How to Navigate the Five Year Holding Period For Roth IRAs
Roth IRAs can be a great way to save for retirement if you are qualified to contribute. With this type of retirement account, you contribute after-tax money, which grows tax free. You don’t receive a tax deduction for these contributions, but earnings will be entirely tax free when making a qualified distribution and the five-year holding period has been met. This holding period is unique to Roth IRAs and can be tricky to navigate. When considering taking a Roth IRA distribution, you will want to categorize your funds in three different buckets:
Roth IRA Contributions
Contributions will always be withdrawn first and never subject to income taxes or early withdrawal penalties. This is because it was non-deductible and already taxed, therefore cannot be subject to double taxation.
Roth IRA Conversions
Once the contribution bucket is depleted, the next place for funds to be distributed is from Roth conversions (beginning with the oldest). When you complete a Roth conversion, the funds are taxed and will not be subject to income taxes again when distributed from the Roth IRA. These funds ARE subject to the 10% early withdrawal penalty for five years after the conversion is complete. Once this holding period is met, you will not be penalized, and the balance will be treated like contributions. Please see below for exceptions to the 10% early withdrawal penalty.
Roth IRA Earnings
Once contribution and conversion buckets are depleted, earnings will be the final place distributions come from. All earnings distributions will need to be considered “qualified”: A qualified Roth IRA distribution is one that meets the five-year holding period requirement and a qualifying event. A qualifying event is attaining age 59.5, you die, you are a first time homebuyer or builder ($10K max), or you become disabled.
Roth IRA Early Withdrawal Penalty Before The Five Years Are Complete
There are some additional exceptions to the early withdrawal penalty (10% if under age 59.5), which includes:
· Unreimbursed medical expenses that are over 7.5% of AGI
· Payments to financial institutions for higher-educations expenses for you, your spouse, children, or grandchildren
· Payments for health insurance premiums if you are unemployed
· For birth or adoption expenses ($5K max)
Another distribution rule to consider is for 60-day rollovers. You can take a distribution from your Roth IRA and roll it back into a Roth IRA within 60 days penalty free. You can only complete this once every 12-month calendar period and if not returned in time, will be subject to the previous distribution rules and you won’t be able to deposit the funds back.
Follow The Roth IRA 5 Year Holding Period Rules
Roth IRAs offer flexibility over other retirement account types and will not be subject to Required Minimum Distributions (RMDs) at age 73 (subject to IRS changes), but if you do not follow the five-year holding period rules, your earnings distributions may be subject to ordinary income tax rates and the additional 10% early withdrawal penalties. As a reminder, you can withdrawal your contributions at any time without taxes or penalties. To prevent this, it’s a good idea to track your contributions/Roth conversion values and work with a trusted CPA.