Understanding the 5-Year Rules for Roth Accounts

Nearly a quarter of a century since the creation of Roth IRAs in 1998, there are still numerous questions surrounding the “5-year rules” for Roth distributions.

It should be noted that these 5-year rules have application not only to Roth IRAs, but also to Roth Thrift Savings Plan (TSP) distributions, to traditional TSP transfers to Roth IRAs, and to conversions of traditional IRAs to Roth IRAs. This column will discuss and explain the “5-year rules” that are applicable to all Roth accounts.

In general, Roth IRA distribution rules are favorable to individuals. All of an individual’s Roth IRAs are aggregated to determine the tax consequences of a distribution from any one of them. Funds are considered to leave the accounts in a specific order. In particular, Roth IRA contributions (which have been previously taxed and therefore are not taxed again when withdrawn) come out first, followed by converted funds, and then accrued earnings.

With respect to Roth accrued earnings, it is important that Roth IRA owners understand the 5-year rule with respect to qualified distributions. By understanding and following this rule, individual Roth IRA owners can cash out their Roth IRAs completely tax-free. Since one of the main goals of saving with Roth IRAs is to receive tax-free distributions, the importance of understanding the 5-year rule cannot be emphasized enough.

In order to have a tax-free distribution of Roth IRA accrued earnings, two conditions must be met.

First, the Roth IRA owner has to be over age 59.5, disabled, a first-time home buyer, or deceased.

The second condition is that the distribution must satisfy a five-year holding period. The five-year holding period starts on January 1 of the year that the Roth IRA owner made his or her first Roth IRA contribution or converted a traditional IRA to a Roth IRA.

The five-year holding period never restarts. In that sense, the five-year period is a ‘forever clock”. Additional contributions or conversions at a later time have no effect on its’ resetting.

The following example illustrates:

On April 10, 2017, Joyce, a federal employee and age 60, contributed $2,000 to her Roth IRA as a 2016-year Roth IRA contribution. This was Joyce’s first contribution to a Roth IRA. Joyce retired from federal service in 2018.

In 2019, Joyce transferred $400,000 of her traditional TSP to a traditional IRA. In 2020 Joyce converted her $400,000 traditional IRA to a Roth IRA. On June 15, 2021 when her $400,000 traditional IRA was worth $480,000, Joyce withdrew the full $480,000 from her Roth IRA. The distribution is a “qualified distribution”, meaning that Joyce does not owe federal and state income tax on the $480,000 distribution nor is there any early withdrawal penalty. This is because: (1) Joyce is over age 59.5 and the five-year holding period began on January 1, 2016, the first day of the year for which her first Roth IRA contribution was made and ended on December 31, 2020. Joyce met the 5-year holding period requirement. Any Roth IRA distributions paid to Joyce thereafter will be tax and penalty-free.

The fact that is it has not been five years since Joyce’s first Roth IRA contribution and has been less than five years since her conversion does not matter. It also does not matter that the contribution that started the five-year clock was made to a different Roth IRA.

Five-year Rule for Converted Roth IRA Funds

In 1998 when Roth IRAs were first available, the rules allowed for immediate distributions of converted funds without penalty. This allowed individuals younger than age 59.5 looking to access their retirement funds early, to avoid the 10 percent penalty to simply do a Roth conversion and take an immediate distribution.

In order to close this loophole, the five-year holding period for penalty-free distributions of converted funds for those under age 59.5 was imposed. The five-year holding period starts on January 1 of the year in which the conversion is completed. For those individuals over age 59.5, no five-year wait is required in order to avoid a penalty. But for those individuals who are younger than age 59.5, failure to wait will result in a 10 percent early withdrawal penalty in addition to having pay federal and state income taxes on the accrued earnings.

Unlike the five-year forever clock for qualified distributions of earnings discussed above, the five-year holding period for penalty-free distributions of converted funds restarts with each conversion. In other words, each Roth IRA conversion will have its own five-year conversion clock.

The following example illustrates:

In 2016 Robert, age 40, converted $20,000 from his traditional IRA to a Roth IRA. In 2019 he converted another $10,000 of his traditional IRA to a Roth IRA. In early 2021 Robert withdrew $30,000 of converted funds from his Roth IRA. Of the $30,000, $20,000, converted in 2016, would be exempt from the 10 percent early withdrawal penalty, since it has been five years since January 1, 2016 and $10,000, converted in 2019, would be subject to the penalty.

It needs to be emphasized that the previous discussion is with respect to the 10 percent early withdrawal penalty. If either the five-year rule or the post-age 59.5 requirement is not met, federal and state income taxes will also have to be paid on the withdrawn earnings. In case of a traditional IRA that was converted to a Roth IRA and had a “deductible” (before-taxed) contribution, the 10 percent penalty and taxation rules apply.

Transfer of Traditional TSP to Roth IRAs

A retired TSP participant is allowed to transfer their traditional TSP account to a Roth IRA. This type of transfer is in many ways a Roth IRA conversion in the sense money in a before-taxed account – the traditional TSP – is being transferred to a Roth IRA. As such, this is a Roth IRA conversion and the Roth IRA conversion rules with regard to taxation of accrued earnings and the early withdrawal penalty (10 percent) apply.

The following summarizes the five-year rule for TSP participants who transfer their traditional TSP to Roth IRAs.

• Retired TSP participants younger than age 59.5. The five-year holding period starts on January 1 of every year that part of a traditional TSP account is transferred to a Roth IRA. Failing to wait those five years will result in a 10 percent penalty, in addition to the federal and state taxes that must be paid each year in which transfers are made.

• Retired TSP participants aged 59.5 and older, or TSP participants aged 59.5 still in federal service. No five-year wait is necessary to avoid 10 percent early withdrawal penalty. However, full federal and state income taxes must be paid in the years of transfer.

Inherited Roth IRAs

For beneficiaries who inherit a Roth IRA from someone else such as a parent, the five-year rule for penalty-free distributions of converted funds is of no concern. This is because there is an exception to the 10 percent penalty for distributions from inherited Roth IRAs.

In summary, there is no doubt that the Roth five-year rules can be confusing and tricky. But for those individuals who keep their Roth accounts intact until they retire and who are over age 59.5, the rules are much simpler and easier to follow.

Leaving one’s Roth account intact (no withdrawals) until the individual is at least 59.5 makes the five year-rules much easier to understand and follow. For most Roth IRA owners, waiting until at least age 59.5 to make withdrawals from their Roth IRAs should not be that difficult. Roth IRA are advised to be in it for the ‘long haul” in the sense of leaving their Roth IRA accounts intact as long as possible. Roth IRAs are the only type of retirement account that is not subject to required minimum distributions (RMDs), meaning that the Roth IRA can continue to grow tax-free indefinitely.

At the death of the Roth IRA owner, a spousal beneficiary can transfer the inherited Roth IRA to their own Roth IRA and continue to grow tax-free over the years. At the death of the spouse designated “non-eligible designated” beneficiaries (such as children) will have to withdraw in its entirety their inherited Roth IRAs within 10 years of the Roth IRA owner’s death. This is in accordance with the Secure Act that was passed inti law by Congress in December 2019. But the heirs will not have to pay any income taxes on their required Roth IRA withdrawals.

A full understanding the 5-year rules for Roth accounts will hopefully result in the preservation of an individual’s Roth IRAs for many years. Roth IRA owners who have to pay their expenses during retirement using their Roth IRAs should certainly do so.

But knowing that no taxes and penalties have to be paid when withdrawals are made will allow for the maximum use of Roth IRAs. Any remaining Roth IRA assets that are transferred to designated Roth IRA beneficiaries will allow these beneficiaries to make tax-free withdrawals of their inherited Roth TSP accounts. In that sense, preserving one’s Roth IRAs as long as possible will hopefully result in the maximum transfer of non-taxable assets from one generation to the next.