facebook twitter instagram linkedin google youtube vimeo tumblr yelp rss email podcast phone blog search brokercheck brokercheck Play Pause
Roth IRA: Understanding The Five-Year Rules Thumbnail

Roth IRA: Understanding The Five-Year Rules

Financial Planning Investments Retirement Funding Roth IRAs Tax Planning

Roth IRA Distributions: When Are They Taxable? 

Roth IRA distributions are almost always tax-free, but there are times when a portion of a Roth IRA distribution can be included in taxable income and may even be subject to a 10% penalty. This typically occurs if the IRA owner takes a distribution and is less than age 59 ½. However, there may still be times when a portion of a Roth IRA is taxable, and the owner is older than age 59 ½. This is dependent on what is known as the Roth IRA five-year rule, and just to complicate things, there are two distinct five-year rules in Roth IRA planning. 

Roth IRA Five-Year Rule 1: The Forever Rule

The first five-year rule is known as the five-year “forever” rule. The beginning of the five-year forever rule is Jan. 1st of the calendar year that any individual opens their very first Roth IRA. It doesn’t make any difference how old you are; when you open your first Roth IRA and wait five years from January 1st of the year you opened your account, you have satisfied the five-year “forever” rule. It is important to note that if you have opened your first Roth IRA and satisfy the 5-year rule with that account, future Roth accounts will not have to wait 5 years.

Roth IRA Five-Year Rule 2: Conversions

The second five-year rule is a bit more complicated, and it helps to understand the three potential components that go into the make-up of a Roth IRA: Contributions, conversions, and earnings. Contributions are what we deposit into our accounts. Under the current rules, an individual can deposit up to $6,500 ($7,500 if age 50 or older) of earned income annually subject to certain adjusted gross income limitations. When a distribution is made from a Roth IRA, there are ordering rules as to what comes out first, and so on. Contributions are first and that distribution is never taxable, even if the five-year forever rule has not been satisfied. 

Conversions are the next component. Conversions are when an individual with a traditional IRA moves any amount from their traditional IRA to a Roth IRA. The IRA owner pays tax on the converted amount for the year of the conversion. When a distribution from a Roth IRA occurs, conversion amounts are what comes out second, after accounting for all contributions.

Conversions and distributions after conversions are where the second five-year rule comes into the equation. If the Roth IRA owner is less than 59 ½ and converts to a Roth IRA, that conversion starts its own five-year clock. Since there is not a 10% early withdrawal penalty for conversions when you are younger than 59 ½, the five-year clock restricts the Roth IRA owner from converting and then taking out the converted amount tax-free and without the early withdrawal penalty. Once the five years are up, the conversion basically becomes a contribution and can be distributed from the Roth IRA (even if still younger than 59 ½) totally tax-free. Every conversion that the Roth IRA owner completes has its own five-year clock. This is only a concern if you convert when you are younger than 59 ½; any conversion after age 59 ½ does not have the five-year restriction.

The third component of a Roth IRA distribution is any earnings that the portfolio has gained. If the Roth IRA owner has taken a distribution that exhausts both the contributions and conversions, the earnings come out last. If the owner is younger than 59 ½, the earnings will be subject to income tax as ordinary income and subject to a 10% penalty. If the owner is over 59 ½, the earnings generally will be tax-free. However, they may be taxable, but not subject to the 10% penalty. This brings back the five-year “forever” clock. If the Roth IRA owner is over 59 ½, and just now opened their very first Roth IRA, this person must wait to the end of the fifth year after January 1st of opening their first Roth IRA to be eligible to take any earnings out income tax-free. The contributions and conversions (if made after 59 ½) could be distributed tax-free before the 5 years are up, but the earnings must remain until the 5 year “forever” requirement is satisfied. 

If you think your plan should include Roth IRAs and you are able to fund it through contributions and/or conversions, you may want to open your first Roth IRA now so that you get that five-year “forever” clock going.