By Dr. Jim Dahle, WCI FounderIf you have been around personal finance for long, you have probably heard of “The 5-Year Rule.” However, if you're like me, you couldn't really explain the 5-Year Rule to your spouse without looking it up and spending 15 minutes understanding it again. You know why? Mostly because there are four of them. This post will be a reference post for all of us for the next time we can't quite remember what the 5-Year Rule is.
5-Year Rule #1: The 5-Year Rule for Roth Conversions
This is probably the most important rule—and the one that affects financial planning most frequently. This rule determines whether you can withdraw PRINCIPAL that came from a Roth CONVERSION PENALTY-FREE. Essentially, you must wait five tax years from the time of a Roth conversion before you can withdraw that principal free of the 10% early withdrawal penalty UNLESS you meet one of the other ways to qualify to have penalty-free withdrawals (such as being 59 ½). Thus, this rule really only applies to early retirees who want to spend Roth principal (that came from a conversion) before age 59 ½. Each Roth conversion has its own five-year clock. Note that this rule does not apply to non-taxable conversions (Backdoor Roth IRAs, Mega Backdoor Roth IRAs).
Chances are good you're not going to get caught up in this rule. That's because Roth IRA withdrawals come out in the following order:
- Contributions
- Conversions
- Earnings
If you don't churn through your contributions in the first five years, you're fine. Plus, when you do withdraw converted principal, you start with the first conversion you ever did and work your way forward. That means if you've done four Roth conversions over the years and three of them have already met their 5-Year Rules, you can probably live off the first three until that final one has met its own 5-Year Rule. Note that violating this rule does not result in you having to pay income taxes on the withdrawal since you are withdrawing principal that has already been taxed. It just means you have to pay a 10% early withdrawal penalty on the withdrawal.
Why Does This Rule Exist?
This rule exists to prevent you from withdrawing money from your traditional IRA before age 59 ½ without paying the 10% penalty simply by first converting it to a Roth IRA before withdrawing it. Essentially, the rule says you can still do this; you just have to wait five years after the conversion. FIRE folk who want to retire at 42 and live on Roth IRA principal might want to make sure they have that conversion done by age 37. Note that earnings on the Roth IRA still can't come out penalty-free until the Age 59 ½ rule (or another exception including death, disability, first home, or the Substantially Equal Periodic Payments rule) is met.
The Backdoor Roth IRA Exception
Note, however, that there is an exception if the conversion is of post-tax dollars. As explained in a nice chart in the Bogleheads Wiki on Roth IRAs:
The conversion of the non-taxable portion of a contribution does NOT have an associated penalty.
More information here:
59 ½ Rule — How to Get to Your Money Before ‘Retirement Age’
5-Year Rule #2: The 5-Year Rule for Roth Contributions
This 5-Year Rule is used to determine whether the withdrawal of EARNINGS that came from a Roth IRA CONTRIBUTION will be TAX-FREE. Remember that contributions always come out tax-free. Earnings generally do, too, but only if all of the requirements are met, one of which is this 5-Year Rule. This rule is in addition to the other rules (such as being at least 59 ½ or having a valid exception to that rule) that allow for tax-free withdrawals of earnings.
The rule is that five tax years must have passed from the time of the first contribution to any Roth IRA before withdrawals of earnings from all Roth IRAs are tax-free. Technically, the five-year period could be as short as three years and eight months since you could put in a contribution for a given tax year on April 15 of the next year. For example, let's say you make a 2020 contribution on April 15, 2021. 2020 counts. So does 2021. Then, 2022, 2023, and 2024 pass. On January 1, 2025, you can withdraw the money tax-free (assuming you meet the other requirements). But you cannot make a tax-free withdrawal of earnings before that.
Note that the clock starts after the first time you make any contribution to any Roth IRA. All four of my children have already met the 5-Year Rule since they made their first IRA contribution years ago. But if, for some bizarre reason, you never contributed to a Roth IRA until you were 57, you couldn't make tax-free withdrawals of earnings at age 59 ½. You'd have to wait until age 62.
You can also start this five-year clock by converting money from a traditional IRA (or 401(k)) into a Roth IRA or by rolling money from a Roth 401(k) into a Roth IRA). Note that there is only one Roth IRA contribution clock, no matter how many contributions or Roth IRAs you have. If one Roth IRA has met this requirement, they all have.
While death is an exception to the early withdrawal penalty, it is not an exception to the 5-Year (contribution) Rule. If someone opened a Roth IRA and then died the next year and the heir took out earnings prior to five years passing, they would have to pay income taxes on those earnings. That's unlikely because the principal comes out first and they could stretch out that Roth IRA for up to 10 years, but it could happen if they wanted all that money right away.
Complicated enough for you? Just wait. This rule also applies to Roth 401(k) contributions. But instead of there only being one clock, each Roth 401(k) has its own clock. And all of those clocks are separate from the Roth IRA clock. If you combine two Roth 401(k)s, you do get to use the one with the longer clock, but if you roll a Roth 401(k) that has met its 5-Year Rule into a Roth IRA, the Roth IRA does not get to use the Roth 401(k) clock. Crazy right? But them's the rules.
The bottom line for this rule is that it really should not catch very many people. Very few people who have a Roth IRA will not have it for at least five years before they start withdrawing from it. And even if they do need to withdraw from it, they can just take out the principal and wait on the earnings. But if you're in some kind of unique situation where this rule could apply, you should be aware of it.
Why Does This Rule Exist?
This rule is simply to encourage people to use Roth IRAs for long-term saving/investing for retirement. Without it, people could contribute to a Roth IRA at age 58 and pull it out at age 60 with two years of tax-free growth without really making a long-term investment toward their retirement. Or perhaps they could use it to save up for six months to make a house down payment (one of the exceptions to the Age 59 ½ rule). The government wants you to use this tax-free account for retirement.
5-Year Rule #3: The 5-Year Rule of Inherited IRAs
The third 5-Year Rule out there has to do with inherited IRAs. There are a lot of options when it comes to taking money out of an inherited IRA. They have also been changing recently, so the rules have been seemingly different every year for the last few years. Whether and how one who has inherited an IRA has to take Required Minimum Distributions (RMDs) from it depends on when the owner died and what their relationship was. Generally speaking, one must have distributed the entire IRA by the end of the 10th year after the year in which the IRA owner died. This is “The 10-Year Rule.” One can still stretch the IRA tax protection for 10 years but not for a lifetime like one could before 2020. I've called this the New Stretch IRA. By the way, the IRS has now clarified that one must take RMDs from an inherited traditional IRA (Roth IRAs are an exception) each year of those 10 years, but only if the decent was already taking RMDs. In that case, you cannot just wait until the 10th year and take it all out like people initially believed. However, if the decedent was not taking RMDs yet, you can wait until the end of the tenth year and take it all out then if you want.
There are exceptions to the 10-Year Rule for certain Eligible Defined Beneficiaries (EDBs) including someone who is:
- The IRA owner's spouse
- The IRA owner's child until they reach 18
- An individual not more than 10 years younger than the IRA owner
- Disabled
- Chronically ill
If the heir is an EDB, they basically have the old stretch IRA, where you can stretch that IRA over your entire lifespan. Once a child has hit 18, the 10-Year Rule starts, and then they have the New Stretch IRA. Spouses also have the option to move the money into their own IRA.
So, where does the 5-Year Rule come in? Before 2020, a person who inherited an IRA had two options to avoid taking money out of the inherited IRA right away. They could take the money out via RMDs based on their own lifetime expectancy, or they could avoid taking out any RMDs, so long as they took all the money out within five years. That rule still applies to an inherited IRA if the owner died before 2020.
However, if an owner dies after 2020, there is also a 5-Year Rule IF the beneficiary is not a person. For example, if the IRA owner designates a business, a trust, a charity, or just their estate (which is what happens if no beneficiary is named), there are no RMDs. But all the money must be distributed by the end of the fifth year following the death of the IRA owner. It can be distributed more quickly but not any more slowly. There is a little exception for trusts that the IRA describes this way in Pub 590-B.
“A trust can't be a designated beneficiary even if it is a named beneficiary. However, the beneficiaries of a trust will be treated as having been designated beneficiaries for purposes of determining Required Minimum Distributions after the owner’s death.”
I think the IRS is saying that an IRA naming a trust as a beneficiary can be stretched over a lifetime (rather than five years) as long as the trust beneficiaries are EDBs and over 10 years if the beneficiaries are individuals who are not EDBs. Otherwise, it's five years.
Why Does This Rule Exist?
Prior to 2020, the 5-Year Rule was just an option you could take if you wanted. People probably mostly took it when they forgot to take out RMDs and didn't want to pay that big fat 50% excise tax on missed RMDs. It allowed them to avoid hassling with RMDs, too. You could just take it all out in year 4 or 5 and never bother with figuring out RMDs. Since 2020, it basically discourages people from leaving IRAs to anyone but real people. It seems to me that Congress wants you to leave your IRA to your spouse, kid, brother, friend, or somebody disabled or ill instead of your family-limited partnership. This is one way they encourage you to do so.
More information here:
5-Year Rule #4: The Social Security 5-Year Rule
There is one more 5-Year Rule to be aware of. To collect Social Security disability, one of the requirements is to have worked and paid into the system during five of the last 10 years. Social Security is not just about old-age payments. There are also disability payments and survivor benefits. The 5-Year Rule only applies to disability. Unlike many pensions that base the benefit amount on the last 3-5 years of working, Social Security old-age benefits are based on your 35 years of highest pay. The 5-Year Rule has nothing to do with this benefit.
Why Does This Rule Exist?
Simply put, taxpayers don't want to pay you disability benefits if you haven't worked for decades. They reason, “Why would you deserve disability payments when you're not working anyway?” and “Why should we pay you a benefit if you haven't been paying into the system regularly?”
Four separate 5-Year Rules with varying levels of complexity and contradictory rules. No wonder we can't keep them all straight.
What do you think? How do you keep all of these 5-Year Rules straight? Has any of them ever affected you?
I can’t keep it all straight. Regarding the 5-Year Rule for Roth Conversions, I believe your comments indicate that since I am over 59 1/2, that I can convert money to a Roth and withdraw that same converted principal at any time without the 10% penalty. I don’t intend to withdraw it that quickly I just want to confirm that I can ignore this particular 5-Year clock on principal for any future conversions?
I was just reading another article that appears to be saying the 5-Year clock still matters on converted principal even if I am over 59 1/2. I have copied that excerpt below because I did not want to paraphrase incorrectly:
“Another important factor is the five-year rule. Many people think they just need to be 59 ½ years old to tap into their retirement accounts penalty-free, but Roth accounts have additional rules. The Internal Revenue Service instituted a five-year waiting period on assets converted to a Roth, and the clock starts over for each tax year.
For example, say you converted money in 2024 and again in 2025, the waiting period for the assets converted in 2024 would expire in 2029, and the assets that were converted in 2025 would expire in 2030. This means you have to pay close attention to how money is distributed from your accounts, so that you’re not taking out money that could be subject to taxes as a result of “early” distribution. It also means you need to consider it in your conversion plans if you intend to rely heavily on the money in a specific year. ”
Thanks for any clarification on the matter.
It was hard for me to keep straight too, so I figured it all out so I had it straight and typed it up into this post. Like most of my posts, that was many months ago, so to answer your question, I’ll go back to my post where I double and triple checked everything. But I’m not going to pretend I can keep this all straight in my head.
The rule that applies in your situation is the first one in this post, which I will quote from:
I can’t vouch for the accuracy of that other article. I can barely be responsible for the accuracy of the ones I write. But I do believe it is accurate as written. If not, I’ll correct it as soon as I see something definitive that I am wrong. I can’t even look at your cited article because you didn’t include a link.
Posts like this are why I’ve stuck with WCI for years.
Am I reading this right, though? The principal from any backdoor roth can be withdrawn before the age of 59 penalty free?
Yes, that is correct. Your contributions to a Roth IRA can always be withdrawn tax free and penalty free.
I think understanding this fact helps young investors start using the accounts early in life. Sometimes I see people who just started making “real money” struggling to decide whether they should use limited “extra” money to either establish an emergency fund or fund an Roth IRA.
It is of course important to develop a true emergency fund in a high-yield savings account or money market fund as quickly as possible but if there is a discreet decision between first getting 3-6 months of expenses in an emergency fund or making Roth IRA contributions, I think it makes sense to have ~1-2 months of expenses saved and then contribute to a Roth IRA before the other 1-4 months of expenses get saved into the emergency fund.
If a true emergency did arise after the Roth IRA is funded and before the rest of the emergency fund is built up then the Roth IRA contributions could be withdrawn to help cover the emergency. Given this scenario is statistically unlikely to occur, the person benefits from taking advantage of that Roth IRA contribution window that closes forever after April 15th of the following year. Missing out on those time limited windows has a real cost 30-40 years from now.
You two are talking past each other a little bit. What Tyler said is true, but it’s not an answer to what is being asked. He’s asking about dollars that were converted into a Roth IRA, not contributed directly to a Roth IRA. The first 5 year rule in this post applies to those dollars until age 59 1/2.
on you tube , this wealth planning firm , Blue Ridge , claims that the prinicipal can be withdrawn without the 10 percent penalty , However any earnings must remain in for 5 years…. assuming you are over 59.5 years of age after the conversion
Thanks for sharing. Not sure what principal you or they are talking about. You’ll need to be more specific. Sounds like you may be referring to the second rule above.
You mention in the article: “By the way, the IRS has now clarified that one must take RMDs from an inherited traditional IRA and from an inherited Roth IRA each year of those 10 years. You cannot just wait until the 10th year and take it all out like people initially believed.” This must be a very recent development. I haven’t seen this anywhere else, so kudos for pointing this out. Can you share a link to this new IRS rule, because this seems like a big deal for inherited Roth IRAs.
It was more that the IRS didn’t say and we all assumed it was going to be the other way because we thought that would make more sense, so when the IRS finally clarified, a lot of people were surprised. This all happened 1-2 years ago as I recall. Here’s my post that ran about it last December.
https://www.whitecoatinvestor.com/inherited-ira-required-minimum-distributions/
Here’s the official IRS notice if you don’t believe me:
https://www.irs.gov/pub/irs-drop/n-22-53.pdf
It was dated October 2022.
On Morningstar recently, Ed Slott’s take on the 10 year rule for inherited Roth IRA’s was a little different from yours. He explained it this way: “…anybody who dies with a Roth IRA, even at 99 years old, is deemed to have died before their required beginning date because there is no required beginning date for Roths during life. So that means they technically never started. So, the Roth IRA beneficiaries can wait until the end of that 10th year after death with all that growing accumulation and take it all out income-tax-free…”
Would you agree with that? Or do you still feel that year 1-9 RMD’s are required from an inherited Roth?
Here’s my post on the topic:
https://www.whitecoatinvestor.com/inherited-ira-required-minimum-distributions/
Which states:
Later Guidance on Required Minimum Distributions
But in February 2022—yes, more than three years after the law went into effect—the IRS clarified the rules in the form of “Proposed Regulations” which took away a few of those planning options.
If the deceased was already taking RMDs from a tax-deferred IRA upon dying in 2020 or later, the beneficiary must start taking RMDs in the year after the death and continue for nine years before taking everything else out in year 10.
If the deceased was not taking RMDs from a tax-deferred IRA, the beneficiary could avoid RMDs. They just had to have all of the money out of the account in year 10.
If the inherited IRA was a Roth IRA, the beneficiary could also avoid RMDs and take all the money out in year 10.
So yes, I agree with Ed Slott on this topic.
Thanks for the correction. I’ll get it fixed in this article. Hard to keep all this stuff straight even when it isn’t changing every few years.
Someone, please make a chart for people over 59 1/2 who first contributed to their first Roth account more than 5 years before they make withdrawals and now only want to do conversions.
There are two 5 year rules that are confusing:
1. “First Roth Ever Opened 5 year Rule” (seems to be known as the “Roth 5 year Rule”)
2. “Roth 5 year Conversion Rule” (seems to be known as the “Special Roth 5 year Rule”)
Clarity on converted principal withdrawals is needed:
When you withdraw converted principal after age 59 1/2, you can do so without penalty as long as you meet Rule 1. Is this correct?
And, there would be no taxes on converted principal because you already paid it upon conversion. Correct?
The table above does not invoke Rule 1 for over 59 1/2 in terms of penalties. But the table is under the heading “Backdoor”, maybe backdoor is different, I don’t understand or need backdoor, just conversions. (Is “backdoor” here being used as another way to say conversion?)
Clarity is needed on withdrawing earnings:
When you withdraw earnings on converted principal after age 59 1/2, you can do so without penalty or taxes as long as you meet Rule 1. Is this correct?
The table above does reflect this in terms of taxes. But I found a chart at Fidelity that says no, there would be penalties not taxes if Rule 1 is not met…. arrrggggh!
Could it be true that the Rule 2 never applies to those over 59 1/2 as long as they made their first Roth contribution more than 5 years ago?
Thanks, this is the best discussion I have found after several weeks of searching!
Sounds like my rule #1 is what applies in your situation:
That rule is what you’re calling “Special Roth 5 year rule”. It basically doesn’t apply after age 59 1/2. Your “Roth 5 Year Rule” is my rule # 2 and doesn’t apply in that situation.
Hope that helps.
WCI,
In your blog, you wrote:
By the way, the IRS has now clarified that one must take RMDs from an inherited traditional IRA and from an inherited Roth IRA each year of those 10 years, but only if the dece(de)nt was already taking RMDs. In that case, you cannot just wait until the 10th year and take it all out like people initially believed. However, if the decedent was not taking RMDs yet, you can wait until the end of the tenth year and take it all out then if you want.
I would like some additional clarification: Am I right to believe that under current IRS regulations?:
a) For an individual (other than a spouse) who inherits a Roth IRA from the original Roth IRA owner, there is no annual RMD. Instead, the 10 year distribution rule applies.
b) For an individual who inherits a Roth IRA from an Inherited Roth IRA owner, there would be an annual RMD
Thank you for another great and insightful article!
This post discussed this topic in great depth.
https://www.whitecoatinvestor.com/inherited-ira-required-minimum-distributions/
Each Roth conversion has its own individual 5 year rule?
Thats not the way I understand it.
Example:
I open a Roth in June of 2020. I convert 20k. Every year I convert 20k. In 2025, if I’m over the age of 59.5 I can withdraw the entire amount tax and penalty free on earnings and contributions.
Is that not correct?
The way I understand it is how this post is written. The only way I can address your question is by quoting from the article above.
Note that statement IS NOT inconsistent with yours. We’re both right. See the bolded partt.
5-year Rule Article, Inherited IRA’s, Minor Child “The IRA owner’s Child until they reach age 18”
We are just struggling with these rules in our Estate Planning. I found that the actual age is much higher for this “eligible designated beneficiary” category.
My Source: Journal of Accountancy, Beneficiary IRAs: A guide to the Mase, by Dayna E Roane, CPA published on March 30, 2023. (This is also covered by Ed Slott but he does not notate the act’s regulations clause. )
Beneficiaries who have not yet reached the age of majority can make withdrawals from the account over their own life expectancy. They lose the “eligible designated beneficiary” designation when they reach the age of majority and the 10-year rule goes into effect. They then have until Dec. 31 of the 10th year from the child’s attainment of majority to withdraw all the funds from the account.
The age of majority for this second type of eligible designated beneficiary is defined in Prop. Regs. Sec. 1.401(a)(9)-4(e)(3) as being reached on the child’s 21st birthday. Note, however, that the proposed regulations would permit defined benefit plans that have used a prior definition of the “age of majority” (under plan terms that were adopted on or before Feb. 24, 2022) that met the requirements of pre–SECURE Act regulations (Regs. Sec. 1.401(a)(9)-6, Q&A-15) to retain that plan provision. In general, under these plans, the age of majority would be 26 if the child has not completed a specified course of education. In addition, a child who is disabled within the meaning of Sec. 72(m) (7) when he or she reaches the age of majority may be treated as having not reached the age of majority so long as the child continues to be disabled.
Interesting. Thanks for sharing.
Hi,
Could you please clarify the terms “taxable portion” vs “non taxable portion” of the Roth conversion in the first column of the provided table.
I did read the referenced article by Bogleheads, but they don’t explain this either.
There is also a sentence there regarding withdrawals:
“Applies only after the taxable portion of the same conversion has been withdrawn.”
How does one know how much is a taxable vs non taxable portion of the one “same” conversion ?
Thanks
Sometimes people have tax-exempt money in their traditional IRAs that is not taxable to convert to a Roth IRA. I believe that is what is being referred to.
You have to track your own IRA basis using form 8606 on your taxes each year.
Hope that answers your questions. Complicated stuff isn’t it?
My understanding is that the “backdoor Roth IRA conversion” or “mega backdoor Roth IRA conversion” are both non-taxable conversions. They are the “Conversion, non-taxable portion” (3rd row) in the table. The #1 5-year rule does not apply to it, that these conversions are penalty free even within 5 years. Am I right?
“backdoor Roth IRA conversion” – People do this because their income is too high and they are not allow to contribution directly to Roth IRA. So they contribute post-tax (non deductable on the year of conversion) money to Traditional IRA first, and convert the post-tax money to Roth IRA. So this should always be non-taxable conversion and is penalty free.
“mega backdoor Roth IRA conversion” – It is similar that people convert their post-tax money from after tax 401k to Roth IRA, that the conversion itself is non-taxable.
Please correct me if I am wrong. Thanks.
That’s right, the conversion of non-deductible contributions to roth is a non-taxable conversion.
I’ll clarify that first section.