It’s almost cliché to extol the virtues of Roth IRAs, but did you know that you can mess them up? If something in the tax code benefits you, there are almost certainly strings attached. Breaking one of the rules could potentially result in taxes and penalties. Here are the three Roth IRA five-year rules you’ll want to be certain to follow.
1. First Contribution
The first of the Roth IRA five-year rules says that you must wait five years after your first contribution before you can withdraw any of your earnings without taxes. Please note that we are only focusing on the earnings here; withdrawals of your contributions will not be taxed. However, tax-free growth is the primary advantage of a Roth IRA, so this is an important rule.
The timing of the rule focuses on the tax year of your initial Roth IRA contribution. So, if you were to make a Roth IRA contribution at any time during the 2021 tax year, the IRS would consider January 1st, 2021 as your start date. If so, you would have to wait until January 1st, 2026 before you could make withdrawals without paying taxes on the earnings.
There is one way to shorten the window, however. If you make a Roth IRA contribution any time before the tax filing deadline, you can elect to have it count toward the prior tax year. For instance, your opportunity for a 2021 Roth IRA contribution extends until April 15th of 2022. However, the five-year rule would still end on January 1st of 2026, even though you only waited for three years, eight months, and fifteen days.
Of course, as we’ve learned with our 2019 and 2020 taxes, the IRS can change the tax filing deadline, so keep this in mind as you plan your Roth IRA contributions.
If you need access to the money before the five years are up, you may be in luck. Your contributions are prioritized in terms of what can be taken out. If you have earnings, but take out only the amount of your contribution (or less), then you can avoid running afoul of this rule. Of course, consult with your CPA to confirm what is best for your situation.
2. Roth Conversion
The second of the Roth IRA five-year rule centers around Roth IRA conversions. It states that you must wait for five years before you can withdraw any converted funds. Unlike the initial contribution rule which is only applied once, each conversion is subject to its own five-year rule.
Again, the timing of this rule focuses on the tax year rather than the exact date. So, the five years on a conversion made in December of 2021 would end at the same time as a conversion made earlier in the year: January 1st of 2026. Please note that conversions must be made before December 31st – you do not have the ability to wait until tax filing deadline.
Why does the IRS impose this rule? Simple – they want to discourage people from making Roth IRA conversions in order to avoid the penalties they would otherwise pay for withdrawing funds before age 59-1/2. You may remember that traditional IRA distributions before that age are subject to both taxes and a 10% penalty. This closes the loophole if someone wanted to access those funds early without paying the penalty.
If you break this rule, you’ll owe a 10% penalty on any distributions.
If you’re making annual back door Roth IRA contributions, it’s important to note that they’re really conversions. This five-year rule does indeed apply to your backdoor Roth contributions.
3. Inherited Roth IRAs
The third of the Roth IRA five-year rules concerns inherited Roth IRAs. The rules for withdrawing funds from any type of retirement account can change from year to year, so please be sure to consult with your financial planner first.
If you’ve inherited a Roth IRA, the initial contribution rule is still in effect even though it wasn’t originally your account. That’s right – you will have to wait five years from the initial contribution date before the taxes on earnings go away. This makes things complicated since one of the distribution options for non-spousal inherited Roth IRAs requires that all of the funds are distributed within five years.
Be very careful if you begin distributions from inherited Roth IRAs; some of the earnings may still be taxable.
A Few Exceptions
There are a few exceptions to the Roth IRA five-year rules. First-time homebuyers can withdraw up to $10,000 to put toward the purchase of a home. According to the IRS, a first-time homebuyer is someone who has not owned a home within the last two years. There are also exceptions for medical expenses and qualified higher education expenses.
As you would expect, there are rules and caveats for tax-advantaged accounts such as Roth IRAs. Knowing these rules could help you maximize their potential. If you’d like help incorporating Roth IRAs into your retirement plan, then click here to set up a quick, complimentary introduction call to see if Prana Wealth is a good fit. We do still have the capacity to take on new clients.
As a fee-only financial advisor in Atlanta, we can (and do) work virtually with clients all across the U.S. and we’re here to help you when you’re ready.