Five-Year Rule
Candlefocus EditorMany investors and savers utilize Roth IRAs for their retirement savings. A Roth IRA is primarily a tax-advantaged investment account designed to help individuals save for retirement. Contributions to Roth IRAs are made with after-tax money; however, the funds grow and are distributed distributions tax-free.
The main consideration for individuals accessing their Roth IRA funds before the age of 59 ½ is the five-year rule. To withdraw earnings from a Roth IRA without owing taxes or penalties, an individual must be at least 59½ years old and have held the account for at least five tax years. For example, if you opened a Roth IRA account in July of 2020, you can begin withdrawing your earnings on or after July of 2025.
Failure to adhere to the 5-year rule will result in tax penalties. Any withdrawal of earnings prior to the five-year anniversary of opening the account will be considered a taxable event, and if you are under the age of 59½, a 10% early withdrawal penalty may apply.
Another 5-year rule that applies to Roth IRAs measures the time period between a Roth conversion and a recharacterization. A Roth conversion lets you convert any eligible retirement account into a Roth IRA, allowing tax-free payments in retirement. However, there is a five-year waiting period for any funds converted from a traditional IRA or an employer-sponsored retirement account.
To be in compliance with the five-year rule for Roth conversions, an individual must hold the converted funds in a Roth IRA for five years or until the individual is at least 59½ years old – whichever occurs later.
It is important to understand the 5-year rule when it comes to conversions and withdrawals from a Roth IRA. Various tax penalties may apply if the 5-year rule is breached and therefore, it’s important to plan your withdrawals carefully. Consulting an experienced tax advisor can help you better understand the 5-year rule, as they will be able to answer specific questions and guide you through any potential tax issues.