What is the Roth IRA 5-Year Rule?

roth ira

Retirement plans are not a one size fits all deal. There are many different options for saving, investing, and insuring your golden years. The Roth IRA has been a longtime favorite for retirement savings because of the tax-free withdrawals people can enjoy during retirement. But as with any kind of tax break, it is important to pay close attention to the fine print. Not every withdrawal from your Roth IRA will be tax-free. Many people with a Roth IRA don’t know about the five-year rule. This rule requires those holding a Roth IRA to wait five years before making tax-free withdrawals from their investment earnings. Before you consider investing in a Roth IRA, you need to know how the five-year rule is applied and how it will impact you as an investor.

Once you make your first Roth IRA contribution, you will need to wait five tax years before you can withdrawal your earnings from this account without being subject to taxes. This five-year period applies across the board no matter the status of the account owner. If the owner were to pass away, the beneficiary would also be expected to wait the full five-year waiting period before taking out any earnings tax-free. It is important to note that the five-year rule only applies to investing earnings, not direct contributions. Any money you put directly into your Roth IRA is considered an after-tax contribution and is available to take out before the five-year waiting period is over. You can always remove direct contributions, but the earnings you make off of these contributions must follow the five-year rule.

Even after five years have passed, you will still need to meet specific criteria to make a tax-free withdrawal. To avoid taxes and penalties, you must be age 59 ½ or older to withdrawal earnings from your Roth IRA. There are some circumstances that may allow you to make early withdrawals from the account without penalty. If you are disabled or intend to use the withdrawal for a big life circumstance, like buying your first home, you may be able to take a distribution without paying taxes or fees. Inherited Roth IRAs still follow the five-year rule from the date of the original account owner’s first contribution, not the date of inheritance.

The five-year period goes by tax years, not calendar years. This means you could make a contribution on the last day of a tax year (the day before your income taxes are due) and the contribution will count for the previous calendar year. This can shorten the waiting time to make a tax-free withdrawal by one year. For instance, if you make a contribution to your Roth IRA the day before your taxes are due in 2020, the contribution will count toward your 2019 tax year. Therefore, you will be eligible to make a tax free withdrawal of earnings in 2024 instead of 2025.

The clock starts with your first contribution to any Roth IRA. Once you get through the five-year requirement for one Roth IRA, any additional Roth IRAs will also be considered “on hold” for five years. Since the five-year waiting period can be applied across other accounts, the earlier you start contributing to a Roth IRA, the less likely you are of running into problems with the five-year rule. Start making contributions well before you plan on needing to make a withdrawal.

A Roth IRA is a great way to save for retirement. Understanding the tax rules surrounding your Roth IRA can help you make the most of your contributions.

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