Master the five-year rule for Roths

The Five-Year Rule for Roths is an essential aspect of retirement planning for individuals utilizing Roth accounts, and it is important to understand its nuances.

Actually involves several variations, and failing to adhere to these rules could result in unintended taxes and penalties.

It is crucial to know how these rules apply to different types of Roth accounts such as Roth IRAs, Roth 401(k)s, and Roth conversions. This guide breaks down the different aspects of the Five-Year Rule for Roths, helping you avoid costly mistakes.

Roth IRA five-year contribution rule

The Five-Year Rule for Roths starts with the Roth IRA’s contribution rule. This rule states that you must have had a Roth IRA open for at least five years before withdrawing any earnings without being subject to taxes.

Even if you are over the age of 59½, failing to meet this five-year holding period means you will have to pay taxes on any earnings withdrawn.

Furthermore, if you withdraw before this period is completed, a 10% penalty could apply to those earnings if you are under the age of 59½.

What is often overlooked is that the Five-Year Rule for Roths applies not only to contributions but also to conversions and rollovers.

Any deposit into a Roth account—whether a contribution, rollover, or conversion—initiates the five-year countdown. This time period starts on January 1 of the year in which the first contribution, rollover, or conversion is made.

Roth conversion five-year rule

Separate from the contribution rule is the Five-Year Rule for Roths as it pertains to Roth conversions.

If you convert funds from a traditional IRA or 401(k) to a Roth IRA, the conversion starts its own separate five-year holding period.

This means that if you withdraw funds from a converted Roth IRA before five years have passed and before reaching age 59½, you may be subject to both taxes and a 10% early withdrawal penalty.

However, once you reach age 59½, you can begin taking distributions from the converted Roth IRA without the 10% penalty, though the Five-Year Rule still applies to determine if taxes are due on the earnings.

Even after age 59½, the IRS continues to enforce this rule for converted funds, which means that if the five-year holding period for the conversion is not met, taxes will apply to any earnings in the withdrawal.

Roth 401(k) and other designated roth accounts

In employer-sponsored Roth accounts like Roth 401(k), Roth 403(b), and Roth 457(b), the Five-Year Rule for Roths works similarly to Roth IRAs, but with some key differences.

Like Roth IRAs, contributions to a Designated Roth account begin the five-year holding period, and this period begins on January 1 of the year the contribution is made.

However, each individual Roth account (whether Roth 401(k), Roth 403(b), or Roth 457(b)) will have its own five-year rule.

One key difference is that with Designated Roth accounts, the IRS does not allow you to withdraw contributions first before the five-year holding period is complete.

This is a departure from the Roth IRA rules, where you can withdraw contributions anytime without tax or penalty.

For Designated Roth accounts, the IRS assumes that any withdrawal is a mix of both contributions and earnings, which could subject the earnings to tax and a 10% penalty if you are under the age of 59½.

Roth-to-roth rollover five-year rules

Roth-to-Roth rollovers also come with their own version of the Five-Year Rule for Roths.

If you are rolling over assets from one Roth account to another—whether from a Roth IRA to a Roth IRA or from a Roth 401(k) to a Roth IRA—the five-year holding period is still relevant, but the rules vary depending on the type of rollover.

• When rolling funds from one Roth IRA to another Roth IRA, the five-year rule applies to all Roth IRAs you own. The first Roth IRA you open starts the clock for all future Roth IRAs, meaning that if you have met the five-year holding period in one Roth IRA, it will apply to others, even if they are opened later.
• If you roll over funds from a Roth 401(k) to a Roth IRA, the holding period for the Roth IRA determines whether the Five-Year Rule for Roths has been met. The five-year rule for the Roth 401(k) does not transfer to the Roth IRA.
• For a Roth-to-Roth rollover between two employer-sponsored Designated Roth accounts (such as from one Roth 401(k) to another), the Five-Year Rule for Roths generally uses the holding period of the older Roth account. This means that if you roll over assets from an older Roth account into a newer one, the older account’s five-year clock continues to govern all assets in the new account.

Understanding the specifics of the Five-Year Rule for Roths is essential to avoid unnecessary taxes and penalties.

With careful planning and an understanding of how the five-year rule applies to your individual Roth accounts, you can maximize the benefits of these tax-advantaged accounts.