In 2021, more people than ever are considering converting their traditional IRA into a Roth IRA. However, though eager to do so, many hesitate because they are confused about what is known as the "five-year rule." If you are one of the many who needs answers to your five-year rule questions, here is the Roth IRA five-year rule explained in easy to understand terms.
Future Distributions
When you have a Roth IRA, future distributions are considered to be tax-free if they are "qualified distributions." However, for a distribution to be qualified, it must meet the five-year rule. Yet once you think you have this part of your Roth IRA understood, there may be more confusion ahead.
One Rule or Two?
In reality, the five-year rule confuses so many people because there are two five-year rules. While the first determines if a Roth IRA distribution will be tax-free, the second determines if a distribution that is taken before you turn age 59 -1/2 will avoid the early distribution tax of 10%. Fortunately, after speaking to your CPA about these rules, you are likely to find out you won't have to worry about either one.
Income Taxes and the Five-Year Rule
Since the first five-year rule will determine if your Roth IRA distribution will qualify to be income-tax free, you'll definitely want to discuss this in detail with your CPA. For the distribution to be qualified, it must pass two tests. First, five tax years must have passed since you made your initial contribution to your Roth IRA. But according to Treasury Department regulations, this rule is very broad, thus allowing contributions to be both direct and converted amounts.
When speaking to your CPA, you will come to realize this rule is not applied separately to each Roth IRA or Roth IRA conversion, nor does the five-year period hit the reset button when one Roth IRA is rolled over to another. Rather, everything is aggregated into one five-year period. Thus, once the five-year rule is satisfied for one Roth IRA, you've met this criteria for life.
Test Number Two
Once you've passed the first test for qualified distributions, it's time for test number two. For the distribution to be qualified to be tax-free, it must have been made on or after you turned 59 - 1/2, the IRA owner died and the distribution was therefore made to a beneficiary or estate, or it was for first-time homebuyer expenses of up to $10,000. To be in the clear for a tax-free distribution, you need to meet criteria from both tests. For example, if you are 59 - 1/2 or older and have had your Roth IRA for at least five years, you'll have a qualified distribution that is tax-free.
The 10% Penalty
Now that you know about the first five-year rule regarding qualified distributions, it's time to move on to the second five-year rule that focuses on the 10% penalty. Since this can have a major impact as to how much money you may actually receive from a distribution, make sure you have discussed this in detail with your CPA. In essence, you won't incur this penalty if a minimum of five tax years have come and gone since the Roth IRA principal was converted. However, this rule will apply to each IRA conversion, meaning you'll need to track the amount of principal year after year if doing multiple conversions.
A Rule Negates A Rule
As you discuss this with your CPA, one thing you'll come to find out is that one rule negates another rule in regards to the 10% penalty. For most people who convert a traditional IRA to a Roth IRA, the 10% penalty doesn't apply if you are at least 59 -1/2 years old.
Is a Five-Year Rule Really a Five-Year Rule?
This question is answered by both yes and no. In reality, a five-year rule does not focus on calendar years or even a 12-month period. Rather, it is centered upon tax years or taxable years. Under the federal tax code, that means a tax year starts on January 1. Thus, since you can make a tax year 2021 contribution to a Roth IRA through April 15, 2022 or convert an IRA as late as December 31, 2021, your five-year period may actually end well before an actual five years have passed.
Exceptions to the Rule
As with most rules of any type, these too have exceptions. For example, both a traditional and Roth IRA may forgo the 10% early distribution penalty if the money goes to first-time homebuyer expenses, payment of unreimbursed medical expenses, or if a series of equal and substantial distributions have taken place.
Why None of it Will Likely Matter
Ultimately, most of the various aspects of the five-year rule likely won't apply to you and your individual financial situation. Since the second rule does not apply to people who are at least 59 - 1/2, you probably won't have to worry about this rule. Also, the first five-year rule may not apply due to what are known as IRA ordering rules.
In a Roth IRA, you will have the principal and the earnings on the principal. When you take a distribution that is less than the full value of the IRA, ordering rules dictate principal is considered to be distributed first. Once all principal is distributed, earnings are then considered to be distributed. The beauty of this is that distributions of principal for a Roth IRA have already had taxes paid on them, and thus are no longer taxable.
Beneficiaries Have No Worries
Finally, beneficiaries of your Roth IRA won't have to worry about the five-year rules, since these complex rules only apply to the original owner of the Roth IRA.
As you have realized by now, there are many different things at play when it comes to the five-year rules and a Roth IRA. To get a full understanding of how they apply to your situation, consult with your CPA.