The Roth IRA can be an attractive retirement savings vehicle due to the benefits they offer. Contributions are nondeductible on your income tax return, but qualified withdrawals of both contributions and earnings are tax-free and there are no required minimum distributions during the owner's life. To ensure that withdrawals are tax- and penalty-free, it is critical to comply with the so-called five-year rule.
Unfortunately, this rule is widely misunderstood. And, it does not help that there are actually two separate five-year rules: One for withdrawals of earnings and one for withdrawals of converted principal (special rules, not discussed here, apply to inherited Roth IRAs).
WITHDRAWALS
Unlike traditional IRAs, contributions to Roth IRAs are nondeductible since they are made with after-tax dollars. The upside to this is that you can withdraw contributions to a Roth IRA any time, free of taxes and penalties, regardless of your age or how much time has passed since you opened the account.
However, for withdrawals of earnings to be tax- and penalty-free, they must:
- Be made after age 59½ (also certain other exceptions); and
- Satisfy a five-year holding period.
If these conditions are not met, your distribution will be "non-qualified," in which case any earnings withdrawn are taxable. Fortunately, the IRS has a hierarchy of amounts withdrawn from your Roth IRA when you have a non-qualified distribution.
The IRS considers your contributions as being withdrawn first, so your distribution may still be 100% non-taxable if it only includes contributions. After contributions are withdrawn, any conversions and rollover contributions amounts come out next. These may be subject to penalties as explained later. Lastly, earnings are withdrawn, which will be taxable and possibly subject to penalty for a non-qualified distribution.
The five-year holding period does not begin on the contribution date to your account, but on January 1 of the tax year for which you made your first contribution to any Roth IRA. For example, suppose you opened a Roth IRA in March 2018, but designated your initial contribution for the 2017 tax year. Your five-year holding period begins on January 1, 2017 and ends on December 31, 2021. Assuming that you are over 59½, then starting January 1, 2022, you may withdraw earnings tax- and penalty-free from any Roth IRA you own.
ROTH CONVERSIONS
A different five-year rule applies to converted principal — funds in a traditional IRA that you convert to a Roth IRA. When you do a Roth conversion, you are immediately taxed on the converted amount (except for funds attributable to nondeductible contributions). Even though this converted principal has been taxed, it must nevertheless be held for at least five years to avoid a 10% early withdrawal penalty. The reason for this rule is that without it, owners of traditional IRAs who are under age 59½ would be able to avoid early withdrawal penalties by converting to a Roth IRA.
The five-year holding period begins on January 1 of the year the conversion takes place. And each Roth IRA conversion triggers a separate five-year holding period. So if you perform multiple conversions over several years, you will need to handle withdrawals very carefully to avoid unexpected penalties.
Keep in mind that this five-year rule exposes you to only early withdrawal penalties that would otherwise apply. If you have reached age 59½, or another penalty exception applies, then you will not be penalized — even if the five-year holding period has not yet expired. Such exceptions are for first time homebuyers and unreimbursed medical expenses to name a few.
Also, this rule applies only to converted principal. Earnings on converted principal are subject to the same five-year rule as earnings on contributions mentioned earlier.
TIPS ON TRACKING
The rules for Roth IRA can get confusing, but that should not deter you from opening up a Roth IRA or doing a Roth conversion. Talk to your ORBA financial advisor about whether this savings tool is appropriate for you, and for tips on tracking investment and withdrawal dates to avoid tax penalties.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
