The Roth IRA Five-Year Rule
The Roth “five-year rule” – often misunderstood – in part governs when you can take tax-free distributions of earnings from your Roth accounts (IRAs, Roth 401k, or other work-based Roth accounts). Your Roth contributions can be withdrawn tax-free at any time. But the for the account’s earnings: The rule says that to take a tax-free distribution of earnings you must wait five years after your first contribution, the distribution must take place after you turn 59½. There are other provisions for when you become disabled, or when your beneficiaries inherit the assets after your death. Roth IRAs (but not workplace plans) also allow up to a $10,000 tax-free withdrawal of earnings after five years for a first-time home purchase, no matter your age.
While this seems straightforward, several nuances may impact your distribution’s tax status. Here are four things to think about.
When does the clock start ticking?
In some cases, the five-year waiting period may be shorter. The countdown begins on January 1 of the tax year for which you make your first contribution. For example, if you open a Roth IRA on December 31, 2020, the clock starts on January 1, 2020, and ends on January 1, 2025 — four years and one day after making your first contribution. Even if you wait until April 15, 2021, to make your contribution for tax year 2020, the clock starts on January 1, 2020.
Does the five-year rule apply to every account?
For Roth IRAs, the five-year clock starts when you make your first contribution to any Roth IRA. With employer plans, each account you own is subject to a separate five-year rule. However, if you roll assets from a former employer’s 401k plan into your current Roth 401k, the clock depends on when you made the first contribution to your former account. For instance, if you first contributed to your former Roth 401k in 2014, and in 2020 you rolled those assets into your new plan, the new account meets the five-year requirement.
What if you roll from a Roth 401k to a Roth IRA?
If you have never previously contributed to a Roth IRA, the clock resets when you roll money into the Roth IRA, regardless of how long the money has been in your Roth 401k. So use caution. If you think you might do a Roth 401k rollover sometime in the future, consider opening a Roth IRA account for it to go into as soon as possible. The five-year clock starts ticking as soon as you make your first contribution, even if it’s just a minimum amount and you don’t contribute again until you roll over the assets.
What if you convert from an IRA to a Roth IRA?
In this case, a different five-year rule applies. When you convert funds in a traditional IRA to a Roth IRA, you will have to pay income taxes on deductible contributions and tax-deferred earnings in the year of the conversion. If you withdraw any of the converted assets within five years, a 10% early-distribution penalty may apply, unless you have reached age 59½ or qualify for another exception. This rule also applies to conversions from employer plans.
