The Roth IRA 5-Year Rules (Part 3)

In the previous two posts we examined the 5-year holding period rules for Roth IRA contributions and conversions. While these holding period rules may be easily understood, they are not so easy to navigate in practice. In this post will look at some of the nuances in their application that may not be readily apparent.

The 5-year holding period for contributions does not apply to every Roth IRA contribution, only the first one.

Example 1. John opens a Roth IRA in 2020 and contributes $2,000 to it in 2020. The 5 year period ends December 31, 2024. Starting in 2025 any distribution of earnings he takes will satisfy the 5-year holding period (but again, the distribution must also be for a qualified reason to avoid taxation and penalty). Furthermore, John doesn’t have another holding period if he funds a new Roth IRA in 2023. Remember, the holding period begins to run the year of the first contribution to any Roth IRA.

If an account holder liquidates a Roth IRA and opens a new Roth IRA several years later, the account owner will not be subject to a new 5-year holding period requirement for contributions to the new Roth.

Example 2 Susan opens and funds a Roth IRA in 2016. She closes the account in 2018 and pays the income taxes and penalty on the earnings withdrawn. In 2022 she opens a new Roth IRA and makes a contribution. The 5-year holding period applicable to earnings on the 2022 contribution began in 2016, with Susan’s first Roth IRA contribution. She is not subject to a new holding period.

The 5-year holding period rule for contributions applies to Roth IRA beneficiaries, too. Earnings distributions from an inherited Roth IRA must satisfy the deceased account owner’s 5-year holding period. In effect, the deceased owner’s holding period carries over to the beneficiary. The beneficiary’s holding period ends the same time as it would have if the account owner had not died.

Example 3. Tim inherited a Roth IRA in 2022 from his father, Steve. Steve opened and contributed to the account in 2020. Tim’s 5-year holding period will end December 31, 2024, which is the same date the holding period would have ended for Steve had he not died.

Note that a Roth IRA owner who inherits a Roth IRA may have different holding periods to track for tax and penalty free earnings withdrawals.

Example 4. Same facts as example 3, only this time Tim has his own Roth IRA which he established and funded in 2021. Tim has two different 5-year holding periods he must track. The holding period for the Roth IRA he inherited from Steve will expire at the end of 2024, and the holding period for his own Roth IRA will not expire until the end of 2025.

An inherited Roth IRA may not be aggregated with a beneficiary’s own Roth IRA (except for other Roth IRAs inherited from the same deceased owner). (A slightly different rule applies where the beneficiary is a surviving spouse.)

A beneficiary need only satisfy the 5-year holding period to withdraw earnings from an inherited Roth IRA without tax or penalty. Assuming the 5-year holding period is met, any distribution would be on account of a qualified reason – the account owner’s death.

Surviving spouses beware! If an earnings distribution is made to a surviving spouse who is the sole beneficiary of her deceased spouse’s Roth IRA and is treating the Roth as her own, the distribution is treated as coming from her own Roth and not the deceased spouse’s account. Therefore, the distribution will not be treated as made to a beneficiary on account of the owner’s death. The earnings distribution must be a “qualified distribution” (discussed in Part 1 of this series) as to the surviving spouse or it will be subject to income tax and penalty.

Example 5. Bill, age 57, died in 2022. Bill’s wife Anne, age 55, is the sole beneficiary of Bill’s Roth IRA. Bill opened the IRA is 2015 with a $5,000 contribution. Anne elects to keep the inherited Roth in Bill’s name, but treat it as her own for tax purposes. Although the 5-year holding period has been satisfied, Anne cannot withdraw any earnings from the inherited account income tax and penalty free without a qualifying reason (ex. - withdrawal after age 59½; disability; chronic illness).

A contribution to a Roth IRA as late as April 15 may be counted as a contribution made in the prior year for purposes of the applicable 5-year holding period.

Example 6. Sam, age 58, makes his first contribution to a Roth IRA on April 14, 2023, and elects to count that contribution as though it had been made for the 2022 tax year. Thus, Sam holding period is deemed to have begun January 1 of 2022. He could make a qualified distribution of earnings from his Roth IRA as early as 2027 (5 tax years passing from the year of the deemed first contribution) even though less than 4 calendar years have passed since the actual date of the first contribution.

Unfortunately, a Roth owner cannot relate a conversion back to a prior tax year. A Roth conversion must occur by December 31 of a given year.

We’ve covered a lot of ground in this series and it wouldn’t surprise me if you have some questions. If so, please give me a call. I can help.