The Roth IRA is probably the most readily available tax shelter that almost all Americans can take advantage of. However, in order to fully take advantage of the tax-free benefits of the plan, understanding the Roth IRA rules is crucial.  In order for Roth IRA distributions to be tax-free the plan owner must be over the age of 59 1/2 and any Roth must have been opened and funded for at least five years.  This article will explore in detail the nuts and bolts surrounding the Roth IRA five-year rule.

Roth IRA Basics

The Roth IRA was created by the late Senator William Roth of Delaware in 1997. It is an after-tax IRA, which unlike a traditional IRA, does not offer an immediate tax deduction when contributing. Instead, a Roth is funded with after-tax money, and all qualified distributions are tax free, including earnings generated by your investments. Contributions can be withdrawn at any time without tax or penalty. Contribution limits for a Roth are the same as with a traditional plan. In 2023, one can contribute up to $6,500, plus an additional $1,000 “catch-up” contribution if you are at least age 50. Lastly, there are no required minimum distributions for Roth IRAs; your funds can continue to grow unhindered without tax for as long as you want

Who is eligible for a Roth IRA?

The Roth IRA rules imposes income limitations on who can make direct Roth contributions. If one has annual income above $153,000 (single) or $238,000 (married) in 2023, then Roth IRA contributions are not allowed. However, there is a work-around known as the “Backdoor” Roth IRA.  If one earns too much to directly contribute to the plan, the Backdoor Roth IRA will allow them to make Roth IRA contributions.

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In order to best understand how the Roth IRA five-year rule works, it is helpful to break them down based on contributions and conversions.

Roth IRA Contributions

In the case of a Roth IRA contribution, in general, if one is over the age of 59 1/2 and the Roth IRA has been funded and opened at least five years, the Roth IRA distribution will be a “qualified” distribution, and the entirety would be without tax.

The rules for counting the five-year rule are a bit peculiar.  For example, a Roth IRA contribution made in April 2023 will still count as a contribution for the 2022 taxable year. The rule basically gives you credit as if you made the contribution as of January 1, 2022, which means the first year of a potential qualified distribution would be 2022. In addition, once you have made a Roth IRA contribution, the clock starts ticking for all Roth IRAs in the aggregate. In other words, once you satisfy the five-year rule once, you will have satisfied it for every Roth IRA in the future.  Note – there is a separate five-year rule for each 401(k) plan you have participated in.

Non-Qualified Roth IRA Distributions

If the Roth IRA distribution is not a “qualified” distribution, either because any Roth IRA was not opened at least five years or the Roth IRA holder was under the age of 59 1/2, then one must look at the Roth IRA distribution ordering rules to determine what percentage of the distribution would be taxable and subject to income tax and, potentially, a 10% early distribution penalty.  This is where the distinction between Roth IRA contributions and Roth IRA earnings comes into play.

Contributions

Roth IRA contributions can always be taken as a tax-free distribution at any time. For example, if you make a Roth IRA contribution on June 1, 2022 you can take the entire amount as a distribution on June 2, 2022 and pay no tax or penalty. The five-year does not come into effect in the scenario. The idea behind this rule is that since the contribution is with after-tax funds, there is no IRS tax loss for allowing the contribution to be taken back immediately. It is important to note, that the rules for Roth IRA conversions are quite different.

Earnings

Roth IRA earnings are the income and gains generated from the investments made inside the plan. In other words, contributions are what you put into the Roth IRA from your personal income or compensation and earnings are the investment returns from those contributions.

For example, if Mike contributed $6,000 to a Roth IRA on June 15, 2022 at age 28, he would be able to take the entire $6,000 as a tax-free distribution at any point in the future. Let’s assume one year later the plan generated $1,000 worth of gains. The original contribution can still be withdrawn with no consequences, however, if Mike were to distribute the earnings, they would be subject to tax and penalty. Fast forward 30+ years, and assume the Roth is now worth $1 million. Since Mike is over the age of 59 1/2, he can now withdraw the entire amount, without tax!

Conversions

A Roth IRA conversion occurs when one converts a pretax IRA to Roth. The benefit of doing a conversion is that one is able to turn pretax IRA funds, which will be subject to tax upon distribution, and a required minimum distribution (RMD) at age 73, into after-tax funds. The downside is that a Roth IRA conversion is subject to income tax based on the value of the IRA that was converted. The Roth is not subject to any RMDs and any distribution of converted funds could be tax-free, subject to certain restrictions, as discussed below. 

When one converts a pretax IRA to a Roth IRA, there are a set of ordering rules that must be used to determine the tax impact of a Roth IRA distribution:

Converted Amount

The first item to examine when determining when a Roth IRA of converted funds would be taxable is the five-year rule. When one converts a pretax IRA to Roth, in general, one must wait at least five years to take out the converted amount as a Roth IRA distribution tax-free. Just like the odd Roth IRA contribution timing rules, the conversion is deemed to have occurred as of January 1st even if the conversion was made on December 31. Even though taxes were paid on the converted amount, they cannot be withdrawn without tax and penalty until satisfying this Roth IRA five-year rule.

However, if one is over the age of 59 1/2, he or she can take a distribution of the funds converted anytime without having to satisfy the five-year rule; this exception only applies to the converted amount. Any earnings stemming from the conversion would need to satisfy the five-year rule to be qualified.

In addition, unlike the five-year rule for Roth IRA contributions, each conversion event has its own five-year time period. A conversion done in 2023 will satisfy the rule in 2028; if another conversion is made next year, those won’t be tax-free until 2029.

Essentially, the ordering rules are as follows: contributions, conversions (in order of when they were made), and finally, earnings. It’s important to keep track of much you may owe in taxes when you take a Roth IRA distribution.

For example, Jen is 45 years old and elects to do a Roth conversion of $60,000 in 2023. Since Jen is under the age of 59 1/2, she will have to wait five years (when she reaches age 50) before taking any of the converted amount tax free. Upon attaining the age of 59 1/2, the Roth is now worth $85,000, Jen can now withdraw the entire amount without tax.

Conclusion

Here is a summation of items to consider regarding the Roth IRA five-year rule:

• Roth IRA contributions can be withdrawn at anytime without tax or penalty
• One must be age 59 1/2 and any Roth must have been opened for at least five years to withdraw earnings tax free
  • Once a Roth IRA has been funded, any future Roth plans opened will have satisfied the five-year rule once it has been five years since the original Roth was opened
  • If you do not already have a Roth, start one now to get that clock started
• Conversions from a traditional, pretax IRA to Roth have their own five-year rule
• If you are under age 59 1/2, you must wait five years until you can withdraw the converted amount tax- and penalty-free
• If you are above the age of 59 1/2, the converted amount can immediately be withdrawn
• Earnings from the converted amount must satisfy the age requirement and five-year rule to be tax- and penalty-free
• Each conversion must satisfy the five-year rule

The Roth IRA five-year rule can get quite confusing, especially when conversions are involved. It’s best to speak with a qualified professional so that you are aware of any tax consequences surrounding a Roth IRA distributions. If you have any questions, feel free to fill out the form to the right!