Roth IRA 5-year Aging Rule: From a Financial Advisor

A Roth IRA is a great way to save for retirement. You can put in money that has already been taxed. This gives you the chance for tax-free withdrawals when you retire.

Many Roth IRA owners may not know about the 5-year rule. This rule is important for deciding if earnings withdrawals are tax-free or if they face penalties. Misunderstanding this rule can result in unexpected taxes, penalties, or both.

Roth IRAs: A Brief Overview

Unlike traditional IRAs, Roth IRA contributions come from money that has already been taxed. In traditional IRAs, contributions may be tax-deductible based on your income. While you don’t get an upfront tax break, your investments can grow tax-free, and withdrawals in retirement—once qualified—can also be tax-free. Another significant advantage is that Roth IRAs don’t require minimum distributions (RMDs) during your lifetime.

One big benefit of Roth IRAs is that you can take out your contributions anytime. You don’t have to worry about taxes or penalties. However, the same flexibility does not apply to earnings. They must meet the 5-year rule to qualify for tax-free withdrawal.

What Is the 5-Year Rule?

The 5-year rule says that money in your Roth IRA must stay in the account for at least five years. This period starts from the first tax year when you made your first contribution. If earnings are withdrawn before the 5-year period is complete, the distribution is considered nonqualified, meaning it may be subject to income taxes, penalties, or both.

Once you meet the 5-year rule and turn 59½, you can take out earnings without taxes or penalties.

Important Note: The 5-year rule applies to all Roth IRAs, including inherited accounts. For inherited Roth IRAs, the clock starts based on when the original owner made their first contribution, not when the new owner inherits the account.

Special Considerations for Roth IRA Conversions

When you transfer money from a traditional IRA to a Roth IRA, there is a waiting period. This waiting period lasts for 5 years.

This rule helps determine whether you’ll face a 10% penalty on early withdrawals of the converted amount. However, penalties apply only to the taxable portion of the conversion and not to the original converted amount. Exceptions such as reaching age 59½, becoming disabled, or making a withdrawal after death may eliminate penalties.

Key Takeaway: Each Roth IRA conversion has its own 5-year rule, which starts on January 1 of the conversion year. For example, a conversion completed in 2024 begins its 5-year countdown from January 1, 2024, regardless of when during the year the conversion occurred.

Inherited Roth IRAs and the 5-Year Rule

For inherited Roth IRAs, qualified distributions require that five years have passed since the original owner’s first contribution. Even if the beneficiary is over age 59½, failure to meet the 5-year requirement could result in taxable withdrawals of earnings. However, penalties do not apply to withdrawals from inherited accounts due to the account holder’s death.

Exceptions to the 5-Year Rule

Certain situations allow for penalty-free withdrawals even if the 5-year rule isn’t met. These include:

●      Using up to $10,000 for a first-time home purchase.

●      Becoming permanently disabled.

●      Paying for qualified educational expenses.

While penalties may be avoided in these scenarios, taxes may still apply to earnings.

Roth IRA Contribution Limits and Income Restrictions

For 2024 and 2025, Roth IRA contribution limits are $7,000 ($8,000 for individuals aged 50 or older). However, your ability to contribute phases out at higher income levels. For single filers, contributions begin to phase out at $146,000 in 2024 and $150,000 in 2025. For married couples filing jointly, the phase-out starts at $240,000 in 2024 and $246,000 in 2025.

Planning for Tax-Free Retirement Income

By knowing the 5-year rule and what it means, you can avoid surprise taxes and penalties. This will help make your Roth IRA a useful part of your retirement plan. Consult a tax or financial advisor to ensure you’re managing your Roth IRA contributions and withdrawals wisely.

Sources:

https://www.fidelity.com/learning-center/personal-finance/retirement/roth-ira-5-year-rule

Disclosures:

This information is an overview and should not be considered as specific guidance or recommendations for any individual or business.

This material is provided as a courtesy and for educational purposes only.

These are the views of the author, not the named Representative or Advisory Services Network, LLC, and should not be construed as investment advice. Neither the named Representative nor Advisory Services Network, LLC gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. Please consult your Financial Advisor for further information.