Time Flies When You’re Having Fun (and Studying Roth IRA Rules)
It’s been a busy past two weeks for Dean Barber and Bud Kasper between celebrating the beginnings of Modern Wealth Management and attending Ed Slott’s Elite IRA Advisory Group SM spring workshop in Baltimore. However, they still found time to get on the airwaves and discuss Roth conversion rules and the Roth IRA five-year rule on America’s Wealth Management Show .
The fact that the five-year rule was a major topic of discussion covered by Ed Slott and his team at the recent workshop illustrates just how important the five-year rule is facing investors today. We want to bring you up to speed on what the Roth IRA five-year rule really means. Five-Year Rules for Roth Contributions and Roth Conversions
In true IRS fashion, there are different five-year rules regarding Roth contributions and Roth conversions. To avoid confusion between the rules, it’s important to understand the difference between a Roth contribution and a Roth conversion.
To simplify, a Roth contribution is a contribution to a Roth IRA every year that is restricted by annual limits on contribution amounts, income levels, and whether you are earning income or not in the year of the contribution. It is important to understand the components of a Roth IRA with contributions. There is basis, which is the sum of all contributions made to the Roth IRA over time and earnings. Earnings are just that, the earnings or capital gains made on the invested contributions in the Roth IRA over time.
To be clear, ALL contributions can be withdrawn from a Roth IRA at any time for any reason without penalty or taxes. It is the earnings on Roth Contributions that can be subject to penalties and taxes. Requirements for Roth IRAs to be Tax-Free and Penalty-Free
The five-year rule regarding earnings on Roth contributions is fairly straight-forward compared to Roth conversions. For earnings in a Roth IRA to be tax-free and penalty-free, BOTH of the following requirements need to be met:
You must reach age 59 ½ at the time of the distribution.
A Roth IRA must be funded for five years before distributing any of the earnings generated within the account.
Earnings that are taken prior to age 59 ½ or an IRA less than five years old are subject to a 10% penalty and taxed as ordinary income.
Alternatively, a Roth conversion is the process of taking an existing IRA/401(k) and converting it into a Roth IRAs/401(k). This takes an asset that would have had taxes deferred to future distributions and makes those converted assets tax-free as long as all requirements are met. It is important to note that when assets are converted from IRA to Roth IRA, taxes on those assets are paid in the year of the Roth conversion. The Difference for Roth Converted Funds
For converted Roth IRAs, the same basis and earnings components exist. However, the difference is r egardless of age, Roth converted funds must be held for five years before you can access them without taking on a 10% penalty (five-year rule).
However, if you’re not aware of the Roth IRA five-year rule with Roth converted funds, that 10% early distribution penalty can be a rude awakening. And a lot of people aren’t aware of that Roth IRA five-year rule. History of the Roth
To understand the logic behind the creation of the Roth conversion five-year rule, it helps to think that once Roth IRAs became law in 1997 and went into effect in 1998 , investors were quickly looking for a way around the 10% early distribution penalty with earnings on contributions to Roth IRAs. At the time, the way to get around it was to convert assets from an IRA to Roth IRA, pay the taxes on the conversion, and access those converted funds penalty-free. Congress wasn’t about to let that fly for long, though. Enter the Roth IRA five-year rule. How the Five-Year Clock Works
For those who are considering Roth conversions, here are a few more things to note. If you decide to do a conversion in 2023, the five-year clock will start on January 1, 2023. And then let’s say you want to do another conversion in 2024. The five-year clock for that conversion starts on January 1, 2024. This rule also applies if there are multiple conversions in any given year. All conversions complete in that year, the clock starts January 1 for that year. Hypothetically, you could have five Roth conversion clocks running simultaneously.
When Can a Roth Conversion Make Sense?
The important thing to remember here is that when saving for retirement, the Roth c onversion works best as a long-term strategy. You don’t want to take early distributions. If you find yourself needing to access recently converted funds, or cannot wait five years, Roth conversions may not be a suitable strategy for you. If you can wait out the 5-year rule, you can just enjoy that wonderful tax-free and penalty-free feeling.
Remember that when you’re doing a Roth conversion, you’re paying the tax up front. So, if you’re under 59½, you can still reap the rewards of those tax-free contributions when you want to access them during your retirement (post 59 ½) .
When Dean, Bud, and the rest of our team talk about tax planning strategies , Roth conversions are typically one of the first ones that comes up. That tax-free element of the Roth can be very attractive in retirement. And with tax rates expected to go up in 2026 when the Tax Cuts and Jobs Act sunsets , why wouldn’t you want to pay the tax up front when rates are lower?
Let’s say that you are younger than 59½, are currently at the 24% tax bracket , and are looking at doing a Roth conversion. If you do that conversion in the next three years (before 2026), you’re paying that tax at the 24% bracket and then will get tax-free growth on the earnings and distributions. You’ll just need to wait five years before accessing those funds to avoid that 10% early withdrawal penalty.
But Roth Conversions Aren’t for Everyone
If you do that conversion after 2026, the 24% bracket that you’re in now will suddenly be the 28% bracket. That’s a big difference. A lot of people are doing Roth conversions now knowing that tax rates will be going up in 2026. Still, it’s no guarantee that it will be the best decision for you. Roth conversions could make more of your Social Security taxable and increase your Medicare premiums to the point where it makes more sense to not do the conversion.
Do You Have Questions About the Roth IRA Five-Year Rule?
This can be very simple to follow by not taking early distributions. However, there can be situations where an early distribution might be necessary. If you have questions about Roth IRAs and/or the Roth IRA five-year rule, let us know. You can schedule a 20-minute “ask anything” session or complimentary consultation with one of our CFP® Professionals by clicking here . We can meet with you in person, by phone, or virtually—it’s whatever is easiest for you. Building a Comprehensive Financial Plan
To truly understand Roth IRAs and the Roth IRA five-year rule, you need to have a financial plan. If you don’t have a financial plan, that’s step No. 1. In addition to answering your questions, we can help get you started with our financial planning tool . The goal of a financial plan is to give you confidence that you’re doing the right things with your money, freedom from financial stress, and time to spend doing the things that you love. You can begin building a plan that’s unique to you by clicking the “Start Planning” button below.
If you have any questions as you’re building your plan, we’re here to answer them for you. We’re committed to helping you have as much confidence, freedom, and time in retirement as possible. As always, the topics covered here are intended to be informational purposes only. Not all strategies may be recommended for every plan. Modern Wealth Management recommends reaching out to a financial or tax advisor to discuss your individual plan before implementing any of the strategies discussed here.