What Is the 5-Year Rule?
The 5-year rule commonly refers to the withdrawal of funds from an Individual Retirement Account (IRA), but there are other types of 5-year rules. Learn more about the various definitions of a "5-year rule" and how they may apply to you.
Key Takeaways
- The 5-year rule applies to withdrawals from Individual Retirement Accounts (IRAs).
- The 5-year rule regarding Roth IRAs requires a waiting period before you can withdraw earnings or convert funds without a penalty.
- To withdraw earnings from a Roth IRA without owing taxes or penalties, you must have held the account for at least five tax years.
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" old. (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 interest, 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 that has already be subject to income tax.
The time period for the 5-year rule starts with your first contribution to a Roth IRA, including if it is from conversion from a traditional IRA.
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 with with no penalties. Each conversion has its own five-year period, but IRS rules stipulate the oldest conversions are withdrawn first. The order of withdrawals for Roth IRAs are: contributions, conversions, and then 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 evaporate in taxes and penalties because you withdrew the earnings before five years.
Inherited IRAs vs. Traditional IRAs vs. Roth IRAs
Inherited IRAs
The 5-year rule applies to one of several options when beneficiaries take distributions from aninherited IRA. Whether it's a traditional IRA or a Roth IRA, heirs are required to take annual allocations from the account, known as required minimum distributions (RMDs).
Beneficiaries who inherit an IRA can take distributions of either contributions or earnings without a penalty. However, this distribution may trigger a taxable event, depending upon the type of IRA you inherit and your relationship to the deceased.
If the IRA wasn't held for five tax years by the original owner, and you take a distribution, any earnings or interest on the contribution will be subject to tax .
With the passage of the SECURE Act, starting in 2020, non-spousal beneficiaries of an IRA must withdraw all funds from the account within 10 years of the original owner's death.
Before the SECURE Act, beneficiaries could stretch out the distribution period and delay paying taxes on distributions, an estate planning strategy known as a stretch IRA.
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 5-year rule, the beneficiary of a traditional IRA will not face the usual 10% withdrawal penalty on any distribution, even if they make it before they are 59½. Income taxes will be due, however, 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 it out in a lump sum, or a combination. Within the five-year window, recipients may continue to contribute to the inherited IRA account. When those five years are up, however, the beneficiary would have to withdraw all assets.
Roth IRAs
A Roth IRA is also subject to a five-year inheritance rule. The beneficiary must liquidate the entire value of the inherited IRA by Dec. 31 of the fifth year after the owner’s death. No RMDs are required during this five-year period.
If the beneficiary is taking distributions from an inheritedRoth IRA that has existed for longer than five years, all distributions will be tax-free. Further, the tax-free distribution may be made up of earnings or principal. For beneficiaries of a fund that hasn't met that five-year mark, withdrawals of earnings aretaxable, but the principal remains untaxed.
Explore all you options with taking distributions from an inherited Roth IRA. Choose one that best suits your situation.
Frequently Asked Questions (FAQs)
What Is the 5-Year Rule for Roth IRA?
The 5-year rule for Roth IRAs states that you cannot withdraw the earnings from your Roth IRA account unless it has been five years since you first contributed to your account.
What Is the 5-Year Rule for Inherited IRA?
The 5-year rule applies to taking distributions from aninherited IRA. To withdraw earnings from an inherited IRA, the account must have been opened for a minimum of five years at the time of death of the original account holder.
Does the Roth 5-Year Rule Apply for Those Aged 59½ or Older?
Yes, the account must be five years old for earnings within a Roth IRA to be distributed without owing taxes or penalties even if you’re already 59½ years old.
What Is the 2 Out of 5 Year Rule?
The 2 out of 5 year rule states that homeowners must have lived in their home for two out of the last five years before the date of sale in order to avoid or reduce capital gains taxes on the appreciated value of the home.
The Bottom Line
A "5-year rule" can apply to a number of 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.
