What Is the Roth IRA 5-Year Rule?

How Does the Roth IRA 5-Year Rule Work?

A Roth IRA is a type of individual retirement account (IRA) that allows you to make tax-free withdrawals, but with a caveat. While you can withdraw your contributions anytime without penalty or taxes, earnings are subject to a holding rule.

Under the Roth IRA five-year rule, before you can withdraw earnings, the account must have been open for at least five years since the tax year of your first contribution. If you withdraw earnings before the five-year holding period ends, you may be subject to taxes and an early withdrawal penalty.

When Does the 5-Year Rule Start?

The clock starts ticking on January 1 in the tax year of your initial contribution, not the actual date you made the contribution. For example, if you made your first contribution on July 22, 2022, you could make a penalty-free withdrawal of earnings starting on January 1, 2027.

Conversion and inherited Roth IRAs also fall under the five-year rule. With a conversion Roth—a Roth IRA you opened to roll funds into from another IRA or other tax-deferred account—you can withdraw the converted amount penalty-free after a five-year waiting period. Each conversion has its own five-year waiting period, which is separate from the five-year waiting period for contributions.

Since contributions and earnings are commingled in the same account, following the IRS' ordering rules can help you avoid breaking the five-year role. Distributions are taken from IRAs in the following order:

1. Regular contributions
2. Conversion and rollover contributions, taxable portion first, then non-taxable portion
3. Earnings on contributions

Keeping up with your contributions and earnings can help you safely withdraw contributions and avoid breaking the Roth IRA five-year rule.

When Can You Withdraw Money From an IRA Without Penalties?

You can withdraw regular Roth IRA contributions at any time tax-free and penalty-free since you've already paid taxes on contributions. But whether or not you pay penalties on other withdrawals depends on if the funds meet the five-year rule.

To understand when you can withdraw earnings from your Roth IRA without penalties, it helps to know the difference between qualified and non-qualified distributions.

Qualified Distributions

After the five-year rule has been met, any distribution is considered qualified as long as you meet at least one of the following conditions:

1. You're at least age 59½.
2. You've become permanently disabled.
3. You are the beneficiary of a deceased IRA owner.
4. You're using the funds to purchase, build or rebuild a first home for you, your spouse, your child or grandchild, or your parent or ancestor. (A $10,000 lifetime maximum applies.)

Keep in mind the five-year rule must be met even if you turn 59½ before it's been five years since your initial contribution.

Non-Qualified Distributions

Non-qualified distributions do not meet the conditions of a qualified distribution. The withdrawal would be subject to regular income tax and a 10% early withdrawal penalty, unless one of the following exceptions applies:

• You're paying for qualified higher educational expenses. The expenses can be for yourself, your spouse, your children or grandchildren and include tuition, fees, books, supplies and equipment. Room and board are also covered as long as the student is attending at least half time.
• You have unreimbursed medical expenses. Distributions can only cover the amount that exceeds 7.5% of your adjusted gross income.
• You're covering health insurance premiums during unemployment. You must have lost your job, received unemployment for at least 12 weeks, received the distribution in either the year you received unemployment compensation or the next year, and received the distribution no later than 60 days after you've started a new job to qualify for an exception.
• The distributions are part of a series of substantially equal payments. Payments must be paid over your life or life expectancy, or that of you and your beneficiary.
• The distribution is due to an IRS levy of the IRA or retirement plan. If the IRS seizes some or all of your IRA, you won't be responsible for paying the penalty.
• You're a qualified reservist . You may qualify if you were called to serve active duty for more than 179 days.

How to Get the Most out of Your Roth IRA

Having a Roth IRA as part of your retirement strategy provides tax advantages, allows you to diversify your retirement savings and provides additional withdrawal options. Here are some tips for getting the most out of your Roth IRA.

• Contribute the maximum amount each year. Roth IRA contribution limits can change from year to year and may be affected by your tax filing status and income.
• Start contributing as early as possible. Thanks to the power of compound interest, the longer your money is invested, the more it can grow.
• Diversify your investments. Mixing stocks, bonds, ETFs, CDs and other assets allow you to balance risk and growth potential.
• Choose low-cost investments. Otherwise, high fees can eat into your returns.
• Avoid early withdrawal of earnings. Avoid taxes and penalties by waiting until you meet age and five-year rule requirements or qualify for an exception.

Roth IRA vs. Traditional IRA vs. 401(k)

Before contributing to a Roth IRA, it may be more beneficial to max out your contributions to your 401(k) or a traditional IRA, especially if your employer offers a 401(k) match. These contributions reduce your taxable income. If you expect to be in a lower tax bracket during retirement, contributing to a 401(k) or traditional IRA can help you defer taxes.

It may be more beneficial to contribute to a Roth IRA if you expect to be in a higher tax bracket during retirement. You'll pay lower taxes on your contributions now and your retirement withdrawals will be tax-free. Roth IRAs also have the benefit of allowing you to withdraw your contributions—but not earnings—anytime without incurring taxes or penalties. You have more control over your withdrawals since distributions aren't required during retirement.

The Bottom Line

Before making a withdrawal from your Roth IRA, make sure you're following the five-year rule and other guidelines to ensure your withdrawal is both tax-free and penalty-free.

Saving for retirement is a big part of ensuring your financial plan is on track. Keeping an eye on your credit as you head for retirement is also important, especially if you anticipate needing to borrow money. Get free access to your credit report and credit score from Experian, and work to improve anything that may need work.