If you’re one of many investors with or considering a Roth IRA, it’s important to understand the “five-year rule” works. Below is a short explanation of how the rule affects your IRA distributions.
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What is the Five-Year Roth Rule?
The five-year rule refers to a five-year period that restricts tax-free distributions on Roth IRA earnings. If a Roth IRA achieves gains in addition to contributions, distributions of those gains before the five-year waiting period AND before the account holder turns 59.5 years of age will be taxable and potentially subject to additional penalties. Similarly, funds converted from a “pre-tax” retirement plan to a Roth IRA must wait five years for tax-free distribution. The five-year period begins when the holder opens and contributes to a Roth IRA OR executes a Roth conversion. In either event, the rule takes effect January 1 of the applicable tax year. This matters because, if you time things right, your wait time can actually be reduced by a fair degree. Let’s take a look at some math to get a clearer understanding.
How to Calculate the Five-Year Roth Rule
New Roth IRA Example: If I open a Roth IRA in April 2012 (remember to backdate) and begin making annual contributions beginning in the 2011 tax year, my five-year time clock will have ended on January 1, 2016. Notice that my effective wait time was less than four years, not five. My wait period begins January 1, 2011, not April 2012.
Traditional to Roth Conversion Example: If I have an existing Traditional IRA, it’s possible for me to perform a Roth conversion. To perform this process, I pay income taxes on the converted balance to change my holdings from “pre-tax” to “post-tax.” I claim the converted amount on my tax return for the year in which I perform the conversion. Once I start this process, the five-year rule begins. As before, the later in the year I perform my conversion, the more my five-year rule becomes a four-year wait.
It’s important to note that I must perform my conversion before December 31 or the effective tax year will change. For example, to qualify for the 2012 tax year, I must complete my 2012 conversion before December 31, 2012. You cannot backdate conversions made between January 1 and April 15, 2013 to the prior year.
How Does The Rule Affect my Distributions?
The rule dictates that distributions over and above contributed or converted balances taken prior to the five-year period are taxable. See the examples below for a comparison of scenarios.
57-year-old John makes a contribution of $6,000 to his Roth IRA on April 15, 2007 for the 2006 tax year. On January 1, 2011, John decided to withdraw $8,000 from his Roth IRA. Of the $8,000 that John withdraws, $6,000 is principal contribution and $2,000 is earnings.
Results: Since John is now over the age of 59.5 and his five-year rule has expired (Jan 1, 2006 – Jan 1, 2011), the entire distribution is qualified for a tax-free distribution and isn’t included as taxable income. In the example above, John made a profit of $2,000 over a period of almost four years, but because his first contribution in the Roth IRA was dated back to January 1, 2006, his wait for tax-free distributions was considerably shorter than five years.
**Note that he was over the required age of 59.5 for tax-free distributions as well.
Ramifications of Early Distributions
Now let’s look at the same example if John takes his distribution after only three years of participating in a Roth IRA:
John, at 57 years of age, makes a contribution of $6,000 to his Roth IRA on April 15, 2007, for the tax year of 2006. On January 1, 2009, John decided to withdraw $8,000 from his Roth IRA. Of the $8,000 that John withdraws, $6,000 is principal contribution and $2,000 is earnings. Even though John is now over the age of 59.5, his distribution on the earnings is being taken out of the account before the five-year rule expires. $2,000 of his distribution must be claimed as taxable income on his tax return.
Results: After age 59.5 and once the five-year holding period is met, any distribution from the Roth IRA will be considered a qualified distribution and be tax free. Remember that each conversion from a pre-tax IRA will start its own individual five-year waiting period. You may consider keeping any conversions and/or contribution accounts separated in different Roth IRAs for organization purposes.
Reach Out With Your Questions
Current NDTCO clients are encouraged to reach out with their questions or concerns by sending secure messages through the Client Portal. Anyone curious about Roth IRAs or self-directed investing are welcome to give our office a call at 877-742-1270.