Making The Five-Year Rule Work For You

Today I’m going to cover a specific rule within the Roth IRA, entitled the Five-Year Rule.

But before I talk about the Five-Year Rule, let’s make sure we understand the basics of the Roth IRA:

When I make a contribution to my Roth IRA, it goes in after tax. This means I’m going to have to pay tax on it upfront. However, after I make that initial contribution, typically the growth will occur tax-free. There are some little concerns that the IRS has placed in our way. Those concerns can be potential landmines for you, and if you step on them, the growth might not come out tax-free. 

Let’s talk about how you can avoid those landmines, so you don’t get caught paying unnecessary taxes.

There are actually three different Five-Year Rules that I want to make sure that we explain. Many times people get them confused.

The First Five-Year Rule that I’m going to explain pertains to your first contribution. (1:02 in video)This is when I’m making new contributions into a Roth IRA indefinitely.

Let’s say I made my first Roth IRA contribution in the year 2019, and then I wanted to take some money out. I would be eligible to take out my original contribution amount over the next five years, but the growth portion would be taxed unless I waited until 5 years later, on January 1st of 2024.

The five-year period always starts on January 1 of the year that we made the contribution. This can be used to strategize, by making that contribution just before the tax deadline. 

For example, you could make a contribution for 2019 in 2020, if you do it before the tax deadline (typically April 15th), you would only need to wait until January 1, 2024. That’s the 5 year rule for your first contributions.

The second Five-Year Rule we need to be aware of is related to Roth Conversions. (2:48 in video) With a Roth Conversion, it is still effective as of January 1st in the year that we make the conversion. So technically, it could be just over four years that the time period stretched over. So technically if I redid my Roth conversion in December, then I’d only have to wait just over four years in order for it to be eligible to be withdrawn tax-free.

Note: One of things that sometimes catches people off guard is, unlike your first contributions, each Roth Conversion is going to be treated separately. This means that every time I do a Roth Conversion, I need to make sure I have a new five-year period that I’m waiting. Another thing that sometimes surprises people is when they do a backdoor Roth IRAthat is treated as a Roth conversion. 

The third Five-Year Rule we’re covering pertains to inheritance. (4:06 in video) When you inherit a Roth IRA from your spouse, oftentimes you can just take it as your own personal Roth IRA. 

However, if you’re a non-spousal beneficiary of a Roth IRA, there are a few things that we need to make sure that we are aware of. 

For example, if the deceased had not placed the money over in the Roth IRA at least five years ago, then I need to make sure that I leave that money over in the Roth IRA for at least the five year period. Otherwise, I can be subject to tax on the growth portion, if I’m taking it out as a lump sum benefit.

There’s also a Ten-Year Rule that may apply to a Roth IRA too. If you’re a non-spousal beneficiary & you want it stretched out over the ten-year period, you need to make sure you withdraw at least the Required Minimum Distribution amount. This is unique, because most people don’t associate a Roth IRA with a Required Minimum Distribution, but it can be applicable.

Whenever it comes to the IRS, there’s almost always rules, and exceptions to those rules, and exceptions to those exceptions. Today we’ve covered the basics of the Five-Year Rule, but are many nuances to it as well.

One exception is if you’re a first-time home buyer. That can be a home for yourself, or if you’re helping somebody else buy their first home. 

Other possible exceptions could be applicable for qualified higher-education expenses or even medical expenses.

If you have any questions for your specific situation, feel free to schedule a complimentary consultation. We’re happy to talk through it with you

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