Depending on your financial situation, a Roth IRA is one of the savviest ways to save for retirement. Itâ€™s an investment account whose contributions are taxed today, but whose earnings then grow tax-free â€” and can then be a source of tax-free income upon retirement.
Roth IRAs have a wide array of additional benefits, too, like their immunity to the required minimum distribution rules many other retirement accounts carry. However, thereâ€™s an important caveat to keep in mind if you want to open a Roth IRA and plan to take distributions sooner, rather than later: the Roth IRA five-year rule. Itâ€™s a fairly straightforward concept, but there are some particularities to be aware of.
As its name suggests, the Roth five-year rule states that in order to maintain tax-free status with the IRS, distributions can only be taken from a Roth if itâ€™s been open for at least five taxable years. While your contributions are after-tax (and thus always available for tax-free withdrawal), the accountâ€™s earnings will be subject to income tax and a 10% early withdrawal penalty.
As with all things in the tax code, itâ€™s important to pay attention to the details. For example, the IRS states that five taxable years must have passed since the year in which you made your first Roth IRA contribution (or someone else made a contribution for your benefit). Since you can make contributions to an IRA until April 15 from the prior year, that means you may not have to wait five full calendar years to meet the requirements.
For example, letâ€™s say you opened a Roth IRA in March of 2016 and funded it to its maximum contribution limit, ensuring those contributions count toward the 2015 tax year. In that case, youâ€™d only have to wait until 2020 (as opposed to 2021) to fulfill the five-year rule. The important date is the one thatâ€™s on your tax return, so thatâ€™s where you should look when youâ€™re running your calculations.
There are some exceptions to the five-year rule, such as being totally and permanently disabled or paying medical insurance premiums during an unemployment period.
Traditional IRAs can be converted to a Roth IRA penalty-free. This is sometimes known as a â€śbackdoor Roth IRA,â€ť which can help those who earn more than the IRS limit take advantage of Roth benefits.
How does the five-year rule affect a traditional IRA account that has been open for many years prior? Converted Roth IRAs must be held for five years as a Roth before qualified distributions can be made. The countdown clock starts in the year you made the conversion.
However, unlike opening a new Roth IRA, you donâ€™t have until April for your conversion to count toward the previous tax year. Instead, the important date to remember for a converted Roth is Dec. 31. Any conversions made by that date will count for that taxable year.
Each Roth conversion has its own five-year countdown period, and if you take early distributions from a converted Roth, youâ€™ll run into the same tax scenario described above.
Remember, the Roth IRA five-year rule applies only to account earnings. You pay income tax on the money you put into a Roth account when you contribute (or when you convert the account), which means you can always take those contributions back out without incurring any additional taxes or penalties.
â€śDistributionsâ€ť refers to withdrawals of both contributions and gains made through compound interest. In order to make qualified (tax-free) distributions from a Roth IRA, you must fulfill the five-year rule and also meet a second requirement.
Since Roth IRAs are intended to be used as an income stream in retirement, the easiest and most common way to take distributions is to wait six months after your 59th birthday. However, qualified distributions from a Roth IRA can also be made under the following circumstances:
One of the most attractive things about Roth IRAs is the fact that theyâ€™re not subject to required minimum distributions (RMD), which means you can leave your money to grow for as long as you live â€” and even thereafter. Having the ability to pass the Roth IRA onto heirs and beneficiaries after the account openerâ€™s death makes it a popular option.
However, the death of the original Roth IRA owner does not eliminate the five-year rule for heirs or reset the clock. In order to make tax-free, qualified distributions, beneficiaries must wait for the account ownerâ€™s projected end-date had he/she have survived. However, unless you are the spouse of the deceased account holder, you will be subject to RMDs on your inherited Roth account.
Although the five-year rule keeps you from instantly accessing your tax-free earnings, Roth IRAs are still a powerful vehicle for aggressively saving money and one of the best ways to fund a stress-free retirement.