There’s a whole lot of lingo packed into the short phrase “Roth IRA 5-Year Rule,” so it may help to unpack it, one step at a time.
First, “IRA” is an acronym for an individual retirement account, an account in which people can invest money for their retirement and also enjoy tax benefits through their contributions. “Roth” is a certain type of IRA, and the 5-year rule is one of the rules that governs what an investor can and can’t do with funds in a Roth IRA.
This rule can apply to Roth IRAs in three broad ways. These include when a person:
• Withdraws funds from the account.
• Rolls a traditional IRA account into a Roth.
• Inherits a Roth IRA account.
Quick Review on Roth IRAs
Numerous financial institutions offer Roth IRAs, including SoFi. Once the account is open, the investor can contribute funds to it each year, up to annual caps, to build a nest egg for retirement years.
For 2020, the maximum IRS contribution limit for Roth IRAs is $6,000 annually. Investors age 50 years or older are allowed to contribute up to $7,000 each year, with the extra $1,000 being a catch-up contribution. There is no upper age limit for contributing to a Roth IRA. But the IRS does limit contributions for certain filing statuses and income thresholds. Employees who contribute to their company-sponsored retirement plan can also contribute to a Roth IRA.
Opening a Roth IRA may be a good choice for some people who expect to be in a higher tax bracket at retirement time than they are now. Because each situation is unique, it is recommended that investors consult with a tax professional to make the best choice.
Contributions to a Roth IRA are made with after-tax income and are not tax deductible. Taxes are paid on an investor’s current income, not on the potentially higher income the investor may be earning at retirement time when they begin taking distributions.
Contributions and Earnings
The generally accepted goal of investing in a Roth IRA is to earn money on the original contributions to create a more substantial retirement account. A Roth IRA typically contains both the original contributions made to it by the investor as well as investment earnings.
Contributions made to a Roth IRA can be withdrawn at any time without tax or penalty, for any reason at any age. Investment earnings on those contributions can typically be withdrawn, tax free and without penalty, when the investor reaches the age of 59½, as long as the account has been in existence for a five-year period.
How does the Roth IRA 5-Year Rule Work?
Because contributions can be withdrawn tax free, this five-year waiting period typically applies to the investment earnings of the account, not to the initial contributions made by the investor.
For example, an investor who contributes $5,000 into a Roth IRA during 2019 earns $400 in interest and wants to withdraw a portion of their money. But this retirement account is less than five years old. It’s possible that the $5,000 contribution could be withdrawn before the account is five years old, because that’s a contribution made out of after-tax income. If, though, part or all of the $400 investment earnings is withdrawn within the initial five-year window of opening the account, this money may be taxed.
If the investor is under the age of 59½ but has had a Roth IRA for at least five years, there are instances when funds can be withdrawn without a penalty or taxes. These include if the investor:
• Has a qualifying disability.
• Is buying, building, or rebuilding a first home ($10,000 withdrawal limit)
There are also circumstances under which investors under the age of 59½ may be able to withdraw funds and still avoid a penalty (but may still need to pay income tax). These include when funds are used for:
• Medical expenses that are more than 7.5% of the person’s adjusted gross income.
• Medical insurance premiums paid when a person is not employed.
• Qualified higher education expenses.
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Shortening the Waiting Period
To shorten the actual five-year waiting period, an investor could make a contribution on the day before income taxes are due and have it applied to the previous year. So, if someone made a contribution in April 2017, that contribution could be considered as being made in the 2016 tax year. As long as this doesn’t cause problems with annual contribution caps, the five-year window would effectively expire in 2021 rather than 2022.
If the same investor opens a second Roth IRA—say in 2018—the five-year window still expires (in this example) in 2021. The initial Roth IRA opened by an investor determines the beginning of the 5-year waiting period for all subsequently opened Roth IRAs.
Roth IRA Conversion 5-Year Rule
Some investors who have traditional IRAs may consider rolling them over into a Roth IRA. Typically, the money converted from the traditional IRA to a Roth is taxed as income, so it may make sense to talk to a financial advisor before making this move.
If this conversion is made, then the question becomes how the 5-year rule applies to this Roth IRA. The key date for this part of the 5-year rule is the tax year in which it happened. So, if an investor converted a traditional IRA to a Roth IRA on September 15, 2018, the five-year period would start on January 1, 2018. If the conversion took place on March 10, 2019, the five-year period would start on January 1, 2019. So, unless the conversion took place on January 1 of a certain year, which is unlikely, then the 5-year rule doesn’t literally equate to five full calendar years.
If an investor makes multiple conversions from a traditional IRA to a Roth IRA, perhaps one in 2018 and one in 2019, then each conversion has its own unique five-year window for the rule.
5-Year Rule for Beneficiaries
When the owner of a Roth IRA dies, the balance of the account may be inherited by beneficiaries. These beneficiaries can withdraw money without penalty, whether the money they take was from the principal (contributions made by the original account holder) or investment earnings. If this account was held for fewer than five tax years, however, the earnings portion of the beneficiary withdrawals is subject to taxation.
People who inherit Roth IRAs, unlike the original account holders, must take required minimum distributions. They can do so by withdrawing funds by December 31 of the fifth year after the original holder died or have the withdrawals taken out based upon their own life expectancy. If the five-year withdrawal plan is chosen, the funds can be taken out in partial distributions or in a lump sum. If the account is not emptied by December 31 of that fifth year, the consequence may be a 50% penalty on remaining funds.
Planning for Retirement with SoFi Invest®
Financial planners at SoFi can help guide investors through their retirement funding options. They bring years of expertise to each session, having worked with thousands of clients. As professional fiduciaries, they must keep the investor’s best interests front of center with no ulterior motives. And this no-cost planning can go well beyond saving for retirement, helping investors to meet a broad range of financial goals.
The process is simple and straightforward:
1. Set up a call.
2. Discuss your options and next steps.
3. Arrange a follow-up conversation whenever it’s needed.
You don’t need in-depth know-how to prepare for retirement using a SoFi-managed Roth IRA. Financial advisors can help develop a diversified portfolio and investment plan that works for you.
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