The Roth IRA 5-year rule refers to a waiting period imposed on certain types of account withdrawals.
The 5-year rule applies in three instances: withdrawing account earnings, converting a traditional IRA to a Roth, and inheriting a Roth IRA.
Unless you qualify for an exception, you're liable for income taxes and penalties if you violate the 5-year rule.










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Roth IRAs offer significant tax breaks: The money grows tax-free within the account, and you don't owe income taxes when you make withdrawals during retirement. But, as with most tax-advantaged vehicles, there are strings attached. 
For Roths, there's something called the 5-year rule, and it applies to account distributions. If you want to keep your distributions free and clear of both taxes and tax penalties, you need to understand its ins and outs. 
Technically speaking, three different 5-year rules apply to Roth IRAs. Here's what you need to know about each.
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The 5-year rule for withdrawing earnings
First, a quick Roth refresher. Roth IRAs are individual retirement arrangements that you fund with after-tax dollars. That means you don't get a tax deduction for contributions made to the account, but then you don't incur taxes on distributions when you take them (so the opposite of the way traditional IRAs work).


At least, that's the general rule. But a key thing you need to know about withdrawing money from a Roth IRA is that there's a difference between taking out contributions you made to the account and taking out the account earnings — that is, any interest, capital gains, or other income generated by your investments.
You can withdraw sums equal to your contributions from a Roth IRA any time, tax- and penalty-free. But earnings are more complicated. 
The 5-year rule imposes a waiting period on them. It states the Roth IRA has to be at least five years old before you can withdraw any of its earnings. Even then, you may have to pay taxes and/or penalties (generally 10% of the distributed sum) depending on your age and how long you've held the account.
Roth IRA withdrawals if you're under 59 ½ 
Since the IRS wants you to save Roth IRA funds for your retirement, it frowns on you withdrawing them too early. It defines "too early" as age 59 ½ and under. If you're under the age limit, you'll have to pay income taxes and the 10% early withdrawal penalty on any earnings you pull out of the account.


However, there are exceptions. They include:
You use the money (up to $10,000) to buy your first home
You use the money to pay for education expenses
You use the money to pay for expenses relating to a birth or adoption
You become disabled or pass away
You use the money to pay for unreimbursed medical expenses/health insurance premiums while unemployed
You take distributions in substantially equal periodic payments

Let's say you do meet one of these exceptions. Here's where the 5-year rule really comes into play. 
If you're under age 59 ½ and you've had your Roth IRA open less than five years, you avoid that 10% penalty. You still owe income taxes in the earnings, though. 
If you're under age 59 ½ and have had the account for five years or more, you avoid paying both taxes and penalties.



Roth IRA withdrawals if you're 59 ½ or older
If you've passed the magic age of 59 ½, things loosen up considerably. But not completely.
If you have had your Roth IRA for more than five years, you can withdraw earnings from your account for any reason without paying taxes or penalties. 
If you've had the account for less than five years, the earnings portion of the withdrawal is taxable, but you don't have to pay penalties.
The 5-year rule for converting a Traditional IRA to a Roth IRA
The second 5-year rule applies only to funds that are part of a Roth conversion. A Roth conversion is when you roll over money from a Traditional IRA into a Roth IRA. You must pay income taxes on the rolled-over, or "converted," amount in the year you do the Roth conversion. That's why people usually only do a Roth conversion if:


They believe their tax bracket will be higher in retirement. Paying taxes on the conversion at their current tax rate is preferable to paying a higher rate later.
Their income is lower than usual this year. If their taxable income is lower than normal this year, they can convert some funds into a Roth with a lower tax impact.

The 5-year rule on Roth conversions requires you to wait five years before withdrawing any converted balances — contributions or earnings — regardless of your age. If you take money out before the five years is up, you'll have to pay a 10% penalty when you file your tax return. 
One bright spot: The clock starts ticking on the first day of the year you do the conversion, no matter what date the conversion actually happened. For example, you could execute the conversion on Dec. 15, 2020, and the five years would be up on Jan. 1, 2025. 
The 5-year rule for inherited Roth IRAs
The final 5-year rule applies to inherited Roth IRAs. Roth IRA beneficiaries can withdraw contributions from an inherited Roth account at any time (in fact, they're required to). But to withdraw earnings tax-free, the account must have been open for at least five years when the original account-holder died.


If the account hasn't been open that long, there are a few options:
Disclaim the inherited assets. You can choose not to accept the funds if you don't need the money or don't want to deal with the tax consequences.
Withdraw the money in a lump sum. You'll have to pay taxes on the earnings portion of the account all at once, but this might be better if you're in a low bracket now.
Withdraw funds annually based on your life expectancy. This option is only available to surviving spouses, minor children of the account holder, disabled or chronically ill people, and beneficiaries who are less than 10 years younger than the deceased (for example, a sibling). The beneficiary's life expectancy is based on the IRS Single Life Expectancy Table.
Roll the inherited funds into your own Roth IRA or a new Roth IRA account. This option is only available to surviving spouses.
Delay withdrawals. You can leave the money in the account until the 5-year mark has passed. The Setting Every Community Up for Retirement Enhancement (SECURE) Act mandates that, for most beneficiaries, inherited IRAs must be emptied within a decade. The beneficiary owes a 50% penalty on any assets left in the account at the end of the 10th year.

The bottom line
Roth IRAs can be an excellent source of tax-free income, but it's important to understand the nuances of the withdrawal rules — particularly the 5-year rule — in all its permutations. Flouting the rule can be costly, especially if you're under 59 ½. So plan carefully — otherwise, you can wind up owing avoidable taxes and penalties. 











Jasmine Suarez


Senior Editor, Personal Finance Insider






Jasmine is a senior editor at Insider where she leads a team at Personal Finance Insider, focusing on explainers, how-tos, and rounds-ups that help readers better understand personal finance, investing, and the economy.
Her team has tackled projects including:
• Women of Means, a series about women taking control of their finances.
• Better, Smarter, Faster, a series that reveals the impactful choices you can make with your money to set yourself up to pursue your passions and fulfill big life goals.
• Master Your Money, a year-long guide for millennials on how to take control of their finances.
• Rethinking Retirement is an editorial collection with stories that will inspire and provide the foundation for planning a different type of future than the 9-5 life allows.
• The Road to Home, a comprehensive guide to buying your first house.
Previous to Insider, she was a senior editor at NextAdvisor, TIME Magazine's personal finance brand launched in partnership with Red Ventures. She was also a content marketing editor at Credit Karma.


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Source: Business Insider

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