The Roth IRA 5 Year Rule

What's the Roth IRA 5 year rule?

This is a common question, and you need to know whether you're in your early 20's and just opening a Roth IRA or you're in your late 60's and looking to withdraw some retirement funds.

Why do you need to know the Roth IRA 5 year rule?

Because regardless of whether or not you've reached age 59 ½ yet, the IRS requires your Roth IRA meet one additional criteria before you can withdraw investment gains tax-free and penalty-free. And that, of course, is the point of a Roth IRA, right? ...To withdraw investment gains tax-free and penalty free.

So what's that one additional criteria you need to meet before getting your hands on tax-free, penalty-free investment gains?

You guessed it... It's called the Roth IRA 5 year rule.

So what exactly is this Roth IRA 5 year rule you've heard about? How does it work? And what do you need to know about it?

Keep reading, and you'll get all the answers you're looking for...

The Roth IRA 5 Year Holding Period

The heart and soul of the Roth IRA 5 year rule is the five year holding period.

So what's this five year holding period?

It's almost like a maturation date. Essentially, once you open and fund a Roth IRA, a clock starts ticking. Five years later, your Roth IRA is in compliance with the 5 year rule, and you get to enjoy all the benefits associated with meeting that requirement.

Now, notice the phrase "and fund." The emphasis isn't just because I got crazy with the bold and italicize buttons (although I do tend to go overboard sometimes).

The emphasis means it's important to remember, because you can't get the clock ticking by simply signing up for a Roth IRA and opening an account. You also need to fund the account. Once you fund your Roth IRA, you set the clock ticking in motion.

So why mention the distinction between open and fund?

Because if you open your account in one tax year, but wait to fund it in the following tax year, you might inadvertently miscalculate your Roth IRA's compliance with the Roth IRA 5 year rule.

For example, let's say you set up a Roth IRA account with an online discount broker on April 1, 2009. You do so knowing that you have until April 15, 2009 to make a contribution for the 2008 tax year. If you deposit money into the account (thus funding the account) by April 15, then your Roth IRA 5 year rule clock starts ticking in the 2008 tax year. But if you don't deposit your money until April 16, 2009 or later, then your Roth IRA 5 year rule clock starts ticking in the 2009 tax year.

Got that?

It's an important concept to grasp when it comes to funding your Roth IRA...

The actual year in which you make a Roth IRA contribution is not always the same as the tax year in which you make your contribution.

The IRS makes a clear distinction between the two, so you need to know the difference.

5 Tax Years, Not 5 Actual Years

The first day of the tax year in which the Roth IRA account is opened and funded is the day your Roth IRA 5 year rule clock starts ticking.

So regardless of what day and month you open and fund your Roth IRA, the clock starts in January.

For instance, say you open and fund your Roth IRA on December 15, 2009. The clock starts ticking in January 2009, not December 2009. So you meet the Roth IRA 5 year rule requirement in January 2014.

Let's look at another scenario...

Say you open and fund your Roth IRA on March 15, 2010. You make a contribution for the 2009 tax year, which you can do prior to April 15th (the tax filing deadline). Even though you opened and funded your Roth IRA in the actual year 2010, the Roth IRA 5 year rule clock starts ticking in the tax year January 2009.

Why?

Because you made a Roth IRA contribution toward the 2009 tax year.

See now why it's five tax years and not five actual years?

If you're in your early 20's and opening a Roth IRA, knowing this distinction isn't as important. But what if you're 55 or older? What if you're nearing retirement?

That's when it becomes really important to know the difference...

The 5 Year Rule on Roth Conversions

Why is it important to know the distinction between the actual year and the tax year when it comes to your Roth IRA's 5 year rule requirement?

Because knowing the difference can save you thousands of dollars and a lot of headaches.

How?

Here's how... Since Roth IRA's didn't exist prior to 1997, most people nearing retirement now invested in alternative vehicles such as a 401k or a Traditional IRA. Now, financial professionals are advising a lot of those people to convert their Traditional IRA to a Roth IRA.

As a result, you might be 59 ½ or older with a well-funded Roth IRA... A Roth IRA which has yet to meet the 5 year rule requirement.

If that's the case, you need to understand exactly when you meet the Roth IRA 5 year rule.

Why?

Because not understanding can cost you a 10% penalty plus income taxes on any investment gains you withdraw "early" as a result of a miscalculation.

When you covert a Traditional IRA or another retirement account to a Roth IRA, the conversion event is treated in the same manner as if you opened and funded your Roth IRA at that moment. So the 5 year rule clock starts ticking in January of the tax year in which the Roth conversion takes place.

Need an example?

Let's say it's 2008, you're 58 years old and you have a Traditional IRA with a balance of $200,000. You decide to convert your Traditional IRA to a Roth IRA.

After paying the applicable income taxes, you end up with $160,000 in a Roth IRA (don't get confused by the dollar figure, it's just an example... your individual tax liability will vary).

In 2010, you're 60 years old, and you decide to withdraw funds... What happens?

Well, you can always withdraw your original contributions tax-free and penalty-free... So that's not a problem.

But if you want to withdraw investment gains, you'll owe income taxes and a 10% Roth IRA early withdrawal penalty.

Why?

Because, even though you're older than 59 ½, your account hasn't met the Roth IRA 5 year rule requirement.

When does it meet the requirement?

January 2013.

Why?

Because you made the Roth IRA conversion in the 2008 tax year, the 5 year rule clock started ticking in January 2008.

Five tax years must pass... 2008... 2009... 2010... 2011... 2012... Five tax years later, it's January 2013.

At that time, your five year holding period is over, you're older than 59 ½, and you're home free! Withdrawals from your Roth IRA are now tax-free and penalty-free.

Now, here's a very important point...

The 5 year clock starts ticking in January of the tax year of your Roth conversion even if you already have a Roth IRA...

So if you opened and funded a Roth IRA in 1997 or 2003, even though your Roth IRA meets the 5 year rule, a new 5 year clock starts ticking for each Traditional IRA or similar retirement account converted to a Roth IRA.

Each conversion is independently subject to the 5 year rule.

Need an example?

Let's say it's 2010 and you're 60 years old...

You opened and funded a Roth IRA in 2000.

In 2003, you converted a Traditional IRA to a Roth IRA, and in 2007, you converted a separate Traditional IRA to a Roth IRA.

In this case, you can withdraw investment gains tax-free and penalty-free from the original Roth IRA as well as the first conversion. But if you withdraw investment gains from the second conversion, those gains are subject to income taxes and a 10% early withdrawal penalty.

Why?

Because you're over the age of 59 ½ and your original IRA and your first conversion have both been open and funded for more than five tax years.

But the second conversion doesn't meet the 5 year rule yet. It's only been open for four years... 2007... 2008... 2009... and 2010. 2011 will be the fifth tax year, meaning you can finally withdraw investment gains from the second conversion tax-free and penalty-free in January 2012.

Exceptions to the Roth IRA 5 Year Rule

Are there exceptions to the Roth IRA 5 year rule?

Yes.

There are cases where the 5 year holding period is waived.

Below are eight (8) such instances in which Roth IRA withdrawals are tax-free and/or penalty-free prior to meeting the 5 year rule requirement (as well as the 59 ½ year age requirement)...

1) Death - The five year holding period is waived if you die and your beneficiary closes your Roth IRA. Apparently, the IRS finds it highly unlikely you'll hatch a conspiracy to die in order to avoid the Roth IRA 5 year holding period. As a result, your beneficiaries can withdraw funds tax-free without penalty.

2) Disability - If you become disabled according to the definition outlined in IRS Code Section 72(m)(7) and IRS Publication 590, you can withdraw investment gains from your Roth IRA tax-free and penalty-free prior to meeting the 5 year holding period. However, double-check with a tax attorney or another financial professional in order to verify that you meet the IRS definition of "disabled." The last thing you need if you've recently become disabled is an unexpected bill from the IRS!

3) Purchase of a First Home - If you withdraw investment gains to pay for the cost of purchasing a first home for yourself, your spouse, your children, and/or your children's descendants, you can take a tax-free, penalty-free distribution from your Roth IRA prior to meeting the 5 year rule.

4) Higher Education Expenses - You can withdraw investment gains from your Roth IRA prior to the end of your 5 year holding period if you're using the funds to pay for qualified higher education expenses for yourself, your spouse, your child, and/or any descendant of your child. But remember, doing so only waives the 10% early withdrawal penalty. You still owe income taxes on investment gains withdrawn early for this purpose.

5) Substantially Equal Periodic Payments - If you receive a series of "substantially equal periodic payments" based on your current life expectancy, you can avoid the 5 year holding period. But remember, doing so only waives the 10% early withdrawal penalty. You still owe income taxes on investment gains withdrawn early for this purpose.

6) Unreimbursed Medical Expenses - If you withdraw investment gains to pay for unreimbursed medical expenses which exceed 7.5% of your adjusted gross income (AGI), then you aren't required to meet the 5 year rule in order to avoid a 10% early withdrawal penalty. However, any investment gains withdrawn are still subject to applicable income taxes.

5) Medical Insurance Premiums - If you withdraw Roth IRA investment gains to pay for medical insurance premiums after receiving unemployment benefits for more than 12 weeks, you don't have to worry about the 5 year rule. However, any investment gains withdrawn are still subject to applicable income taxes.

6) Payment of Back Taxes - If you withdraw investment gains from your Roth IRA in order to pay back taxes as a result of an IRS levy placed against you, then you don't have to worry about meeting the 5 year rule. However, any investment gains withdrawn are still subject to applicable income taxes.