Roth IRA 5-Year Rule – It Can Be Complicated

Take-Away: One of the conditions to enjoy tax-free distributions from Roth IRAs and Roth 401(k) accounts is that the distribution must satisfy a 5-year holding period to be a qualified, tax-free distribution. The failure to satisfy the 5-year holding period subjects the earnings on the distributed Roth funds to be taxed.

Background: With the threat of higher income tax rates on the horizon, many more individuals are opening Roth IRAs or seriously considering converting their traditional IRA to a Roth IRA. When establishing a Roth IRA (or Roth 401(k) account), the goal is tax-free distributions, of both the contributions to the Roth account and the earnings generated by the Roth account. As a generalization, contributions to the Roth IRA will always be tax-free because they were made with after-tax assets. It is the earnings on the Roth IRA that may be subject to income taxation if a couple of conditions are not met.

• Aggregation of Roth IRAs: For purposes of determining the taxability of distributions (if any) from a Roth IRA, all Roth IRAs owned by the same individual are aggregated.
• Ordering Rules for Distributions: Funds that are distributed from Roth IRAs follow a specific ordering sequence. (i) Contributions to the Roth IRA come out first; (ii) Next to come out of the Roth account in a distribution are converted IRA funds, e.g. a conversion of a traditional IRA to a Roth IRA; and (iii) Finally, earnings on the funds held in the Roth IRA are deemed last to be distributed to the Roth IRA owner.

Roth Earnings: For the earnings of a Roth IRA to be distributed income tax-free, two conditions must be satisfied. First, the distribution must be taken from the Roth IRA when the Roth IRA owner is age 59 ½  or older, or is disabled, or a first-time homebuyer, or deceased. Second, the distribution from the Roth IRA must satisfy a 5-year holding period.

Five Year Holding Period: The 5-year holding period condition is when a Roth IRA owner can get tripped up and have to pay income taxes on distributed Roth IRA earnings.

• Not Really 5 Years: The 5-year holding period may not actually be five years; more likely it is shorter than five years. The 5-year holding period is determined from January 1 of the calendar year in which the Roth IRA owner made either their first Roth contribution or conversion. This 5-year holding period for Roth IRAs never restarts. Additional contributions or conversions of traditional IRAs to Roth IRAs will not affect the initial start of the 5-year holding period- it is a ‘snapshot’ date to measure from going forward.

Example: On February 15, 2017 Judy, age 65, contributed $1,000 to a new Roth IRA that she opened; it is Judy’s first Roth IRA. Judy’s Roth IRA contribution was made for the prior year, 2016. In 2018, Judy converted $400,000 of her traditional IRA to her Roth IRA, but the converted funds are placed by Judy with a different Roth IRA custodian. On February 28, 2021, Judy’s converted Roth IRA is worth $425,000 [$400,000 contribution + $25,000 earnings.] Judy takes a full distribution of $425,000 from that ‘converted’ Roth IRA account. Judy pays no income taxes on the earnings of her ‘converted’ Roth IRA account because: (i) she is over the age the 59 ½ when the distribution was taken; and (ii) the 5-year holding period is satisfied, as it is measured from January 1, 2016. The fact that it has been less than 5 years since Judy converted her traditional IRA to the Roth IRA is irrelevant- Judy’s initial $1,000 contribution to her first Roth IRA back in 2016 ‘starts the 5-year clock running.’

Roth IRA Conversions: With regard to a conversion of a traditional IRA to a Roth IRA, the 5-year holding period started on January 1 of the year in which the conversion is completed. If the IRA owner is over the age 59 ½, then the owner does not have to ‘wait’ to take distributions of earnings  from the Roth IRA income tax-free. If the Roth IRA owner is younger than 59 ½,  he or she must wait 5 years before withdrawing the earnings on their Roth IRA to avoid income taxes and the 10% excise tax. Unlike the one-time 5-year ‘clock’ for distributions of earnings on a Roth IRA, each conversion of a traditional IRA to a Roth IRA has its own 5-year ‘conversion clock.’

Example: Back to the prior example with Judy. Judy converted $400,000 from her traditional IRA to the Roth IRA in 2018. Judy takes a distribution from the ‘converted’ Roth IRA in early 2021. Judy does not have to pay either income taxes or a 10% early distribution excise tax even though it has been less than 5 years since the conversion because Judy is over the age 59 ½.

Example: Jeff, age 35, converted $15,000 of his traditional IRA to a Roth IRA back in 2015. In 2020, Jeff converted another $5,000 to his Roth IRA in 2021. If Jeff withdraws all of the $20,000 in converted funds from his Roth IRA [$15,000 initial Roth conversion and $5,000 subsequent conversion] $15,000 of Jeff’s distribution will be free of income taxes and the 10% excise tax for the early distribution, but the remaining $5,000 derived from the second conversion will be subject to income taxes and the 10% excise tax because 5 years have not passed from the second conversion.

Inherited Roth IRAs: If a beneficiary inherits a Roth IRA, that individual does not need to worry about the 5-year rule for excise tax-free distributions of converted funds. There is an exception to the tax for distributions from inherited Roth IRAs. Yet a Roth IRA beneficiary must still wait the 5-year holding period to receive a tax-free distribution of the Roth IRA’s earnings. The ‘holding period’ of the deceased Roth IRA owner carries over to the inherited Roth IRA, starting with either (i) the deceased Roth IRA owner’s first contribution to the Roth IRA, or (ii) with the conversion of a traditional IRA to the Roth IRA.

Example: In 2021 James inherits a Roth IRA from his mother. His mother had converted $60,000 of her traditional IRA to a Roth IRA in 2019. James can take a distribution of those converted Roth IRA funds without paying income or excise taxes. The earnings on the $60,000 held in James’ inherited Roth IRA is another matter. If James’ mother had not made any earlier contributions to a Roth IRA, and the only Roth IRA that she owned was the $60,000 converted Roth IRA, then James will have to wait until January 1, 2024 to take tax-free distribution of the earnings from the inherited Roth IRA.

Inheriting Spouses: Suppose a surviving inherits a Roth IRA. If the survivor elects to take an inherited account (not a rollover to his or her own Roth IRA) the survivor must also wait the 5-year holding period to avoid paying taxes on the distribution of Roth earnings. If the surviving spouse does a rollover of the inherited Roth IRA, he or she is permitted to use the shorter of either (i) the 5-year holding period on the deceased spouse’s Roth IRA that he or she inherited, or the 5-year holding period of their own Roth IRA.

Example: William and Kate are married. In 2020 William is age 60 years. William had his Roth IRA opened for more than 5 years; accordingly, the earnings on William’s Roth IRA can be withdrawn excise tax-free. Kate is named as the beneficiary of William’s Roth IRA. William dies in February, 2021, at age 61. Kate does a spousal rollover with William’s Roth IRA to her own, newly opened Roth IRA. All distributions taken by Kate from the rollover Roth IRA will be free from the 10% excise tax even though her she has not held a Roth IRA of her own for 5 years. Kate is permitted to use William’s holding period as her own, so that any distributions from the rollover Roth IRA are tax-free.

401(k) Roth Accounts: Roth 401(k) plans are treated much like Roth IRAs with regard to taking qualified distributions. Distributions can be taken from a Roth 401(k) plan when the participant is age 59 ½, disabled, or deceased. Like a Roth IRA, there is a 5-year holding period to be satisfied. When there is a qualified distribution from a Roth 401(k) account that is held for 5 years and the account owner is over age 59 ½, which is rolled-over to a Roth IRA, those funds will be considered ‘basis’ in the owner’s Roth IRA, which means that they will be immediately available tax-free. However, the Roth IRA 5-year holding period for qualified distributions of additional earnings  from the Roth IRA will still apply.

Example: Jermaine, age 62, has $50,000 in his Roth 401(k) account. Jermaine made the first contribution to his Roth 401(k) account in 2015. In 2020, Jermaine takes a $50,000 distribution from his Roth 401(k) account. Because the 5-year holding period was satisfied, the distribution to Jermaine is free of all taxes.

Example: Suppose, though, that in 2021 Jermaine, who had never funded a Roth IRA before, rolls over his 401(k) account balance to a Roth IRA and he then takes  later in 2021 a distribution from the Roth IRA that includes the $50,000 rolled over from his Roth 401(k) account, plus $5,000 in Roth earnings. The $50,000 is considered tax-free basis. However, the $5,000 in earnings distributed to Jermaine will be taxable because the 5-year holding period for qualified distributions of earnings from the Roth IRA has not yet been satisfied. Had Jermaine funded a nominal amount, e.g. $1,000, in a Roth IRA 5 years earlier, Jermaine would not have had to pay any tax on the distributed Roth IRA earnings.

Conclusion: Navigating the 5-year rule to avoid taxation on distributions from Roth IRAs and 401(k) accounts can be a bit challenging. Perhaps the best practice is to avoid taking any distributions from Roth retirement accounts until well into retirement years, where the tax-free distribution rules are much easier to follow.