The Roth IRA 5-year rule sounds like it is far from the sexiest topic in the world.
However, if you invest in a Roth IRA, it’s crucial that you understand it unless you’re cool with paying extra taxes. You’re not? We didn’t think so.
Following the 5-year rule when taking funds out of your Roth IRA can help you avoid taxes and substantial penalties.
This article seems a little sexier now, doesn’t it?
Keep on reading if you want to learn more about how understanding the 5-year rule can save you serious cash.
An IRA (short for Individual Retirement Account) is a retirement savings account you can open and manage without going through an employer. Traditional IRAs are “tax-deferred,” which means that you can invest pre-tax funds in the account. With a traditional IRA, you can contribute up to $6K of pre-tax income each year. Once you hit 50, that annual limit jumps to $7K.
While you can invest in a traditional IRA with pre-tax money, you know Uncle Sam isn’t going to let you avoid taxes forever. Once you turn 72, or 70½ if you hit 70½ before January 1, 2020, the IRS is done waiting for its tax money. You’ll have to start taking required minimum distributions (RMDs) each year, and, unsurprisingly, you have to pay income taxes on them.
While you use pre-tax income to invest in a traditional IRA, Roth IRAs are the exact opposite. With a Roth IRA, you are only allowed to invest post-tax income. However, for many people, Roth IRAs actually offer more significant tax benefits and more flexibility.
First, since you already paid taxes on the money you invest, the IRS won’t make you take RMDs from a Roth IRA. You can keep your money invested and keep earning more and more income. And the kicker is, you don’t have to pay taxes on your earnings. Unlike traditional IRAs, you pay income tax on the amount you invest, not the amount you take out, so any money you make with your Roth IRA investments is almost always tax-free!
Of course, the feds have to put SOME restrictions on the awesomeness of Roth IRAs. As with Traditional IRAs, you can only contribute $6K each year ($7K for our 50+ friends). There are also income requirements for who is allowed to use a Roth account. As of 2021, phase-out amounts for married couples who file jointly are $198,000 to $208,000 and $125,000 to $140,000 for single people and heads of households.
Now that we’ve given you way more information about Roth IRAs than you probably needed let’s move on to what we’re actually supposed to be talking about: The 5-year rule. While you can always withdraw contributions you have made to your Roth IRA without taxes or penalties, the Roth IRA 5-year rule refers to the five-year waiting period imposed on some withdrawals from a Roth IRA account. There are three circumstances where the 5-year rule applies: earnings withdrawals, conversions from a traditional IRA to a Roth IRA, and inherited Roth IRAs.
The most commonly encountered situation involving the Roth IRA five-year rule is when attempting to withdraw money that you earned from account interest rather than money that you contributed to the account.
For earnings withdrawals to be tax-free, you must withdraw the earnings at least five tax years after the date you made your first contribution to any Roth IRA you own. You must also be at least 59½ years old. This means that even if you are over the age limit, you have to wait until it has been five years since your first contribution to take out your earnings without taxes or penalties.
The second way the five-year rule applies to Roth IRA withdrawals is when you convert a traditional IRA or a traditional 401(k) to a Roth IRA. Since traditional IRAs and 401(k)s are funded with pre-tax money, you have to pay taxes on any funds you convert from a traditional account to a Roth IRA.
Once you convert to a Roth IRA, you’ll have to wait five years to withdrawal any converted funds. This can get confusing because each conversion has its own five-year waiting period before you can withdraw the funds tax- and penalty-free.
However, IRS rules state that when you take money out of a Roth IRA, the oldest conversions are considered to be withdrawn first. When the IRS decides whether your distribution should be subject to early-withdraw penalties, the order of withdrawals are contributions first, followed by conversions, and then earnings.
Say, for example, that you have $100K in a Roth IRA - $75K in contributions; $20K in conversions; and $5K in earnings. If you were to withdraw $80K from the account, the IRS would consider you to have depleted your contributions before moving to converted funds, so only $5K of your balance of conversions would need to comply with the 5-year rule.
The rules surrounding inherited IRAs can be incredibly confusing, but fortunately, applying the 5-year rule to inherited Roth IRAs is relatively straightforward. When the owner of a Roth IRA passes away, a beneficiary who inherits the account can withdraw contributions or earnings without penalty as long as the Roth IRA has been open for five years. If not, you’ll need to wait until you hit the five-year mark before withdrawing any earnings if you want to avoid a penalty. However, you can still take out all of the contributed funds regardless of the age of the account.
We’ve covered the basic principles about the 5-year rule in this article, but many other factors must be considered before withdrawing funds from a Roth IRA. We recommend consulting with your lawyer or CPA before taking an unscheduled distribution from your Roth IRA to ensure you won’t suffer penalties or have to pay taxes.
Especially when it comes to your money, a second opinion is very sexy indeed!
Scott Royal Smith is an asset protection attorney and long-time real estate investor. He's on a mission to help fellow investors free their time, protect their assets, and create lasting wealth.
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