All You Need to Know about Roth IRA 5-Year Rule

The Roth IRA is a distinctive investment account that offers the appealing benefit of tax-free income in retirement. However, like all retirement accounts—and anything involving the IRS—there are specific rules regarding contributions, limits, and tax-free withdrawals. Here’s a breakdown:

• Contribution Limits: For 2024, you can contribute up to $7,000 to a Roth IRA.
• Five-Year Rule: Earnings in a Roth IRA cannot be withdrawn tax-free until at least five years have passed since your first contribution.
• Universal Rule: This five-year rule applies regardless of your age, whether you’re 59½ or older.

The Roth IRA five-year rule

The five-year rule can impact your ability to withdraw earnings from a Roth IRA tax-free if you’re not aware of it. According to this rule, you must wait five years from the start of the tax year in which you made your first Roth IRA contribution before you can withdraw earnings tax-free.

The five-year period begins on January 1 of the year you made your first contribution. This means that even if you contributed on December 31 of a given year, that full year counts toward the five-year requirement. Contributions made up until the tax deadline for that year (such as April 15) are included. For instance, a contribution made by April 15, 2025, would count for the 2024 tax year.

Inherited Roth IRAs have a separate five-year clock that is based on the original account owner’s contributions, not the date of inheritance.

Additionally, Roth IRA conversions have their own five-year clock, which determines whether the conversion principal will be subject to tax penalties.

Roth IRA income and contribution limits

The Roth IRA is a straightforward investment account. Qualified investors can make contributions on an after-tax basis and enjoy tax-free withdrawals once they reach retirement age, which is defined as 59½ or older.

In 2024, you can contribute up to $7,000 to a Roth IRA if your income falls within the specified limits. If you’re 50 or older, you can contribute up to $8,000 due to the “catch-up contribution” allowance.

High earners may face restrictions on their contributions due to income caps:

• For married couples filing jointly in 2024, contributions are phased out if your modified adjusted gross income (MAGI) is between $228,000 and $240,000, and you cannot contribute if your income exceeds $240,000.
• For single filers in 2024, the phase-out range is between $146,000 and $161,000, with no contributions allowed above $161,000.

Remember, contributions are limited based on your MAGI, not your salary. However, individuals at any income level can still contribute through a backdoor Roth IRA if they exceed the income thresholds.

Roth IRA early withdrawal taxes

When it comes to Roth IRA contributions, it’s important to know that you can withdraw your contributions at any time without incurring a penalty, regardless of your age. However, this applies only to contributions, not earnings. Generally, you can’t withdraw earnings before age 59½ without facing a 10 percent early withdrawal penalty. Earnings can be withdrawn tax-free after age 59½, provided you have met the five-year rule.

You don’t need to take any special steps to ensure that you’re withdrawing only contributions, as the IRS has specific rules governing the order in which funds are withdrawn from a Roth IRA. Distributions are taken in the following sequence:

• Contributions
• Conversions or rollover contributions
• Earnings on investments

These rules simplify the process of withdrawing your contributions without incurring taxes or penalties.

Qualified vs. non-qualified distributions

Understanding Roth IRA distributions involves distinguishing between qualified and non-qualified distributions, and knowing when exceptions apply.

Qualified distributions

A distribution from a Roth IRA is considered qualified if it meets the five-year rule and at least one of the following conditions:

• The account holder is age 59½ or older.
• The distribution is due to the account holder’s death or disability.
• The distribution is for a first-time home purchase, up to a $10,000 limit.

For example, if you opened a Roth IRA in 2020 at age 58 and contributed $5,000 annually through 2023, you would not be able to take tax-free distributions until you have met the five-year requirement. Once five years have passed and you are 59½ or older, your distributions will be considered qualified, making them entirely tax- and penalty-free.

Non-qualified distributions

Distributions that do not meet the criteria for being considered “qualified” may be subject to ordinary income taxes and a 10 percent early withdrawal penalty, unless an exception applies. However, this only applies to earnings. You can always withdraw your contributions from a Roth IRA without incurring taxes or penalties.

When can you withdraw earnings from a Roth IRA without penalty?

Withdrawing earnings from a Roth IRA before meeting the required conditions can lead to income taxes on those earnings and an additional 10 percent penalty, unless certain exceptions apply. We’ve discussed some exceptions, such as withdrawing up to $10,000 for a first-time home purchase, distributions due to disability, or payments made to your estate after your death.

You can also avoid the 10 percent penalty (but not the income taxes) for early withdrawals in the following situations:

• Paying qualified higher education expenses for yourself or eligible family members.
• Reimbursing yourself for medical expenses that exceed 10 percent of your adjusted gross income.
• Covering health insurance premiums if you become unemployed.
• Receiving substantially equal periodic payments for five years or until you reach age 59½, whichever is later.
• When an IRS levy is imposed on your account.

These are some of the main exceptions, but the IRS provides additional ways to avoid the penalty under specific circumstances.

Roth IRA withdrawal timeline

Here’s a simplified guide to Roth IRA distribution rules based on your age and how long you’ve had the account, outlining when you can withdraw earnings without facing the 10 percent penalty or taxes:

Under Age 59½ with a Roth IRA Less Than Five Years Old: You can avoid the penalty but will still owe income taxes on earnings if you:

• Withdraw up to $10,000 for a first-time home purchase.
• Use funds for qualified higher education expenses.
• Withdraw funds due to disability or death.
• Cover unreimbursed medical expenses exceeding 10 percent of your adjusted gross income (AGI).
• Pay health insurance premiums if you’re self-employed.
• Take funds in substantially equal periodic payments.

Under Age 59½ with a Roth IRA More Than Five Years Old: You can avoid both the penalty and taxes on earnings if you:

• Withdraw up to $10,000 for a first-time home purchase.
• Use funds for qualified higher education expenses.
• Withdraw funds due to disability or death.
• Cover unreimbursed medical expenses exceeding 10 percent of your AGI.
• Pay health insurance premiums if you’re self-employed.
• Take funds in substantially equal periodic payments.

Ages 59½ or Older:

• If you have met the five-year rule, you can withdraw money from your Roth IRA without any taxes or penalties.
• If you haven’t met the five-year rule, earnings will be subject to income taxes, but not penalties.

In Conclusion

Roth IRAs can be incredibly beneficial for future retirees who consistently contribute and adhere to the rules, including the crucial five-year distribution rule. Before you begin investing in a Roth IRA, it’s important to understand the regulations governing contribution limits and withdrawal conditions. While the five-year rule might not have been on your radar previously, you now have a clear understanding of how it operates and how to initiate the countdown.