The Roth IRA Five Year Rule

Roth IRAs are an excellent savings vehicle for your later years. If you have earned income this year and are within the earnings limits, you can contribute money already taxed into the account ($7k in 2024 or $8k if you’re 50+), which grows tax-free. All withdrawals after age 59 ½ are tax-free. This account, though, has a lesser-known five-year withdrawal rule. I want to discuss that here so you’re better aware of what you can and can’t do with the money in your account.

One fabulous fact is that any original contribution to a Roth account can be withdrawn anytime. That’s because it’s already been taxed (remember, we fund this account with after-tax dollars). The flexibility is nice, but I suggest you avoid taking the money out in your working years other than for emergencies. That’s because as soon as you do, you unplug the tax-free growth of those contribution dollars. It might indicate that you didn’t plan for or save enough for other goals like funding your kid’s education or saving for a house downpayment. (We’d love to help you uncover your goals and have a plan to get you there) I’m mentioning the penalty-free withdrawal of the original contribution to contrast it with withdrawing the growth of the money in your Roth account.

Any growth you withdraw from a Roth account before age 59 ½ will have a penalty levied and regular income taxes owed on the growth that comes out. That’s pretty straightforward. But the nuance I want to explain is the second requirement: that the account be open for five years. That’s right; even if you are 59 ½ or 62 or 67, if you just opened your Roth account, you can’t touch the growth (remember original contributions can always be touched) until after five years have passed from your first contribution. You want to keep that in mind when planning for the cash you need to fund your living after you’ve stopped working. That’s why you might as well get that Roth account open and make a small contribution as soon as possible. The five-year clock starts with any Roth account you open, so if you open a new one at another institution, your five-year clock doesn’t restart. Let’s call that the universal Roth contribution clock.

Roth Conversions, on the other hand, amplify this five-year clock. As a refresher, Roth conversions entail transferring funds from a traditional IRA or 401k into a Roth IRA. When you make this conversion, the total amount is included in your year-end taxable income because you deferred the taxes initially when contributing to your traditional IRA or 401k in previous years. That’s only fair, right? The government has to get its money. The good news is that from here on out, all growth is tax-deferred, and qualified withdrawals are still tax-free.

But what makes the withdrawal of those Roth conversion dollars qualified? Remember I said the five-year clock gets amplified? By that, I mean every Roth conversion has its own five-year clock! That’s right. Each subsequent Roth conversion has its own distinct clock. (This clock applies only to the specific funds being converted and NOT to the entire Roth balance) As soon as the clock runs out on a specific five-year window, you can withdraw those funds without penalty (As long as you are over 59 ½). Think of this as juggling a bunch of alarm clocks that go off at different times.

Managing multiple conversion dates and their respective waiting periods requires careful tracking and planning to optimize withdrawal strategies in retirement. Roth conversions have an immediate tax impact in the year of conversion, potentially pushing you into a higher tax bracket. So, before you execute one, get in touch with us so we can guide you in understanding the tax impact.

If you want a deep-dive and even more nuance about Roth contributions and conversion in the tax code, click here.