STWS Advisor David Fei goes over the complicated 5-year Rule for Roth Individual Retirement Accounts.
When you contribute to a Roth IRA, it is done with dollars that have already been subject to taxation, so for contributions into a Roth, there is no 5-year rule. Contributions are not the same thing as money that comes into a Roth IRA via a conversion from a traditional IRA, though. And if you inherited a Roth IRA from a deceased individual, then the 5-year rule only applies if the account was opened less than 5 years from the date it was inherited. Here we explore the three situations in which this 5-year Roth rule is applicable, and a few exceptions as well.
Is the Roth IRA 5-Year Rule Actually 5 Years?
No. Or, it depends. The 5 “years” referenced in the “5-year rule” is in regard to tax years. Basically, a contribution made at any point within the 2021 tax year timeframe (January 1, 2021 – April 18, 2022) is considered as a contribution made on January 1, 2021, for tax purposes. The pandemic made the span of time even longer for the two prior years as the tax deadline was moved to July 15 in 2020 and 2021 (for filing taxes for 2019 and 2020 income, respectively). The 2021 tax return (which has to be filed by April 18th this year) will include Roth contributions made from 1/1/21 to 4/18/22.
If a Roth IRA owner is 59½ years old or older, then they can withdraw any portion of their Roth IRA without any tax consequences or penalties so long as the account received its initial contribution at least five years ago. If the first contribution was made in tax-year 2017 or earlier, then withdrawals on or after January 1, 2022, are penalty and tax-free so long as the owner is 59½ or older when the money is taken. This means, for example, if an actual contribution was made April 1, 2018, to a Roth IRA as a 2017 contribution, then it counts as if made 1/1/17 and therefore this isn’t actually five years. Any amount converted from a traditional IRA, regardless of when the conversion occurred, can also be withdrawn without penalty so long as the account was funded and opened at least 5 years prior, and the owner is 59½.
As contributions to a Roth IRA are made post-tax, they can be taken any time without tax implications, even before reaching the age of 59½. However, earnings (money gained from investment performance within the account) are subject to the 5-year rule and age restriction. If earnings are withdrawn before the owner turns 59½, there is a 10% tax penalty. And likewise, it is this earnings portion that is subject to the 5-year rule for Roth IRAs.
Conversions and Inheritances
A Roth conversion is when money is withdrawn from a Traditional IRA, taxed, and then deposited into a Roth IRA. This money that is converted into Roth funds is not considered a contribution as in the scenarios explained above. If you are younger than 59½, then converted funds, if withdrawn, are subject to the 10% tax penalty, if the conversion into the Roth IRA happened less than 5 years before the withdrawal. (And remember these are “tax years”) After these 5 years have passed, the converted amount (again, not including earnings) can be withdrawn without penalty even if the Roth IRA owner hasn’t yet turned 59½.
If a Roth IRA is inherited, the 5-year rule may apply, but is not based on the inherited date. If less than 5 years passed since the initial money in the inherited Roth IRA was contributed, then the 10% penalty of the 5-year rule applies. If the Roth IRA was opened and funded more than 5 years from the date of inheritance, then the beneficiary doesn’t need to worry about this rule, regardless of their age. If a Roth IRA is inherited by a non-spouse, though, then all of the money in the account has to be withdrawn within 10 years from when the account was inherited. (This provision was added in 2019 by the SECURE Act.)
Exceptions to the Rule
There are two situations in which the IRS will waive the penalty inflicted by this 5-year rule for Roth IRAs. One of these is if the money is used for higher education for the account owner, their spouse, child, or grandchild. If the owner of the Roth IRA is unemployed and their medical premiums are 10% or more of their adjusted gross income (AGI), then the penalty is similarly inapplicable.
**Written by David Fei, CERTIFIED FINANCIAL PLANNER™, ChFEBC℠.. The information has been obtained from sources considered reliable but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of David Fei and not necessarily those of RJFS or Raymond James. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy suggested. Every investor’s situation is unique and you should consider your investment goals, risk tolerance, and time horizon before making any investment or financial decision. Prior to making an investment decision, please consult with your financial advisor about your individual situation. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.**
