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Investing Specialists

The Ins and Outs of the 5-Year Rule for Roth IRAs

What you don't know about this complex rule could cost you.

What a mess.

Sorry, Congress, but that's my reaction as I survey the various rules governing contributions to and withdrawals from IRAs and other retirement vehicles. These regulations are clearly there to keep people from gaming the system for extra tax benefits and to help ensure that they don't raid their retirement assets prematurely--both worthy goals. But the net effect is still off-putting, especially for IRA holders aiming to figure out how--and when--they can withdraw their money.

One of the particularly Byzantine wrinkles in the IRA regulations is the so-called five-year rule for withdrawals from Roth IRAs. While it seems straightforward at first blush, in reality it's anything but, as comments related to my recent article about backdoor Roth IRA conversions attest.

Here's an overview of the rule, as well as a look at some of those unexpected wrinkles.

5-Year Rule Basics
Contributions to a Roth IRA can be withdrawn at any time and for any reason with no taxes or penalty. That's how it should be, because you've already paid tax on that money. But if you want to take a tax- and penalty-free withdrawal of the portion of a Roth that consists of investment earnings (that is, the amount above and beyond your initial contribution), you need to be age 59 1/2, disabled, or using the money to pay for a first-time home. (Alternatively, your heirs can take tax- and penalty-free withdrawals after you've died.) In addition, you'll need to meet what's called the five-year rule, meaning that the assets must have been in the Roth for at least five years before you began withdrawing them.

That seems straightforward enough, but there are still some peculiarities to consider. First, the five-year clock doesn't start on the day you opened or funded your Roth IRA account. Rather, it starts on the first day of the tax year for which the IRA is opened and funded. So if you squeaked in a 2011 Roth contribution in early April 2012, your five-year clock started Jan. 1, 2011. That means you could withdraw your investment earnings free of penalty and tax, provided you meet the other criteria for Roth IRA withdrawals (again, you're 59 1/2, disabled, or using the money for a first-time home), as of Jan. 1, 2016.

Because you may not need to hold the assets in your Roth a full five calendar years to be able to take tax- and penalty-free distributions, the rule isn't as onerous as it might sound at first. Another plus? The five-year waiting period doesn't start again each time you make additional contributions. Using the previous example, even if you made additional contributions for the 2012 and 2013 tax years (following your initial contribution for 2011), you'll still have satisfied your five-year holding period at the beginning of 2016, because your five-year clock started at the beginning of 2011.

The 5-Year Rule Meets Your IRA Conversion
Unfortunately, the five-year rule gets a bit more complicated if you've gotten the assets into a Roth due to converting a traditional IRA. In that case, you need to be either 59 1/2 or five years must have elapsed since your conversion for you to be able to take penalty-free withdrawals on the converted amounts on which you paid taxes at the time of conversion. (Note, if you withdraw before these age/time thresholds, you wouldn't owe ordinary income tax on that money because you already paid any taxes due at the time of conversion. But you would owe a 10% penalty, which I will discuss shortly.)

Moreover, if you've converted amounts to a Roth over a period of years, each conversion amount has its own five-year holding period. For example, the assets you converted in the 2010 tax year can be withdrawn penalty-free in 2015, the assets you converted in 2011 can be withdrawn without penalty in 2016, and so on.

The penalty will be waived if you meet certain conditions--for example, if you're using the money for qualified education or medical expenses. And if you made additional contributions to the Roth after converting, you can withdraw those amounts at any time and for any reason, just as if you had contributed to any other type of Roth account.

Whether that additional penalty applies depends on the nature of your IRA at the time you did the conversion, and hinges on the Internal Revenue Service's ordering rules for distributions, as laid out in IRS publication 590. If you're taking a withdrawal from a Roth, the IRS assumes that contributions are withdrawn first (and are always tax- and penalty-free), followed by the taxable portion of a conversion, followed by the nontaxable portion of a conversion, followed by investment earnings.

Note the language above; the penalty only applies to the converted amounts on which you've paid taxes during the conversion process. For example, say you had a $100,000 rollover IRA that you set up when you left your old firm, which you in turn rolled into a Roth IRA in 2010. If you wanted to withdraw that money prior to turning age 59 1/2, you'd have to wait until 2015 to tap that $100,000 penalty-free. Because you owed taxes on your whole IRA amount at the time of conversion, that amount will be subject to the 10% penalty if withdrawn before five years have elapsed.

If you converted a traditional IRA that consisted of nondeductible and deductible contributions, things get even trickier. Say, for example, you've built up $15,000 in a traditional IRA, $10,000 of which consists of your own nondeductible contributions and $5,000 of which is deductible contributions. When you do the conversion, you'll owe tax on the $5,000 (money on which you never paid taxes). If in three years you need to withdraw $5,000, before you're 59 1/2, that amount will be subject to penalty because the IRS assumes that the amount withdrawn first is the taxable portion of your rollover--in this case, $5,000. Withdrawing the other $10,000 wouldn't trigger a penalty, however.

Backdoor Roth IRA investors can usually avoid the 10% penalty because all or nearly all of their converted amounts will consist of money they have already paid taxes on and they'll owe next to nothing in taxes at the time of conversion. For example, say you put $5,000 into a money market account in a traditional nondeductible IRA in March 2012 and converted a few weeks later, with your balance still at $5,000. Because none of your conversion amount was taxable--you had already paid tax on the money and you hadn't gained anything--you could turn around and withdraw that amount without owing a penalty or taxes, even if you weren't 59 1/2 and hadn't met the five-year holding period.

Portfolio Makeover Week

Are you looking for tips on improving your portfolio? As part of Morningstar.com's Portfolio Makeover Week, May 14-18, director of personal finance Christine Benz will be making over five real-life portfolios to show how investors of all stripes may streamline and upgrade their holdings. To be considered for a makeover, submit a request to portfoliomakeover@morningstar.com. Include a general description of your situation, including portfolio size, as well as your goals for the makeover. If you are selected, your before and after portfolios will be featured in a Morningstar.com article, but you will not be identified by your real name. (Click here to see last year's portfolio makeovers.) We look forward to hearing from you soon!

Note: Makeovers are not intended to be individualized investment advice, but rather to illustrate portfolio strategies that investors should consider in the full context of their own financial situations.