ROTH IRAs are good retirement savings accounts. While you can't deduct contributions to a Roth IRA now, the beauty of these accounts is that monies inside the account potentially grow tax-free! Payouts of earnings after age 59 ½ are generally not taxable. You can also withdraw your contributions at any time on a tax-free basis and without having to pay a penalty. Note – Payouts of earnings before age 59 ½ are hit with a 10% fine.
The Five-Year Rules – But be sure you know the two five-year rules.
The first applies to Roth IRA contributions. And whether distributed earnings are tax-free to you. Payouts of earnings after age 59 ½ aren't taxed if at least five tax years have passed since the owner first contributed to a Roth IRA.
The five-year clock starts the first-time money is deposited into any Roth IRA that you own, through either a contribution or a conversion from a traditional IRA. The clock doesn't restart for later Roth “payins” or for newly opened Roth IRA accounts.
The following illustrates two examples of this first five-year rule.
First Scenario – You are 61 and you founded your first Roth IRA three years ago at age 58. In 2024, you take a distribution. You will be taxed on the earnings in the account because it's been less than five years since you first contributed to the Roth IRA.
Second Scenario –You've owned a Roth IRA since 2014. In 2022, you opened and founded a second Roth IRA. Because you funded your first Roth in 2014, you needn't wait five years to take money from your second Roth for the earnings to be tax-free, provided you are at least age 59 ½ at the time of the distribution.
The second five-year rule applies specifically to Roth IRA conversions. And whether the l0% early distribution penalty hits pre-age 59 ½ payouts. This five-year rule doesn't apply to new contributions to Roth IRAs, but to conversions of pretax income from traditional-IRAs to Roths. Under the rule, if someone under age 59 ½ does a Roth conversion, and later takes a payout within five years of the conversion and before turning age 59 ½, then the amount of conversion principal that is withdrawn is hit with the 10% penalty. Once you turn age 59 ½, you needn't worry, even if you take a payout before your conversion meets the five-year period.
For example, there's no 10% penalty if you do a conversion at age 58 and withdraw funds at age 60. Under this rule, each conversion has its own separate five-year period, which differs significantly from the first five-year rule discussed above.
- For instance, if you do multiple Roth IRA conversions, there will be multiple five-year time periods, even if each conversion is done into the same Roth IRA account you owned for years.
- Let’s explain this second five-year rule with an example. Say you are 51 and convert your traditional IRA into a Roth that you have had for many years. You will be taxed on the converted amount – at the time of conversion. Four years later, you liquidate the Roth at age 55. Your post-conversion earnings will be subject to ordinary income tax rates and the 10% penalty because you are not age 59 ½ at the time of the distribution.
- Additionally, your converted principal will also be hit with the 10% penalty because you were not 59 ½. At the time of the distribution and the converted amount was only taxed no 10% penalty applied to the converted amount provided it was left in their age 59 ½.
Disclosures:
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
Traditional IRA account owners have considerations to make before performing a Roth IRA conversion, These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take a required minimum distribution (RMD) in the year you convert you must do so before converting to a Roth IRA.
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