Roth IRA 5-year Rules and Roth Conversions
There are two Roth IRA 5-year rules: the Roth IRA Conversion 5-year rule and the Roth IRA Contribution 5-year rule.
Roth IRA Conversion 5-year rule
This rule applies to funds that are converted from a traditional IRA or 401(k) to a Roth IRA. It states that you must wait at least 5 years from the beginning of the tax year in which you made the conversion before you can withdraw the converted funds without penalty or taxes. This rule applies to each conversion separately, so if you make multiple conversions, each one will have its own 5-year waiting period.
Roth IRA Conversion 5-year rule example:
Let’s say you have a traditional IRA with a balance of $100,000 and you decide to convert it to a Roth IRA in 2023. The 5-year waiting period for this conversion will begin on January 1st, 2023. This means that you will need to wait until January 1st, 2028 (i.e., five years from the beginning of the tax year in which you made the conversion) to withdraw any of the converted funds without penalty or taxes. If you withdraw the converted funds before this waiting period is over, you may be subject to taxes and penalties.
If you make multiple conversions over the years, each conversion will have its own 5-year waiting period. For example, if you make a second conversion in 2025, the 5-year waiting period for that conversion will begin on January 1st, 2025, and you will need to wait until January 1st, 2030 to withdraw those converted funds without penalty or taxes.
Roth IRA Contribution 5-year rule
This rule applies to Roth IRA contributions. It states that you must wait at least 5 years from the beginning of the tax year for which you made your first contribution to any Roth IRA before you can withdraw earnings on those contributions without penalty or taxes. This rule applies to all Roth IRA contributions, regardless of whether they were made directly to the Roth IRA or through a conversion.
Roth IRA Contribution 5-year rule example:
Let’s say you make your first Roth IRA contribution in 2023. The 5-year waiting period for this contribution will begin on January 1st, 2023. This means that you will need to wait until January 1st, 2028 (i.e., five years from the beginning of the tax year for which you made your first contribution to any Roth IRA) to withdraw any earnings on that contribution without penalty or taxes.
For example, if your Roth IRA contribution was $6,000 in 2023 and it grew to $7,000 by 2028, you could withdraw the original $6,000 at any time without penalty or taxes. However, if you withdraw any of the $1,000 in earnings before the 5-year waiting period is over, you may be subject to taxes and penalties.
It’s important to note that the two 5-year rules are independent of each other. For example, if you make a Roth IRA conversion and a Roth IRA contribution in the same year, the conversion will have its own 5-year rule, and the contribution will have its own 5-year rule, but the two 5-year periods will not overlap or affect each other.
It’s also worth noting that there are exceptions to both of these rules. For example, you can withdraw converted funds before the 5-year waiting period is up if you meet certain criteria, such as being age 59 1/2 or older or using the funds for a qualified first-time home purchase. Similarly, there are exceptions to the Roth IRA contribution 5-year rule, such as if you are withdrawing the contributions for a qualified reason, such as a disability or certain medical expenses.
Overall, it’s important to understand both of these rules if you are considering opening or contributing to a Roth IRA or making a Roth IRA conversion. It’s a good idea to consult with a financial advisor to determine how the rules apply to your specific situation and to ensure that you are making the most of your Roth IRA.
For those who are not familiar, a Roth conversion is the process of transferring funds from a traditional IRA or 401(k) into a Roth IRA. Unlike traditional retirement accounts, Roth IRAs are funded with after-tax dollars, meaning that all future withdrawals in retirement will be tax-free.
So why should you consider doing a Roth conversion?
First and foremost, Roth conversions can provide significant tax benefits. By moving funds from a traditional IRA or 401(k) into a Roth IRA, you can pay taxes on the amount converted at your current tax rate, which may be lower than the tax rate you will face in retirement when you start withdrawing funds from your traditional IRA or 401(k). This means that by doing a Roth conversion, you could potentially save on taxes in the long run.
Additionally, Roth conversions can offer greater flexibility in retirement. Traditional retirement accounts require you to start taking required minimum distributions (RMDs) at age 72, which can limit your ability to control your tax liability in retirement. With a Roth IRA, there are no RMDs, allowing you to withdraw funds on your own schedule and potentially reducing your overall tax burden in retirement.
Another benefit of Roth conversions is that they can help you manage your estate planning. Roth IRAs have no required minimum distributions during the owner’s lifetime, which means that you can leave the account to your heirs tax-free. This can be a significant advantage when it comes to passing on your wealth to your loved ones.
Of course, it’s important to note that Roth conversions are not suitable for everyone. Depending on your individual financial circumstances, it may make more sense to stick with traditional retirement accounts. However, if you are in a lower tax bracket, expect to be in a higher tax bracket in retirement, or want to maximize your flexibility and estate planning options, a Roth conversion may be worth considering.
In conclusion, a Roth conversion can provide significant tax benefits, greater flexibility in retirement, and improved estate planning options. If you are interested in exploring whether a Roth conversion is right for you, we recommend consulting with a financial advisor who can help you make an informed decision based on your individual circumstances.
Internal Revenue Service Publication 590-A (2021), Contributions to Individual Retirement Arrangements (IRAs). Retrieved from https://www.irs.gov/publications/p590a