Take-Away: There are two, separate, ‘5-year rules’ that need to be satisfied before taking a distribution from a Roth IRA.

Background: A recent article by Ed Slott, the well-known IRA expert, on the Roth 5-year rules is the source of this missive. And to give full credit to Mr. Slott, this missive will use his descriptive names for each of these two 5-year holding rules. With the SECURE Act 2.0 encouraging more individuals to open Roth IRAs and Roth 401(k) accounts it is important to gain a working  familiarity with these different 5-years rules since we can expect many more individuals to open Roth IRA and Roth 401(k) accounts in the years to come.

Qualified Roth Distributions: Before we get to the two separate Roth 5-year rules that need to be satisfied before taking a distribution, what follows is a short ‘refresher’ of what constitutes a qualified Roth distribution. If the distribution from a Roth IRA is qualified, the entire distribution, including its earnings, is tax-free. However, to be a classified as a qualified distribution: (i) the Roth IRA owner must be over the age 59 ½, or the distribution must be for the Roth owner’s disability, or for the Roth owner’s purchase of a new home, or it must be to a beneficiary who has inherited the Roth IRA from its owner; and (ii) the Roth IRA owner must have held a Roth IRA for a period of at least 5 years. This last 5-year Roth holding period condition applies of any of the owner’s Roth IRAs, starting with his/her first contribution to any Roth IRA, or a conversion of a traditional IRA to any Roth IRA held by its owner.

5-Year Forever Rule: This rule never restarts. Once an individual makes his/her first Roth IRA contribution, or he/she converts his/her traditional IRA to a Roth IRA, that starts the 5-year Forever Rule period. This is the case even if the Roth IRA owner empties his/her initial Roth IRA, and later opens and funds a new Roth IRA. This 5-Year Forever Rule starts on January 1 of the year in which the first contribution is made to the Roth IRA, or the first conversion is made from a traditional IRA to a Roth IRA. Due to the January 1 starting  ‘snapshot’ date for this  5-year holding period, the reality is that the 5-Year Forever Rule is probably going to be for a period of something less than 5 full years.

Example: Ken made a $10,000 contribution to his Roth IRA in 2001. In 2004, Ken withdrew all of his Roth IRA account balance (including all of its earnings.) In 2009 Ken converted $350,000 of his traditional IRA to a ‘new’ Roth IRA. In 2016 Ken converted yet another $75,000 from his traditional IRA to his existing Roth IRA. Ken’s 5-year Forever Rule started back  in 2001 with his first contribution to his Roth IRA. The fact that Ken withdrew the balance of his Roth IRA in 2004 does not matter when he deals with the 5-Year Forever Rule. Nor does it matter that Ken made future Roth conversions in 2009 and 2016 to his Roth IRA. Ken has met, for all time, the Roth 5-Year Forever requirement.

Example: Barbie, age 50, made her first Roth IRA contribution on April 2, 2023, but that Roth IRA contribution by her was for 2022. Consequently, Barbie’s 5-Year Forever Rule started on January 1, 2022 (not April 2023, when the funds were actually transferred by her.)To satisfy the 5-Year Roth Forever Rule, Barbie can take her first qualified Roth IRA distribution beginning on January 1, 2027; her Roth IRA account will have been held for technically a little less than 5 full years.

5-Year 10% Penalty Rule: This rule applies to distributions of converted  funds to a Roth IRA by Roth owners who are under the age 59 ½. One big difference between this 5-year rule and the 5-Year Forever Rule is that this rule applies, again and again, each time to a new conversion to the Roth IRA. If an individual who is under the age 59 ½ takes a distribution of converted funds before the end of the 5-year holding period, then a 10% early distribution penalty is applied to the distribution of any converted funds that were taxable at the time of the conversion. The converted funds distributed are the first dollars ‘out’ of the Roth IRA.

Example: In 2015 Sarah, age 47, converted $200,000 from her traditional IRA to a Roth IRA. In 2022 Sarah converted another $50,000 to her Roth IRA. In 2023 Sarah takes a distribution of $250,000 from her IRA. $50,000 of that distribution taken by Sarah will be subject to the 10% early distribution penalty if Sarah does not qualify for an exception. That taxation is because Sarah’s 2022 Roth conversion did not satisfy the 5-year holding rule.

Example: Evan, age 79, never before had opened a Roth IRA. In 2021 Evan converted $330,000 of his traditional IRA to his ‘new’ Roth IRA. In 2023, when Evan’s Roth IRA has grown to $350,000, he takes a distribution of his entire Roth IRA balance. The distribution of the converted $330,000 and the $20,000 of Roth earnings are penalty-free since Evan is over the age of 59 ½. However, because Evan’s Roth IRA has not been in existence for at least 5 years, the 2023 distribution will not be a qualified distribution. Accordingly, Evan will be taxed on the $20,000 of earnings because he did not meet the 5-year Forever Rule.

Inherited Roth IRAs: For those beneficiaries who inherit a Roth IRA, the 5-Year 10% Penalty Rule does not apply since inherited IRAs are never subject to the 10% early distribution rule. But the 5-Year Forever rule might still apply. Fortunately, the inheritor of the inherited Roth IRA can ‘tack’ the original Roth IRA owner’s holding period onto the inheritor’s own holding period.

Example: Hunter, age 47, inherits a Roth IRA from his father Guy who died in 2023. Guy had converted $300,000 of his traditional IRA to his first Roth IRA in 2020. Guy’s Roth IRA has increased in value between 2020 and 2023, the year of his death, to $330,000. If Hunter withdraws the entire balance of the inherited Roth IRA in 2023 after Guy’s death, $300,000 of that distribution will be penalty-free even though it has been in the Roth IRA for less than 5 years after the conversion. That is because the 5-Year 10% Penalty Rule does not apply to the beneficiaries of inherited IRAs. However, the 5-Year Forever Rule will apply since Guy started his Roth IRA only 3 years earlier, in 2020. Accordingly, if Hunter withdraws the entire balance of the $330,000 inherited Roth IRA, $30,000 will be taxable to Hunter. If Hunter delays emptying the inherited Roth IRA until January 1, 2025, Hunter will pay no income tax on the entire distribution.

Roth 401(k) Accounts: As noted earlier, the SECURE Act 2.0 contains provisions that are intended to encourage more employers to sponsor Roth 401(k) accounts and for employees to contribute to those Roth 401(k) accounts. These same 5-year rules also apply to Roth 401(k) accounts. If the plan participant converted funds in his/her employer’s qualified plan, the 5-Year 10% Penalty Rule follows the converted amount to the Roth IRA when it is rolled-out from the qualified plan. If the participant-Roth IRA owner is over the age 59 ½, any distribution will be immediately available from the Roth IRA penalty-free. If a qualified distribution is made from a Roth 401(k) and rolled into a Roth IRA, meaning that it is held for at least 5 years and the Roth IRA owner is over the age 59 ½, the rolled over funds to the Roth IRA are considered basis in the Roth IRA and thus they will be immediately available for distribution from the Roth IRA tax-free and penalty-free. However, the Roth IRA 5-Year Forever Rule for qualified  distributions of Roth earnings accrued after the rollover will still apply, and therefore an income tax might be involved in a distribution before the 5-years has fully run.

Example: Adam, age 64, contributed to his employer’s 401(k) plan for several years. In 2022, Adam decided to convert $200,000 of his 401(k) account to a Roth 401(k) account. Adam decides to retire in 2023. Adam rolls over the entire balance of his Roth 401(k) of $350,000 account to Adam’s first Roth IRA. The 5-Year 10% Penalty Rule does not pose a problem for Adam since he is over the age 59 ½. Moreover, since Adam is age 65 and he has participated in his employer’s 401(k) plan for several years, the full $350,000 rollover will be considered as the basis for Adam’s Roth IRA, which will be available to Adam tax and penalty-free. However,  the 5-Year Forever Rule will still  apply to Adam’s Roth IRA and it will start to ‘run’ only from 2023 when the Roth IRA account was opened by Adam. In other words, even though Adam is age 65 and he has maintained a Roth 401(k) account for several years, Adam will still need to wait until January 1, 2028 before the earnings of his Roth IRA (accrued after the 2023 rollover) will be available to him tax-free.

Surviving Spouses: If a spouse is named as the beneficiary of an inherited  Roth IRA, he/she must also wait the 5-year holding period in order to receive a qualified distribution from the Roth IRA. Yet, if the surviving spouse does a spousal rollover he/she will be permitted to use the more beneficial 5-year holding period on the inherited Roth IRA from their spouse, or the 5-year holding period if they have their own Roth IRA.

Example: Joe is age 60 and he has owned a Roth IRA for more than 5 years. Joe’s Roth IRA funds are fully qualified and thus they can be withdrawn by him tax-free. Jill, Joe’s wife, is the designated beneficiary of Joe’s Roth IRA. Jill has never owned her own Roth IRA of her own. Joe dies. Jill is age 62. Jill rolls Joe’s Roth IRA funds to a Roth IRA that she just opens in her own name. All the distributions from Jill’s Roth IRA will be qualified tax-free distributions, even though her Roth IRA has not yet been in existence for 5 years. The rules permit Jill to ‘tack’ Joe’s 5-year Forever Rule as her own, so complying with that 5-Year Forever Rule will not pose a problem for Jill.

Conclusion: The overriding goal is for qualified distributions from Roth accounts- no penalties, no taxes. Roth IRA and Roth 401(k) account owners need to keep track of their contributions and their conversions so that these 5-year rules can be monitored, and if need be worked around, in order to avoid any penalties or income taxes on the Roth account earnings.