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The 5-Year Rule and Roth IRAs

The 5-Year Rule and Roth IRAs

January 22, 2024

Roth IRA’s and the 5-year Rule

INTRODUCTION

You probably know that Roth IRAs are funded with after-tax money that can be withdrawn tax free in retirement, however, you may not know some of the nuances of distributions from a Roth IRA. You should be aware of 5-year rules and how it may affect your distribution.

To begin, I will briefly touch on the basics of what an IRA is. IRA stands for “individual retirement account”. The two most common types of IRA’s are Traditional and Roth. Traditional IRAs are funded using income that does not get taxed until it is withdrawn after age 59.5 and Roth IRAs are funded using income that you have already paid taxes on so that you can make withdrawals that are completely tax free in retirement. This of course is over simplified and excludes many of the important nuances of these accounts, however a full review is not in the purview of this article, so if you would like more information, please leave a comment or shoot me an email and I would be glad to dig into the nitty gritty of these accounts with you.

THE 5 YEAR RULE

When discovering how and when you can take tax free and or penalty free withdrawals, you first need to consider your age. If you are 59.5 or older you will never pay a 10% penalty on any type of Roth IRA withdrawal, but you still may pay taxes on earnings1. If your Roth IRA was opened in the last 5 years, then you will need to pay regular income taxes on earnings2. Notice that you will only need to pay taxes on earnings not on contributions. Paying extra income tax can have a significant impact on retirement, especially if are trying to stay under the threshold of provisional income for social security.

If you are under the age of 59.5 and you take a distribution from a Roth IRA that has been open for less than 5 years you will be subject to a 10% penalty and taxes on any earnings you withdraw3. Note that you will never be taxed or penalized on the contributions that you have made to the Roth, only the earnings could be subject to taxes or penalties. If you have had your Roth more than 5 years and are under 59.5 you can distribute earnings penalty free, but not tax free unless special circumstances arise like a first-time home purchase*.

THE 5 YEAR RULE FOR CONVERSIONS

When a Roth was funded via IRA conversion, this 5-year rule differs from the 5-year rule for contributions and earnings. For those funds that have entered a Roth via conversion you must wait 5 years from the time the money entered the account rather than five years from the date the account was opened4. This rule states that if you are under 59.5 and take a distribution from a conversion that was made less than 5 years ago, you will be subject to a 10% penalty. This rule does not apply if you take the distribution over the age of 59.5.

CONTRIBUTIONS, CONVERSIONS, AND EARNINGS

With all the distinct aspects of withdrawing contributions, conversions, and earnings, a natural question occurs, “How do I know whether I am withdrawing contributions, conversions or earnings?” This is a great question and has a relatively simple answer. The first funds to come out of a Roth are always Contributions, followed by conversions, and finally earnings. For example, if you have a Roth in

which you have contributed $50,000 over the years, also 3 years ago you converted $100,000 from your Traditional IRA, and finally you have another $75,000 of earnings. If you were to withdraw $80,000 from this account, the first $50,000 would be considered a withdrawal of contributions and would never be subject to taxes or penalties. The next $30,000 of your $80,000 withdrawal would be a withdrawal of converted funds which could be subject to the 5-year rule if you are under 59.5.

CONCLUSION

There are many factors to consider prior to withdrawing money from a Roth IRA Make sure you are clear on the potential tax or penalty that you may incur from taking a distribution. implications of what you are doing. My intent on writing this article is to make you aware of some of the issues you should consider prior to any distributions from a Roth IRA. Please consult your Financial Advisor or a tax advisor so you can make an educated decision.


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OneAscent Financial Services, LLC (“OAFS”), d/b/a The Cornerstone Financial Group, is a registered investment adviser with the United States Securities and Exchange Commission. OAFS does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by OAFS or any unaffiliated third party. OAFS is neither an attorney nor accountant, and no portion of the presented content should be interpreted as legal, accounting, or tax advice. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly

Endnotes

*You can withdrawal up to $10,000 from a Roth IRA for a first-time home purchase without tax on earnings. 1Taylor, J. (2023, June 24). Two five-year rules for Roth IRAS: Kiplinger Tax Letter. Kiplinger.com. https://www.kiplinger.com/taxes/five-year-rule-on-roth-ira-contributions-and-payouts-kiplinger-tax-letter#:~:text=1.,contributed%20to%20a%20Roth%20IRA. 2Hartill, R. (2023, February 22). Do you pay taxes on Roth IRA capital gains?. The Balance. https://www.thebalancemoney.com/do-you-pay-taxes-on-roth-ira-capital-gains-5223086#:~:text=Roth%20IRAs%20Don’t%20Tax%20Any%20Gains,-Your%20Roth%20IRA&text=But%20if%20you%20tap%20into,penalty%20on%20the%20earnings%20portion. 3Schwab.com. (n.d.). Roth IRA withdrawal rules. Schwab Brokerage. https://www.schwab.com/ira/roth-ira/withdrawal-rules#:~:text=If%20you’re%20under%20age,become%20disabled%20or%20pass%20away. 4Viewpoints, F. (2023, November 28). What is the Roth IRA 5-year rule and how does it work? https://www.fidelity.com/learning-center/personal-finance/retirement/roth-ira-5-year-rule 5Distributions after a Roth IRA conversion -. Fairmark.com. (2023, April 17). https://fairmark.com/retirement/roth-accounts/roth-distributions/distributions-after-a-roth-ira-conversion/#:~:text=The%20first%20distributions%20you%20take,your%20distrib