Woman calculating the five year rules

The Five Year Rules of Roth Distributions

Roth IRA’s are one of the most popular retirement accounts. Roth IRAs have many advantages over tax-deferred accounts, namely the ability to provide tax-free growth. The ability to provide tax-free growth is premised on making contributions with after-tax dollars.

As I’m sure you are well aware, you must pay taxes on essentially each dollar you make. The Roth IRA allows you to pay that tax before you contribute.

Assume you make $100,000 and contribute $5,500 to an IRA. If that IRA is a Roth, you will owe income tax on the full $100,000 (ignoring all other tax implications). If it is a Traditional IRA you will only owe income tax on $94,500 because you can deduct the contribution.

This provides advantageous withdrawal options in addition to tax-free growth. Since you have already paid income tax on the contributions to a Roth IRA, you are allowed to withdraw your contributions at any time, for any reason, with no tax liability or early withdrawal penalty. Not so with a Traditional IRA.

The earnings  in a Roth IRA however, in addition to early withdrawal penalties, are subject to the five year rule.

Most investors are aware of the Roth IRA five year rule, although few understand the details. In fact, there are actually multiple five year rules, each pertaining to a different circumstance.

I’m going to explain the various five year rules and then apply them to an example.

Five Year Rule for Earnings on Roth Contributions

As mentioned, you can withdraw Roth IRA contributions at any time without incurring an early withdrawal penalty or tax liability.

You must meet two conditions in order to withdraw earnings tax and penalty free. Meeting the two conditions makes the distribution a “qualified distribution”.

The first condition is that you must have held the Roth IRA for at least five years.

Second, you must be over 59&½, disabled, or a first-time homebuyer. Distributions made to the beneficiary of a deceased IRA owner also count.

Distributions that do not satisfy these conditions are “non-qualified distributions” and are subject to income tax and early withdrawal penalties.

Satisfying the Five Year Rule

Satisfying the five year rule simply requires that you made a Roth contribution over five years ago. This is not a per-account or per-contribution rule. If you have made ANY Roth contributions to ANY Roth IRA that satisfy the five year rule then you have satisfied the five year rule for ALL contributions for ALL accounts.

When Does the Five Year Clock Start?

The five year clock starts on January 1st of the year for which you make your first contribution. You can make contributions for a given year up until April 15th of the next year. You could make a contribution on April 15th for the preceding year, and the clock would start on January 1st of the preceding year.

You decide on March 5th of 2025 to make a Roth contribution for 2024. Assuming this is the first Roth IRA contribution you have ever made, your five year clock starts on January 1, 2024. You will satisfy five year rule on January 1, 2029.

Roth IRA Conversions

Roth Conversions have a separate five year rule. This rule is quite different from the five year rule for contributions.

First, realize that you paid income tax on the conversion amount when you converted from a traditional retirement account. This means that you will not owe income tax a second time when you withdraw from the Roth IRA, regardless if you have met the five year rule or not. This is true whether the withdrawal is from principal or earnings.

The five year rule for conversions then determines whether or not you will be liable for a 10% early withdrawal penalty on withdrawals that consist of Roth IRA conversion amounts.

Five Year Rule for Roth Conversions

Distributions from Roth IRA conversions that occurred less than five years ago are subject to the 10% early withdrawal penalty. Understand up front that this doesn’t mean you will necessarily owe the 10% penalty. This simply means that you will be subject to the normal rules for the 10% early withdrawal penalty.

There are two key ways that the five year rule for conversions is different than the five year rule for contributions:

  1. Each conversion has its own five year clock. If you have multiple conversions, you must hold each one for five years. This is different than the rule for contributions where satisfying the rule once means satisfying it forever.
  2. Conversions apply to the calendar year in which they actually occur, and cannot be applied to the prior tax year. The clock still starts on January 1 of the year they are made.

As long as the conversion is five years old, then distributions from it do not incur a 10% early withdrawal penalty.

If you take distributions from conversion amounts before the five year rule is satisfied, then you are subject to the 10% early withdrawal penalty.

Remember though, whether or not you actually have to pay the 10% early withdrawal penalty hinges on a separate set of rules. For instance, you won’t owe the 10% penalty if you are over 59&½ regardless of how long ago the conversion occurred.

Order of Withdrawals

Clearly, the tax treatment of withdrawals from Roth IRA accounts depends on the type and source of withdrawal.

Qualified or non-qualified distribution? Does the distribution come from contributions, earnings, or conversions?

Given that your IRA will likely contain a mixture of contributions, earnings, and conversions, it is very important to understand how the tax laws treat distributions.

Qualified or Non-Qualified Distributions

If your distribution is qualified you will not owe income tax or an early withdrawal penalty.

Non-qualified distributions from Roth IRA accounts follow a specific order. Any distribution comes from, in order:

  1. Roth Contributions
  2. Roth Conversions
  3. Earnings

This is a very favorable assumption. Even if you have a mix of all three in your account, any distributions will come first from your contributions until all of your contributions have been withdrawn.

Remember, distributions from your contributions will NEVER be subject to income tax or early withdrawal penalties.

Example:

Assume you have $1,000,000 in a Roth IRA and withdraw $50,000 per year. Of your Roth IRA balance:

$250,000 is from your contributions

$250,000 is from a conversion from a 401k

$500,000 is from earnings

You can take withdrawals for five years (5x$50,000 = $250,000) and not owe income tax or early withdrawal penalties regardless of how long you have held the account or how old you are

Next, conversions come out. For the next five years (5x$50,000 = $250,000) your distributions will not be subject to income taxation because conversion amounts never are – you already paid the tax when you converted. You are subject to early withdrawal penalties and MAY have to pay a 10% penalty. You will owe a penalty if you don’t satisfy the five year rule for conversions OR if you don’t otherwise satisfy one of the normal exceptions to the early withdrawal penalty. Remember, if you are over 59&½ you are good.

Lastly, the remaining withdrawals will all come from earnings because you have already withdrawn your contributions and conversions. You will owe income tax on the withdrawal and are subject to the 10% early withdrawal rules. Realize though that you are now 10 years into withdrawals. You have satisfied the five year rule. If you meet the second part of the “qualified” test these distributions are now qualified distributions and you will not owe tax or early withdrawal penalties.

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