What Is the Roth IRA 5-Year Rule & How Does It Affect My Retirement Planning?
We’re big fans of the Roth IRA at Hosler Wealth Management. It’s one of the key vehicles we use to help our clients build a tax-free retirement.
The Roth IRA is an amazing tool, but much like other retirement vehicles, it’s not without certain regulations that limit how and when people can access the money tax-free.
For instance, access to Roth IRA earnings is subject to what is referred to as the five-year rule.
What Is the 5-Year Rule?
Essentially, the five-year rule is a required holding period instituted by the IRS to keep individuals from withdrawing any earnings from their Roth accounts earlier than the age of 59 and a half.
To put it more simply, you must wait five years after your first Roth contribution — and, you must have reached the age of 59 and a half years of age — before you can withdraw any earnings or interest from a Roth IRA without paying the 10% early withdrawal penalty.
Note that the five-year rule applies only to withdrawing earnings. You can always withdraw your original contribution amounts from a Roth IRA without penalty at any age because you already paid taxes on those funds before you added them to your Roth.
When does the 5-Year Rule Start?
When we talk about waiting five years in terms of withdrawing earnings from a Roth IRA, we’re really talking about tax years. In other words, the clock starts running on January 1 of the first year you made your first Roth contribution, or your first Roth IRA conversion.
For example, you could contribute funds to your Roth IRA in late December and be one year into your five-year waiting period because the clock started running clear as of January 1 of that same year.
The five-year rule will apply to all your other Roth IRA retirement accounts as well, including the Roth 401(k). But there are nuanced differences with how the rule is applied between Roth IRAs and Roth 401(k) accounts.
Roth IRA accounts can use the oldest Roth IRA account to fulfill the terms of the five-year rule. This means if you have multiple Roth IRAs, after you reach a five-year holding period for the first one of them — and so long as you’ve achieved age 59 and a half — you can take a qualified distribution from any of your Roth IRA accounts.
For a Roth 401(k), though, the five-year rule is plan specific. Meaning, if you have multiple 401(k) accounts from multiple jobs, you must meet the five-year holding period for each one individually before you can withdraw funds without penalty.
How To Bypass the Roth 401(k)’s Plan-Specific 5-Year Rule
If you own one or more Roth 401(k) accounts, you’re not stuck waiting out their respective five-year holding periods before taking qualified distributions.
Instead, you can make a direct transfer of your Roth 401(k) accounts into an existing Roth IRA, and it will assume the characteristics of Roth IRAs. That means if you have a Roth IRA that has satisfied its five-year holding rule — and, again, you meet the 59 and a half age requirement — you can withdraw the funds that were moved in a direct transfer from your old Roth 401(k) into one of your Roth IRA accounts.
The only potential issue with this strategy is that you may not be able to affect the direct transfer from your Roth 401(k) account to your Roth IRA account until after you separate from service with your employer.
Exceptions to the 5-Year Rule
Generally, before you can withdraw earnings from your Roth IRA, you must meet the following criteria:
• Hold your Roth IRA account for five years (the five-year rule)
• Be at least 59 and a half years old
But, as we know, life happens. That’s why, under certain situations, you can withdraw earnings without satisfying the five-year rule, regardless of your age.
These exceptions include:
• If you become disabled or pass away
• Use up to $10,000 to pay for a first-time home purchase
• Qualified education expenses for yourself, a spouse, child or grandchild
• Qualified expenses related to a birth or adoption
• Unreimbursed medical expenses or health insurance if you become unemployed
Remember, too, that in case of an emergency that doesn’t fall under these exceptions, you can always withdraw your original Roth IRA contributions or conversion amounts without penalty, no matter your age.
Ready to Explore Your Roth IRA Options?
Roth IRAs are one of the best vehicles to build tax-free income in retirement. That’s why it’s critically important to open your first Roth IRA as soon as possible, to get the clock started on the five-year rule.
The experienced team at Hosler Wealth Management can help you plan for and ensure you satisfy the five-year rule as soon as possible so you can enjoy tax-free income in retirement.
Request a call or send us a message to see how our financial experts in Scottsdale and Prescott, Arizona, can help you achieve your financial goals and map out your own Roth IRA strategy to create a tax-free retirement.
This material is intended for informational/educational purposes only and should not be construed as specific tax, legal or investment advice. Individual circumstances may vary.
Disclosure: Securities and advisory services offered through Commonwealth Financial Network®, Member www.FINRA.org/www.SIPC.org, a Registered Investment Adviser. 700 S. Montezuma Street, Prescott, AZ 86303. Phone: 928.778.7666. This communication is strictly intended for individuals residing in AK, AZ, CA, CO, FL, GA, HI, ID, IL, MA, ME, NE, NJ, NM, NV, OH, TX, UT, VA, WA, WI. No offers may be made or accepted from any resident outside these states due to various state requirements and registration requirements regarding products and services. Fixed Insurance products and services offered through CES Insurance Agency. Tax preparation and accounting service offered by Hosler Wealth Management, LLC are separate and unrelated to Commonwealth. Any tax advice contained in this article is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding Federal or State tax penalties or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.
© 2023 Hosler Wealth Management LLC