Definition and Examples of the 5-Year Rule
The 5-year rule refers to three different rules that apply to IRA distributions. It applies in these three scenarios:
- You’re withdrawing money from a Roth IRA.
- You’re converting a traditional retirement account to a Roth IRA.
- You’ve inherited an IRA from someone who died before 2020.
The 5-year rule for Roth IRA withdrawals requires that you wait five years after opening your account to withdraw your investment earnings. Otherwise, taxes and a penalty will apply, though there are some exceptions that we’ll cover in the next section.
The 5-year rule applies only to when you withdraw the investment earnings on a Roth IRA. Your contributions are always yours to withdraw without taxes or a penalty, regardless of how long you’ve held the account or how old you are.
The second 5-year rule applies to Roth IRA conversions. When you convert money from a traditional IRA or 401(k) to a Roth IRA, you pay income taxes at the time of the conversion. However, to take a tax-free distribution, you must leave the money in the account for at least five years. A 10% additional penalty could also apply if you withdraw money before age 59 ½.
The final 5-year rule applies if you inherit an IRA from someone who died Dec. 31, 2019, or earlier and hadn’t yet reached the age when required minimum distributions (RMDs) begin. RMDs are mandatory distributions from retirement accounts that begin at age 72 if you were born after June 30, 1949, or age 70 ½ if you were born earlier.
One option is to roll the deceased individual’s IRA into an inherited IRA. If you don’t take distributions according to your life expectancy, you can follow the 5-year rule for inherited IRAs, which is that you don’t have to take distributions for five years after the original owner’s death. However, you must withdraw the entire balance by Dec. 31 of the fifth-year anniversary of their death.
If you inherited an IRA from someone who died on Jan. 1, 2020, or later, the SECURE Act rules will apply.
How the 5-Year Rule Works
The 5-year rule works differently in each of the three scenarios described above. Here are some examples of how each 5-year rule works.
5-Year Rule for Roth IRA Withdrawals
When you fund a Roth IRA, you don’t get an upfront tax deduction for your contribution. But if you withdraw the money once you’re 59 ½, and you’ve held the account for the 5-year minimum, your withdrawals are tax-free and penalty-free.
Suppose you opened your Roth IRA at age 57 and you’re now 61. You’ve contributed $5,000 a year for four years straight. Let’s say your account is now worth $30,000, consisting of your $20,000 in contributions, plus $10,000 of investment earnings.
If you decided to withdraw $25,000 from your account, the first $20,000 would be completely tax- and penalty-free because that’s the amount of your contributions. The IRS always considers contributions as the first money you withdraw from a Roth IRA. Earnings are only withdrawn once you’ve depleted your contributions.
In this case, because you haven’t met the 5-year rule yet, you’d owe income taxes on the $5,000 of earnings. However, because you’re over 59 ½, you’d avoid the 10% early withdrawal penalty. If you waited one more year to withdraw the $5,000, you’d avoid any tax bill whatsoever because at that point you’d meet the 5-year rule requirements.
There are some exceptions to the 5-year rule. For example, you can avoid the 10% penalty if you become disabled or you withdraw up to $10,000 of earnings for what the IRS considers a first-time home purchase, even if you’ve had the account for less than five years. However, you’d still owe income taxes on the distribution in these scenarios. Once you’ve held the account for five years, you’d avoid both the 10% penalty and the taxes in both situations.
The five-year clock starts on Jan. 1 of the year you made your first contribution to any Roth IRA, even if it isn’t your existing account. For example, if you made your first Roth IRA contribution in June 2021, you’ll have met the 5-year rule requirement on Jan. 1, 2026.
5-Year Rule for Roth IRA Conversions
Suppose you’re ineligible to contribute directly to a Roth IRA because your income is above the limits, which are $140,000 for single filers and $208,000 for married couples filing a joint return in 2021. If this is the case, you could choose to use a backdoor Roth IRA—a workaround that lets you fund a traditional IRA, and then convert the money to a Roth IRA.
Under the 5-year rule, you’d need to:
- Wait at least five years to make tax-free withdrawals on your conversions
- Be at least 59 ½ before you withdraw your money
Otherwise, unless you qualify for an exception, you’ll pay income taxes and a 10% early withdrawal penalty. You’d pay the penalty on the entire early distribution, rather than just the amount you contributed.
The 5-year rule applies to each conversion. So if you converted $5,000 to a Roth IRA in 2020 and another $5,000 in 2021, you’d have to wait until at least 2025 to withdraw the first $5,000 and 2026 to withdraw the next $5,000.
5-Year Rule for Inherited IRAs
Let’s say you inherited an IRA from someone who wasn’t yet 70 ½ and died on May 1, 2019. You could roll the IRA into an inherited IRA and let the money grow. However, on Dec. 31, 2024, you’d need to withdraw the entire balance, per the 5-year rule.
With this 5-year rule, if you wanted to take distributions out of the inherited IRA prior to the Dec. 31, 2024, deadline, you could.
You typically won’t incur a 10% early withdrawal penalty no matter what your age if you take money out of an inherited IRA, provided that the account meets the five-year holding requirement. That means at least five years must have passed since the original owner opened an IRA to avoid the early withdrawal penalty unless you qualify for an exception.
If you inherited a traditional IRA, you’ll be taxed on your entire distribution. However, if you inherit a Roth IRA, you’ll only be taxed on the earnings portion of the distribution.
The penalty for not taking any required IRA distribution by the deadline is up to 50% of the amount that should have been withdrawn. Using the example above, suppose the account balance is $100,000 by the end of 2024. If you failed to take your distribution by Dec. 31, 2024, you risk a penalty of $50,000.
- The 5-year rule for Roth IRA withdrawals, which technically involves several rules, requires you to wait at least five years to withdraw investment earnings to avoid penalties.
- You must wait five years to withdraw the money you converted to a Roth IRA to avoid paying income taxes on your distributions.
- If you’re not at least age 59 ½, a 10% early withdrawal penalty will also apply to early Roth IRA distributions, unless you qualify for an early withdrawal exception.
- If you inherited an IRA from someone who died before age 70 ½ and whose death occurred in 2019 or earlier, you can take distributions according to the 5-year rule. Your account can grow tax-free for five years, but you must withdraw the entire balance by Dec. 31 following the five-year anniversary of the original owner’s death.