little awareness of the pitfalls of running afoul of the five-year rules, and you'll be able to avoid any adverse consequences for your retirement savings strategy.