Imagine you are 65 years old and have just completed a Roth conversion during a low-tax year before you retire to avoid future required minimum distributions (RMDs). However, shortly after the conversion, you want to withdraw the money you just paid taxes on. But making the withdrawal without first understanding the five-year rule for Roth IRAs could leave you paying income taxes and penalties on the money.
Would the rule apply to you in this situation? Unfortunately, the answer is the always unsatisfying “it depends.” In fact, there are several five-year rules to keep in mind with Roth IRAs. We’ll review two that would likely come into play and explore how they would affect your withdrawal strategy.
Need help planning your Roth conversion or navigating the five-year rule? Connect with a financial advisor today.
The first five-year rule, which applies to Roth IRA contributions, focuses on whether withdrawals of any accumulated earnings will be subject to taxes. This rule requires account holders to wait at least five tax years from the time of their first contribution, whether made directly or through conversion, to withdraw earnings, provided they have reached age 59½. If you make subsequent contributions or open new Roth accounts, the clock doesn’t reset.
For earnings distributions to be qualified, that is, tax-free, you must meet the age requirement and this five-year rule. There are exceptions to the age requirement for the death of the account holder, disabilities, and first-time home buyers. But even for these exceptions, the five-year rule must be followed or any profits taken from the account will be subject to taxes.
If you are at least 59½ years old but have not met the five-year rule requirement, you will pay income taxes on any earnings you withdraw. Since contributions to Roth IRAs are made with after-tax dollars, you can always withdraw the value of your contributions tax-free and penalty-free, but any earnings generated and distributed before the five-year period ends will be subject to taxes. . The distribution would also be subject to a 10% early withdrawal penalty if you are under age 59 ½. (Talk to a financial advisor if you need help navigating the five-year rule for your Roth IRA.)
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The second five-year rule relates specifically to Roth conversions and whether an early withdrawal of the converted principal will be taxable. In effect, the rule only applies if you receive a distribution before you turn age 59½.
For example, suppose you have a Roth IRA and complete a conversion when you are 56. If you wish to withdraw the converted capital two years later, at age 58, the withdrawal would be subject to a 10% early distribution penalty. However, if you wait until at least age 59½, you will not face the penalty even if less than five years have passed since the conversion.
While the five-year clock for the first rule begins with your initial Roth contribution, each Roth conversion you execute has its own five-year clock that begins on January 1 of the year in which you complete the conversion. For example, if you do a Roth conversion in May 2024, your five-year clock would have started on January 1, 2024.
As a result, you should take your conversion history into account when making distributions. The IRS helps you avoid potential mistakes to some extent by requiring contributions to be withdrawn first, balances converted second, and investment gains last.
Additionally, conversion withdrawals are done on a first-come, first-served basis, so the oldest conversions are withdrawn first once direct contributions have been fully distributed. (Need more help? A financial advisor can help you better understand the withdrawal rules surrounding Roth conversions.)
A man researches the five-year rules to determine when he can withdraw money from his IRA tax-free and penalty-free.
Let’s apply each rule to the hypothetical scenario above to see why this case is not as simple as it might have initially seemed.
We will start with the second rule, since in our hypothetical example you are over 59 and a half years old. As a result, you can withdraw all of the converted capital without paying a 10% penalty. The first rule is a little more complicated since its application will depend on the answers to some questions. Specifically:
When was your Roth IRA initially funded?
Has the account generated any profits?
How much do you want to withdraw?
If the conversion represents your first time investing money in a Roth IRA, the first five-year rule would apply. That is, while you can withdraw the converted capital tax-free and penalty-free due to your age, you will still have to pay taxes on any investment gains you want to withdraw. The key question then is how much you intend to distribute if the account has accumulated profits since its initial funding.
Let’s look at some potential scenarios, since we are missing some key details to give a definitive answer. In each scenario, let’s assume you have $50,000 in the account after the conversion and that the conversion was, in fact, the initial funding for your first Roth IRA.
Scenario 1: You completed the conversion five days ago, the account has not generated any profits, and you want to withdraw the full value of the account. Since there are no profits to distribute and the account value is simply the value of the conversion, the first rule is irrelevant. You can withdraw the entire account whenever you want.
Scenario 2: You completed the conversion a month ago, the account generated $2,000 in profits, and you want to withdraw $25,000. In this case, the first rule is also irrelevant since you are only taking advantage of the capital and not the profits. Therefore, you can withdraw $25,000 in principal and pay no taxes or penalties.
Scenario 3: Let’s assume the same background as Scenario 2, but you want to withdraw the $52,000 from the account instead. In this case, the first five years rule applies, since you have not waited five years to withdraw your earnings. Even if you are over age 59½, you will still have to pay taxes on the $2,000 of earnings.
A financial advisor can help you make specific calculations based on your circumstances. Contact a financial advisor today.
The application of these two five-year rules can be somewhat complex. Just remember that the first rule applies to earnings and the timer starts with the initial funding of the account. You cannot get around this rule even if you have turned 59 and a half. However, initial funding can come in the form of a direct contribution or conversion.
The second five-year rule applies to money converted to Roth assets. However, this rule stops applying if you are at least 59½ years old, even if you withdraw the converted funds less than five years after the conversion was completed.
If a Roth IRA is part of your retirement strategy, the surest way to avoid confusion and an unexpected tax bill is to start contributing early, taking distributions only once you’ve turned 59½ (if circumstances allow). and wait five years from the beginning. funding before beginning withdrawals.
But if you need additional help managing your Roth IRA or executing a Roth conversion, talk to a financial advisor. Finding a financial advisor doesn’t have to be difficult. SmartAsset’s free tool connects you with up to three vetted financial advisors serving your area, and you can take a free introductory call with your matched advisors to decide which one you think is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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