The Two Roth IRA 5-year Rules

June 05, 2023

Roth IRAs are powerful retirement savings vehicles that offer tax advantages to individuals. When it comes to Roth IRAs, there are two distinct 5-year rules to consider: the 5-year rule for earnings and the 5-year rule for conversions. In this article, we will delve into each of these rules, explain how they work, and provide examples using fictional individuals to illustrate their impact. These two rules are often misunderstood and conflated, so it is important to clarify them. I have encountered instances where these rules were misinterpreted, even by CPAs. Forgivable, because CPAs are generally not retirement planners (and human, like the rest of use).

The 5-Year Rule for Roth IRA Earnings

The 5-year rule for Roth IRA earnings determines the tax treatment of earnings upon withdrawal (maybe that was obvious, but...). It's important to note that withdrawals of contributions can be made at any age, regardless of the 5-year rule, without incurring taxes or penalties. This is because contributions are made with after-tax dollars. This is where I have had more than one "discussion" with a tax-professional and even a few other financial "gurus". The good news is that I was able to help them understand this important distinction on contributions vs earnings regarding this rule. 

Simply put, you may withdraw earnings (growth) from your Roth IRA completely tax and penalty free if you have had a Roth IRA for at least 5 years AND are 59 ½ years old. Both conditions must be satisfied.

Example: Meet Sarah, a diligent saver

At age 57, Sarah opens her first Roth IRA on January 1, 2019, and diligently contributes to her account. The following year, Sarah (now 58) decides to withdraw some of her contributions. She does so without taxes or penalties because the 5-year rule only applies to earnings. Had she withdrawn her earnings instead, she would have been taxed (not having owned the account for 5 years and being under 59 ½ years old) and penalized (being under 59 ½ years old). She must wait until 2024 before using her gains because that is when she will be over 59 ½ and have had a Roth for 5 years. 

In December 2022, Sarah (now 60) decides to open a second Roth IRA and makes a contribution. Here's where the more of the 5-year rule comes into play:

Since Sarah already owns a Roth IRA that has been open for three years, the clock for the 5-year rule has already started. A new 5-year clock does not start for the new Roth IRA; it starts with the first opening and funding of any Roth IRA. Sarah doesn't need to wait an additional five years for the new account; she only has to wait two more years to access any earnings/gains since her existing Roth IRA has already been open for three years. However, as before, Sarah is free to withdraw her contributions from either Roth IRA at any time.

The 5-Year Rule for Roth IRA Conversions

The 5-year rule for Roth IRA conversions primarily focuses on individuals who are younger than 59 ½ years old. It determines the tax treatment of converted amounts and their subsequent withdrawals. The main purpose of this rule is to prevent individuals from circumventing the early withdrawal penalty on traditional IRAs.

Example: Introducing John, the savvy converter

John, who is 63 years old, decides to convert his Traditional IRA into a Roth IRA on June 1, 2021. Since John is already older than 59 ½, the 5-year rule for conversions does not apply to him. Therefore, he can immediately withdraw any converted amounts without concern for the 5-year rule. Essentially, the converted amount is treated the same as a contribution in this case. If John were, say, 53 when he converted, the converted amount would now be subject to the 5-year conversion rule. When John turns 58, he may withdraw the converted amount without penalty. If john were 58 when he converted, the 5-year rule kicks in but no longer applies when he turns 59 ½. The key take-away is that the 5-year conversion rule enforces the pre age 59 ½ early withdrawal penalty. If you’re 59 ½ or older, you’re in the clear.  

However, the 5-year rule regarding withdrawal of earnings still applies. If this is the first time John has had a Roth IRA, the 5-year clock for withdrawals of earnings begins now. If he has already owned a Roth IRA for 5 years AND is over 59 ½,  he is free to withdraw any earnings without taxation or penalty. 

It's important to note that the 5-year rule for conversions primarily applies to individuals younger than 59 ½ years old. It prevents them from converting their Traditional IRAs to Roth IRAs and immediately accessing the converted amounts as if they were contributions, thereby circumventing the early withdrawal penalty.

Important Considerations

  1. Clear distinction on contributions and earnings: It's crucial to understand that the 5-year rule for earnings applies to the taxation of earnings, not contributions themselves. Contributions can be withdrawn at any time, regardless of the 5-year rule, without taxation or penalties.

  1. Impact of existing Roth IRAs: When opening a new Roth IRA, the 5-year rule for earnings takes into account any existing Roth IRAs. The clock starts when the first Roth IRA is opened and funded. Openning a new Roth IRA does not start a new 5-year clock. The same holds for new contributions to a Roth IRA. 

  1. Determining the start of the 5-year rule: Contributions made within a calendar year are considered to have been made on January 1 of that year for the purpose of determining the start of the 5-year rule. In fact, you can open and fund your first Roth IRA on April 15, 2023, counting that contribution for 2022, which would mean the clock would have actually started January 1, 2022! In this case, you would only have 3 ⅔ years left on the 5-year countdown.

  1. Age consideration for the 5-year rule for conversions: The 5-year rule for conversions primarily applies to individuals who are younger than 59 ½ years old. Those over 59 ½ need not concern themselves with this restriction. However, the 5-year rule regarding withdrawal of earnings (5 years and 59 ½) still applies.