Roth IRA 5-year rule: The tax-free earnings clock starts ticking at different times

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The cinema provides movie goers with certain tenets to live by. From Gremlins: "Don't feed Mogwai after midnight." From Ghostbusters, "Don't cross the streams." And definitely, "Don't talk about Fight Club." These are the rules and everyone knows them.

One rule that may be less well known is the 5-year rule for Roth IRAs. Breaking this rule won't turn your adorable pet into a gremlin, explode the molecules in your body or thrust you into an existential paradox. It can, however, be expensive.

What is the Roth IRA 5-year rule?

The 5-year rule for Roth IRA distributions stipulates that 5 years must have passed since the tax year of your first Roth IRA contribution before you can withdraw the earnings in the account tax-free.

The Roth IRA is a retirement saver's dream. Contributions to the account can be withdrawn at any time tax- and penalty-free. The earnings on contributions come out tax-free in retirement or retirees can just let it ride. No distributions are ever required.

But there is one significant caveat: the Roth IRA 5-year rule. Five years must have elapsed since the tax year of your first Roth contribution before the earnings can be withdrawn tax-free. That applies across the board to retirees, even if the account owner is 110 years old, a first-time homebuyer or in fact, dead.

The Roth IRA is a retirement saver's dream. Contributions to the account can be withdrawn at any time tax- and penalty-free.

Easy, but complicated

One common misconception about the rule is that each Roth account you own has its own clock. Not so, says CFP professional Bryan Hoover, vice president and financial adviser at Fragasso Financial Advisors in Pittsburgh.

When you can make tax-free earnings withdrawals

"It starts with the tax year you make your first Roth contribution," he says.

That means it's not necessarily a whole 5 years. A saver can contribute up to April 15 for the previous year.

"You get a bonus year and 3 months just on standard Roth IRA contributions, and again it is really on the growth," says CFP professional Peter Lazaroff, CFA, wealth manager and director of investment research at Plancorp in St. Louis.

"Be aware of when the first contribution was made. With multiple Roth accounts it only matters when the first contribution was made," he says.

What are the Roth IRA distribution rules?

Savers don't need to do anything special to ensure that only the contributions are withdrawn.

"The Roth goes by the rule, 'first-in, first-out,'" says Hoover.

That means that the money that went in first is the first to be distributed. Investors only need to worry about the 5-year rule if their withdrawal is in excess of the amount contributed, Hoover says.

The IRS decrees that Roth IRA distributions are taken in this order:

  1. Contributions.
  2. Conversions or rollover contributions.
  3. Earnings on investments.

Roth IRA conversions have their own clock

Conversions to a Roth IRA work a little differently than contributions.

The clock begins on Jan. 1 for the year in which the conversion was done.

"Each conversion has its own 5-year clock," Lazaroff says. "The way they're often done is in December, based on someone's tax situation and what the market did that year. If I do it in December 2015, the clock goes back to Jan. 1, 2015 to start."

Inherited IRAs have a 5-year clock

Inherited IRAs can have a 5-year waiting period as well, but it starts with the original account owner. If the account owner dies before 5 years have elapsed, the clock keeps going when the inheritor gets it.

Roth 401(k)s have a different clock

The Roth 401(k) is a little confusing. Like Roth conversions, each Roth 401(k) has its own 5-year clock.

"If you have a Roth 401(k), those have their own clock. If you open a new 401(k) with a new employer, that Roth 401(k) has its own clock," says Hoover.

If you move an older 401(k) to a newer 401(k) with a new employer, the old clock is the one that counts.

For most investors, the important thing to know is that there is a 5-year waiting period for tax-free withdrawals of earnings, and it is applied differently, depending on if you made Roth IRA contributions, converted a traditional IRA to a Roth, rolled over Roth 401(k) assets or inherited the Roth account.


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