What is the Roth 5-Year Rule?

Actually, there are three five-year rules you need to know about.

The first five-year rule determines when you can begin receiving tax-free qualified distributions from your Roth IRA.  Withdrawals from your Roth IRA — including both your contributions and any investment earnings — are completely tax- and penalty-free if you satisfy a five-year holding period and one of the following conditions also applies:

• You’ve reached age 59½ by the time of the withdrawal
• The withdrawal is made due to a qualifying disability
• The withdrawal is made for first-time homebuyer expenses ($10,000 lifetime limit)
• The withdrawal is made by your beneficiary or estate after your death

This five-year holding period begins on January 1 of the tax year for which you made your first contribution (regular or rollover) to any Roth IRA you own. For example, if you make your first Roth IRA contribution in March 2022 and designate it as a 2021 contribution, your five-year holding period begins on January 1, 2021 (and ends on December 31, 2025). You have only one five-year holding period for determining whether distributions from any Roth IRA you own are tax-free qualified distributions (Roth IRAs you inherit are subject to different rules).

The second five-year rule is a little more complicated. When you convert a traditional IRA to a Roth IRA, the amount you convert (except for any after-tax contributions you’ve made) is subject to income tax in the year of the conversion. However, your conversion isn’t subject to the 10% early distribution penalty, even if you haven’t yet reached age 59½.

But what the IRS giveth it can also taketh away. If you withdraw any portion of your taxable conversion within five years, you’ll have to pay the 10% early-distribution penalty on those funds that previously avoided the tax — unless you’ve reached age 59½ or qualify for another exemption from the penalty tax. This five-year holding period starts on January 1 of the year you convert your traditional IRA to a Roth IRA. And if you have more than one conversion, each will have its own separate five-year holding period for this purpose.

The third five-year rule applies to In-Plan Roth’s (i.e., Roth 401k or Roth 403b). While it’s similar to the five-year rule that applies to Roth IRAs, there are important differences. Learn more here about Roth’s in retirement plans.

Withdrawals from your Roth 401(k) plan account — including both your contributions and any investment earnings — are completely tax- and penalty-free if you satisfy a five-year holding period and one of the following conditions also applies:

• You’ve reached age 59½
• You have a qualifying disability
• The withdrawal is made by your beneficiary or estate after your death

(Note: There is no first-time home buyer exception for a Roth 401k).

The five-year holding period begins on the first day of the calendar year in which you make your first Roth 401(k) contribution (regular or rollover) to the plan. For example, if you make your first Roth contribution to your company’s 401(k) plan in December 2022, your five-year holding period begins on January 1, 2022, and ends on December 31, 2026.

If you participate in 401(k) plans maintained by different employers, your five-year holding period is determined separately for each plan. But there’s an important exception. If you make a direct rollover of Roth dollars from your prior employer’s plan to your new employer’s plan, your five-year holding period for the new plan will be deemed to start with the year you made your first Roth contribution to the prior plan.

For example, Beth made Roth contributions to the Acme 401(k) plan beginning in 2018. In 2022, she changed jobs and began making Roth contributions to the Beacon 401(k) plan. Her five-year holding period for the Acme plan began on January 1, 2018, and ends on December 31, 2022. Her five-year holding period for the Beacon plan began on January 1, 2022, and ends on December 31, 2026. In 2022, Beth decides to make a direct rollover of her Acme Roth account to Beacon’s 401(k) plan. Because of the rollover, Beth’s January 1, 2018, starting date at Acme will carry over to the Beacon plan, and any distributions she receives from her Beacon Roth account after 2022 (rather than after 2026) will be tax free (assuming she’s at least age 59½ or disabled at the time of distribution).

There are many rules you must be aware of when establishing a Roth, completing a rollover, or when doing a Roth conversion. If you’d like to learn more about retirement planning strategies using Roth retirement accounts, feel free to Talk With Us!

Prepared by Broadridge Advisor Solutions. Edited by BFSG. Copyright 2022.

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