What You Need to Know About the Roth IRA 5-Year Rule

If you have a Roth IRA, you may be wondering how long you have to wait before you can withdraw your earnings without paying taxes or penalties. The answer is not as simple as you might think. There is not one, but two 5-year rules that apply to Roth IRAs, depending on whether you are withdrawing contributions or conversions.

The 5-Year Rule for Contributions

The first 5-year rule applies to the contributions you make to your Roth IRA. These are the money you put in after paying taxes on your income. Unlike traditional IRAs, Roth IRAs do not offer an immediate tax deduction for your contributions, but they offer tax-free growth and withdrawals in retirement.

The good news is that you can always withdraw your contributions from your Roth IRA at any time, without paying taxes or penalties. This is because you already paid taxes on them when you earned them. However, this does not mean you can withdraw your earnings (the money your contributions have made) without any consequences.

The 5-year rule for contributions states that you have to wait at least five tax years after your first contribution to a Roth IRA before you can withdraw your earnings tax-free and penalty-free. This rule applies regardless of your age or the reason for your withdrawal.

For example, let's say you opened and funded your first Roth IRA in 2020. You can withdraw your contributions anytime, but you have to wait until 2025 (five tax years later) before you can withdraw your earnings without paying taxes or penalties. If you withdraw your earnings before 2025, you will owe income tax and a 10% early withdrawal penalty, unless you qualify for an exception.

The 5-Year Rule for Conversions

The second 5-year rule applies to the conversions you make from a traditional IRA or a 401(k) to a Roth IRA. These are the money you move from a pre-tax account to a post-tax account. When you do a conversion, you have to pay income tax on the amount you convert, but you can enjoy tax-free growth and withdrawals in the future.

The 5-year rule for conversions states that you have to wait at least five tax years after each conversion before you can withdraw the converted amount without paying a 10% early withdrawal penalty. This rule applies only if you are under 59 1/2 years old or if you do not meet the requirements for a qualified distribution.

For example, let's say you converted $10,000 from a traditional IRA to a Roth IRA in 2020. You paid income tax on the $10,000 in 2020. You have to wait until 2025 (five tax years later) before you can withdraw the $10,000 without paying a 10% penalty. If you withdraw the $10,000 before 2025, you will not owe any income tax, but you will owe a 10% penalty, unless you qualify for an exception.

Note that the 5-year rule for conversions is different from the 5-year rule for contributions. The 5-year rule for conversions starts with each conversion you make, while the 5-year rule for contributions starts with your first contribution to any Roth IRA. Also, the 5-year rule for conversions only affects the penalty, not the tax, while the 5-year rule for contributions affects both the tax and the penalty.

Exceptions to the 5-Year Rules

There are some exceptions to the 5-year rules that allow you to withdraw your earnings or conversions without paying taxes or penalties, even if you have not met the 5-year requirement. 

These exceptions include:

- Being 59 1/2 or older

- Being disabled

- Being a first-time homebuyer (up to $10,000)

- Paying for qualified higher education expenses

- Paying for unreimbursed medical expenses that exceed 10% of your adjusted gross income

- Paying for health insurance premiums if you are unemployed

- Inheriting a Roth IRA from a deceased owner

- Taking substantially equal periodic payments

Before you withdraw any money from your Roth IRA, make sure you understand the 5-year rules and the exceptions that apply to your situation. If you are not sure, consult a tax professional or a financial planner. Roth IRAs are a great way to save for retirement, but they also have some complex rules that you need to follow to avoid unnecessary taxes and penalties.

Explore the links for more insights!

• How much Retirement Savings Do You Need?
• Understanding Social Security Benefits: A Comprehensive Guide
• The 4% Rule for Retirement Fund Withdrawals
• The Perfect Plan for Retirement Savings: 8 Key Elements for Employees
• How to Save for Retirement with 401K