Getting the right tax advice and tips is vital in the complex tax world we live in. The Kiplinger Tax Letter helps you stay right on the money with the latest news and forecasts, with insight from our highly experienced team (Get a free issue of The Kiplinger Tax Letter or subscribe). You can only get the full array of advice by subscribing to the Tax Letter, but we will regularly feature snippets from it online, and here is one of those samples…
Roth IRAs are good retirement savings options. Although you can’t deduct contributions to a Roth IRA, the money inside the account grows tax-free. Payouts of earnings after age 59½ are generally not taxable. You can also withdraw your contributions at any time on a tax-free basis and without having to pay a penalty. Payouts of earnings before age 59½ are hit with a 10% additional tax or penalty.
But be sure you know the five-year rules. Failing to comply with the rules can result in a surprise federal tax bill. They can be complicated, but we break them both down for you with examples.
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1. Five-Year Rule: Roth IRA contributions
The first rule applies to Roth IRA contributions and whether distributed earnings are tax-free to you.
Payouts of earnings after age 59½ aren’t taxed if at least five tax years have passed since the owner first contributed to a Roth IRA. The five-year clock starts the first time money is deposited into any Roth IRA that you own, through either a contribution or a conversion from a traditional IRA. The clock doesn’t restart for later Roth payins or for newly opened Roth IRA accounts.
Here are two examples that illustrate the effect of this first five-year rule.
- Scenario 1: You are age 61 and you funded your first Roth IRA three years ago. In 2024, you take a distribution. You will be taxed on the earnings in the account because it’s been less than five years since you first contributed to the Roth IRA.
- Scenario 2: You’ve owned a Roth IRA since 2014. In 2022, you opened and funded a second Roth IRA. Because you funded your first Roth in 2014, you needn’t wait five years to take money from your second Roth for the earnings to be tax-free, provided you are at least age 59½ at the time of the distribution.
2. Five-Year Rule: Roth IRA conversions
The second rule applies specifically to Roth IRA conversions and whether the 10% early distribution penalty hits pre-age-59½ payouts.
This five-year rule doesn’t apply to new contributions to Roth IRAs but to conversions of pre-tax income from traditional IRAs to Roths. Under this rule, if someone under age 59½ does a Roth conversion, and later takes a distribution within five years of the conversion and before turning age 59½, then the amount of conversion principal that is withdrawn is hit with the 10% early distribution penalty. Once you turn 59½, you needn’t worry about this five-year rule, even if you take a payout before your conversion meets the five-year period. For example, there’s no 10% penalty if you do a Roth IRA conversion at age 58 and withdraw funds two years later at age 60. (However, based on the circ*mstances, the first five-year rule may apply to tax the post-conversion earnings).
Under this rule, each conversion has its own separate five-year period, which differs significantly from the first five-year rule discussed. For instance, if you do multiple Roth IRA conversions, there will be multiple five-year time periods, even if each conversion is done into the same Roth IRA account you owned for years.
Let’s explain this second five-year rule with an example. Say you are 51 and convert your traditional IRA into a Roth IRA that you have had for many years. You will be taxed on the converted amount. Four years later, you liquidate the Roth. Your post-conversion earnings will be subject to ordinary income tax rates and the 10% penalty because you are not age 59½ at the time of the distribution. Additionally, your converted principal will also be hit with the 10% penalty.
This first appeared in The Kiplinger Tax Letter. It helps you navigate the complex world of tax by keeping you up-to-date on new and pending changes in tax laws, providing tips to lower your business and personal taxes, and forecasting what the White House and Congress might do with taxes. Get a free issue of The Kiplinger Tax Letter or subscribe.
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FAQs
5-Year Rule for Roth IRA Conversions
As with contributions, the five-year rule for Roth conversions uses tax years, but the conversion must occur by Dec. 31 of the calendar year. For instance, if you converted your traditional IRA to a Roth IRA in November 2023, your five-year period begins on Jan. 1, 2023.
What is the 5-year holding requirement for a Roth IRA? ›
This rule for Roth IRA distributions stipulates that five years must pass after the tax year of your first Roth IRA contribution before you can withdraw the earnings in the account tax-free.
What is the 5-year rule for backdoor Roth IRAs? ›
The Internal Revenue Service (IRS) requires a waiting period of 5 years before withdrawing balances converted from a traditional IRA to a Roth IRA, or you may pay a 10% early withdrawal penalty on the conversion amount in addition to the income taxes you pay in the tax year of your conversion.
What is the 59 1 2 5-year rule for Roth IRAs? ›
Withdrawals must be taken after age 59½. Withdrawals must be taken after a five-year holding period. If you transfer your Traditional or Roth IRA at any age and request that the check be made payable to you, you have up to 60 days to deposit that check into another IRA without taxes or penalties.
How do I avoid the 5 year rule for Roth IRA? ›
Once you turn 59½, you needn't worry about this five-year rule, even if you take a payout before your conversion meets the five-year period. For example, there's no 10% penalty if you do a Roth IRA conversion at age 58 and withdraw funds two years later at age 60.
At what age do you have to stop Roth conversions? ›
However, there are no limits on conversions. A taxpayer with a pre-tax IRA can convert any amount of funds in a year to a Roth IRA. Roth IRAs also are exempt from required minimum distributions (RMDs). These mandatory withdrawals from retirement accounts begin at age 72 and can create a tax burden on affluent retirees.
Do you have to wait 5 years for each Roth conversion? ›
Five-year rule for Roth IRA conversions
Each conversion or rollover you make is subject to a separate five-year waiting period. If you don't wait the requisite five-year period from conversion to withdrawal, you may have to pay a 10% penalty, along with any income taxes owed.
What is the 5-year rule for Roth Forbes? ›
This IRS rule says you can't withdraw your Roth earnings tax-free without owing taxes for at least five years from the beginning of the tax year for which you made your first Roth IRA contribution. This applies even if you are retired and/or older than 59.5.
What is the 5-year rule for inherited Roth IRAs? ›
5-year rule: If a beneficiary is subject to the 5-year rule, They must empty account by the end of the 5th year following the year of the account holders' death. 2020 does not count when determining the 5 years. No withdrawals are required before the end of that 5th year.
How to avoid pro-rata rule backdoor Roth? ›
One can reduce or even eliminate pre-tax IRA funds, therefore avoiding the pro-rata rule. Bypassing the pro-rata rule on the Roth conversion portion of the backdoor Roth strategy requires the account owner to have $0 of pre-tax money in all non-Roth IRAs at the end of the year of the conversion (i.e., December 31).
Right now, the mega backdoor Roth is not going away as long as your employer plan allows it. That's good news! But it's not permanent news – there could be legislation on the way that eliminates the option to make after-tax contributions.
When to avoid a backdoor Roth IRA? ›
You may not need a backdoor Roth conversion if you are able to meet your savings goals with the maximum retirement limit through your workplace retirement account, and are not expecting a need for additional savings.
What is the 5 year rule for Roth IRA dividends? ›
The 5-year rule regarding Roth IRAs requires a waiting period before you can withdraw earnings or convert funds without a penalty. To withdraw earnings from a Roth IRA without owing taxes or penalties, you must have held the account for at least five tax years.
What is the 5 year rule for Roth IRA investopedia? ›
Withdrawal rules for Roth IRAs are more flexible than those for traditional IRAs and 401(k)s. Account holders can withdraw their contributions without incurring taxes or penalties. People over age 59½ who've held their accounts for at least five years can withdraw contributions and earnings with no tax or penalty.
What is the 5 year rule for Roth 401k and Roth IRA? ›
“If you open a Roth IRA for the first time in order to receive Roth 401(k) rollover funds, then you must wait five years to take a distribution penalty-free.” This rule wouldn't prevent you from withdrawing your original contributions after the rollover is complete.
What is the 5 year rule for Roth 401k conversion? ›
Once contributions are converted to Roth, you may withdraw those converted dollars— including any related earnings—federally tax-free in retirement, as long as your withdrawal is taken at least five years from your first Roth contribution or conversion and after you reach age 59½, or due to disability or death.
How do you calculate the basis of conversions for a Roth IRA? ›
In order to calculate the percentage of your Roth conversion that's tax-free if you have some basis, you'd divide your total nondeductible contributions by the year-end value of all of your IRA accounts plus the value of all conversions and any distributions taken during the year.
How many Roth IRA conversions can you do in a year? ›
There are no limits to how many conversions you can make per year. In some cases, a multi-year Roth conversion plan may be the best option.
Do I pay taxes twice on Roth conversion? ›
Ideally, a nondeductible (after-tax) traditional IRA that gets converted into a Roth IRA would not be subject to any taxes, so the funds would not be taxed twice. To be clear, no converted funds would get double-taxed, but some circ*mstances can result in a taxable transaction.
