What is the 5-year rule for Roth conversions? 

The 5-Year Rule for Roth conversions is an important rule that novice and experienced investors alike will come across. It’s vital for leveraging the Roth Individual Retirement Account (IRA), which offers tax advantages that investors can benefit from immensely.  

Knowing and understanding the intricacies of the 5-Year Rule is crucial for maximizing the Roth conversion's benefits and coming up with an optimal retirement planning strategy.  

In this article, we discuss the 5-Year Rule, its implications, and how it can impact an individual investor’s retirement savings and retirement strategy. InvestmentNews aims to provide you with a comprehensive understanding of the Five-Year Rule for Roth conversions. 

Understanding the 5-Year Rule for Roth conversions 

What is the 5-Year Rule and what is its purpose? How does the 5-Year Rule work for Roth Conversions? The Five-Year Rule is a fundamental aspect of Roth conversions that can essentially determine the tax treatment of your converted funds.  

Because Roth IRAs offer significant tax advantages like tax-free earnings and tax-free withdrawals upon retirement, the 5-Year Rule is also meant to ensure that Americans keep their retirement savings intact.  

Here are the key points to bear in mind regarding the 5-Year Rule: 

• it determines whether account owners can withdraw Roth IRA earnings tax-free 
• Roth IRA conversions and inherited Roth IRAs have different 5-Year Rules 
• the five-year waiting period starts with the first contribution to any Roth IRA 

The 5-year Rule restricts withdrawals from a Roth IRA account. The withdrawals consist of investment earnings within the Roth account. As per the rule, these earnings cannot be withdrawn without incurring a penalty for at least 5 years.  

The contributions to a Roth IRA, however, can be withdrawn at any time without penalty. This is because Roth IRA contributions have already been taxed.  

The 5-Year Rule determines whether a withdrawal of earnings from a Roth IRA will be taxable or not by the IRS. If the IRS deems the withdrawal taxable, then the account owner can be liable to pay a 10% penalty on the earnings in addition to the applicable income taxes.  

When does a 5-year period begin on a Roth Conversion? 

Each Roth conversion amount gets its own 5-year period. However, the period is retroactive to the start of the tax year. The start of the 5-year period for a conversion is always set to January 1 of the year the account owner made their first contribution. 

For example, a Roth IRA conversion made at any time in 2024 is deemed as having been made as of January 1, 2024. For that specific 2024 conversion, the account owner would be able to take a penalty-free withdrawal in 2029. But remember, withdrawals must also be made only after the account owner reaches the age of 59½ for them to be tax- and penalty-free.  

This video illustrates the start of the 5-Year Rule and discusses the difference between the Roth IRA contribution and IRA conversion. Watch the video to get more clarification on the 5-Year Rule, its purpose, and the penalties involved.  

Roth IRA guidelines on early withdrawals

When an investor decides to withdraw some of the contributions from their Roth IRA, they can do so at any time without fear of incurring a penalty and/or income taxes. But if they are withdrawing earnings, certain conditions must be met to avoid taxes and penalties.  

In the sections below are comparisons between younger and older Roth owners making withdrawals from a Roth account. You will also notice the effects of them withdrawing or taking distributions from a Roth account that meet the 5-Year Rule and from one that does not:  

Withdrawals from a Roth IRA existing foThis is clearly a violation of the Roth IRA Five Year Rule. Moreover, since the account owner has not reached the minimum age, they would have to pay taxes and the additional penalty on their early withdrawals.  r less than 5 Years (younger than 59½) 

The account owner can avoid the penalty (but not the income taxes) in the following circumstances:  

1. The withdrawal was for purchasing their first home. 

In this case, the penalty on the early withdrawal is waived if the withdrawal was for buying, building, or renovating the account owner’s first home.  

Account owners can also buy the first home for their parents or qualified beneficiaries. They can withdraw up to $10,000 from their Roth exclusively for this purpose, and this is the maximum amount for their lifetime. 

2. The withdrawal was for paying qualified educational expenses.  

Investors can likewise withdraw a portion of their Roth early to pay for tuition and other expenses that the IRS deems qualified. They can pay educational expenses for themselves, their spouse, children, or even grandchildren without paying the penalty.  

These are required to avoid the penalty:  

• the student is studying at a reputable, eligible institution 
• the withdrawn amount was for the exclusive use as payment for qualified educational expenses 
• the withdrawn amount does not exceed the qualifying expenses 
• the account owner must still pay income taxes on the withdrawal 

3. The withdrawal was used to pay for emergency expenses.  

Early Roth IRA withdrawals can avoid the 10% penalty if they were made to pay for emergencies like the loss of employment or serious illness.  

4. The withdrawal was for qualified expenses for the birth or adoption of a child.  

The IRS allows for certain qualified expenses for the adoption process to be exempt from penalties, if they were paid via an early Roth IRA withdrawal. 

Account owners can file the adoption expenses with Form 8839. For an adoption or birth of a child, the account owner can get exempted from the 10% penalty on an early Roth withdrawal of up to $5,000. 

5. The withdrawal was for paying unreimbursed medical expenses or health insurance.  

This penalty exemption only applies to account owners who are currently unemployed.  

6. There was a distribution warranted by a federally qualified disaster.   

There may be times when the country is hit by a federally qualified disaster, and U.S. Congress decides to pass a law for the IRS to give tax relief to plan participants in affected areas.  

One example is the Disaster Tax Relief and Airport and Airway Extension Act of 2017, which allowed qualified disaster distributions. These were exempted from the 10% additional tax on early distributions for plan participants younger than 59 ½.  

7. The withdrawal or distribution was made for a survivor of domestic abuse.  

This is a new feature coming in 2024. Since the Biden administration passed the SECURE Act 2.0 in 2022, domestic abuse survivors can take a distribution from their Roth account without penalty.  

Plan administrators can allow plan participants to take funds if they were victims of domestic abuse by a spouse or partner. There are certain rules to this exemption:  

• the distribution must be taken within 12 months from reporting the domestic abuse incident 
• the survivor can take $10,000 or 50% of their vested account balance, whichever is lesser 
• the distribution will be exempt from the 10% early distribution/withdrawal tax but will incur income tax 
• the survivor can repay the withdrawn amount in the next 3 years 
• if the survivor repays the amount within the 3-year period, the income tax on it will be refunded 

8. The distribution was made because of an IRS levy.  

An IRS levy is the legal seizure of an asset or property to cover unpaid taxes. If the Roth account holder owes taxes, and if after several notices the tax remains unpaid, the IRS may take hold of their property. This includes property belonging to the Roth account owner but held by another entity. That means their wages, retirement savings, dividends, bank accounts, rental income, etc., can be seized. Such a levy is exempt from the 10% penalty when taken from a Roth account. 

9. The distribution was made via Substantially Equal Periodic Payments.  

Substantially Equal Periodic Payments or SEPP is a way for individual taxpayers to receive money from their retirement accounts before turning 59½ with penalties. 

These withdrawals can be made from IRAs or 401(k) plans only if they are no longer employed by the plan providers. Distributions or payments can be made from the account for 5 years or until the account owner turns 59½, whichever is later.  

10. The account owner becomes disabled or dies.  

The list of exemptions can be quite extensive; the above listed conditions are a sample of the more common exemptions to the 10% early withdrawal penalty. You can check the IRS website’s section on exemptions for more details.  

Withdrawals from a Roth IRA existing for over 5 Years (Younger than 59½) 

If the account owner is under the age of 59½, but their Roth IRA has been open five years or more, these are the conditions required for the withdrawals on earnings to be tax-exempt: 

• the withdrawal was used to buy, build, or renovate a first-time home purchase (up to a $10,000 lifetime maximum) 
• they become disabled or pass away 

Withdrawals from a Roth IRA existing for less than 5 Years (Age 59½ or older) 

If the investor hasn’t met the five-year holding requirement yet, their earnings will be subject to income taxes but not penalties. 

Withdrawals from a Roth IRA existing for more than 5 Years (Age 59½ or older) 

In this case, older account owners who have met the five-year holding requirement can withdraw money from their Roth IRA without incurring any taxes or penalties.   

*Even if the 10% penalty or income tax typically applies here, there are conditions when the withdrawals or distributions can be exempt from either the penalty or income tax.  

Inherited Roth IRAs and the 5-Year Rule 

The rules on inherited Roth IRAs have changed slightly in recent years. If an investor should inherit a Roth IRA from a parent or other non-spousal relative who passed away in 2020 or later, these are their options:   

• Open an inherited IRA and withdraw all the funds within 10 years - in this setup, the beneficiary does not have RMDs, but the account must be emptied within the next 10 years 
• Open an inherited IRA and stretch RMDs over their lifetime - this is possible if the investor qualifies as an eligible designated beneficiary 

Penalties for not meeting the 5-Year Rule 

Should an investor withdraw money from their Roth IRA or Roth conversion before the account has been open for five years, they will pay a 10% early withdrawal penalty on the conversion amount.  

In addition to the penalty, they will also have to pay income taxes on the tax year of the conversion.  

However, these are waived if the account owner makes withdrawals when they are already 59½ or older. But remember, an elder investor who withdraws from a Roth less than five years old is not penalized but must pay income tax.   

Understanding the nuances of the Five-Year Rule is very important for investors, as it can significantly impact their financial and retirement planning decisions. For instance, if an investor wishes to retire in a few years and they are considering a Roth conversion, timing and conditions are of utmost importance.  

Also, being aware of the exceptions and limitations associated with this rule can help you make informed decisions for your client’s retirement savings. The 5-Year Rule is a vital component of Roth conversions. Having a clear understanding of its implications can help you make better choices that align with clients’ long-term financial goals.  

How does the 5-Year Rule impact your clients’ financial goals? Know more about other retirement planning tools and strategies right here in InvestmentNews!