Roth’s Five-Year Rule

IF YOU MAKE REGULAR annual contributions to a Roth IRA, you can withdraw those contributions at any time with no taxes or penalties owed. It’s a different story, however, with the account’s investment gains.

Those gains will be subject to both income taxes and tax penalties if you withdraw them within the first five years and if you are under age 59½ (or, to put it another way, you need to wait five years and until after age 59½ for the account’s growth to be totally tax-free). The five-year clock starts on Jan. 1 of the tax year for which you made your first regular annual contribution—and it doesn’t reset with each subsequent annual contribution or if you open a Roth at another financial firm.

What if you are over age 59½? From then on, if you made a withdrawal, you wouldn’t owe a tax penalty if your first annual contribution had been made less than five years earlier. You could owe income taxes, but it’s unlikely. How come? When you withdraw, the IRS lets you assume that any withdrawals initially consist of your original annual contributions. If you are drawing down the account relatively slowly, you probably wouldn’t start pulling out the account’s investment earnings until after you crossed the five-year mark.

Now, consider a different scenario: What if you convert a traditional IRA to a Roth? In that situation, a slightly different five-year rule comes into play. This time, the rule applies not only to the account’s investment earnings, but also to the sum converted. In other words, if you withdraw the sum converted within the first five years, you would owe a tax penalty if you were under age 59½. You wouldn’t, however, have to pay income taxes, because you already paid income taxes on the money involved when you did the original conversion. Unlike with regular annual contributions, a new five-year waiting period applies to each conversion.

What if you made a conversion more than five years ago and you’re under age 59½? Because you have met the five-year rule, you can withdraw the sum converted with no penalty or income taxes owed. It’s only if you touch the account’s investment gains that taxes and penalties come into play—though you may be able to avoid the penalty if you meet one of the allowable IRS exceptions.

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