What is the Roth IRA 5 Year Rule?
What is it and how do you Avoid Penalties?
Somebody is always trying to break the rules and as a result, the IRS has to create rules to close a loophole. The Roth IRA 5 year rule is one such rule.
Contributions and Earnings
Before we look at the rule, let’s define 2 key terms about a Roth IRA that are highly important: Contributions and earnings.
Contributions are the funds that you deposit into the account. Before you deposited the money, you paid taxes on it so never again will pay taxes on those same dollars. Also, because the IRS got its share, you can take your contributions out of your account at any time. Unlike a traditional IRA or the earnings of your Roth IRA, you don’t have to wait until you’re 59 ½ years old to withdrawal the money penalty-free.
Earnings are the income you make from your contributions. Because earnings were generated from your contributions, you haven’t paid taxes on that money yet and because you aren’t required to pay taxes on the earnings until you withdrawal the money, it will grow to a much larger amount than if the IRS required you to pay taxes on the earnings each year.
Earnings are where all the rules go into effect—no withdrawals before age 59½ unless you pay a 10 percent penalty accept under certain exceptions, for example.
What is the Roth IRA 5-Year Rule?
One of the rules concerning withdrawing your earnings is the IRA 5-year rule. The rule states that you have to wait 5 years since the tax year of your first contribution before you can withdraw earnings from the account without paying taxes.
How does the IRS calculate the 5 years? By tax year. Let’s say that you opened a Roth IRA on June 1 of 2017. The date of June 1 isn’t important to the IRS—only that you opened in in the 2017 tax year. In this case, you can’t withdrawal the earnings of your account until January 1, 2022 without paying a penalty even if you’re over the age of 59½.
If you time the opening of your Roth IRA correctly, you really only have to wait 4 years. The IRS allows you to make contributions to a retirement account as late as April 15 for the previous tax year. If you started a Roth IRA on March 3, 2018, it’s the same as starting it on January 1, of 2017 to the IRS. In this case, you opened the account in 2018 but only have to wait 4 years before you can collect withdrawals.
What’s the Penalty?
It’s that pesky 10 percent penalty again but with a really painful twist. The beauty of the Roth IRA is not only will you never again pay taxes on the contributions but assuming you meet all of the rules, you won’t pay any taxes on the earnings either. It’s quite the nice gift but if you don’t wait 5 years to make a withdrawal, not only will you pay the 10 percent penalty on any earnings that come out of the account, you will pay income taxes as well. You could end up paying 40 percent or more on that earnings withdrawal even if you’re 59½. Stay away from those earnings!
If you’re not great a record keeping, the IRS makes keeping track of earnings and contributions a little easier. It doesn’t matter the dates of contributions—you (or your broker) just need to keep track of the total amount of contributions. When you make withdrawals you will exhaust all contributions before the IRS considers you withdrawing from the earnings.
How about some good news? There are plenty of exceptions to the 5-year rule. You could withdrawal the funds before the 5 years for a first-time home purchase and if you were to get seriously ill, you won’t pay penalties and taxes either. There are many other exceptions to this rule but possibly the most important consideration is that retirement accounts are considered long-term investments not just by the IRS but in any solid financial plan. Although there are some exceptions, you probably don’t want to invest money into an IRA unless you plan to keep it there for more than 5 years anyway.
With that in mind, the Roth IRA is one of the greatest retirement planning tools around—even with that 5 year rule.