What Is the 5-Year Rule?

In the context of individual retirement accounts (IRAs), the 5-year rule commonly refers to a waiting period before you can withdraw funds without penalty from a Roth IRA. Learn more about the various definitions of a "5-year rule" and how they may apply to you.

How the 5-Year Rule Works

You can withdraw contributions to a Roth IRA at any time. However, to withdraw earnings from your Roth without owing taxes or penalties, you have to have held the account for at least five years, which is the "5-year rule." You must also be at least 59½.

The 5-year rule only limits when you can withdraw your earnings from your Roth IRA, not your deposits. Your earnings include the i🌼nterest, dividends, capital gains, and any other income your Roth investments have accumulated. You can withdraw contributions at any time because they were made with money already subject to income tax.

Another type of "5-year rule" applies when you convert a traditional IRA to a Roth IRA. You'll need to wait five years to do so without penalties. Each conversion has its own five-year period, but IRS rules stipulate that the oldest conversions are withdrawn first. The order of withdrawals for Roth IRAs is: contributions, conversions, and earnings.

If you break the 5-year rule by withdrawing earnings or converting funds from a Roth IRA too soon, your withdrawal will be subject to taxes at your current ordinary income tax rate, plus a 10% penalty.

This can be a large additional tax: If you were in the 24% tax bracket, you would lose 34% of your Roth IRA’s earnings to taxes aℱnd penalties because you withdrew the earnings before five years.

🅘 Inherited IRAs vs. ꦕTraditional IRAs vs. Roth IRAs

Inherited IRAs

A separate 5-year rule applies to one of several options when beneficiaries take distributions from an 澳洲幸运5官方开奖结果体彩网:inherited IRA if the account holder's death occurred before 2020. Whether it's a traditional IRA or a Roth IRA, heirs must take annual allocations from the account, known as 澳洲幸运5官方开奖结果体彩网:required minim꧃um distributions (RMDs).

澳洲幸运5官方开奖结果体彩网:Beneficiaries who inherit an IRA can take distributions of either contributions or earnings without a penalty. However, this distribution may trigge🌳r a taxable event, depending upon the type of IRA you inherit and your relationship to the deceased.

If the original owner did not hold the IRA for five taxꦉ years and you take a distribution, any earnings or interest on the contribution will be subject to tax.

With the passage of the 澳洲幸运5官方开奖结果体彩网:SECURE Act, starting in 2020, non-spousal beneficiaries of an IRA generally must withdraw all funds from the account within 10 years of the original owner's death.

Eligible designated beneficiaries such as spouses, beneficiaries who are not 10 years younger than the decedent, a minor child of the plan participant, a disabled person, or a chronically ill person, have more flexibility under the SECURE Act. They can transfer the existing IRA into their name and defer distributions.

Traditional IRAs

Under the regular 5-year rule, the beneficiary of a traditional IRA will not face the usual 10ꦕ% withdrawal penalty on any distribution, even if they make it before they are 59½. However, income taxes will be due on the funds at the beneficiary's regular tax rate.

The new owner of the IRA may roll all funds over into another account under their name, cash them out in a lump sum, or combine them. Within the five-year window, recipients may continue contributing to the inherited IRA account. When those five years are up, however, the beneficiary would have to withdraw all aไssets.

Roth IRAs 

An inherited Roth IRA is subject to a 10-year inheritance rule. The beneficiary of an account owner who died in 2020 or later generally must liquidate the entire value of the inherited IRA by Dec. 31 of the tenth year after the death of the original account owner or of an inheriting spouse or certain other people, also known as eligible designated beneficiaries. No RMDs are required during this 10-year period. Alternative timetables for emptying an inherited Roth IRA can involve distributions based on the beneficiary's own life expectancy.

If the beneficiary takes distributions from an inherited Roth IRA that has existed for over five years, all distributions will be tax-free. Further, the 澳洲幸运5官方开奖结果体彩网:tax-free distribution may be made up🗹 of earnings or principal. Fo🔯r beneficiaries of a fund that hasn't met that five-year mark, withdrawals of earnings are taxable, but the principal remains untaxed.

The Bottom Line

A "5-year rule" can apply to several situations, but is most commonly used when referring to how you withdraw funds from an IRA. For guidance on the best ways to withdraw money from your tax-advantaged account, consider consulting with a financial advisor.