What is the Roth IRA 5-year rule?
Planning for retirement is one of the most important financial decisions you can make. One commonly recommended retirement savings method is an Individual Retirement Account (IRA). Along with traditional IRAs, Roth IRAs are an excellent retirement vehicle. However, the savvy investor needs to understand that the Internal Revenue Service has imposed many rules and regulations regarding Roth IRAs. One of these regulations requires waiting a certain time to make some types of withdrawals from your Roth IRA. This waiting period is called the 5-year rule.
To help you make intelligent decisions about Roth IRA investments, the following is an explanation of the advantages and disadvantages of a Roth IRA and the consequences of the 5-year rule.
Roth IRA Advantages
Roth IRAs can be an important part of a retirement plan. You pay taxes on the money you invest at the time you contribute to the Roth IRA and your contributions grow tax-free. After all the legal requirements have been met and you withdraw funds, you pay no additional taxes. This is especially attractive to consumers who expect to be in a higher tax bracket when they reach age 59 ½ or retire.
There are several additional advantages to owning a Roth IRA. Withdrawing funds from your Roth IRA contributions before retirement age is easier in a Roth than a traditional IRA. For this reason, some people like to think of a Roth IRA as a form of an emergency fund. This emergency fund usage is viable only if you withdraw from contributions you have made and not the earnings portion of your account.
You may have heard about required minimum distributions (RMDs) that investors must take from traditional IRA accounts. With the passing of the CARES Act in 2020, the age for taking your first RMD increased from 70 ½ to 72. However, many consumers are reluctant to take RMDs when the money is not needed or the economy is not favorable for withdrawing. With a Roth IRA, you are not required to take an RMD.
Previous to the passing of the SECURE Act in 2020, eligibility for contributions to a traditional IRA ended at 70 ½. The SECURE Act removed that age limit. You can also contribute to a Roth IRA forever as long as the money is earned income. As an employee, earned income includes salaries, wages, commissions, bonuses, and other money paid to you by an employer. If you are self-employed, you can also contribute to a Roth IRA up to the contribution limits. Money received in a divorce such as child support or alimony or settlement funds is also eligible. Also, many people include Roth IRAs in their estate planning. It is an excellent way to save for future generations as beneficiaries can receive tax-free income.
Roth IRA Disadvantages
The major disadvantage of a Roth IRA is that you are making contributions with money you have already paid taxes on. These contributions may be a drain on your current income. Another concern for some people is that the contribution levels for Roth IRAs are relatively low. In 2021, the contribution maximum is $6,000 or $7,000 if you are over 50. Also, there are income limits for people making contributions to a Roth. In 2021, your adjusted gross income must be under $140,000 if you are single and under $208,000 if you file jointly. These regulations can be difficult for some people to manage.
What is the Roth IRA 5-year rule?
The Roth IRA 5-year rule applies in three different circumstances. The first situation is when you withdraw accounts earnings. The second situation that might trigger the 5-year rule is when you convert a traditional IRA to a Roth IRA. Sometimes people inherit Roth IRAs, and the 5-year rule may apply to inherited accounts. Understanding these regulations is important. Ignoring the 5-year rule can result in paying taxes on the withdrawals and a 10% penalty.
Following is an explanation of each of these three circumstances.
Roth IRA 5-year Rule Regarding Funds Withdrawal
You must ask yourself two important questions to determine if the 5-year rule applies when withdrawing funds. To be tax-free the withdrawal must occur,
1. After you are age 59 ½
At least five years after you made your first contribution to a Roth IRA
One special note to remember is that once the five years requirement has been satisfied it applies to any Roth IRA you own. This means that if you own several Roth IRAs, you are good to go five years after the first contribution to any one of the Roth accounts.
2. Roth IRA 5-year Rule Regarding IRA Conversions
When you convert an account from a traditional IRA to a Roth IRA, the 5-year rule must be acknowledged. With a traditional IRA, you do not pay taxes until you receive the funds. If you decide to convert your traditional IRA to a Roth IRA, you must pay taxes before opening the Roth. You are also subject to the 5-year fund withdrawal rule. The countdown begins the first day of the tax year you converted from the traditional to the Roth IRA. For conversions or rollovers, each new account is subject to a separate 5-year waiting period.
3. Roth IRA 5-year Rule Regarding Inherited Roth Accounts
When the owner of a Roth IRA dies, the beneficiaries can take withdrawals from the account without penalties. However, if the beneficiary takes a distribution of principal or earnings from the Roth, you will have to pay taxes if the account was not held for five years. Beneficiaries will need to research the timing of the contributions to understand if the 5-year rule applies to their inheritance.
Exceptions to the 5-Year Rule
The Internal Revenue Service has provided for some exceptions to the Roth IRA 5-year rule. Even if you are younger than 59 ½, you can withdraw $10,000 of your Roth IRA to pay for your first home without penalty. You can also pay back taxes from your Roth funds. Also, you can withdraw $10,000 without penalty to pay for education expenses for yourself, your children, grandchildren, or spouse. If you are unemployed, you can pay health insurance premiums from your Roth IRA account. If you become disabled you can also withdraw funds from your Roth IRA. In some cases, you can reimburse yourself for medical expenses. This expense must exceed 10% of your adjusted gross income. Your adjusted gross income is your annual income minus certain expenses like contributions to retirement accounts or health savings accounts.
Investing in a Roth IRA may be one of the best retirement decisions you ever make. However, it is important to understand the many rules and regulations imposed by the IRS, including the 5-year rule. If you need additional information, many full-service and discount brokers and financial advisors offer detailed guidance to consumers. Taking advantage of this expert advice is another smart investment decision.