Roth IRA 5 Year Rule

There are two related, but slightly different 5-year rules that apply to Roth IRA withdrawals. The first has to do with earnings on contributions you've made to your account, while the second rule has to do with Roth IRA conversions.

In this article, we're going to explain the five-year rules that apply to Roth IRA withdrawals. If you've a better understanding these rules, then you should be able to avoid taking a taxable distribution. Or even worse, you could be paying a 10% additional tax penalty for an early withdrawal.

Understanding Each 5-Year Rule

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There are two five-year rules that apply to Roth IRA conversions and contributions. Both of these rules affect the tax status of a distribution taken from the Roth IRA. And the exact rule that applies depends on whether or not you're age 59 1/2, the distribution was taken from a direct contribution, or it involved an IRA conversion.

Qualified Distributions

The first five-year rule we're going to discuss has to do with the requirements of what are referred to as qualified distributions. It's within the tax law that we can find what the IRS defines as a qualified distribution. Generally, a payment made from a Roth IRA account is considered a qualified distribution if it meets both of these requirements:

It is made after a five-year period beginning with the first taxable for after which a contribution to the Roth IRA occurs.
The payment or distribution is made on or after you reach age 59 1/2.

You have until April 15 of the following calendar year to make a Roth IRA contribution for any tax year. For example, a Roth IRA contribution made in March 2010 for the tax year 2009 starts the five-year clock on January 1, 2009.

A distribution that is not considered a qualified distribution is subject to a 10% additional tax penalty. Keep in mind that since the money placed in a Roth IRA is an after-tax contribution, these penalties apply to earnings on those contributions - which are normally tax-free when withdrawn. This is one of the big advantages of this type of retirement account.

Roth IRA Conversions

The second five-year rule we're going to cover in this publication deals with Roth IRA conversions - or, more specifically, traditional IRA accounts that are converted to into a Roth IRA. Once again, this rule has to do with qualified distributions, and an additional 10% tax penalty applies if this rule is not followed.

If you convert a traditional IRA into a Roth IRA, then you must wait at least five years from the first day of the tax year in which you made the conversion before you can take a qualified distribution. For example, if you convert a traditional IRA on March 30, 2010, then the five-year clock starts on January 1, 2010.

Unlike the five-year rule that applies to contributions, the five-year rule that applied to a conversion is unique to each conversion. That is to say, each conversion has its own five-year waiting period before a qualified distribution can occur.

As was the case with a contribution, you also need to wait until age 59 1/2 before a qualified distribution can occur with a conversion. Once you reach age 59 1/2, you can withdraw the converted asset at any time without penalty. The earnings on the conversion assets are subject to penalties - not the original money placed in the account.

For many taxpayers, it has been difficult to qualify for a conversion since your adjusted gross income has to be less than $100,000. However, in 2010, the Roth conversion rules change slightly and the income limit is removed. This change is expected to increase the popularity of Roth conversions.

Ordering Rules for Roth IRA Distributions

Since a penalty may apply only to the withdrawal of earnings on contributions or conversions, it's important to understand the ordering rules that apply to Roth IRA distributions. The ordering rule is simply the method used by the IRS to determine what portion of the Roth IRA is actually being removed from the account first.

According to the IRS, the order of a distribution from a Roth IRA is:

Regular Contributions - by considering the first money withdrawn from the account "regular contributions," and not earnings, the IRS allows account holders to remove a portion of their accounts before the five-year rule applies.
Conversions - this is on a first-in, first-out basis. So the money placed into an account because of a conversion that occurred in 2008 would be removed before a conversion that occurred in 2009.
1. Taxable - the taxable portion of the conversion is removed first. This is the amount claimed as income because of the conversion.
2. Non-Taxable - this is the portion of the conversion not included in gross income.
Earnings - finally, the last money to be removed from an account are the earnings on the assets placed in the account.

The ordering for withdrawals allows taxpayers to remove money that has already been taxed before removing taxable money. This is both a logical and generous process for taxpayers since this ordering helps to minimize the chances an account holder takes a non-qualified, taxable distribution.

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