Roth IRAs offer one of the most attractive benefits in retirement planning: tax-free withdrawals. But not all withdrawals are created equal. To take full advantage of the Roth IRA’s tax-saving potential, you need to follow all the rules, including the often-misunderstood five-year rule. Otherwise, you could face unnecessary taxes and penalties.
Three Withdrawal Types
The five-year rule requires you to satisfy a five-year holding period before you can make certain Roth IRA withdrawals penalty-free or tax-free. To understand the five-year rule, you first need to be aware of three types of funds you potentially can withdraw from your Roth IRA:
1. Contributed principal, which includes all of your annual contributions to the account,
2. Converted principal, which consists of amounts that had been in a traditional IRA that you converted to a Roth IRA, and
3. Earnings, which are the interest, dividends and capital gains on contributed or converted principal.
Roth IRA contributions aren’t tax deductible, which means the income contributed has already been taxed. Therefore, you generally can withdraw contributed principal at any time tax- and penalty-free, regardless of your age or how long the funds have been in the Roth IRA. The five-year rule doesn’t come into play.
However, the five-year rule can affect withdrawals of converted principal and of earnings.
Five-Year Rule and Converted Principal
You can withdraw converted principal without owing income tax, because you were taxed at the time of the conversion. However, violating the five-year rule can trigger the 10% early withdrawal penalty. The penalty applies to withdrawals before age 59½ that don’t qualify for an exception.
The five-year holding period begins on January 1 of the tax year you did the conversion. For instance, if you converted a traditional IRA into a Roth IRA at any time during 2020, the five-year period began January 1, 2020, and ended December 31, 2024.
Each Roth IRA conversion is subject to a separate five-year holding period. If you do multiple conversions over the years, you must carefully track each five-year period to avoid triggering penalties.
Keep in mind that the five-year rule comes into play only if you’re otherwise subject to early withdrawal penalties. If you’ve reached age 59½ or a penalty exception applies, you can withdraw converted principal penalty-free even if the five-year period hasn’t expired.
You may wonder why the five-year rule applies to withdrawals of funds that have already been taxed. The reason is that the tax benefits of Roth and traditional IRAs are intended to promote long-term saving for retirement. Without the five-year rule, a traditional IRA owner could circumvent the penalty for early withdrawals simply by converting it to a Roth IRA, paying the tax and immediately withdrawing it penalty-free.
Note, however, that while the five-year rule prevents this, it’s still possible to use a conversion to withdraw funds penalty-free before age 59½. For example, you could convert a traditional IRA to a Roth IRA at age 45, pay the tax, wait five years and then withdraw the converted principal penalty-free — years before you turn 59½.
Five-Year Rule and Earnings
To make tax-free withdrawals of earnings, you must meet two requirements: 1) the withdrawal must be made after you turn 59½ or become disabled (or pass away) or you must qualify for an exception (such as withdrawals for qualified first-time homebuyer expenses); and 2) you must satisfy the five-year rule.
So, even if you’re over age 59½, violating the five-year rule can trigger ordinary income tax on the portion of a distribution that’s attributable to earnings. However, failure to satisfy the five-year rule won’t trigger the early-withdrawal penalty if you otherwise would be exempt from it, such as due to age or a specific exception.
For earnings, the five-year period begins on January 1 of the tax year for which you made your first contribution to any Roth IRA. It doesn’t apply individually to each Roth IRA contribution — or to each Roth IRA, if you have more than one.
For example, let’s say you opened your first Roth IRA on April 1, 2021, and treated your initial contribution as one for the 2020 tax year. The five-year period started on January 1, 2020, and ended December 31, 2024. This means that, if you were over age 59½ during that period, you still would have been subject to income tax (but not the early withdrawal penalty) on Roth IRA distributions attributable to earnings. Then, beginning on January 1, 2025, such distributions would be tax-free.
The Ordering Rules
The consequences of violating the five-year rule can be costly, but there are ordering rules that help you avoid inadvertent mistakes. Under these rules, withdrawals from a Roth IRA are presumed to come from contributed principal first, converted principal second and earnings third.
So, if contributions are large enough to cover the amount you wish to withdraw, you’ll avoid taxes and penalties even if the five-year rule hasn’t been satisfied for converted principal or earnings. Of course, if you withdraw the entire account balance, the ordering rules won’t help you.
Achieving Your Goals
Because of their unique tax advantages, Roth IRAs can play a valuable role in creating a financially secure retirement. But the rules are complex. Please contact us with questions. Contact us. We can help you make informed decisions and ensure your Roth IRA strategy supports your broader financial goals.