Roth IRAs (individual retirement accounts) are an increasingly popular retirement savings vehicle, funded with after-tax dollars, offering tax-free growth and withdrawals. Unlike traditional retirement accounts, Roth IRAs do not require minimum distributions in your 70s, but there are several rules that can impact how and when you can take withdrawals tax- and penalty-free. In this short blog, we explore the two different 5-year rules associated with Roth IRAs and their retirement planning implications.
The 5-Year Rule for: Contributions
Contributions you make to a Roth IRA can be withdrawn at any time or age, tax- and penalty-free, since you already paid taxes on those funds when making the initial contribution. However, if you make a withdrawal before age 59 ½, including earnings on your contributions, you may face taxes or a penalty unless you meet certain criteria to create a “qualified” distribution.
One such criteria is the 5-year rule which requires waiting five years from the first day of the tax year which you made your first contribution before you can withdraw any earnings from your account without penalty. For example, if you made your first contribution for the 2022 tax year on April 18, 2023, you must wait until January 1, 2027, before you can withdraw any earnings without incurring an additional 10% penalty.
Additionally, if you use the funds for qualified expenses, such as a first-time home purchase, qualified education expenses, and medical expenses, you may be able to avoid the penalty – but not taxes – on the earnings if younger than 59 ½.
It’s also important to note that the 5-year clock does not restart with each additional contribution and only applies to the first contribution of the account, creating an incentive for everyone to open and contribute (even just $1!) to a Roth IRA as soon as possible.
The 5-Year Rule for: Conversions
If you convert traditional IRA assets to a Roth IRA, you may be subject to a completely different 5-year rule for withdrawals. You must wait five calendar years from the year of your conversion to withdraw any earnings on those converted assets without penalty.
So, whether you complete a conversion on January 1 or December 31 of this year, you still must wait until January 1, 2028. If you withdraw your earnings before the five-year period is up, you may be subject to a 10% penalty, in addition to any applicable taxes.
Similar to the contribution rule, you can withdraw your converted funds at any time without penalty or taxes, as you have already paid taxes on those funds when you made the conversion. However, unlike contributions, each conversion starts a new 5-year clock for those converted funds. Taking advantage of Roth conversions early in your career can steer you clear of incurring additional penalties on portfolio gains, allowing you to take advantage of the tax-free growth of the Roth account. Furthermore, for those looking to enjoy an early retirement before 59 ½ with Roth assets, employing a Roth conversion ladder strategy, where you convert a certain amount over several years, can help avoid penalties.
It's important to understand these rules and plan your retirement savings strategy accordingly in order to avoid penalties and ensure you have enough to support your retirement lifestyle. Keeping both 5-year rules in mind as it can impact how and when you can withdraw funds from your account. Working with a financial advisor or tax professional can be advantageous in planning contributions and conversions to balance with your withdrawal needs during retirement.
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Please consult with an attorney or a tax or financial advisor regarding your specific legal, tax, estate planning, or financial situation. The information in this article is not intended as legal or tax advice.