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What is the Roth 5 Year Rule?
In order to harness the full potential of a Roth account you’ll want to have a good grasp of the “5 year rule” so you can plan accordingly.
This 5 year holding requirement must be met in order to have a “qualified distribution” that allows you to take your investment earnings out tax-free. Tax-free growth on your investments is the main benefit of utilizing a Roth IRA or Roth 401(k).
Roth accounts can also be subject to a 10% early withdrawal penalty on earnings (or principal if a Roth conversion) if you don’t meet certain criteria. There are some inherent complexities with the 5-year rule, particularly when it comes to Roth contributions vs. Roth conversions. Here we will explain the rule in full detail and give you situational examples to help you navigate your situation correctly.
Requirements for tax and penalty-free withdrawals
- You must be over age 59 1/2.
OR
- A distribution is made due to death, disability, or under the first-time home-buyer rules.
AND
- You must have held the Roth IRA or Roth 401(k) for at least 5 tax-years since your first contribution or first conversion.
When does the Roth 5-Year clock start?
The first caveat you need to be aware of is that there are two separate 5-year clocks! – one for Roth contributions and one for Roth conversions.
For contributions, the 5-year rule determines whether or not earnings can come out tax-free; While the other 5-year clock for conversions determines whether or not the principal is penalty-free.
Your 5-year clock starts whenever you first make any contribution or conversion to a Roth IRA or Roth 401(k). However, the 5-year clock on a Roth 401(k) will NOT carry over if you roll it out to a Roth IRA, even if you had the Roth 401(k) for 5 years. I discuss the different ways a rollover situation can play out later in the article.
To illustrate the timing of the different 5-year clocks here are a few examples:
If you contribute to a newly established Roth IRA in June of 2019, your 5-year clock started January 1st, 2019. You actually have until tax-filing date in April of the following year (2020) to contribute, therefore if you make your first new Roth contribution instead on April 1st, 2020, your clock will still have started on January 1st, 2019.
If you convert from a traditional (pre-tax) account like a regular IRA or 401(k) to a Roth IRA, that conversion amount will have its own 5-year clock and the rules are slightly different. If you convert in June of 2019, your 5-year clock started January 1st, 2019 for that converted dollar amount. But if you convert in April of 2020, your clock will have started January 1st, 2020. The conversions go by the calendar year in which you actually made the conversion.
Planning Tips: When it comes to the 5-year clock, all Roth IRAs are aggregated and the clock will be based off the earliest Roth account established and contributed to. For example, you could have a total of three Roth IRAs and if you contributed to just one of them 15 years ago, the 5-year clock for all of your Roth IRAs is met.
This is not the same for Roth 401(k)s. For Roth 401(k)s, each plan has its own 5-year rule. If you roll one Roth 401(k) from one plan to another employer’s Roth 401(k), the rule is based on whichever has been around longer – Best to work with a professional on this one.
If you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA.
Next we will look at some examples to help you determine the outcome of withdrawals, or any planning strategies you may be considering.
Under Age 59 1/2 Situational Examples
You are under 59 1/2 and have met the Roth 5 year rule:
All earnings are subject to taxes and penalty. Taxes and penalties can be avoided if earnings are used for first-time home purchase, death, or disability.
You are under 59 1/2 and have not met the Roth 5 year rule:
All earnings are subject to tax and penalty. You can possibly avoid just the penalty if you are disabled, use earnings for first-time home purchase, qualified education expenses, unreimbursed medical expenses, or upon death.
You are under 59 1/2 and have met the 5 year rule in Roth 401(k):
If you met the 5-year clock in your Roth 401(k) before rolling it out and are under 59 1/2, your rollover is not a “qualified distribution”. Meaning that if you had $50,000 in contributions to your Roth 401(k) and another $10,000 in earnings, then roll it to a Roth IRA, the amount you can withdrawal tax and penalty-free is still your contribution amount (basis) of $50,000.
The $10,000 in earnings would be subject to both taxation and the 10% early withdrawal. This is because you are not 59 1/2 (or disabled) yet and you just started a new 5-year clock. Now you will have to wait to satisfy both to tap that $10,000 and any additional earnings going forward without taxes and penalties.
You are under age 59 1/2 and have converted funds to any Roth IRA:
You will pay taxes on the converted amount, and it will start its own 5-year clock. Immediately after conversion you can take out the amount converted (principal) tax-free since you already paid it. However, the entire principal amount would be subject to a 10% penalty if withdrawn before 5 years from conversion.
If you wait 5 years after you convert, then you can tap all of that principal with no taxes or penalties. This essentially can give you access to IRA funds earlier than 59 1/2 but you still have to wait an additional 5 years.
Any earnings made after conversion in this situation would be subject to the normal contribution rules. This means that you would need to wait until 59 1/2 to get those out tax and penalty-free.
Imagine you convert $60,000 total from a Traditional IRA or 401(k) to a Roth IRA. Your contributions make up $50,000 and your earnings make up $10,000. You pay tax on the entire amount in the year you convert.
You can take any amount of this $60,000 out tax-free at this point but you would owe the 10% penalty any amount taken before 5 years. However, if you wait 5-years from the conversion year, you can now take this same $60,000 out penalty and tax free.
Since you have waited 5 years, you may have another gain of $10,000 for example, since the day you converted. That $10,000 in gains is subject to the contribution rules, and in this case would be subject to taxes and penalty if taken before you reach 59 1/2.
Over Age 59 1/2 Situational Examples
You are over 59 1/2 and have met the Roth 5 year rule:
All money comes out tax and penalty free.
You are over 59 1/2 but have not met the Roth 5 year rule:
No 10% early withdrawal penalty on the earnings withdrawn, but will pay income tax on earnings.
You are over 59 1/2 and have met the 5 year rule in Roth 401(k):
This situation confuses almost everyone! If you roll out into a Roth IRA in this situation, this would be a “qualified distribution” – meaning your basis in the new Roth IRA (amount you can get out tax and penalty-free) is the entire amount your rolled over! But remember the new Roth IRA starts a new clock – meaning any growth/earnings made after the rollover would be subject to the 5-year rule in order to take those out tax-free.
Therefore, if you have $50,000 in contributions and $10,000 in earnings in the Roth 401(k) that you roll to the brand-new Roth IRA, you can then take out that entire amount penalty and tax-free! But if you rolled it over and let it earn another $15,000, that $15,000 is subject to the new clock.
You are over age 59 1/2 and have converted funds to any Roth IRA:
You will pay taxes upon conversion. In this exact situation the 5-year clock for conversions will not affect you! Yes, that conversion amount gets its own new 5-year clock but it essentially doesn’t matter. The reason is that upon conversion you will pay all taxes due on principal and earnings (as always with a conversion from pre-tax accounts), and the fact that you are already over 59 1/2 means you have met the exception for the 10% early withdrawal penalty.
Roth 401(k) Rollover Situational Examples
You had a Roth 401(k) balance and subsequently roll it to a new Roth IRA:
That Roth IRA will have its own new 5-year clock. As mentioned previously, it doesn’t necessarily matter how long you owned your Roth 401(k), its clock won’t carry over. Here are some caveats to this exact situation:
You had a Roth 401(k) balance and subsequently roll it to an existing Roth IRA:
If the money is rolled from your Roth 401(k) into an existing Roth IRA, you would not have to start a new 5-year clock as it will be based off of your current Roth IRA clock. If you are over 59 1/2 and met the 5-year clock in your Roth 401(k), and roll it to an existing Roth IRA that has also satisfied the 5-year clock, then you won’t have to worry about any taxes or penalties at all going forward.
Why roll your Roth 401(k) to a Roth IRA?
There are a couple potential benefits that become available to you by rolling your Roth 401(k) to a Roth IRA. The main reason being that Roth IRAs are not subject to required minimum distributions (RMD) at age 72!
A required minimum distribution is essentially a minimum amount that a retirement account owner must withdrawal from their accounts by April 1st of the year following the year they reach age 72. You can take your first RMD in the year you turn 72 in order to avoid taking two RMDs in the following year after you turn 72. Please consult your advisors to see what’s best for you.
Planning Tips: Prior to January 1, 2020 the RMD age was 70 1/2. This means if you reached age 70 1/2 in 2019 you are still “grandfathered” into the old rules and you must begin taking your RMDs.
Your first RMD would have needed to be taken in 2019, or by April 1st of 2020 unless you waived your 2020 RMD under CARES Act regulations. If you did waive your RMD in 2020, your first RMD needed to come out in 2021.
One thing most people don’t know is that Roth 401(k) accounts do have required minimum distributions (RMD). In this case the Roth 401(k) distribution would not be taxed but you still have to take a minimum amount out. Go figure…
Another potential advantage of rolling to a Roth IRA is that you will likely have access to many more investment options as opposed to what was offered in your employer’s 401(k). There are certain investments 401(k)s cannot own or likely won’t be included due to certain risk-factors or plan limitations.
Keep in mind there are some potential benefit to leaving money in a 401(k) plan and weighing the pros and cons for your exact situation is critical. Speak with your advisors to see what is best for you.
The bottom line
As if your brain isn’t in a pretzel already, here are some quick takeaways and tips:
- Remember, for contributions the 5-year rule determines whether or not earnings can come out tax-free; While the other 5-year clock for conversions determines whether or not the principal is penalty-free.
- Deemed order of withdrawals – When you make a withdrawal from a Roth IRA, the IRS will assume the following order: After-tax contributions first, conversions second (if multiple, earliest conversion first, and so on), and earnings last. It is important to know that there is no reporting from your investment custodian that will report this. You will need to keep track on your own.
- You may want to consider opening new Roth IRAs for each conversion you do if you plan to do multiple. Creating multiple Roth IRAs isn’t required, but it can help you keep track of where each conversion is in its own 5-year clock.
- Remember that if you are already RMD age and plan on making Roth conversions, you must take your RMD before converting any amount to a Roth IRA. This means that you will recognize additional taxable income from your traditional IRA above and beyond the conversion amount. Do not forget to account for this in your planning strategies!
- Depending on your financial plan, it may be useful for you to just open a Roth IRA ASAP, even if it is with a mere $100. This way you get your clock running.
- If you don’t qualify for a Roth IRA, no worries. In order to get your Roth IRA clock started, either convert a small amount from your traditional accounts, or make a non-deductible contribution to a traditional IRA then later convert it to a Roth IRA. This is also known as the Back-Door Roth IRA strategy. Please consult your tax and financial advisors before implementing this strategy on your own.
- Save this article to refer back to when needed, and check out the blog at Planable Wealth for more actionable financial planning tips!
Last Updated 10/10/2021
Cameron Valadez is a CERTIFIED FINANCIAL PLANNER™ located in Riverside and Orange County, CA.
Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, and CFP® in the U.S., which it awards to individuals who successfully complete CFP Board’s initial and ongoing certification requirements.
Cameron Valadez does not provide tax advice. This is meant for educational purposes only. It should not be considered specific legal, tax or other professional advice, nor does it constitute a recommendation to take a particular course of action. Please consult with a tax advisor and other financial professionals regarding your personal situation prior to making any financial related decisions.
Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA.
This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific tax issues with a qualified tax or legal advisor.