The following summarizes Bob Carlson’s article “Retirement Watch” on the two, five-year rules governing whether Roth distributions are taxed. Knowing these two rules should help avoid taxes on Roth withdrawals.
ROTH DISTRIBUTIONS
Roth distributions are tax-free to the original owners when they are "qualified distributions”, which means they must satisfy two "five-year rules". A qualified distribution is money you invested directly, and the distributions do not come from a 401(k) rollover or similar employee plan and/or converted IRA accounts. The first five-year rule determines whether a distribution avoids income taxes. The second five-year rule determines if a distribution taken before age 59½ avoids the 10% early distribution penalty tax. The IRS first considers if the Roth IRA distribution is taken from the principal. If so, the distribution from a Roth IRA is always tax-free because the income taxes have already been paid.
For a Roth distribution to be qualified and avoid income taxes, five years must have passed since the first contribution was made to any Roth account of the taxpayer. The five-year period starts January 1 of the year money is put into the investors first Roth. The five-year rule does not apply to each Roth IRA. It applies to the taxpayer. It does not start again if you change custodians. Because of the five-year rule it’s best to start a Roth account as soon as possible.
The second test is broader. It is a 10% penalty tax on early distributions taken before the owner turns 59 ½ years old, the owner passed away and the distribution is made to an estate or a beneficiary, or for a first-time qualified home purchase of up to $10,000.
Both tests must be satisfied for a qualified distribution to be income-tax free. The 10% early withdraw penalty tax would apply only to earnings for conversions made before you reach 59 ½. So, if you have reached 59 ½ years and had a Roth account for at least five years, both tests are met, and any distribution from any Roth account you own would be qualified and income-tax free.
EARLY DISTRIBUTION PENALTY
The 10% early distribution penalty is not imposed if at least five years have passed since the principal was converted. The penalty applies only to accumulated income and gains, not contributions. The rules for this penalty apply separately for each conversion. So, you must keep track for each conversion made prior to age 59½. Note, the 10% penalty tax no longer applies to conversions once you are over 59½.
ORDERING RULES
When a distribution from a Roth account is made and it is less than the full balance under the ordering rules, the first distribution is from the principal. Only after all principal is distributed are earnings distributed. So, income taxes are not an issue until all the principal is distributed. Thus, you can avoid income taxes by only withdrawing principal, until the five-year holding period is met and the account holder is 59 ½ or older. When a Roth IRA distribution is tax-free, it is not included in adjusted gross income (AGI) or modified adjusted gross income (MAGI) used to determine taxable Social Security benefits. So, you minimize all your taxes by carefully making tax-free distributions from your Roth account.
INHERITED ROTH ACCOUNTS
Beneficiaries who inherit Roth IRAs do not need to worry about these rules because they automatically avoid the early distribution of income tax and 10% early withdrawal penalty and receive tax-free distributions. As an example, if someone has a Roth account and names their children as beneficiaries, the children will not incur income taxes on the Roth account when they inherit them. Note, under the new 2026 federal tax rules beneficiaries must withdrawal all funds by the end of the 10th year after the death of the original owner.
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Important 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
This information is not intended to be a substitute for individualized tax advice. We suggest that you discuss your specific tax situation with a qualified tax advisor.