What to Know About the Five-Year Rule for Roths

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A note from Charles Schwab this month about Roth IRA’s and the five-year rule…

There are actually several versions of the five-year rule governing Roth accounts, some of which overlap, and falling afoul of any of them could trigger additional taxes and penalties.

If your investing and tax strategy for retirement includes tax-advantaged Roth accounts, you’ve probably heard about the IRS’s five-year rule.

The simple version says the Roth account needs to have been funded for five years before you withdraw any earnings—even after you’ve reached age 59½—or you could owe taxes. In addition, nonqualified withdrawals before that age could also trigger a 10% penalty.

What may come as a surprise to Roth investors is that there are actually several versions of the five-year rule, some of which overlap, governing not just contribution start dates, but also rollovers and conversions. Here are the five-year rules to be aware of…

  • Roth IRA five-year contribution rule
  • Roth conversion five-year rule
  • Five-year rule for Designated Roth accounts
  • Roth-to-Roth rollover five-year rules

Falling afoul of any of them could trigger additional taxes and penalties. Paying unnecessary taxes or penalties would undercut the rationale for having a Roth in the first place, so it’s important to understand how the various holding periods work.

Roth IRA five-year contribution rule

This is perhaps the most familiar holding period and determines whether earnings are taxed. As mentioned, if earnings are withdrawn before the five-year contribution rule is met, taxes will apply to those earnings (plus a 10% penalty on earnings if taken before age 59½).

Any money going into the account—regular contribution, conversion, or rollover—sets the clock ticking. But it’s not measured from the date the first dollar lands in the account. Instead, the holding period back dates to January 1 of the year of the first contribution, conversion, or rollover.

You are also allowed to make contributions to a Roth IRA for the prior tax year up until Tax Day, which would move the start of the five-year holding period for prior-year contributions back to the previousJanuary. (Keep in mind that this applies only to contributions, not conversions or rollovers.) In other words, even a standard five-year holding period could end up being a little less than that, depending on the timing.

Finally, the first contribution to any Roth IRA starts the clock for all your Roth IRAs, including those you open in the future. So, investors interested in Roth strategies should consider opening and funding a Roth IRA as soon as they can.

Examples

Marcus, 55, opens a Roth IRA with a $1 contribution in late December. The clock for the account’s five-year holding period is January 1 of that year. As a result, Marcus’s Roth IRA will have met the five-year rule in about four years.

Sally, 57, opens a Roth IRA with a $1 contribution on April 14, but designates the contribution as being for the previous tax year. That pushes her start clock back to January 1 of the previous year. As a result, Sally’s Roth IRA will have met the five-year rule in a little more than three-and-a-half years.

Roth conversion five-year rule

This is a completely separate five-year rule covering Roth IRA conversions from a traditional IRA or 401(k). Importantly, each Roth conversion has its own five-year holding period, which starts on January 1 of the year in which the conversion occurs.

Under this rule, if you withdraw converted funds before age 59½, you will generally have to pay a 10% penalty on the any pre-tax assets that were converted—not just the earnings—as well as income taxes on the earnings. It doesn’t matter if you have already met the five-year Roth contribution rule.

After age 59½, you can withdraw converted funds without a 10% penalty. But remember, the five-year contribution rule (mentioned above) still applies—if that rule hasn’t been met, taxes may apply for the earnings portion of the withdrawal.

So, how do you know whether you’re taking a withdrawal of contributions, conversions, or earnings? For Roth IRAs, the IRS assumes you’re taking out contributions first, followed by converted balances (on a first-in, first-out basis, so oldest conversions first), and then earnings last. However, this can get complicated, especially if you have a mix of funds in your account, so be sure to work with a tax or wealth management professional.

Examples

Brenda, 55, converts $10,000 of pre-tax traditional IRA funds into a Roth IRA. Two years later, she withdraws $6,000. However, because she hasn’t met the five-year conversion holding period and is under age 59½, the entire sum is subject to the 10% early withdrawal penalty.

Susan, 58, decides to convert $7,000 of pre-tax traditional IRA funds into a Roth IRA. It is her first Roth account. At age 61, the Roth account has grown to $11,000 and she decides to withdraw the entire amount thinking she can do so tax free since she’s older than age 59½. However, because she hasn’t met the five-year rule for Roth contributions, the earnings on the withdrawal will be taxable, but she won’t be subject to the 10% penalty since she is over age 59½.

Five-year rule for Designated Roth accounts (e.g. Roth 401(k), Roth 403(b), or Roth 457(b) plans)

While these employer-sponsored plans offer similar tax benefits to a Roth IRA, the holding periods work a little differently.

Like with a Roth IRA, the five-year holding period starts on January 1 of the year for which you make your first contribution. However, unlike with Roth IRAs, if you participate in multiple employer-sponsored plans that have Designated Roth accounts, each plan will have its own five-year holding period.

More significantly, with a Designated Roth, you don’t have the option of tapping just contributions before the fifth year—thereby avoiding the five-year rule for contributions— as you would with a Roth IRA. Instead, the IRS will assume that any withdrawal is a mix of both contributions and earnings—which could trigger taxes on the earnings portion (and a 10% penalty if you’re under 59½).

To determine how much of a distribution would be taxable, you would use the pro rata rule to calculate the ratio of contributions versus earnings in the account, and then multiply your distribution by that ratio to determine the taxable portion of the distribution.

Example

When Sam was age 58, he contributed $20,000 to a Roth 401(k). At age 61, Sam is now retired and the Roth account is worth $23,000, and he decides to withdraw $10,000. Since the account hasn’t met the five-year contribution holding period, the pro rata rule will apply, meaning the distribution will be considered part contribution and part earnings. Because Sam is over age 59½, there is no 10% penalty on the distribution, however, the earnings portion of the withdrawal will be subject to taxes.

Roth-to-Roth rollover five-year rules

Believe it or not, rolling Roth assets from one account to another Roth account involves still more applications of the five-year rule. Here are the basics…

  • Roth IRA rolled over to another Roth IRA: As mentioned above, the first contribution to any Roth IRA starts the five-year clock for all Roth IRAs. So, if the five-year contribution rule has been met for one Roth IRA, it applies to all the others.
  • Designated Roth account rolled over to a Roth IRA (e.g., Roth 401(k) to Roth IRA): The holding period for the Roth IRA account determines whether the five-year contribution rule has been met. The holding period of the designated Roth account doesn’t matter. So, if you rolled assets from a Roth 401(k) that had met the five-year contribution rule into a Roth IRA that did not meet the five-year contribution rule, the Roth IRA’s holding period would apply to all assets that were rolled over. Note: Not all employer plans allow in-plan rollovers, so consult with your plan sponsor and/or administrator to confirm if this option is available.
  • Designated Roth account rolled over to another Designated Roth account (e.g., Roth 401(k) to Roth 401(k)): Generally, the five-year holding period is based on whichever account is older. For example, if you transferred all the assets from a 10-year-old Roth 401(k) from your last employer to a new Roth 401(k) with your current employer, the older Roth would determine the holding period for all the assets in the new Roth 401(k). Note: Not all employer plans allow in-plan rollovers, consult with your plan sponsor and/or administrator to confirm if this option is available.

Bottom line

If tax-free distributions are an attractive idea to you, then consider adding a Roth IRA as part of your wealth management plan. The sooner you open and fund a Roth IRA, the sooner you have the 5-year Roth contribution clock ticking. Again, talk with a planning or tax professional if you have questions.

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