Roth IRA 5 Year Rule and More Explained
A Roth IRA can offer significant tax advantages but there are some strings attached. You will need to abide by IRS rules in order to avoid the shock of paying taxes or penalties when you take distributions.
What Is a Roth IRA and Its Five Year Rule?
A Roth IRA is a retirement account that can be used as money management tool that will encourage you to save by giving you a tax benefit. Your money will grow tax-free and there won’t be a tax when you withdraw the money in retirement. Roth IRAs can be useful if you think your tax rate will be higher in the future. This is because you contribute money now that you won’t have to pay in the future.
Just like a traditional IRA, a Roth IRA holds your investments instead of being the investment itself. You open a Roth IRA at a bank or brokerage and then select what you want to invest in, such as stocks, bonds, mutual funds, or bank savings products. You are able to contribute money as one lump sum or make minor contributions over the year, as long as your total contributions aren’t exceeding $6,000.
For a longer-term goal such as retirement, it’s best to invest in bonds and stocks since they can get higher returns.
Are You Eligible for a Roth IRA?
In order to contribute to either a traditional or Roth IRA, you need to have an income from work. The maximum annual contribution is $6,000 of your income. You aren’t going to be eligible for a Roth IRA if you earn too much. The amount you can contribute will begin to shrink at certain thresholds and keeps shrinking as your income rises.
Spousal IRA
There are some exceptions to the contribution limits. You aren’t allowed to contribute more than you make in a year. If your taxable compensation for the year is only $5,000 then that is all you will be able to contribute. If you are a spouse not working, you are allowed to have what is known as a spousal IRA, only if your spouse earns enough to cover this. This means if you both want to contribute the maximum limits and are both under 50 then your spouse needs to earn at least $12,000 to cover the annual maximum for both of you.
The limits won’t apply to transfers from other retirement accounts, such as those in a rollover IRA. The deadline for any IRA contributions for a given tax year is on Tax Day of the following calendar year.
What Is a Rollover IRA?
A rollover IRA happens when you transfer money from a 401k or other retirement account into an IRA. One benefit of a rollover IRA is that it keeps your retirement money safe from taxes, as long as you do the process correctly. When you open a rollover IRA, you can choose the type you want. If you are moving money from a regular 401k then a traditional one can make sense. If you are moving from a Roth 401k then a rollover Roth IRA may make sense.
What Happens with It When You Leave Your Job?
There are many benefits of a rollover IRA and when you leave your job, you have three choices.
You can first let it be if your employer lets you but this isn’t usually a great plan. When you do this, you won't have an HR team to turn to for help and you could be charged higher fees.
The best choice for many people is to roll it over. The IRA is usually the best destination of choice since you will have a variety of investment options and lower fees, especially when compared to a 401k.
Cashing out can be the worst option and not only can it sabotage your retirement but you will have some taxes and penalties. You will pay an early 10% withdrawal fee, along with ordinary income taxes on the amount that was distributed.
The 5 year rule for Roth IRA withdrawals means that you have to hold your account for at least five years before you can start tapping into earnings without facing a penalty. This rule applies specifically to investment earnings. You can withdraw contributions you have made at any time since you have already paid the taxes.
This Roth IRA 5 year rule determines whether the IRS will consider the withdrawal of your earnings tax-free. If they aren’t tax-free then you could be liable to pay a 10% penalty on the earnings portion and taxes. The five year period starts in January of the year you made the first contributions to any Roth IRA. Once you have cleared that five year period for withdrawals of earnings to qualify for tax-free status the withdrawals then must be done after the age of 59.5 since you qualify for certain exceptions.
If you have had your IRA for less than five years, there can be exceptions to get you off the hook for this rule but not on all the income taxes.
Similar to the above Roth IRA 5 year rule, withdrawals of money from the conversion of a traditional IRA to a Roth IRA are also subject to a five-year period in order to avoid a penalty. The five-year period starts the first day of the tax year when you converted the money. For example, if you do the conversion in July then the rule for that conversion begins on the prior January 1st. Each rollover or conversion you make is also subject to a separate five-year waiting period. If you don’t want to wait then you can pay a 10% penalty as well as any income tax that is owed.
The last Roth IRA 5 year rule is for distributions to beneficiaries of a deceased IRA holder. Death is an exception to penalties for early withdrawals. However, if you want to avoid the ordinary taxes, beneficiaries will also need to abide by the first two rules for the waiting period to make withdrawals of investments or from converted accounts.
If you find you are the beneficiary of a Roth IRA, be sure to check the timing of the first contributions, rollovers, or conversions. Distributions of rollovers or earnings won’t necessarily be tax-free if the five-year rules don’t allow for it, even after the owner has died. The amounts are included in the beneficiary’s gross income and will be subject to income taxes, just as if the money had originally gone to the first owner.
Qualified vs. Non-Qualified Distributions
Contributing to a Roth IRA is easy but there are things to remember to understand which distributions are non-qualified and when exceptions can be made.
Qualified Distributions
When a Roth IRA participant meets the rules for distributions, any additional distribution is considered qualified if one of the conditions is met. The participant needs to be 59.5 or older, or a disability or death would help the participant meet the criteria for an exception. The best way to describe it is with an example.
Imagine you opened a Roth IRA in 2015 when you were 58 and then contributed money every year in 2015, 2016, 2017, and 2018. Even though you actually turned 59.5 in only the second year of contributing, you aren’t eligible to take distributions from the account without paying any taxes until the first five years have passed. Then the distributions are considered qualified and are penalty and tax-free.
Non-Qualified Distributions
Unless there is an exception, distributions that don’t meet the requirements to be qualified are subject to the 10% early withdrawal penalty and ordinary income taxes.
When Are You Able to Withdraw Without Penalty?
If you take your earnings out of a Roth IRA too early, you will need to pay income taxes and a penalty. You are able to take out some money from your Roth IRA without penalty for the purchase of a home or if you are disabled. However, there are also some other exceptions.
Exceptions can include if you are using the funds to pay for qualified higher education, to reimburse yourself for certain medical expenses, to cover health insurance premiums if you are unemployed, or if the IRS files a levy against the plan.
Withdrawal Timeline
When you have an understanding of the Roth IRA 5 year rule, it helps to have a rundown of distribution rules for each different age group.
Age 59 and Under with a Roth IRA You Have Had for Less than Five Years
This is when the rules apply and you can only withdraw for certain reasons, such as first-time home purchases, education, or health insurance premiums.
Age 59 and Under with a Roth IRA You Have Had for More than Five Years
You are able to withdraw up to $10,000 for first-time home purchases, if you become disabled, or have medical expenses that exceed 10% of your adjusted gross income.
Age 59.5 to 70
If you have met the requirements for the Roth IRA 5 year rule then you are able to withdraw money without taxes or penalties. If you haven’t met the requirements then your earnings aren’t subject to penalties but will be to income taxes.
Age 70.5 and Over
This is the same as above and you have to meet the requirements for the Roth IRA 5 year rule in order to withdraw your money penalty and tax-free.
Besides opening a roth account and saving for retirement, you should also consider opening a savings account. It is an inerest bearing account, with limited number of withdrawals, that really helps you save money because you only have limited number of withdrawals. Below, you can take a look at some of the best options:
Opening a Roth IRA
If you are aware of the Roth IRA 5 year rule and other tax rules and are interested in using one to help with your retirement, you need to know how to open one. There are four fundamental steps in opening an IRA. When you open a Roth IRA, the five-year periods starts so the earlier you open one, the better.
Decide How Much Help You Want
What kind of investor are you? Are you more hands-off or hands-on? If you want to manage your investments then choose an online broker. This means that you will open an account and then buy and sell investments yourself. If you want something automated then a robo advisor chooses the low-cost way to rebalance your portfolio and keeps it in line with investment preferences and your timeline.
Where to Open
Where you open your IRA should align with the type of investor you want. For someone more hands-off choose a robo advisor. Choose one with a low management fee and the services that work for your needs. Portfolio allocation and automatic balances are usually standard but other features, such as access to a human financial advisor, can vary.
For the hands-on investor, you want to choose a broker that has small account fees and has a wide selection of mutual funds. If you are new then you want to have someone who gives solid customer support and plenty of educational resources. Pay attention to any investment and account minimum. Some funds do have minimum investments.
Open an Account
This process only takes a few minutes and is easy to do. The actual steps do vary slightly by the provider. In general, you will want to go to the provider’s website and then fill out some personal details, such as employment information, Social Security number, and contact information.
Start Funding the Account
If you are going with a broker, you should look for low-cost mutual funds. If you choose a robo one then they pick investments for you. Banks also do offer IRAs but these options are usually more about saving money than growing money. For a long-term goal for retirement, investing with a robo advisor or broker usually makes the most sense.
Funding your account can take different forms. If you have a 401k from an old job, you can move those funds. Rolling over into an IRA can be the best option since IRAs have different investment choices and lower fees. The IRA broker can help you do this and there may even be a rollover specialist on staff. Generally, you will contact the former employer's administrator for the plan and fill out a few forms and they will send you a check or wire the funds to the new provider.
If you are funding from a brokerage or bank then you need the account number and routing number. If you are just beginning, you may want to consider an automatic transfer but do remember the annual contribution limits. Even if you have multiple accounts, you need to keep the total contributions for IRA under the maximum.
If you are going to use a robo advisor then you don’t need to choose investments since the robo advisor asks for your preference and goals and then picks investments that match up. It will also adjust those investments over time. It’s really a hands-off process. If you are choosing a hands-on route with an online broker then you may want to consider a portfolio of low-cost index funds and exchange traded funds.This approach can give you adequate diversification and can help minimize fees you will pay.
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Why a Roth IRA Beats a Traditional One
Even with the Roth IRA 5 year rule, there are still a number of reasons why a Roth IRA can be a better choice than a traditional one. Money management articles can explain the difference between the two in detail.
Tax-Free Income
The main reason is that you get tax-free income in retirement. It’s not just contributions that are tax-free but also any of the earnings. This can be a great deal, especially when you consider decades of compounding interest. The only catch is paying taxes on your contributions upfront.
If you are looking for tax diversification in retirement then a Roth IRA can help make sure you do have some tax-free income during your retirement days. Since it allows you to prepay your taxes your heirs also benefit. It’s an estate planning tool where your grandchildren receive tax-free income for the rest of their lives.
Flexible
There is flexibility with a Roth IRA. In a pinch, your Roth IRA can be used to provide some quick cash in certain circumstances. It should really be a vehicle to help with your retirement savings but it still provides that flexibility, which can be helpful.
You are able to contribute after age 70.5, which you can’t do with a traditional IRA. There are no minimum distributions, which means you can technically live to 120 without having to get into your Roth IRA funds.
To Sum Up
A Roth IRA can be a great tool for future retirees but there is a Roth IRA 5 year rule on distributions. Before you start investing with a Roth IRA, it helps to know that the rules that will dictate how much you can save.
While the rules may not have been on your radar before, knowing how the account works and how to get the clock to start ticking is important. While it’s important to note the Roth IRA 5 year rule, also know that it’s one of the best tools for retirement, especially with the tax benefits.