Roth IRA Five Year Rule- Can You Dig It?
You might be asking yourself what the Jackson Five has to do with the Roth IRA five year rule for qualified withdrawals? I’m sad to say, “Absolutely nothing”. Other than then number “five”, of course. I just thought it was fitting with all the recent tributes to the King of Pop to have my own. Now that I have your attention…..
The basics of the Roth IRA include the phrase “Tax Free Money”. That phrase makes the Roth IRA the most attractive retirement planning tool of our time. When it comes to the intricacies of the Roth IRA, in regards to how it works, some confusion can set in. One provision of the Roth IRA that can leave many scratching their heads is the Five Year Rule. The Five Year Rule pertains to when you can take qualified distributions from your Roth IRA tax and penalty free. Nobody wants to pay tax and penalties, right? That’s why it’s important to know how this rule works. Just to add more fun to the mix, you need to first know that there are two sets of Five Year rules. One pertains to Roth IRA contributions and the other pertains to Roth IRA conversions. We’ll begin with Roth IRA contributions.
Withdrawal on Roth IRA Contributions
In order for you to take money from the Roth IRA tax and penalty free, it has to be considered a “qualified distribution”. We’ll get to what a qualified distribution is in one moment. First thing I need to remind you is that all contributions can be taken at any time, tax and penalty free. That means what you put into the Roth IRA (contribution) can be taken out the following day without consequence (not factoring sales charges and market risk). Let me illustrate:
Example 1
You open a Roth IRA at your bank and decide to put $5000 into a money market account inside the Roth. A month goes by and something happens where you need to withdraw your money. You can withdraw the original $5000 tax and penalty free. What has to stay is the earnings or, in this case, the interest that you made off the $5000 (which should be minimal considering you didn’t have it that long). Now keep in mind, the bank may charge you some cancellation fee of some kind, so read the fine print. But as far as the IRS is concerned, you are in the clear.
Example 2
Just to illustrate another side of the first example, let’s say this time you decide to invest at a brokerage firm and choose an investment more tied to the stock market. After a month goes by, your original $5000 investment now plummets to $3000. (I think a lot of people can relate to that). All you are allowed to withdraw is the $3000. That’s it! Sometimes that gets overlooked. Also, if you paid a sales charge or commission on that investment, that’s not being refunded to you either.
What is a Qualified Distribution for Roth IRA?
What’s so important about a qualified distribution? If it’s deemed qualified, you then avoid taxes and the 10% early withdraw penalty. Taken directly from IRS pub 590 this defines what qualified distribution is:
A qualified distribution is any payment or distribution from your Roth IRA that meets the following requirements.
- It is made after the 5-year period beginning with the first taxable year for which a contribution was made to a Roth IRA set up for your benefit, and
- The payment or distribution is:
- Made on or after the date you reach age 59½,
- Made because you are disabled,
- Made to a beneficiary or to your estate after your death, or
- One that meets the requirements listed under First home under Exceptions in chapter 1 (up to a $10,000 lifetime limit).
Remember that you have until April 15 of the following calendar year to make a Roth IRA contribution for any tax year. But the five year window begins January 1st of the actual tax year. Also, the five year window is based on when you made your first deposit. Meaning that a new five year window does not begin with each additional deposit. Is your head spinning? Let’s look at another example:
Example 3
You open a Roth IRA but don’t actually make your first contribution until April 10th, 2006. Your five year window would then begin on January 1st, 2005. If you didn’t make another deposit until 2008, your five year window is still based on the January 1st, 2005 date. Don’t forget that it’s Five Year rule plus one of the other factors (most likely 59 1/2) to get the money tax and penalty free.
(couldn’t resist having a picture of #5 Albert Pujols)
Roth IRA Conversions
The Five Year Rule works a bit differently when it pertains to Roth IRA Conversions. The major difference is starting of a new five year window with each new conversion. Once you reach the age of 59 1/2 this isn’t much of an issue, but you still need to aware of this. Especially, if you haven’t had a Roth IRA open for at least five years. If so, the conversion amount will come out tax free, but the earnings are still subject to a five year holding period. Let’s look at another example:
Example 4
If you started a Roth IRA at age 50 with a contribution and then decide to convert at ages of 58, 59, and 60 respectively, you are immediately eligible to take all funds out tax and penalty free (even earnings) since you satisfied age and “any or “a” five year holding period in a Roth.
The above example is one what I wrestled with trying to find the answer and as it stands right now, that is the best interpretation of the rule that I’ve found.
Similar to Roth IRA contributions, the five year clock begins on January 1st of the year that you convert. The key difference is that the you must convert in the calendar year and not the tax year: before December 31st.
Converting has been difficult to qualify for a conversion since your adjusted gross income has to be less than $100,000. But as I’ve written about on more than one occasion, Roth conversion rules change slightly and the income limit is removed in 2010. Expect many to take advantage of this next year.
Keep it in Order-Rules For Taking out of Roth IRA
You have made it thus far- congratulations! We’re almost there. The last step that we have to address is the ordering rules for taking out withdrawals from your Roth IRA. This is important because of, once again, the taxes and penalties that might occur. According to the IRS, the order of a distribution from a Roth IRA is:
- Regular Contributions – by considering the first money withdrawn from the account “regular contributions,” and not earnings, the IRS allows account holders to remove a portion of their accounts before the five-year rule applies.
- Conversions – this is on a first-in, first-out basis. So the money placed into an account because of a conversion that occurred in 2008 would be removed before a conversion that occurred in 2009.
- Taxable – the taxable portion of the conversion is removed first. This is the amount claimed as income because of the conversion.
- Non-Taxable – this is the portion of the conversion not included in gross income.
- Earnings – finally, the last money to be removed from an account are the earnings on the assets placed in the account.
Logically, it makes sense. The monies that you have paid taxes on will come out first tax and penalty free. After the contributions are taken out, just work down the list to see what you can or cannot take. Still confused? This is where a CPA or a Certified Financial Planner can assist you computing the numbers for you.
Required Minimum Distributions and Roth IRA
One last note when doing conversions and you are over the age of 70 1/2. Since you are the IRS magic age to begin required minimum distributions, those distributions can’t be converted to a Roth IRA. In the year you wish to convert, you must first withdraw your required distribution, and then you can convert any or all remaining funds to a Roth. This is only if you do a full conversion. If you are looking to do a Roth IRA conversion at the beginning of the year, but postpone your RMD; then you’ll want to do a partial conversion and leave at least the amount of the RMD in the IRA. Be sure to double check with your IRA custodian to see what their policy is on the matter of RMD’s and converting. Keep in mind that in 2009 RMD’s are suspended, so that would not apply. It will continue as scheduled in 2010.
Securities offered through LPL Financial, Member FINRA/SIPC
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Being I am in my first year of my Roth IRA am working towards maxing it out, this is nice to know. I enjoy learning more about the Roth IRA and how it can contribute to my future.
Craig´s last blog ..Quit blaming the economy and start protecting yourself already
Another great IRA article.
Your example one is worth a small comment – given the ability to withdraw that money with no penalty, someone who is in a tight situation, unable to fund both an emergency account as well as the Roth, should consider putting those emergency funds “in” a Roth. If they do run into some financial issues, the money is there for withdrawal (to be clear, this is CD money, not invested in stocks) and if not, they didn’t miss the chance to start funding their retirement account.
This also makes the emergency fund feel a bit less accessible, it shouldn’t be raided for anything should of a true emergency.
JoeTaxpayer´s last blog ..Frugal Friday Week 9
Great explanation, Jeff -
One clarification in your Example #3: in order for the 5-year clock to begin on 1/1/2005, the contribution on 4/10/2006 in your example must be attributed to tax year 2005… if for some reason you are ineligible to make a 2005 contribution (no earned income or MAGI above $100k, for example), then the 4/10/2006 contribution would be attributed to tax year 2006 and the five-year clock would begin on 1/1/2006.
Keep up the great work!
jb
Jim Blankenship, CFP®, EA´s last blog ..Linksharing 7/19/2009
@Jeff – I agree with Jim, another excellent Roth commentary! You cover a complicated topic in easy to understand language. And most importantly, you cover a subject most Roth IRA participants don’t even know about…
While most people are aware of the 5 year rule, it isn’t common knowledge that there’s a difference between the tax year and the actual year in which you make a contribution. Obviously, that’s an important distinction.
Also, just to clarify, you quote IRS publication 590 in relation to what constitutes a qualified distribution. According to that quote, it’s qualified if the payment or distribution is:
“Made because you are disabled.”
It’s important that people understand the IRS definition of what constitutes “disabled.” That definition is also covered in IRS publication 590. So if someone reading this is on disability, they shouldn’t make the assumption that just because they qualify for disability payments or meet other government definitions of “disabled,” that they also meet the definition in IRS publication 590.