By Sarah Brenner, IRA Analyst
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Do you have a Roth IRA or are you thinking about starting one? You may have heard that a “five-year” rule is important for these accounts. Well, that’s just the beginning of the story. There are actually three different five-year rules for Roth IRAs. You need to understand each of them to maximize the benefits of your Roth IRA.
1. Five-Year Rule for Penalty-Free Distributions of Converted Funds
If you convert your traditional IRA to a Roth IRA, any pre-tax funds in the traditional IRA that you convert are taxable to you in the year of the conversion. No matter what age you are when you convert, the 10% early distribution penalty does not apply. If you then take a distribution of the converted funds from your Roth IRA, that distribution will always be tax-free. This makes sense because you already paid taxes when you converted your Traditional IRA. However, if you are under age 59 ½ and take a distribution within five years of your conversion, your distribution will be subject to the 10% early distribution penalty, unless an exception such as disability applies. This rule was put in place to close a loophole in the rules, where traditional IRA owners, under age 59 ½, would have been able to convert to Roth IRA and then take a Roth IRA distribution to evade the early distribution penalty that would have applied if they took the distribution directly from their traditional IRA.
The five-year period starts January 1 of the year you convert, regardless of the date of the actual conversion. It applies separately to each conversion you do, if you do more than one. After-tax dollars converted from a traditional IRA are never subject to the penalty. If you are over age 59 ½, no worries, you can access converted funds in your Roth IRA whenever you want without penalty.
2. Five-Year Rule for Tax-Free Distributions of Earnings
A big reason why many people have a Roth IRA is the opportunity for tax-free earnings. You will want to be sure, therefore, that you understand the rules to achieve this benefit. For earnings to be distributed tax-free from a Roth, there must be a qualified distribution. To be a qualified distribution, the distribution must be taken from the Roth IRA after age 59 ½, disability, death, or be used to purchase a first home. In addition, the distribution must be taken after a five-year period is satisfied. The five-year period begins January 1 of the year of your first Roth IRA conversion or of the year for which you make your first Roth IRA contribution. It may be less than five actual years. The
3. Five-Year Rule for Beneficiaries
The third five-year rule that applies to Roth IRAs will affect you if you are a beneficiary. Under the rules, named beneficiaries, not those who inherit through the estate of the deceased Roth owner, have the options of stretching RMDs (required minimum distributions) from inherited Roth IRAs over their life expectancy or using the five-year rule. The five-year rule for beneficiaries is often misunderstood. Under the law, all named Roth IRA beneficiaries have the choice to use the five-year rule, but are never mandated to do so. Some Roth IRA documents may require the five-year rule, but that is relatively rare.
What must you do if you elect the five-year rule? The Roth IRA you inherited must be distributed by December 31 of the fifth year following the year of the IRA owner’s death. Within the five-year period there is complete flexibility. You can take a lump sum or take a distribution each year. You just need to be sure the Roth IRA is emptied by the end of the five-year period or you will face a 50% penalty on the amount not taken in that year. That is a hefty penalty for a Roth IRA distribution, which most likely would not be taxable.