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 the 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 Five-Year Rule pertains to when you can take qualified distributions from your Roth IRA tax and penalty-free. Nobody wants to pay taxes and penalties, right? That’s why it’s important to know how the Roth IRA withdrawal 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.
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 Roth IRA Distributions Rules For Withdrawals: 5-year rule.
Table of Contents
- Withdrawal Rules on Roth IRA Contributions
- What Is the Rule For Qualified Distributions on a Roth IRA?
- Roth IRA Conversions
- Keep It in Order: Rules for Taking Out of Roth IRA
- Required Minimum Distributions and Roth IRA
- The Bottom Line – 5-Year Rule for Roth IRA Qualified Distributions and Withdrawals
Withdrawal Rules 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 the rules on qualified distribution are in one moment.
The 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:
You open a Roth IRA at your bank and decide to put $5,000 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 $5,000 tax and penalty-free.
What has to stay is the earnings or, in this case, the interest that you made off the $5,000 (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.
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 $5,000 investment now plummets to $3,000. (I think a lot of people can relate to that). All you are allowed to withdraw is the $3,000. 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 the Rule For Qualified Distributions on a Roth IRA?
What’s so important about a qualified distribution? If it’s deemed qualified, you then avoid taxes and the 10% early withdrawal penalty. Taken directly from IRS Pub 590-B (2022), this defines what qualified distribution is:
A qualified distribution is any payment or distribution from your Roth IRA that meets the following rules.
- 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.
- The payment or distribution is:
1. Made on or after the date you reach age 59½
2. Made because you are disabled
3. Made to a beneficiary or to your estate after your death or
4. One that meets the requirements listed under First Home under Exceptions in Chapter 1 (up to a $10,000 lifetime limit).
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:
You converted your traditional IRA to a Roth IRA but didn’t actually make the conversion until April 10, 2006.
Your five-year window would then begin on January 1st, 2006. If you didn’t make another conversion until 2008, your five-year window is still based on the January 1st, 2006 date.
Don’t get this mixed up with the extra months’ allowance you have to make a direct contribution to your Roth. Remember, it’s a Five-Year rule plus one of the other factors (most likely 59 1/2) to withdraw the money tax and penalty-free.
Roth IRA Conversions
The Five Year Rule works a bit differently when it pertains to Roth IRA Conversions. The major difference is starting off 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 be 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:
If you started a Roth IRA at age 50 with a contribution and then decide to convert at ages 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 that 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 you must convert in the calendar year and not the tax year before December 31st.
Converting has been difficult to qualify for 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 changed slightly, and the income limit was 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:
1. 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.
2. Conversions – this is on a first-in, first-out basis. So, the money placed into an account because of a conversion that occurred in 2022 would be removed before a conversion that occurred in 2023.
3. 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 in computing the numbers for you.
Required Minimum Distributions and Roth IRA
One Last Note:
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 RMDs and converting.
The Bottom Line – 5-Year Rule for Roth IRA Qualified Distributions and Withdrawals
Navigating the waters of Roth IRA withdrawals and qualified distributions is essential for any investor seeking tax and penalty-free retirement benefits. The Roth IRA, while lauded for its “Tax-Free Money” advantage, comes with its intricacies, notably the 5-year rule.
With two sets of this rule—one for contributions and one for conversions—it’s paramount to understand the specifics to avoid costly mistakes.
Whether discussing direct contributions, conversions, or the ordering rules for withdrawals, each aspect plays a vital role in ensuring maximum benefits.