That is right; there are two 5-year rules for Roth IRA accounts. The first rule applies to Roth contributions and regulates whether earnings will be tax free. The second rule applies to conversions and determines if the converted dollars will be penalty free. Not understanding how these rules impact your withdrawals can lead to unnecessary taxes or even penalties. Today I will cover what the rules are, how they work, and when they may be relevant to you.

5-Year Rule for Contributions

This rule is used to assess if a withdrawal of investment earnings or growth will be taxed or treated as a “qualifying distribution.” Just because investment dollars are in a Roth does not mean they will automatically be tax free!

To qualify as a tax-free distribution from a Roth IRA, withdrawals need to meet two requirements. One, the withdrawal must be on or after the date the owner turns 59 ½, passes away, becomes “totally disabled,” or used for first time homeowner expenses. The second requirement is that the Roth meets the 5-year contribution rule.

The 5-year rule requires that 5 tax years have passed from the date the first contribution was made to any Roth IRA. That’s why it’s called the 5-year rule. The IRS is not known for their creativity. Importantly, the language references “tax years.” Because the IRA allows until the tax filing deadline this means that contributions made in 2013 for the 2012 tax year would allow someone to meet the requirements of the rule in 2017. Additionally, one must note that the rule references any IRA. The 5-year rule does not start over with subsequent contributions or additional accounts. The rule applies to the FIRST contribution made to ANY Roth account. Like Traditional IRA accounts, all Roth IRA accounts are aggregated together in the eyes of the IRS. Also, like Traditional IRAs, you do not aggregate their retirement plan counterparts. Meaning, Roth 401(k) accounts are not included in that aggregation. Closing one Roth IRA and rolling it into another Roth IRA does not start the 5-year period over again either. Of course, the Roth 401(k) exception still applies. If you roll a Roth 401(k) balance into a Roth IRA and you had never owned a Roth IRA, the clock starts with the inception of the new Roth IRA account.

Accordingly, once the 5-year requirement has been met, it has been met for life. Recent contributions to Roth IRAs do not need to meet the 5-year seasoning even if the initial funding occurred years ago. Remember, the 5-year rule is only one requirement. Withdrawals also need to meet the second test: after age 59 ½, death, disability, or first time homebuyer exception.

401(k) Accounts

Like Roth IRA accounts, Roth 401(k)s are subject to the 5-year rule for distributions. Unfortunately, you will recall that these accounts are tracked separately. In the above example, the Roth 401(k) contribution did not start the clock on the Roth IRA holding period. Likewise, even if the Roth IRA holding period has been met, the Roth 401(k) is subject to its own 5-year rule. Interestingly, unlike Roth IRA accounts, each Roth 401(k) is subject to its own 5-year holding period. Unless you roll the old Roth 401(k) balance into your new Roth 401(k). In which case, you can “carry forward” your holding period. But again, rolling the Roth 401(k) balance into a Roth IRA starts the clock over again.

5-Year Rule for Conversions

True to form, the IRS has kept their nomenclature simple. As you probably guessed, this rule applies to dollars converted from a Traditional IRA to a Roth IRA and determines whether the converted principal can be withdrawn tax-free.

This rule is not too different from the previous and essentially states that a 5-year holing period must be met in order to satisfy the guidelines. However, because conversions must take place in a calendar year, there is no way to start the clock on a prior year. However, conversion done at any time during the year count for that year.  Meaning a conversion as late as December 2013 would start the clock in 2013.

Another notable difference is that each conversion has its own 5-year requirement. Subsequent conversions are subject to a new 5 years every time they occur. Fortunately, Uncle Sam has determined that Roth withdrawals occur on a first in, first out basis. This essentially means that the oldest converted dollars are assumed to withdrawn first.  In the case of Roth IRA accounts the IRS assumes funds are withdrawn in the following order: contributions first, conversions second, and earnings last.

Here is an example:

How would a $15,000 withdrawal be taxed? It wouldn’t be, $15,000 has been contributed and contributions are not taxed. While the 5-year rule has been met, even if it hadn’t, the rule applies to how earnings on contributions are taxed, not contributions themselves. What about $25,000? If there is no special purpose (age 59 ½, death, disability, first home purchase) it would still be tax-free. The first $15,000 because it is a contribution and an additional $10,000 because it is converted dollars that met the 5-year rule. Now, what about the whole $40,000? $25,000 still comes out tax free but the $15,000 of earnings is taxed with a 10% penalty because it did not meet the 2^nd requirement of age 59 ½, death, disability, or first time homebuyer.

Lastly, it is important to note that the 5-year holding period subjects converted principal to the 10% penalty on early withdrawals. Exceptions to the 10% penalty, like attaining age 59 ½, also exempt converted dollars making the 5-year rule for conversion irrelevant for any one over the age of 59 ½. Likewise, death, disability, and first time homebuyer exceptions (up to $10,000) also exempt Roth owners from the 5-year rule on conversions.

Included in this blog are two infographics to make things easy. To keep things simple for this article I have referenced the “triggering events” of age 59 ½, death, disability, and first home purchase. However, when it comes to earnings there are additional “special purposes.” These are medical expenses, medical insurance premiums while unemployed, 72(t) payments, and higher education expenses. As with most tax situations, this can be a complicated process and it always makes sense to review your situation with a qualified tax professional and a financial planner.

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