Understanding the Roth IRA 5-year rule

If you're contributing to a Roth individual retirement account (IRA) as part of your retirement planning, you're enjoying the benefits of growing your nest egg while setting yourself up to potentially pay less income tax in your golden years. But you should be aware of some rules about when you can withdraw your money without incurring taxes or penalties.

You may be familiar with the well-known Roth IRA 5-year rule that covers withdrawals, but it's only one of three rules that are equally as important:

• Withdrawals. If you withdraw Roth IRA earnings from your account within 5 years of your first contribution or conversion, you have to pay taxes on your earnings and potentially a penalty.

• Conversions. If you convert a different type of retirement account to a Roth IRA, you must leave that money in the account for 5 years or pay a penalty unless an IRS penalty exception applies.

• Inheritances. If you inherit a Roth IRA, you'll owe taxes on the earnings you withdraw unless it's been at least 5 years since the account owner's first contribution or conversion to the Roth account.

Here's a closer look at these rules, when they apply and how to comply.

The primary Roth IRA 5-year rule is in order for your growth to be withdrawn tax-free, your first deposit must have been at least 5 years ago and you're age 59½, disabled, making your first time home purchase or you've inherited the IRA. 

It depends. For contributions, the IRS starts counting from the first day of the tax year that your first contribution applied to rather than the specific date you made the contribution. For instance, if you made your first contribution in February 2022 for the 2021 tax year, the 5 years would start counting on January 1, 2021, even though that was before you deposited the money. For conversions, the timer starts on the first day of the tax year in which you made the conversion. So if the conversion happened in February 2022, the 5 years would start counting on January 1, 2022.

Because of the rule, dipping into your Roth IRA soon after you first fund it can be expensive. If you withdraw money from a Roth IRA before the waiting period has passed, you owe taxes on the earnings. You may also have to pay a penalty, which is typically an extra 10% on top of the calculated income tax.

However, this rule is all about your earnings, not your original contribution. You already pay taxes on your money before you make a contribution to your Roth IRA. So when you withdraw the funds you contributed, you don't have to pay income tax again. Let's say you put $5,000 in a Roth IRA and that less than 5 years later, you have $5,300 in the account. If you were going to withdraw all of it early, you'd be looking at paying income tax on the $300 your investment earned plus 10% penalty unless one of the IRS penalty exceptions was met. The original $5,000 that you contributed won't be subject to income tax.

You can avoid taxes and penalties on earnings from Roth IRA withdrawals by taking qualified distributions. These are defined by happening after the 5-year period and with one of these conditions: you've reached age 59½, you are disabled as defined by the IRS, the money's being distributed to a beneficiary following your death, or the money is being used for a first home purchase as defined by the IRS.

Another option is to close your account without making any withdrawals and roll over all the money into another Roth IRA. You won't incur taxes or penalties in that case because you're simply transferring the money to a different Roth IRA account without actually taking any of it out.

A Roth IRA conversion happens when you take money from one type of retirement account, such as a traditional IRA, and put it into a Roth IRA.

The money held in a traditional IRA hasn't been taxed yet. But when you convert it to a Roth IRA, you owe taxes on it immediately. That can be good in a down market because you'll be paying tax on a distribution that now has a lower value. However, the assets will grow tax deferred in the Roth IRA and potentially the earnings may be tax free in the future.

If you use money from the traditional IRA to pay the taxes, you may be subject to a 10% penalty because those funds are not considered part of the Roth conversion. You may want to consider other options for paying the IRS. Moreover, when you convert to a Roth IRA, an additional 5-year waiting period begins. You need to leave the money you converted in the account for a separate set of 5 years, unless the distribution meets one of the IRS penalty exceptions, or you could be charged the 10% penalty when you withdraw the conversion amount. This separate 5-year rule applies to each conversion you have. Figuring out whether a withdrawal is coming from a conversion or an original contribution is complicated. It's a good idea to talk with a financial advisor about your specific situation before withdrawing money so you know what the tax implications might be.

In the event of an inherited Roth IRA, you are still required to pay taxes on earnings if you take money out within 5 years of the first deposit by the original owner. However, inherited IRAs are excluded from the additional 10% penalty.

Common exceptions to the 10% penalty include:

• Age 59½
• Withdrawing up to $10,000 for a first-time home purchase
• Disability
• Distributions paid to a beneficiary
• Funding health insurance premiums if you're unemployed or disabled
• Paying unreimbursable medical expenses if they exceed 10% of your adjusted gross income
• Addressing an IRS tax levy
• Contributing to higher education expenses for either yourself or a family member

In addition to these exceptions, the Secure Act 2.0 created additional exceptions for early withdrawal in these situations:

• Anyone diagnosed with a terminal illness or medical problem that could cause death within 84 months or less has no withdrawal penalty if they pass away in that time frame or repay within three years.
• After December 27, 2020, if the plan owner's residence is located in a federally declared disaster area and they experience disaster-related economic loss, they may withdraw up to $22,000 without penalty.
• Beginning January 1, 2024, individuals experiencing domestic abuse may make hardship withdrawals of $10,000 or 50% of their vested balance, whichever is less. The withdrawal must be made within one year of the abuse and all or part must be repaid within three years to avoid penalty.
• Beginning in 2026, it's possible to withdraw $2,500 per year without penalty for long-term care contract premiums.
• Workers under age 59½ may withdraw up to $1,000 per year without penalty for emergencies and can repay within three years.
• Firefighters, corrections officers and other similar workers do not have a 10% penalty for distributions if they retire in the year they turn 50 or after and have at least 25 years of service with the employer.

You also don't have to follow the 5-year rule when you cancel a contribution. If you contribute to a Roth IRA, you can change your mind until the tax due date plus extensions for that year. Pulling out the money you contributed (plus the earnings on it) by this deadline cancels the contribution. It's like that contribution never happened, so the 5-year rule doesn't apply—however, you would need to count those earnings toward your income when you pay taxes and if you're under 59½ you'll have the 10% penalty on the earnings also.

Financial advisors can offer guidance on planning for retirement and incorporating a Roth IRA into your retirement strategy. So if you currently own a Roth IRA or if you're thinking about a Roth IRA conversion, you may want to connect with a financial advisor for help navigating these complex 5-year rules.