Over the years, we’ve likely talked about the benefit of Roth IRA’s and how they can help in your overall financial plan. Their tax-free nature makes them excellent accumulation vehicles — and withdrawals from them are tax-free…in most cases. There are rules that must be satisfied in order for withdrawals to be tax and penalty-free. We thought we’d spend a few minutes reviewing the basics so you know what to lookout for.
You may have heard of something called the “Five-Year Rule” when it comes to Roth IRA withdrawals. Well, actually, there are three five-year rules to be aware of. And you’ll want to make sure you’ve satisfied the appropriate rule to ensure your withdrawals don’t come with an unexpected tax and/or penalty. These three rules pertain to:
- Your first contribution
- Roth IRA conversions
- Inherited Roth IRAs
The five-year rule on Roth IRA conversions is different in that it applies separately to each Roth conversion you do. Each new conversion starts its own five-year clock, and you’ll need to account for multiple conversions to make sure you don’t take out too much money too soon.
Here’s an interesting point to keep in mind with this rule though – once age 59 1/2 has been reached, there will be no 10% penalty even if the 5-year rule on conversions is not met. Why? Because there would have been no penalty on a distribution from a traditional IRA at age 59 1/2 or older.
If you inherit a Roth IRA from someone other than your spouse, you have a couple of options for withdrawing the funds.
If the original account owner lived beyond the required minimum distribution age (either 70 ½ or 72), you can elect to spread out distributions up to 10 years, taking required minimum distributions based on your life expectancy each year.
If the original account owner DID NOT live beyond the required minimum distribution, you must deplete the account by Dec. 31 of the fifth year following the death of the original owner. You can take distributions of any amount up to that date, but you must withdraw 100% of the funds by the end of the fifth year.
And just to make it a little more complicated, inherited IRAs are also subject to the first-contribution five-year rule. So, if it’s been less than five years since the owner’s initial contribution to a Roth IRA, the earnings are subject to taxes. Something to be mindful of if you find yourself in this situation.
Exceptions to the five-year rules
The IRS does provide a list of exceptions to the five-year rule, which would remove the early withdrawal penalty for those under 59 1/2. However, the earnings would still be taxable.
First-time home purchases – You may withdraw up to $10,000 from a Roth IRA for a first-time home purchase
Qualified higher education expenses – you may use your Roth IRA to pay for higher education expenses for yourself, a spouse, a child, or grandchild.
Medical expenses – You may use funds from your Roth IRA to pay medical insurance premiums and / or unreimbursed medical expenses exceeding 7.5% of your adjusted gross income.
We’ve intended this to be a primer on Roth IRA withdrawals – and so it may not be all-inclusive. We are not tax-advisers and acknowledge that everyone’s situation can be a little bit different. Our objective here is to educate you a little bit on the nuances of these rules so that you can let us know if you think any of these might apply to you. As always, we’re happy to get very specific about your situation and create a plan to minimize or eliminate and potential tax or penalties from situations like these.