There’s a whole lot of lingo crammed into the short phrase “Roth IRA 5-Year Rule,” so it may help to unpack it, one step at a time.
1. 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.
2. Roth is a certain type of IRA, where contributions are made with after-tax dollars, and withdrawals in retirement are not taxed.
3. 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. The Roth IRA 5-year rule comes into play when a person withdraws funds from the account; rolls a traditional IRA account into a Roth; or inherits a Roth IRA account.
Quick Review of 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 2021, the maximum IRS contribution limit for Roth IRAs is $6,000 annually. Investors over age 50 are allowed to contribute an extra $1000 a year in catch-up contributions, for a total of $7,000. There is no upper age limit for contributing to a Roth IRA, though 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.
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.
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How does the Roth IRA 5-Year Rule Work?
Roth IRA contributions can be withdrawn at any time without tax or penalty, for any reason at any age. Investment earnings on those contributions can typically be withdrawn, tax-free and without penalty, once the investor reaches the age of 59½, as long as the account has been open for at least a five-year period.
For example, say 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. Since this retirement account is less than five years old, only the $5,000 contribution could be withdrawn. If part or all of the $400 investment earnings is withdrawn sooner than five years after opening the account, this money may be subject to a 10% tax.
Special Circumstances and Exceptions to the Five-Year Rule
According to the IRS , a Roth IRA account holder who takes a withdrawal before the account is five years old may not have to pay the 10% additional tax in the following situations:
• You have reached age 59½.
• You are totally and permanently disabled.
• You are the beneficiary of a deceased IRA owner.
• You use the distribution to buy, build, or rebuild a first home.
• The distributions are part of a series of substantially equal payments.
• You have unreimbursed medical expenses that are more than 7.5% of your adjusted gross income for the year.
• You are paying medical insurance premiums during a period of unemployment.
• The distributions aren’t more than your qualified higher education expenses.
• The distribution is due to an IRS levy of the qualified plan.
• The distribution is a qualified reservist distribution.
How to Shorten the 5-Year Waiting Period
To shorten the five-year waiting period, an investor could open a Roth IRA and make a contribution on the day before income taxes are due and have it applied to the previous year. For example, if one were to make the 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 five-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 five-year rule applies to this Roth IRA. The key date for this part of the five-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.
Inherited Roth IRA 5-Year Rule
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 is from the principal (contributions made by the original account holder) or from investment earnings. If the original account holder had the Roth IRA for fewer than five tax years, however, the earnings portion of the beneficiary withdrawals is subject to taxation until the five-year anniversary is reached.
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.
For Roth IRA account holders, five is the magic number. After the account has been opened for five years, an account holder who is 59 1/2 or older can withdraw investment earnings without incurring taxes or penalties. While there are exceptions to this so-called 5-year rule, for anyone who has a Roth IRA account, this is important information to know about.
Some people choose a Roth IRA as part of their retirement planning because the account is funded now with after-tax dollars, and qualified withdrawals can be made tax-free. SoFi Invest® offers Roth IRAs as well as traditional and SEP IRAs.
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