In case the rules surrounding Roth IRAs weren’t confusing enough so far, there are actually TWO 5-year rules that can apply to your Roth IRA account.
5-Year Rule #1: The Account’s Age
The first 5-year period begins on January 1 of the tax year when you established and first funded the account. This 5-year rule is important in determining if any distributions you receive from the account are qualified. In order to be qualified, a withdrawal must occur at least 5 years after the account establishment date (January 1 of the year you first funded the account). In addition to the 5-year rule, one of the following conditions must also apply in order for your distribution to be considered qualified:
- You are over age 59½
- You are disabled
- You (the account owner) are deceased
- The distribution is for a qualified first home purchase
See the IRS’ flowchart in Figure 2-1 (page 30) at this link in order to determine if your distribution is qualified.
5-Year Rule #2: Age of a Conversion
The second 5-year rule applies to a 5-year period beginning on January 1 of the year of a conversion to a Roth IRA from a traditional IRA or from a qualified retirement plan such as a 401k. If any amount that was subject to taxation during the conversion is distributed before the 5-year period is complete will be subject to an additional 10% penalty applied to the distribution. This would also include post-conversion earnings on all amounts converted within the prior 5 years.
There are several exceptions to this rule, listed here:
- You have reached age 59½
- You are disabled
- You are the beneficiary of a deceased IRA owner
- You use the distribution to pay certain qualified first-time homebuyer amounts
- The distributions are part of a series of substantially equal payments (SOSEPP)
- You have significant unreimbursed medical expenses
- You are paying medical insurance premiums after losing your job
- The distributions are not more than your qualified higher education expenses
- The distribution is due to an IRS levy of the qualified plan
- The distribution is a qualified reservist distribution
- The distribution is a qualified disaster recovery assistance distribution
- The distribution is a qualified recovery assistance distribution
Why These Rules Are Important: Distribution Ordering Rules
The two 5-year rules come into play when considering the order in which distributions are attributed. The IRS has specific rules determining which money is coming out of your account based on the source. The distribution ordering rules determine how each distribution is to be treated, depending on if it’s qualified or not. The order of distribution is as follows:
- Regular contributions (this is your annual contribution amount to the account, not rollovers or conversions)
- Conversion and rollover contributions, on a first-in, first-out basis. This means that the total of conversions and rollovers from the earliest year are distributed first. These conversions and rollovers are further sorted as follows:
- Taxable portion (that portion that was taxed during the conversion or rollover) is distributed first, followed by the
- Non-taxable portion (any amounts that were not taxed during the conversion)
- Earnings on all contributions
It should be noted that, in determining the amounts for #2 (conversion and rollover contributions) that certain aggregation rules apply:
- Add all distributions from all your Roth IRAs during the year together.
- Add all regular contributions made for the year (including contributions made after the close of the year, but before the due date of your return) together. Add this total to the total undistributed regular contributions made in prior years.
- Add all conversion and rollover contributions made during the year together. For purposes of the ordering rules, in the case of any conversion or rollover in which the conversion or rollover distribution is made in 2018 and the conversion or rollover contribution is made in 2019, treat the conversion or rollover contribution as contributed before any other conversion or rollover contributions made in 2019.
Of course, the regular contributions can always be taken out of the account tax free (no 5-year rule applies). After that, the two 5-year rules kick in on the rest of the types of funds in your account.