What’s the 5 Year Rule for Roth IRA’s and What You Need To Know | When Should You Open a Roth IRA

Roth IRAs can be one of the most powerful tools in your financial planning arsenal. But there are rules you must follow: and the big one is the five-year rule, and technically there are three five-year rules. So, we’re going to go through them [to] help you understand how they apply, so you can make sure you stay within the boundaries, so you can have tax-free and penalty-free access to your dollars in retirement.

Hi, I’m Troy Sharpe, CEO of Oak Harvest Financial Group, CERTIFIED FINANCIAL PLANNER™ Professional (CFP®)and host of the Retirement Income Show.
So, first thing we have to understand is that when we’re looking at Roth IRAs: there are Roth contributions, and then Roth IRA conversions. So, contributions is the first one we’re going to talk about here, this is when we take money from our savings or bank account or paycheck and we contribute it into a Roth IRA. There are limitations. You can only (depending on how old you are) deposit somewhere around $6,000 or $7,000 per year as a Roth IRA contribution. And you have to have income that is beneath certain limits, to be able to qualify to make a Roth IRA contribution.

The second way to get money into a Roth is to convert an IRA to a Roth IRA. That is a conversion, that is not a contribution. There are no income limits and there are different five-year rules that apply to both the contribution way to get money into the Roth, and also the conversion way to get money into a Roth.
So, for contributions, the rule applies to earnings. In order for our earnings to be tax- and penalty-free, we have to satisfy not only a five-year wait period for that contribution, but we also must be either 59 and a half, disabled (this is the Social Security definition of disabled). [Also,] you can access up to $10,000 of your Roth IRA if you’re a first-time homebuyer (there are specific rules here you have to follow: look those up if you’re looking to take money out to buy a home), or death. Death is for the person who is inheriting the Roth, there’s a five-year rule there as well.

In order to have our money inside the Roth, growing tax-free and being able to access it tax-free (the principal and the earnings) down the road, [then] we must have that Roth IRA open for five years and be either 59 and a half, disabled, a first time homebuyer or inherited the money from someone who passed away.
If you are younger than 59 and a half, and you’ve met the five-year window, [than] you can take the principal out tax free — but you still will have a 10% penalty on a withdrawal of that principal. This is because you have not met the other stipulation, which is not just five years, but 59 and a half.

It’s important to understand here that when we contribute money into the Roth IRA, this is a long term planning strategy. This is designed for our retirement. The IRS set it up this way to disincentivize people from putting money into here and then taking it out, because the money you put in — if you take it out and you’re not 59 and a half, disabled, first time homebuyer or inheriting the account [then] there will be a 10% penalty on your principal. You will not pay taxes on that (you already have), but there will be a 10% penalty.

It’s important to understand [that] for contributions, all Roth IRAs are aggregated. This means if you have one Roth here, one Roth here, one Roth here, the one that was opened the earliest, the soonest, that gets the clock started for the five-year rule, you do not have another five-year rule for each Roth IRA. For every contribution you make into a Roth IRA, you do not create a new five-year rule.
Most important thing here: Is to get the Roth IRA open so you’ve started your five-year window. Once it’s satisfied, [then it s] satisfied for life.

So, cool feature here: You can make a Roth IRA contribution for — right now I’m in December of 2020 — I can make a 2020 Roth IRA contribution as late as April of 2021. So, it’s actually April 15, would be the last day (it’s the tax filing day), for to make an IRA or Roth IRA contribution for the prior year. But the cool thing here is we can wait all the way until April 14th or 15th of next year, make a Roth IRA contribution for this 2020 tax year, and the clock will start January 1 2020. So, we’ll have a whole year, 2020, as well as 2021, already behind us essentially, if we make the Roth IRA contribution as late as next year. So: by tax time.

So the main takeaway here is open your Roth now, let’s get this five year window going. I don’t care if it’s $5, $2, $10 dollars, $1, open the Roth IRA! Again, if you make over a certain income limit, you can’t open a Roth IRA, but you can open a regular IRA and then convert it to a Roth to get that window going.
So, five-year rule for contributions applies to earnings. And we have to satisfy both the five-year wait period plus one of the other stipulations, which is [to] be 59 and a half, disabled, inherit the account from someone who passed away or be a first-time homebuyer (which that has its own rules, as well).

Now the second five-year rule has to do with Roth conversions. This is when we have money in an IRA, and we convert it to a tax free Roth IRA by paying the taxes upfront. So, a different five-year rule here. The five-year rule for conversions, this only applies to whether your principal is penalty free. {It] has nothing to do with taxes because you’ve already paid taxes on that conversion. So, the five-year rule applies to whether your principal is penalty free.

So again, we have the 59 and a half, disabled, first time homebuyer or death exception here.

So if we’re already 59 and a half, this rule does not apply to us for Roth conversions. The five-year rule is completely moot if you’re 59 and a half. If you’re 60, 62, 65, you’ve just retired, you’re starting on this tax plan — which you should have been started on long before (most likely) — and the five-year rule does not apply to those conversions. [However,] it will apply to contributions if you decide to open up a Roth. But if you’ve retired, you can’t open up a Roth and contribute because you have to have earned income. So this is strictly for conversions.

This is what we do for clients a lot of times: we have to take the money out of that IRA. Taxes are the lowest they’ve been in the history of your life. We need to take money out and get it into the Roth IRA.
So, the five-year conversion window or, excuse me — the five-year rule for conversions: If you’re over 59 and a half, it doesn’t apply to you. But if you’re under 59 and a half, you can access principal without penalty, earnings would be taxed if you take earnings out — if you’ve waited five years. So, let’s say Joe is 40 years old, and Joe has $50,000 in an IRA. Joe cannot touch that money without penalty and paying taxes until he’s 59 and a half. But if Joe does a conversion to a Roth IRA, and waits five years, Joe can access the principal without that 10% penalty or tax because he paid taxes already on the conversion. So, this is the way to get access to your money younger than 59 and a half, inside a retirement account, as long as you wait five years — and then you can avoid that 10% penalty.

Because, again, the five-year rule for conversions applies only to whether your principal is penalty free. When you do the conversion taxes are irrelevant, because you paid taxes on the conversion. So this rule only applies to the penalty.

There is, if you’re younger than 59 and a half and you do conversions in in an incremental fashion over a period of years, each new conversion that you do creates a new five year window. If you’re under 59 and a half, be aware of that. If you’re over 59 and a half, again, it doesn’t matter. This is moot for those that are over 59 and a half.
The third five year rule has to do with Roth 401K’s. So inside of your 401k at work, you may have the ability to contribute into a Roth part, which means you pay taxes on your income upfront, you put the money into that Roth, and it will always be tax free. Now there is a five year rule for Roth 401 K’s, but when you roll this money into a Roth IRA, the important thing to note here is that you start a new five year window. So this is why, again, Roth IRAs are aggregated which means all you have to do to avoid this is open up a Roth IRA today, put $1 in it, that gets the clock rolling for your five year window. So when you roll your Roth 401k into a Roth IRA later, you won’t have this problem because you would have already satisfied that five year rule.

Now for inherited Roth accounts, it’s important to understand if you inherit money inside a Roth IRA, you have to determine was this something that was contributed to? So annual contributions were made into it? Or was it converted? Now the reason why this is important is because if it was recently established and contributed to, the five year rule now carries over to you. So if they made two years of contributions and passed away, you inherit it, you have three more years before you can access that money.
If it’s converted, completely moot, no five year rule. So just understand if you inherit a Roth and it has a smaller balance, 6000, 12000, 15, 20,000 we need to find out was this, how long has this Roth IRA been open?

So to summarize, the five year rule for Roth contributions applies to earnings or growth of the account, and two requirements must be met, a five year window and be either 59 and a half, legally disabled, a first time homebuyer or you inherit the account through death.

For Roth conversions, the five year rule applies to principle only and it determines if there’s a penalty or not. If you’re younger than 59 and a half, there could be a penalty. If you’re over 59 and a half, the five year rule is completely moot for Roth conversions, and also for Roth 401 K’s when you roll that into a Roth IRA, even if you’ve satisfied the five year window inside the 401k, you create a new five year window when you roll it to a Roth, unless you’ve taken my advice and you, after this video, went, opened up your Roth IRA to get that five year window started. Once it starts, and once it’s satisfied, you never have to worry about the five year rule for IRAs ever again.

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