Everything You Need to Know About The Roth IRA 5-Year Rule

Our topic on this episode of the Ready for Retirement podcast is about everything you need to know about the Roth IRA 5-year rule.

Questions answered: How does the Roth IRA 5-year rule impact my retirement strategy? What strategies can I implement to maximize my income in retirement? What is the best strategy for your individual situation? 

Are you ready to start focusing on the things that truly matter when it comes to your financial future?

We’re on YouTube! 

Check us out here for more content to help you create a secure retirement: YouTube – Root Financial Partners

Key Points

• 3 Important Considerations (Roth IRA 5-year Rule)
  • Timing of when you can withdraw earnings.
  • Timing of when you can withdraw money converted from an IRA to a Roth IRA.
  • Timing of when you can pull money from an inherited Roth IRA.
• Roth IRA Principal
  • Any contributions to a Roth IRA can be pulled out at any time with no taxes and no penalties.
    • Example: You could fund a Roth IRA today for $6,000 and pull your own $6,000 contribution tomorrow with no penalties.
• Taxes
  • Roth IRAs become eligible for a qualified distribution (no taxes/penalties) at age 59.5.
  • To be a qualified distribution (take advantage of the tax-free benefits), your Roth IRA must be established for a minimum of 5 tax years.
    • Example: 
      • Assume you make a Roth IRA contribution for the tax year of 2021. Because you’re unsure of your income for 2021, you decide to wait to contribute in 2022 (you have until April 15th, 2022). If you do make a contribution on April 14th, 2022 for the tax year of 2021, this counts as a contribution for the tax year of 2021.
      • You can begin withdrawing funds from this Roth IRA on January 1st, 2026 (technically fewer than 5 years, because it depends on when you contribute).
    • Example 2:
      • Assume you begin making a Roth IRA contribution at age 65 and retire next year. If you make a contribution of $7,000 and the account has grown to $10,000, you still cannot access the $3,000 penalty-free because you must be over age 59.5 and have waited for 5 tax years.
    • The benefits of Roth IRAs come from decades of tax-free compounding growth and this is why I usually recommend pulling funds from your Roth IRA once you’ve withdrawn other taxable accounts.
• Roth Conversions
  • There is a different rule for converting from your IRA to your Roth IRA.
    • Each individual conversion has its own 5-year rule.
  • Example:
    • If you make a conversion on December 15th, 2021, this gets credited to a tax year of 2021.
      • You can begin pulling these funds without penalty in 2026.
  • Any amount that you convert (deductible or non-deductible) requires 5 years of waiting before you can access these funds.
    • Example:
      • Assume you initiated a Roth IRA conversion in the middle of 2020.
      • You can not touch these funds until January 1st of 2025.
        • Assume you initiated another Roth IRA conversion in the middle of 2021.
        • You can not touch these funds until January 1st of 2026.
  • Each conversion has its own 5-year rule.
• General IRS Guidelines
  • Who tracks all of this information?
    • The custodian where your assets are track all of this information.
  • How can I track contributions, conversion amount, growth, etc.?
• The IRA treats Roth IRA withdrawals in the following order:
  •  #1 IRA participant contributions are automatically withdrawn first.
  • #2 Once contributions are withdrawn, taxable conversions are the next dollars that come out.
  • #3 Once conversions are withdrawn, nontaxable conversions (Backdoor Roth Conversions or Mega Backdoor) are withdrawn.
  • Earnings (growth on your money).
    • Example:
      • Assume you’ve been contributing to your Roth IRA for 30 years and you’ve contributed $100,000.
      • Assume you begin doing Roth Conversions today and one year from now you need to start pulling funds.
        • You don’t have to wait for the 5-year rule with Roth Conversions because your contributions would be the first dollars that come out (penalty-free & tax-free).
    • Fun Fact: Roth IRA didn’t come out until 1997!
• Inheriting Roth IRA(s)
  • There are no RMD(s) for your own Roth IRA, but there are RMD(s) for when you inherit a Roth IRA.
  • You must fully distribute your Roth IRA within 10 years regardless if you’re 59.5 or not.
  • The five-year rule applies even if it is an inherited Roth IRA.
  • Example:
    • If you’re a beneficiary and take a distribution that was not held for five tax years, the earnings will be subject to taxes (even if it’s a Roth IRA!).
    • Most funds you’re taking out upfront will not cause you to owe any amount in taxes because the earnings will be distributed last (order of operations referenced above).
  • Example 2:
    • Assume you inherit a Roth IRA (after January 1st of 2020) and your parents converted $100,000 one year prior to their passing.
    • The $100,000 can’t be taken out without paying a penalty until 5 tax years have passed.
      • These funds can’t be withdrawn tax-free or penalty-free until January of 2025.
• Roth IRA exceptions
  • You can withdraw up to $10,000 tax-free and penalty-free to purchase your first home.
  • You can withdraw funds from your Roth IRA without having to abide by the five-year rule for special education considerations.
  • You can withdraw funds from your Roth IRA for health insurance premiums if you become unemployed or need to reimburse yourself for medical expenses that exceed 10% of your adjusted gross income.
  • Note: If possible, try to avoid using your Roth IRA for these exceptions as this account is best used for long-term growth that is tax-free forever. With this being said, it’s still helpful to know this information exists.

Timestamps

1:31 – Five-Year Rule

4:29 – Roth IRA Contribution Example

6:48 – Tax Year(s)

10:02 – Roth Conversions

12:52 – Roth IRA Growth Benefits

14:40 – IRS General Guidelines

16:17 – When Are Earnings Taxed?

18:56  – Roth IRA Exceptions

20:21 – Aligning Your Investments With Your Financial Goals

Resources:

Submit your question:

Subscribe to the show

Work with James