The Roth Five-Year Rule: What You Need to Know

The Roth Five-Year Rule:…

Roth accounts are popular vehicles for saving for retirement. Nearly 20% of American households have a member with a Roth IRA, and nearly 70% of employers offer a Roth 401(k) option. If you have a Roth IRA, Roth 401(k), or other Roth account, you may have heard of the “five-year rule” and wonder how it affects you. In this article, we will break down aspects of the rule you may not be fully aware of.

What is the “Five-Year Rule?”

In a nutshell, the five-year rule dictates when you are able to take tax-free distributions from your Roth IRA or other account. Specifically, the requirement is that your first distribution must be at least five years after your first contribution to the account. Further, the distribution needs to happen after you reach age 59 ½ or become disabled (or, following your death, when the account assets go to your surviving beneficiaries).

If that was all there was to it, this would be a much shorter article. But the devil, as they say, is in the details. Those details can have an impact on the tax status of your distributions from a Roth account, so they are worth understanding.

When Do the Five Years Begin?

“Five years” does not necessarily mean five years from the date of your first contribution. Rather, the clock begins ticking on January 1 of the tax year in which you first contribute to the Roth account.

To illustrate: if you made your first contribution on May 1, 2020, the five year period would begin on January 1, 2020 and end five years later, on January 1, 2025. In reality, your “five year” period would be four years and eight months—and if you made that first contribution at any time up until April 15, 2021, it would be even shorter.

How is My Account Affected By the Five-Year Rule?

The answer depends on the type of account. If you have one or more Roth IRAs, the five-year period begins with the first contribution to any of those accounts. It’s different if you have a Roth account through an employer plan. In that case, each account has its own five-year clock.

Things change even more if you have rolled assets from a previous job’s 401(k) into a Roth 401(k). In that case, the five-year period began at the time you initially contributed to the original 401(k), not when you rolled it into the current Roth 401(k).

Things change even more if you have rolled assets from a previous job’s 401(k) into a Roth 401(k). In that case, the five-year period began at the time you initially contributed to the original 401(k), not when you rolled it into the current Roth 401(k).

A note of caution if you have rolled a Roth 401(k) into a Roth IRA: the rule is not the same as the above example, in which one 401(k) is rolled into a Roth 401(k). When rolling a Roth 401(k) into a Roth IRA, it does not matter when you first contributed to the Roth 401(k). If you have not had a Roth IRA before, the five-year clock begins to run at the time of the rollover to a Roth IRA, NOT the time of the original contribution of the Roth 401(k).

With a little foresight, there is a way to get around this problem. If you have a Roth 401(k) and anticipate that you might want to roll it into a Roth IRA at a later date, you can open a Roth IRA and make a contribution to it. As noted above, the five-year period begins to run with the first contribution to any Roth IRA.

Does the Five-Year Rule Apply to Conversions from Traditional IRAs?

If you have converted your traditional IRA to a Roth IRA, things operate a little differently. In the year that you make the conversion, you will pay income tax on the account’s tax-deferred earnings as well as on tax-deductible contributions to the account. There is still a five-year rule that applies to distribution of any of the assets in the converted account: if you withdraw those assets, you may have to pay a 10% penalty for early distribution. (You may not be subject to a penalty if you have reached age 59 ½ or if some other exception applies.) Conversions from employer plans are also subject to this rule.

A noteworthy exemption from the 10% early distribution penalty: withdrawals that qualify as “coronavirus-related distributions” in 2020. If you need extra cash due to a job loss or other circumstances related to COVID-19, make sure you are clear on the requirements for a coronavirus-related distribution before making a withdrawal.

If you have further questions about Roth IRAs or 401(k)s, we invite you to contact our law office to schedule a consultation.

Categories: Finances

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