Roth IRA Contributions & Conversions – Understanding The 5-Year Rules (Part 1)

The Roth IRA is a very popular retirement savings vehicle. The primary driver of its popularity is the promise of tax free distributions – provided that complex income tax rules regarding Roth IRA distributions are followed.

I regularly field questions from clients and prospects concerning the Roth IRA holding period rules affecting Roth contributions and conversions. These rules can be confusing and can trip up an unwary Roth owner. I thought it might be helpful to look at how these rules impact Roth distributions.

There are two 5-year holding period rules governing Roth IRAs. The first of these rules applies to earnings on contributions to a Roth IRA. The second rule applies to Roth conversions from traditional IRAs and other qualified plans. In this post, I’ll take you through the holding period rule affecting taxation of earnings. I’ll take up the second rule that applies to Roth conversions in the next post.

Before we go any further, understand that contributions to a Roth IRA may be withdrawn at any time both income tax and penalty free. And, contributions are deemed to be the first funds distributed from a Roth IRA. So as long as you are withdrawing no more than the total amount you contributed to your Roth IRA, income taxes and penalties will not be an issue for you.

That said, let’s take a look at the 5-year rule applicable to Roth IRA contributions. This rule is used to determine whether earnings on contributions to a Roth IRA may be withdrawn income tax and penalty free as a “qualified distribution.”

A “qualified distribution” of earnings from a Roth IRA is a distribution that meets both of the following requirements:

a) The first contribution to a Roth IRA was made at least 5 tax years before the year of the distribution; and

b)The distribution is made – i) on or after the account owner attains age of 59½, ii) because of the account owner’s death; iii) because of the account owner’s disability; or iv) for another qualified special purpose (first-time home buyer, etc.).

A qualified Roth IRA distribution is excluded from income and is exempt from the additional 10% early distribution penalty.

The 5-year holding period requirement is met as of January 1 of the 5th year following the year the first Roth contribution is made. If Jack opens a Roth IRA and makes the first contribution to the account on December 15 of 2022, the 5-year holding period will be satisfied as of January 1, 2027.

The rule focuses on tax years, the first tax year being the year of the initial contribution to a Roth IRA. So in Jack’s case, the 5 tax years that must pass to satisfy the holding period are 2022, 2023, 2024, 2025, and 2026.

Further, the 5-year holding period does not apply separately to each Roth IRA an individual may own. Multiple Roth IRAs may be aggregated [but multiple Roth 401(k)s may not]. The holding period begins to run as of January 1 of the year in which an individual makes his first contribution to any Roth IRA. Thus, if Jack opens a second Roth IRA in 2025. The 5-year holding period applicable to his Roth account opened in 2022 applies to the Roth account opened in 2025. Thus, Jack could take a distribution from the Roth IRA opened in 2025 in 2027 and still satisfy the 5-year holding period rule.

In addition, tax regulations provide that the 5 year clock begins to run the first time any money is deposited into any Roth IRA, regardless whether the money deposited is a contribution or conversion.

Beware! A Roth IRA owner like Jack must also satisfy the second part of the test – that the distribution is for a qualifying reason, such as being at least age 59½. If a Roth distribution does not meet both parts of the test, the distribution will be subject to income taxes and penalty.

Like most tax rules, there are subtleties in the rule’s application that may pertain to your situation. Make sure you are working with a competent advisor before pulling money from a Roth IRA.

Are you looking for an independent, fiduciary, fee-only investment advisor? Give me a call, I can help.