Master Your ROTH IRA and the 5-Year Holding Rules Now

REVIEW: The Roth IRA and Why We Love It

For a quick review, let’s go over why the Roth is such a great passive income investment:

• Tax-free status–when done properly, according to the Roth five year holding period rules
• NO Required Minimum Distributions (RMDs) during the owner’s lifetime (see below for RMD rules for inherited IRAs)

The Roth 5 year Holding Period

Q: I’ve heard about a five year holding period for Roth IRAs, but I don’t understand it. What’s the deal?

When it comes to withdrawing funds from a Roth, there are actually two five-year rules: one for the earnings you make on your Roth investments and another rule for any money you convert to this type of IRA.

Roth Holding Period Rule 1–Roth IRA Earnings

The five-year rule for earnings on your Roth begins on January 1 of the year in which you open your very first account. It does not reset each time you make a contribution or open another Roth account.

Earnings: Withdrawing BEFORE the end of the Roth Holding Period

Withdrawals of earnings from your Roth investments are free from income taxes and penalties once you’ve satisfied the five-year holding period AND you’re over age 59. If you’ve met the five-year holding period but you’re not yet 59 years old, you’ll be subject to a 10% early withdrawal penalty.

Consider Investing in a Roth Crypto IRA

Roth Holding Period Rule 2–Roth IRA Conversions

Every conversion to a Roth is subject to a five-year holding period, which begins on January 1 of the year in which you made the conversion. If you do a series of conversions over several years, you’ll have five-year holding periods for each conversion.

Conversions: Withdrawing BEFORE the end of the Roth Holding Period

If you decide to withdraw funds before the end of the five-year holding period, you could be subject to a 10% early withdrawal penalty. (You may be exempt from the early withdrawal penalty if you turn 59 before taking the withdrawal, even if you haven’t held the account for the full five years.) Once you’ve satisfied the five-year holding period, you can make withdrawals of converted funds freely and without penalty, even if you’re under age 59.

Deciding to withdraw funds before the end of the five-year holding period, means you could be subject to a 10% early withdrawal penalty.

Contributions

Unlike conversions and earnings, Roth IRA contributions are not subject to a holding period, so you can withdraw them without paying taxes or penalties at any time in most cases. It’s also important to note that when withdrawing from your Roth account, the IRS rules for these IRAs work in your favor: Withdrawals first come from contributions, then from conversions (on a first in, first out basis), and finally from earnings.

Unlike conversions and earnings, Roth IRA contributions are not subject to a holding period, so you can withdraw them without paying taxes or penalties at any time in most cases.

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Should I Convert to a Roth?

Now for the taxes part. To convert your traditional IRA (a pre-tax retirement vehicle) to a Roth IRA (a post-tax vehicle), you have to pony up current income tax on the money based on your federal tax rate. Your tax rate and how you pay for the conversion tax are both crucial in your decision whether or not to convert all or part of your traditional IRA money.

Converting to a Roth: the How…

In simple terms, keep these things in mind when deciding if you should convert:

— Your current vs. future tax bracket when you will withdraw the money

It is generally better to leave the money in a traditional IRA if your future tax rate is LOWER than current rate

— Your time horizon

— What sources you will draw from for paying the tax (taxable brokerage/bank accounts, etc.)

NOTE: Paying the tax from the IRA you are converting defeats the purpose and selling assets to pay the tax could incur capital gains tax.

Other Things to Consider (Gifts and Inheritance)

Even if the numbers don’t necessarily work in your favor, you might decide to establish a Roth IRA for gift or inheritance purposes.

How to Contribute to Someone Else’s Roth (like a Child)

To contribute to another person’s Roth IRA, the account holder must have earned income for the year, including summer jobs like lifeguarding, modeling or babysitting.

How to Give a Roth Through Inheritance

You can also give someone a Roth IRA by designating them as your account beneficiary upon your death. Be sure to avoid these 4 common mistakes when setting up a Roth for inheritance.

Your beneficiaries will continue to enjoy the tax-free status for some period of time after inheriting the Roth account. However, your inheritors will NOT be able to maximize their tax savings with the Roth account unless it’s passed down in the correct manner: you MUST designate the correct beneficiaries (not a spouse, for example) when you open the account. Be sure to check on the beneficiaries for your ROTH account on a regular basis, and update them as needed.

NOTE to SELF: Remember to check the beneficiaries on Roth accounts. Also, while you are at it, check to make sure the 5 year holding period has been met.

A common misconception is that beneficiaries do not need to take Required Minimum Distributions (RMDs). Under the SECURE Act rules, most non-spouse beneficiaries generally have approximately 5 years to completely withdraw and disperse the funds in an inherited Roth IRA.

The rules for inherited IRAs are complicated, especially where the IRA account holder has died after 2019, and the rules under the SECURE Act apply. Depending on your relationship to the deceased (spouse or non-spouse) or if you are an Eligible Designated Beneficiary or Designated Beneficiary.

Be sure to talk with your accountant or tax advisor about whether converting to a Roth makes sense for your situation. As always, it’s not how much you make, but how much you keep.

But don’t just take our word for it, be sure to consult the IRS publication, Publication 590-B (2020), Distributions from Individual Retirement Arrangements (IRAs) for more detailed information about the confusing five-year Roth holding rules.

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Disclaimer: All the information provided above  and on this site is for informational purposes only and should not be considered as professional investment, legal, or tax advice. You should conduct your own research or consult with a professional financial advisor when investing.