A Guide to the Roth IRA 5 Year Rule

Roth IRAs are a widely used retirement planning option in the United States. In fact, Roth IRA assets totaled $1.4 trillion in 2023, and about 31.9 million U.S. households held Roth IRAs during that year. That is a notable number, and it continues to grow as more investors open Roth IRAs each year.

One of the main reasons for their popularity is the tax advantages they offer. A Roth IRA allows you to make tax-free withdrawals in retirement, which can help keep your tax burden low during your golden years when your income may be limited. Contributions to a Roth IRA are made using after-tax money, and your withdrawals in retirement can be completely tax-free.

If you already have a Roth IRA, are planning to open one, or have inherited one from a spouse, parent, or another relative, it is important to understand its rules. One of the most important among them is the 5-year rule for Roth IRAs. Let’s find out what this is and how it impacts your retirement planning.

What is the 5-year aging requirement for a Roth IRA?  

The 5-year rule for Roth IRAs is a non-negotiable requirement for withdrawals made from the account. If you do not follow the rule, withdrawals will not be tax-free or penalty-free. 

The basic idea behind the 5-year rule for Roth IRAsis that for your earnings to be withdrawn tax-free, you must wait at least 5 years from the beginning of the tax year in which you made your first Roth IRA contribution. You need to start calculating time from January 1 of the year you made your first contribution, regardless of when you actually contributed. Once 5 full years have passed, your account meets the 5-year requirement.

When your withdrawals become fully tax-free

The 5-year rule for Roth IRAs is only one part of the equation. To take out your investment earnings tax-free, you must also meet another qualifying condition. To understand this, you must note that the Roth IRA’s withdrawal age is 59½. 

Your Roth IRA withdrawals are considered qualified distributions when both of these conditions are met: 

• Your Roth IRA has been open for at least 5 years, and 
• You are 59½ or older

Once you meet both requirements, you can withdraw your investment earnings completely tax-free and penalty-free. This feature is, in fact, what makes a Roth IRA stand out when compared with other retirement accounts.

Contributions vs. earnings

It is important to understand that the 5-year rule applies specifically to investment earnings, not your contributions. With a Roth IRA, contributions can be withdrawn at any time, for any reason, tax-free and penalty-free.

Earnings, however, are subject to the 5-year rule and age requirements. If you withdraw earnings before the 5-year period ends and before the Roth IRA retirement age of 59½, the withdrawal may be considered a non-qualified distribution. In that case, the earnings portion of the withdrawal could be subject to the following charges:

• Ordinary income taxes
• A 10% early withdrawal penalty

Understanding qualified vs non-qualified withdrawals from a Roth IRA and how the 5-year rule affects them?

When you withdraw money from a Roth IRA, the Internal Revenue Service (IRS) classifies the withdrawal as either a qualified distribution or a non-qualified distribution. This distinction determines your taxability. One of the most important factors that determines this is the 5-year rule. Let’s understand the two types of distributions:

1. Qualified distributions

A qualified distribution is the most favorable type of withdrawal you can make from a Roth IRA. It is completely tax-free and penalty-free. For a withdrawal to qualify, two main requirements must generally be satisfied:

First, your Roth IRA must have been open for at least 5 years. The 5-year period begins on January 1 of the tax year in which you made your first Roth IRA contribution.

Second, at least one qualifying condition must be met at the time of withdrawal. These qualifying conditions include:

• You are age 59½ or older
• You are permanently disabled
• The withdrawal is made by a beneficiary after the account holder’s death
• Your withdrawal meets some other exceptions specified by the IRA

If both the 5-year rule and one of these conditions are satisfied, the withdrawal is treated as a qualified distribution. In this case, your contributions and your investment earnings can be withdrawn without paying taxes or the 10% early withdrawal penalty.

2. Non-qualified distributions

A non-qualified distribution is when you withdraw earnings from your Roth IRA before meeting the 5-year rule or before meeting one of the qualifying conditions. In these situations, the withdrawal may be subject to ordinary income tax on the earnings portion and a 10% early withdrawal penalty.

It is important to note that these taxes and penalties apply only to the earnings portion of the withdrawal, not to your contributions. 

Types of Roth IRAs affected by the 5-year rule for Roth IRAs

The 5-year rule affects all types of Roth IRAs. The ones you open yourself, the ones you inherit, and the ones you convert from a traditional IRA. Let’s understand this in detail:

1. Understanding the 5-year rule for converted Roth IRAs

When you convert funds into a Roth IRA using a Backdoor IRA, the IRS applies a separate 5-year rule before those converted amounts can be withdrawn without a penalty. As per the prevailing rules, you must wait at least 5 years from January 1 of the year in which the conversion took place before withdrawing those converted funds without triggering the 10% early withdrawal penalty, if you are under age 59½.

The 5-year waiting period for conversions is primarily designed to prevent people from converting funds to a Roth IRA and then immediately withdrawing. If this rule did not exist, you could easily avoid early withdrawal penalties that would normally apply to traditional retirement accounts. And while this may sound perfect to you, it evidently would not help the government, as its tax revenue would be substantially lowered.

It is important to note that each conversion has its own 5-year waiting period. Say you make multiple conversions over the years, one in 2021, one in 2023, and another in 2025. In this case, each will be tracked separately for purposes of the 5-year rule. 

2. Understanding the inherited Roth IRA 5-year rule  

If you have inherited a Roth IRA, the key question you must answer as a beneficiary is: 

“Did the original owner already follow the 5-year holding period before they passed away?”

Now, you may face the following situations: 

• The original owner met the 5-year rule for Roth IRAs

If the original Roth IRA owner had already satisfied the 5-year aging requirement before their death, any withdrawals of earnings taken by the beneficiary are generally tax-free. The beneficiary can withdraw funds without worrying about income taxes on the earnings.

• The original owner had not met the 5–year rule for Roth IRAs

If the original account holder had not yet held the Roth IRA for 5 years at the time of their death, the beneficiary must wait until the 5-year period is completed before earnings can be withdrawn tax-free. Until the inherited Roth IRA’s 5-year rule window closes, withdrawals of earnings may be subject to income tax.

The important thing to note here is that the 5-year clock starts when the original owner first opened the Roth IRA, not when the beneficiary inherited it. If the original owner made their first Roth contribution in a particular tax year, the 5-year period begins on January 1 of that year. In most cases, beneficiaries do not have to wait long for the rule to be satisfied, especially if the original owner passes away in retirement or old age. 

• Contributions vs earnings for beneficiaries

Just like with a Roth IRA you own, contributions for an inherited Roth IRA are treated differently from earnings. Beneficiaries can generally withdraw contributions at any time, tax-free, and avoid penalties on withdrawals. However, earnings withdrawals depend on whether the 5-year holding requirement has been met.

• Understanding the 10-year Roth IRA rules

The rules for inherited retirement accounts changed after the SECURE Act took effect in 2020. Under this law, most non-spousal beneficiaries must withdraw the entire balance of the inherited IRA within 10 years of the original owner’s death. This is commonly known as the 10-year rule.

Earlier beneficiaries were able to stretch withdrawals over their lifetime. But the SECURE Act now requires most inherited accounts to be fully distributed within that decade. Keep in mind that the 10-year rule does not apply to eligible designated beneficiaries, such as:

• Surviving spouses
• Children under age 21
• Disabled or chronically ill people
• Beneficiaries who are not more than 10 years younger than the account holder

When the 5-year and 10-year rules apply to the same inherited Roth IRA, the beneficiary must empty the account within 10 years. But if the 5-year requirement has not been met, early withdrawals of earnings could still be taxable. You can speak to a financial advisor about this in detail. 

Are there any exceptions to the penalty?

Even if you withdraw earnings before meeting the 5-year rule for Roth IRAs or before age 59½, you may still qualify for penalty exceptions in certain circumstances. 

Some common exceptions include:

• Once you reach age 59½, the early withdrawal penalty no longer applies. However, if the Roth IRA has not yet met the 5-year rule requirement, the earnings portion of the withdrawal could still be taxable. 
• If the Roth IRA owner passes away, the beneficiary who inherits the account can take distributions without facing the 10% early withdrawal penalty. 
• If you become permanently disabled, you may withdraw funds from your Roth IRA without paying the early withdrawal penalty. 
• You may withdraw up to $10,000 from your Roth IRA without the 10% penalty if the funds are used toward the purchase of a first home. 
• You can withdraw up to $5,000 penalty-free within one year of the birth or adoption of a child.
• If you withdraw funds to cover unreimbursed medical expenses that exceed 7.5% of your Adjusted Gross Income (AGI) for the year, the early withdrawal penalty may be waived.
• If the IRS places a levy on your retirement account, the distribution/levy is not subject to the 10% early withdrawal penalty.
• In some cases, the IRS may allow additional exceptions for specific situations, depending on the type of withdrawal.

Final checklist for the 5-year rule for Roth IRAs

Make sure you follow the rule carefully and pay close attention to the relevant dates and timelines. Calculating the 5-year period is generally straightforward, but if you are unsure how it applies to your situation, you can always consult a financial advisor for guidance. Explore our financial advisor directory to find a financial advisor near you. 

Things can be a bit more complex in the case of inherited IRAs, especially if you are not fully aware of the original account details. In such cases, professional advice can be especially helpful in ensuring you avoid mistakes. Working with a financial advisor can help ensure that you follow the correct procedures and avoid unnecessary penalties or taxes. 

It is also important to remember that retirement account rules can change over time. For example, the SECURE Act introduced new requirements for inherited retirement accounts. So, stay informed with such updates.

Frequently Asked Questions (FAQs) about the 5-year rule for Roth IRAs

1. What is the 5-year aging requirement for a Roth IRA?

The 5-year rule states that you must wait for 5 years before making a tax-free withdrawal from a Roth IRA. If you withdraw your earnings before the 5-year period is completed and before meeting other qualifying conditions, the withdrawal may be subject to taxes and potential penalties. 

2. How can I make sure I follow the rule correctly?

Here are some steps to follow:

• Know when your 5-year clock started
• Check whether the withdrawal is qualified
• Remember that contributions are always accessible tax-free
• Track conversion timelines carefully
• Be extra careful with inherited Roth IRAs
• Consider getting professional guidance when in doubt

3. Does the 5-year rule apply to all IRAs?

No, the rule does not apply to all IRAs. It does not apply to traditional IRAs in the same way. However, it does apply to Roth IRAs, Roth IRA conversions (such as backdoor Roth IRAs), and inherited Roth IRAs. However, each of these has its own specific conditions.

For additional information on retirement planning strategies tailored to your specific financial needs and goals, please visit Dash Investments or email me directly at dash@dashinvestments.com.

About Dash Investments

Dash Investments is privately owned by Jonathan Dash and is an independent investment advisory firm that manages private client accounts for individuals and families across America. As a Registered Investment Advisor (RIA) firm with the SEC, they are fiduciaries who put clients’ interests ahead of everything else.

Dash Investments offers a full range of investment advisory and financial services tailored to each client’s unique needs, providing institutional-caliber money management services based on a solid, proven research approach. Additionally, each client receives comprehensive financial planning to ensure they are moving toward their financial goals.

CEO & Chief Investment Officer Jonathan Dash has been profiled by The Wall Street Journal, Barron’s, and CNBC as a leader in the investment industry with a track record of creating value for his firm’s clients.