IRAs are great retirement savings tools, but the laws that govern them are complicated. This is especially true when navigating the taxes and penalties that can be assessed on distributions and conversions. We help people work through these issues all the time, and one of the most common traps we see people fall into are around the Roth IRA 5 year rules.

These are rules that are designed to assess penalties and/or taxes on money withdrawn from a Roth IRA. Distributions are generally tax free, which leads many to gloss over the finer points. But you could end up with a surprise when you file your taxes if you aren’t careful. We’ll show you what to watch out for in this article.

The Basics

In most situations you can withdraw your principal from your Roth IRA at any time tax and penalty free. However, Roth IRA earnings are income tax free but only when withdrawn as part of a qualified distribution. So what makes a distribution qualified? It’s got to meet one of the following stipulations:

  • Account owner is at least age 59.5 at the time of distribution
  • Account owner has passed away (i.e. distribution due to death)
  • Account owner is totally disabled
  • Account owner is using funds for qualified first-time homebuyer exemption (cap of $10,000 and subject to other limitations)

AND

  • The account has passed the five-year length of time requirement. This is formally called the “non-exclusion period” per IRC Section 408A(d)(2)(B).

Rule 1 – Taxes on Earnings

The Roth IRA must be open for at least five years before earnings can be withdrawn tax-free. The non-exclusion period is measured as five tax-years, which are a little different than calendar years. It doesn’t matter when something happens in a tax year so long as it happens. This means that from the IRS’ point of view, a contribution made in January is no different than one made in December. Even better, contributions can be made up until the point at which you file your taxes (though not conversions).

This means you can make a 2022 contribution as late as April of 2023, or October 2023 if you file extensions. And again, from a tax year standpoint that contribution is no different than one made in January of 2022 despite it being almost a full two years later! This effectively shortens the holding period to 3 years and 2 months.

Moreover, the non-exclusion period starts anytime money is deposited into the Roth IRA. It doesn’t matter if its from a contribution or a conversion. The day the first dollar lands in the account is the day the clock starts. And it’s just one clock! The non-exclusion period doesn’t apply per contribution so that you’re overlapping multiple five year time periods on every deposit.

Notably, once the non-exclusion period has been satisfied it stays satisfied for life. This is true if even if you drain your Roth IRA down to zero after satisfying the requirement and open a new one several years later. If that first Roth IRA had met the 5 year rule then you’re good to go on any future Roth IRA. Just be sure to keep your documentation to prove it!

Aggregating between accounts

The non-exclusion period is satisfied whenever any of your Roth IRAs have been open for at least five tax years. This means that rollovers and consolidating accounts won’t disrupt your time period. You get to keep the date the first deposit was made to your first Roth IRA. But time periods don’t stack cumulatively across accounts, so opening five Roth IRAs and holding them each for one year won’t cut it.

And for a final note on Roth 401(k) balances – time in these accounts does not count towards the non-exclusion period. If you’ve had a Roth 401k for a decade and roll it to your first ever Roth IRA, then you will still need to meet the non-exclusion period on that Roth IRA per Treasury Regulation 1.408A-10, Q&A-4(a).

Quantifying the pain

Remember, the five year rule/non-exclusion period must be satisfied in addition to the death, disability, age 59.5, or first-time homebuyer requirements listed above. If those aren’t met then the distribution isn’t a qualified distribution and taxes and penalties will apply.

For most people this means that you still need to be at least 59.5 before you can withdraw tax and penalty free! Specifically, when it comes to this rule it’s only the growth within the Roth IRA that is impacted. The earnings will be subject to ordinary income taxes when you violate this rule, but you can still withdraw your principal tax and penalty free. However, penalties could still apply to principal from Roth conversions in some situations (see Rule 2 below).

For this reason it generally makes sense to get started early with a Roth IRA, even if its just a small amount. Throwing a $100 in a Roth, be it through a conversion or a contribution, starts the clock on the non-exclusion period. You may not have grand designs for it now, but getting it started could open the door for conversions and useful tax planning between the age you retire and the age you take your first Required Minimum Distribution.

Rule 2 – Penalties on Conversions

There is a second, separate rule for money that is converted to a Roth IRA. This rule states that the converted amount must be held for at least five tax years before the principal from that converted amount can be withdrawn penalty free. Unlike contributions however, which can be made as late as April or October of the following year, conversions must be done within the calendar year. This still affords some flexibility as December conversions are considered the same as January conversions in the eyes of the IRS, but the *effective* holding period isn’t as short as with the previous rule.

Moreover, each conversion completed has its own five year holding period per Treasury Regulation 1.408A-6, Q&A-5(c). Conversions that are spread over years to avoid creeping into higher tax brackets will therefore carry multiple and overlapping five year periods!

The Roth Ordering Rules

How do you determine what comes out first if you have a Roth IRA with six years’ worth of contributions and a brand-new conversion? There’s a pecking order to this, which is contributions first, taxable conversions second, non-taxable conversions third, and earnings fourth. First in, first out treatment applies within those tranches as well, which means that if the only Roth money you have is from conversions, then any distributions you make are considered to be from the oldest conversions first (i.e. the first money in)!

Graphic flow chart showing the distribution order for Roth accounts

The purpose of the conversion rule and a BIG notable exception

The conversion rule exists to prevent some clever workarounds to accessing IRA money, which the IRS is intent on you spending only during your retirement. Consider the following:

Susan is 38 years old and needs to tap $35,000 from her Traditional IRA. But doing so will trigger taxes and a 10% early withdrawal penalty. She can’t avoid paying the tax, but absent the five-year conversion rule she could skirt the 10% penalty. This is because withdrawals of after-tax principal from a Roth are  tax and penalty free, so if the second five year holding period weren’t in effect Susan could theoretically convert to a Roth and then immediately withdraw funds to avoid the 10% penalty!

Now carry this example forward five years. Susan is now 43 and has a Roth IRA with $35,000 of converted funds (i.e. her principal) and another $12,000 of growth. She can now withdraw the original $35,000 tax and penalty free as it’s her principal balance. But she’ll pay taxes the early withdrawal penalty if she dips into the $12,000. That portion constitutes earnings, and taxes and penalties will apply since she hasn’t met the requirements to make it a qualified withdrawal or reached age 59.5.

However, if Susan were over age 59.5 the conversions rule would be essentially moot. The rule makes converted principal potentially subject to the early withdrawal penalty, but the exceptions to the early withdrawal penalty still apply. This means that if Susan converts after reaching age 59.5, a recognized exception under IRC section 72(t)(2)(A)(i), then the penalties disappear!

Rule 1 is always in effect no matter your age, but rule 2 only applies if you’re under age 59.5.

Seeing it in real life

Clear as mud? These are technical rules that even veteran planners get tripped up on from time to time. Check out a few examples below to help make sense of it.

Example 1:

Mara is 48 years old and thinking of retirement. She decides to convert $25,000 from her pre-tax IRA balance to her first-ever Roth IRA. The first rule applies. She will need to satisfy the five-year non-exclusion period AND meet one of the other four requirements (death, disability, age 59.5, or first time homebuyer) before those earnings are tax-free.

Additionally, the second five-year rule will apply as she is under age 59.5. This means that withdrawing any of the $25,000 of converted principal will be penalized (but not taxed) if she takes it out within the first five years.

To summarize…

  • Withdraw up to $25k anytime before age 53 with penalties but no tax
  • Withdraw up to $25k anytime after age 53 with no penalties or tax
  • Withdraw more than $25k at anytime before age 53 with penalties and tax on the amount withdrawn
  • Withdraw more than $25k at anytime between age 53 and 59.5 with a qualifying exception and pay no tax or penalties on the amount withdrawn
  • Withdraw the whole thing anytime after age 59.5 with no tax or penalties

Example 2:

Mara is now 58 instead of 48 and converting $25,000 from her pre-tax IRA to her first ever Roth IRA. She needs to satisfy the five-year non-exclusion period before she can pull earnings tax-free but the second rule will only be in effect for the first year and a half! She can withdraw penalty free after reaching age 59.5.

To summarize…

  • Withdraw up to $25k anytime before age 59.5 with penalties but no tax
  • Withdraw up to $25k anytime after age 59.5 with no penalties or tax
  • Withdraw more than $25k anytime before age 58 and 59.5 with penalties and tax on the amount withdrawn
  • Withdraw more than $25k between age 59.5 and 63 (five years) and pay tax but no penalties
  • Withdraw more than $25k anytime after age 63 tax and penalty free

Notably, if Mara had put $100 in an IRA at age 50 then she would have already satisfied the non-exclusion period. She’d be able to pull everything out at anytime time after reaching 59.5 in that case.

Example 3:

Julian is 52 years old and makes too much money to directly contribute to a Roth IRA. He converts $10,000 of after-tax IRA money to a Roth IRA in December of 2022, making it a non-taxable conversion. He then converts $15,000 from a pre-tax 401(k) to a Roth IRA in January of 2023 to spread out the tax bite between tax years.

Julian falls on hard times five years later in 2027 and withdraws $10,000. Unfortunately, the distribution is penalized despite being in the account for a full five years. It’s due to the Roth distribution pecking order.

Julian’s IRA consists only of converted balances. Due to the Roth ordering rules for distributions, taxable conversions are assumed to come out before non-taxable conversions. And because each Roth conversion has its own five year holding period (rule 2), the taxable conversion done in 2023 is penalized as the first chunk of money to come out!

If Julian had instead converted his 401(k) in December and then converted the after-tax money in January, he’d be in the clear. (Kind of, there would be other technical issues at the time of conversion due to the IRA aggregation rule and mandatory withholding requirements from 401(k) accounts). But the Roth distribution pecking order tripped him up and subjected him to penalties.

Just like with Mara in the previous two examples, Julian will have to wait until he is at least age 59.5 or hit some other qualifying exception for any earnings in his Roth IRA to come out tax-free.

The Bottom Line

Roth IRAs have complicated rules to obey when you’re taking money out early, but all of these complications melt away once the account is open for five years and you’ve reached age 59.5. The simplest thing to do is just not touch it! There’s plenty of information out there about using a Roth IRA as an emergency fund or some kind of tax panacea. But the former is messy and ill-advised and the latter is just ill-informed.

Roth IRAs work best as long-term savings vehicles. They were never intended to help solve short-term cash crunches. Know the rules and plan wisely!

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