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Roth IRA and Roth 401(k) 5-Year Rules

Roth IRA and Roth 401(k) 5-Year Rules

August 16, 2019
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The Roth IRA and Roth 401(k) are some of the most, if not potentially the most powerful and flexible wealth building vehicles in existence today. However, most people don't fully understand all of the rules and regulations that need to be followed in order to harness the full potential of owning a Roth account. Some of the most confusing and unique rules to Roth accounts are the 5-Year Rules that must be met to have a "qualified distribution" that allows you to take your earnings/growth out tax-free  - This is the main benefit of owning a Roth IRA or Roth 401(k) to begin with; tax-free growth potential on your investment.

Roth accounts can also be subject to a 10% early withdrawal penalty on earnings (or principal if a Roth conversion) if you don't meet certain other criteria. There are some inherent complexities with the 5-year rules, particularly when it comes to Roth contributions vs. Roth conversionsHere I will explain the rules in full detail and give you situational examples to help you navigate your situation correctly.

   

Requirements for tax and penalty-free withdrawals

  
  1. You must be over age 59 1/2.

                       OR
  2. A distribution is made due to death, disability, or under the first-time home-buyer rules.       

    AND
  3. You must have held the Roth IRA or Roth 401(k) for at least 5 tax-years since your first contribution or first conversion.

    

When does the 5-Year clock start?

The first thing you need to know is that there are two separate 5-year clocks - one for Roth contributions and one for Roth conversions. For contributions, the 5-year rule determines whether or not earnings can come out tax-free; While the other 5-year clock for conversions determines whether or not the principal is penalty-free. 

Your 5-year clock starts whenever you first make any contribution or conversion to a Roth IRA or Roth 401(k). However, the 5-year clock on a Roth 401(k) will NOT carry over if you roll it out to a Roth IRA, even if you had the Roth 401(k) for 5 years. I discuss the different ways a rollover situation can play out later in the article.

To illustrate the timing of the different 5-year clocks here are a few examples:

If you contribute to a newly established Roth IRA in June of 2019, your 5-year clock started January 1st, 2019. You actually have until tax-filing date in April of the following year (2020) to contribute, therefore if you make your first new Roth contribution instead on April 1st, 2020, your clock will still have started on January 1st, 2019.

If you convert from a traditional (pre-tax) account like a traditional IRA or 401(k) to a Roth IRA, that conversion amount will have its own 5-year clock and the rules are slightly different. If you convert in June of 2019, your 5-year clock started January 1st, 2019 for that converted dollar amount. But if you convert in April of 2020, your clock will have started January 1st, 2020. The conversions go by the calendar year in which you actually made the conversion.

NOTE: When it comes to the 5-year clock, all Roth IRAs are aggregated and the clock will be based off the earliest Roth account established and contributed to. For example, you could have a total of three Roth IRAs and if you contributed to just one of them 15 years ago, the 5-year clock for all of your Roth IRAs is met. This is not the same for Roth 401(k)s. For Roth 401(k)s, each plan has its own 5-year rule. If you roll one Roth 401(k) from one plan to another employer's Roth 401(k), the rule is based on whichever has been around longer - Best to work with a professional on this one...

Situational examples

If you own a Roth account, find your situation below to help you determine the outcome of withdrawals or any planning strategies you may have:

You are over 59 1/2 and have met the 5-year rule: All money comes out tax and penalty free.

You are over 59 1/2 but have not met the 5-year rule: You will not pay a 10% early withdrawal penalty on the earnings withdrawn, but will pay income tax on them.

You are under 59 1/2 and have met the 5-year rule: All earnings are subject to taxes and penalty. Although both can be avoided if earnings used for first-time home purchase or death or disability.

You are under 59 1/2 and have not met the 5-year rule: All earnings are subject to tax and penalty. You can possibly avoid just the penalty if you are disabled, use earnings for first-time home purchase, qualified education expenses, unreimbursed medical expenses, or upon death.

You had a Roth 401(k) balance and subsequently roll it to a NEW Roth IRA: That Roth IRA will have its own new 5-year clock. As stated earlier it doesn't necessarily matter how long you owned your Roth 401(k), it won't carry over. Here are some caveats to this exact situation:

You are under 59 1/2 and have met the 5-year rule in Roth 401(k): If you met the 5-year clock in your Roth 401(k) before rolling it out and are under 59 1/2, your rollover is not a "qualified distribution". Meaning that if you had $50,000 in contributions to your Roth 401(k) and another $10,000 in earnings, then roll it to a Roth IRA, the amount you can withdrawal tax and penalty-free is still your contribution amount (basis) of $50,000. The $10,000 in earnings would be subject to both taxation and the 10% early withdrawal. This is because you are not 59 1/2 (or disabled) yet and you just started a new 5-year clock. Now you will have to wait to satisfy both to tap that $10,000 and any additional earnings going forward without taxes and penalties.

You are over 59 1/2 and have met the 5-year rule in Roth 401(k): This situation confuses almost everyone! If you roll out into a Roth IRA in this situation, this would be a "qualified distribution" - meaning your basis in the new Roth IRA (amount you can get out tax and penalty-free) is the entire amount your rolled over! But remember the new Roth IRA starts a new clock - meaning any growth/earnings made after the rollover would be subject to the 5-year rule in order to take those out tax-free.

Therefore if you have $50,000 in contributions and $10,000 in earnings in the Roth 401(k) that you roll to the brand new Roth IRA, you can then take out that entire amount penalty and tax-free! But if you rolled it over and it earns another $15,000, that $15,000 is subject to the new clock.

You had a Roth 401(k) balance and subsequently roll it to an EXISTING Roth IRA: If the money is rolled from your Roth 401(k) into an existing Roth IRA, you would not have to start a new 5-year clock as it will be based off of your current Roth IRA clock. If you are over 59 1/2 and met the 5-year clock in your Roth 401(k), and roll it to an existing Roth IRA that has also satisfied the 5-year clock, then you won't have to worry about taxes or penalties going forward.

You are over age 59 1/2 and have converted funds to any Roth IRA: You will pay taxes upon conversion. In this exact situation the 5-year clock for conversions will not affect you! Yes that conversion amount gets its own new 5-year clock but it essentially doesn't matter. The reason is that upon conversion you will pay all taxes due on principal and earnings (as always with a conversion from pre-tax accounts), and the fact that you are already over 59 1/2 means you have met the exception for the 10% early withdrawal penalty.

You are under age 59 1/2 and have converted funds to any Roth IRA: You will pay taxes on the converted amount, and it will start its own 5-year clock. Immediately after conversion you can take out the amount converted (principal) tax-free since you already paid it. However, the entire principal amount would be subject to a 10% penalty if withdrawn before 5 years from conversion. If you wait 5 years after you convert, then you can tap all of that principal with no taxes or penalties. This essentially can give you access to IRA funds earlier than 59 1/2 but you still have to wait an additional 5 years. Any earnings made after conversion in this situation would be subject to the normal contribution rules. Meaning you would need to wait until 59 1/2 to get those out tax and penalty-free.

To illustrate this point further: Imagine you convert $60,000 total from a Traditional IRA or 401(k) to a Roth IRA. $50,000 was made up of contributions and $10,000 from earnings. You pay tax on the entire amount. You can take any amount of this $60,000 out tax-free at this point but you would owe the 10% penalty any amount taken before 5 years. However if you wait 5-years from the conversion year, you can now take this same $60,000 out penalty and tax free.

Now, since you have waited 5 years, you may likely have another gain of say $10,000 since the day you converted. That $10,000 in gains is subject to the contribution rules and in this case would be subject to taxes and penalty if taken before you reach 59 1/2. This is of course unless you meet one of the qualifying events that prevents you from paying the 10% penalty.

Why roll your Roth 401(k) to a Roth IRA?

There are a couple potential benefits that become available to you by rolling your Roth 401(k) to a Roth IRA. One main reason being that Roth IRAs are not subject to Required Minimum Distributions! (RMD). A required minimum distribution is essentially a minimum amount that a retirement account owner must withdrawal from their accounts when they reach age 70 1/2. One thing many people don't know is that Roth 401(k) accounts do have Required Minimum Distributions. In this case the Roth 401(k) distribution would not be taxed but you still have to take a minimum amount out, go figure.

Another potential advantage of rolling to a Roth IRA is that you will likely have access to many more investment options as opposed to what was offered in your employer's 401(k). There are certain investments 401(k)s cannot own or likely won't be included due to certain risk-factors. 

The bottom line

As if your brain isn't in a pretzel already, here are some quick takeaways and tips:

-Remember: For contributions, the 5-year rule determines whether or not earnings can come out tax-free; While the other 5-year clock for conversions determines whether or not the principal is penalty-free. 

-Order of withdrawals: The IRS overall withdrawal order rules are as follows - After-tax contributions first, conversions second (if multiple, earliest conversion first, and so on), and earnings last.

-You may want to consider opening new Roth IRAs for each conversion you do if you plan to do multiple. This isn't required but it can help you keep track of where each chunk of money is in its own 5-year clock.

-Depending on your financial plan, it may be useful for you to just open a Roth IRA, even if it is with a mere $100. That way you get your clock going.

-If you don't qualify for a Roth IRA, no worries. You could either convert a small amount from your traditional accounts to get your Roth IRA clock started, or make a contribution to a non-deductible IRA, wait at least a year and then convert it to a Roth IRA.

-Check out this retirement portfolio strategy using Roth accounts!

-Save this article to refer back to when needed!

     

Cameron Valadez is a CFP® Practitioner.

 

Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, and CFP® in the U.S., which it awards to individuals who successfully complete CFP Board's initial and ongoing certification requirements.

Roth IRA contributions are subject to income limitations.  Waddell & Reed and its representatives do not provide tax advice.  This is meant for educational purposes only.  It should not be considered specific legal, tax or other professional advice, nor does it constitute a recommendation to take a particular course of action. Please consult with a tax advisor and other financial professionals regarding your personal situation prior to making any financial related decisions.  08/19