Self-Directed Roth IRAs and the 5-Year Rule
The Roth IRA is a popular choice for self-directed investors due to the nature of alternative assets. A Self-Directed Roth IRA account allows investors to avoid tax liability on potentially large profits, as well as avoid RMDs in assets where the process may prove administratively challenging. However, there are some regulations unique to the Roth IRA and these apply in self-directed situations as well. One of the most practical of these regulations is called the 5-year rule.
What is the Roth IRA 5-year rule?
The Roth IRA 5-year rule states that an account holder may not withdraw earnings from a Roth IRA before 5 years has passed since the account was set up. This 5-year window is one of the requirements to validate it as a Qualified Distribution (i.e. one not subject to taxes or penalties.) However, like most tax regulations, the 5-year rule possesses a lot of caveats, situation-dependent regulations, and exceptions. Let’s parse the regulations and break them down into manageable bites.
Why did the IRS institute the 5-year rule?
When Roth IRAs were first introduced as part of the Taxpayer Relief Act of 1997, they were legislated much in the way that we envision them today. Namely, contributions were made with post-tax dollars, and as a result there were no RMDs and no problems with early distributions. The logic behind this stance was that since the government had already been paid, the account holder could now use the funds however they saw fit. If that meant continuing to invest them, that was fine, and if it meant taking withdrawals, that also worked. In short, an investor could take an early distribution from the Roth IRA without any financial penalty.
What changed the government’s mind was the fact that investors started taking advantage of Roth accounts to bypass Traditional IRA rules. They did this by converting their Traditional IRAs into Roth accounts. In a Traditional IRA, an account holder may not make any distributions before 59.5 years of age and they must start taking RMDs at 72. Investors realized that by converting a Traditional IRA into a Roth, they could bypass the age requirements and make withdrawals without penalty. To prevent this from happening, the IRS introduced the Roth IRA 5-year rule. Now, even if an investor made a Roth conversion, they would still have to wait 5 years before accessing the funds.
Which Roth IRA funds are regulated by the 5-year rule?
To get a clearer answer to this question, we have to understand that the 5-year rule can have different applications depending on three different factors:
- Type of Roth IRA funds – Is the source of funds in the Roth IRA a contribution, conversion, earnings, or a combination of the three?
- Type of consequence - The consequence of a distribution could be a tax payment (standard income taxes), penalty (10%), both, or no consequence at all.
- Age of the Roth IRA account holder – Is the account holder past the minimum retirement age of 59.5?
Here are the general guidelines that apply to these factors:
- Contributions and earnings - Contributions to a Roth IRA can always be withdrawn without taxes and penalties, irrelevant of the age of the account holder or the amount of time that the Roth IRA has been in existence. Earnings, however, are subject to both tax liability and penalty depending on when they are withdrawn.
- Tax liability - Earnings withdrawn before 59.5 years of age are subject to standard tax liability. Earning withdrawn after 59.5 but before 5 years have elapsed will also be subject to taxes. Earnings withdrawn after 59.5 and after 5 years have elapsed will remain tax free.
- Penalty - Earnings withdrawn before the Roth IRA has been in existence for 5 years are subject to a 10% penalty. Earnings withdrawn after a 5-year duration do not have to pay a penalty. Similarly, earning withdrawn after 59.5 are not subject to the 10% penalty.
- Determining contributions and earnings - Contributions and earnings are mixed together in a Roth IRA. However, the IRS does not view withdrawals as being composed of a corresponding proportion. Rather, when the account holder makes a withdrawal, it is considered as if the withdrawal is coming fully from the contribution. This continues until the full amount of the contribution has been used up. For example, if a Roth IRA contains $100,000 and $65,000 of that came from contributions, then the account holder could withdraw up to $65,000 tax free. It is only when the remaining $35,000 begins getting withdrawn does the possibility of paying taxes and a penalty become relevant.
Roth IRA Scenario #1
Susan just turned 40 (although she hasn’t told anybody) and she would like to withdraw $15,000 from her Roth IRA to cover emergency house expenses. She had started the Roth IRA six years ago and it currently has $47,000 in it. $32,000 of that amount is direct contributions while $15,000 is earnings. In this case Susan can withdraw the funds without any tax responsibility or penalties because the amount she is withdrawing is within the contribution amount.
Roth IRA Scenario #2
When Jamie was 58 he converted a Traditional IRA into a Roth IRA which is now valued at $300,000. Having just turned 62, he plans on distributing the entire Roth IRA and buying a retirement property with it. In this case Jamie would be exempt from the 10% penalty because he is past the age of 59.5. However, he would still be liable for taxes on earnings because he is still within the 5-year window.
How is the Roth IRA 5-year rule calculated?
The clock for the 5 year calculation starts running on January 1 of the year in which you made the Roth IRA contribution. For instance, if you funded a Roth IRA in September 2020, then the 5-year calculation is made from January 1, 2020. That means your 5 years would be up on January 1, 2025. Sometimes you can even gain more than a year due to the fact that Roth IRA contributions can be made all the way until the tax deadline, April 15. If you made a contribution in March 2021 to have it count for tax year 2020, the clock would still start from January 2020.
What are the exceptions to the Roth IRA 5-year rule?
The IRS has outlined a number of situations where the 10% penalty would be avoided.
- The Roth IRA is left to a beneficiary due to the account holder’s death.
- The account holder has become fully disabled.
- The funds are withdrawn to cover qualified higher education expenses.
- The funds are withdrawn to pay for certain medical expenses.
- Other situations include birth and adoption, first-time homebuyers, and qualified reservist distributions.
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