Understanding the Roth IRA Five-Year Rules and Their Application to the Roth TSP- Part I
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Five-Year Rule #1 – Qualified Distributions from a Roth IRA
- The distribution must be paid to the Roth IRA owner after age 59.5, or the owner must be disabled, or the distribution is for the purchase of a first home, or the distribution is made to a beneficiary after the death of the Roth IRA owner; and
- A five-year waiting period must be satisfied. This five-year period applies across the board to all of an individual’s Roth IRAs. The five-year waiting period starts on January 1st of the year of an individual’s first Roth IRA contribution or January 1st of the year of the of an individual’s first Roth IRA conversion. It does not restart with future contributions or conversions. For that reason, this five-year rule is called the “Five-year forever” rule. Once a Roth IRA owner makes his or her first Roth IRA contribution or Roth IRA conversion, his or her starting date for the “Five-year forever” rule is locked in - even if the Roth IRA is distributed at some point. The following two examples illustrate:
Example 1. James made his first Roth IRA contribution of $4,000 on July 26, 2013. In 2015, James withdrew his entire Roth IRA. In 2018, James converted $100,000 of a traditional IRA he owned to a Roth IRA. James’ “Five-Year forever” rule for all of his Roth IRAs started as of January 1, 2013. It does not matter that he withdrew his $4,000 Roth IRA he contributed on July 26,2013 and that he converted a $100,000 traditional IRA to a Roth RIA during 2018.
Note that the five-year holding period always begins on January 1 of the year of the first contribution or conversion to any Roth IRA.
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Example 2. Amanda, age 52, is disabled and made her first Roth IRA contribution on March 17,2022 for tax year 2021. Amanda’s “Five-year forever” rule started on January 1, 2021. This means that as of January 1, 2026, Amanda can take a qualified distribution from her Roth IRA.
Five-Year Rule #2 - Avoiding a 10 Percent Early Withdrawal Penalty
There is a second five-year rule that Roth IRA owners must satisfy. This rule applies to Roth IRA owners under age 59.5 and who convert traditional IRAs to Roth IRAs. This five-year rule is called the “Five-year 10 percent penalty” rule. Unlike the “Five-year forever” rule discussed above, a new “Five-year 10 percent penalty” rule is applied each time a traditional IRA is converted to a Roth IRA.
The “Five-year 10 percent penalty” rule works as follows: If an individual who is under age 59.5 takes a distribution of converted traditional IRA funds before the end of the five-year holding period, then a 10 percent early distribution penalty will apply to the distribution of any converted funds that were taxable at the time of the conversion. The converted funds will leave the Roth IRA beginning with the first dollars converted. The exception to the 10 percent early withdrawal penalty is for a Roth IRA owner over age 59.5, for a disabled Roth IRA owner, for the pre-age 59.5 distributions used for the purchase of the Roth IRA owner’s first home, or for a beneficiary after the death of the Roth IRA owner. The following example illustrates.
Example 3. In 2016, Peter, age 42, converted a traditional IRA worth $180,000 to a Roth IRA. In 2020 Peter converted another traditional IRA worth $220,000 to his Roth IRA. In early 2023, Peter took a distribution of $400,000 of converted funds from his Roth IRA. $220,000 will be subject to the 10 percent early withdrawal penalty, unless Peter qualifies for an exception. That is because the 2020 Roth IRA conversion did not satisfy the five-year holding period.
Five-Year Rules Application to Roth IRA Owners Older than Age 59.5
Roth IRA owners over age 59.5 frequently ask the question whether they are subject to the five-year rules. The answer is yes when it comes to the “Five-year forever” rule but no to the “Five-year 10 percent penalty” rule.
The “Five-year 10 percent penalty” rule is not applicable once an individual reaches age 59.5. But the “Five-year forever” rule could still be an issue because the rule does not disappear when an individual becomes age 59.5. The five-year holding period must still be satisfied if a Roth IRA owner wants a tax-distribution of earnings. The following example illustrates:
Example 4. Sheridan, age 73, has never owned a Roth IRA. In 2021, she converted a $300,000 traditional IRA to a Roth IRA. In early 2023, when her Roth IRA account has grown to $338,500, Sheridan withdraws the entire Roth IRA. The $300,000 of converted funds and $38,500 of accrued earnings will not be subject to a 10 percent early withdrawal penalty. This is because Sheridan is over age 59.5. However, the $38,500 of earnings will be taxable because the “Five-year forever” rule has not been satisfied.
Five-Year Application to Beneficiaries of Inherited Roth IRAs
For beneficiaries of inherited Roth IRAs, the “Five-year 10 percent penalty” rule is not applicable and therefore not an issue. Inherited IRAs are never subject to the 10 percent early withdrawal penalty regardless of the age of either the Roth IRA owner or the beneficiary.
But the “Five-year forever” rule will apply. While that is not good news, the good news is that the beneficiary can use the original Roth IRA’s owner’s “Five-Year Forever” rule. The following example illustrates:
Example 5. Bernard, age 45, inherited a Roth IRA from his mother who died in 2023. His mother had converted her $300,000 traditional IRA to a Roth IRA in 2021. The account has since grown to $372,000. If Bernard takes a total distribution of the Roth IRA during 2023, $300,000 in converted traditional funds will be distributed penalty-free, even though it has been less than five years since the funds were converted. This is because the “Five-year 10 percent penalty” rule does not apply to IRA beneficiaries. However, the “Five-year forever” rule has not been satisfied since Bernard’s mother started her Roth IRA only two years earlier in 2021. Therefore, the $72,000 of accrued Roth IRA earnings will be fully taxable. The inherited Roth IRA earnings can be withdrawn tax-free only if Bernard waits until at least January 1,2026 to withdraw the accrued earnings of his inherited Roth IRA.
Spousal Roth IRA beneficiaries also must satisfy a five-year holding period. But if a spouse does a spousal rollover to their own Roth RIA, they are permitted to use the more beneficial five-year holding period on the Roth IRA inherited from deceased spouse or the five-year holding period from their own Roth IRAs.
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Edward A. Zurndorfer is a CERTIFIED FINANCIAL PLANNER™ professional, Chartered Life Underwriter, Chartered Financial Consultant, Chartered Federal Employee Benefits Consultant, Certified Employees Benefits Specialist and IRS Enrolled Agent in Silver Spring, MD. Tax planning, Federal employee benefits, retirement and insurance consulting services offered through EZ Accounting and Financial Services, and EZ Federal Benefits Seminars, located at 833 Bromley Street - Suite A, Silver Spring, MD 20902-3019 and telephone number 301-681-1652. Raymond James is not affiliated with and does not endorse the opinions or services of Edward A. Zurndorfer or EZ Accounting and Financial Services. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.
