Understanding the Nuances of the Roth “Five-Year” Rule

Many people who won’t need to rely on their Traditional IRA and 401(k) plan assets for income during retirement are exploring the potential benefits of converting some or all of these assets to a Roth IRA.

However, if you’re considering a conversion, it’s important to understand the nuances of the Roth “five year” rule. This rule refers to amount of time you need to own the account before you can start taking qualified tax-free distributions. 

In general, you must wait five years after making your first contribution, and the distribution must take place after you turn 59½, when you become disabled, or when your beneficiaries inherit the assets after your death.

While this seems straightforward, several nuances may affect your distribution's tax status. Here are four questions that examine some of them.

1. When does the clock start ticking?

The term "Five-year rule" is a bit misleading; in some cases, the waiting period may be shorter. That’s because the countdown begins on January 1 of the tax year for which you make your first contribution.

For example, if you open a Roth IRA on December 31, 2020, the clock starts on January 1, 2020, and ends on January 1, 2025 — four years and one day after making your first contribution. Even if you wait until April 15, 2021, to make your contribution for tax year 2020, the clock starts on January 1, 2020.

2. Does the five-year rule apply to every account?

For Roth IRAs, the five-year clock starts ticking when you make your first contribution to any Roth IRA.

With employer plans, each account you own is subject to a separate five-year rule. However, if you roll assets from a Roth account in your former employer's 401(k) plan into the Roth account in your new employer’s plan, the clock starts when you made the first contribution to your former account. For example, if you first contributed to your former plan’s Roth account in 2014, and in 2020 you rolled those assets into your new plan’s Roth 401(k) account, the new account meets the five-year requirement.

3. What if you roll over from a Roth 401(k) to a Roth IRA?

Proceed with caution here. If you have never previously contributed to a Roth IRA, the clock resets when you roll money into the Roth IRA, regardless of how long the money has been in your Roth 401(k).

Therefore, if you think you might enact a Roth 401(k) rollover sometime in the future, consider opening a Roth IRA as soon as possible. The five-year clock starts ticking as soon as you make your first contribution, even if it's just the minimum amount and you don't contribute again until you roll over the assets.1

4. What if you convert from a traditional IRA to a Roth IRA?

In this case, a different five-year rule applies. When you convert funds in a traditional IRA to a Roth IRA, you'll have to pay income taxes on deductible contributions and tax-deferred earnings in the year of the conversion. If you withdraw any of the converted assets within five years, a 10% early-distribution penalty may apply, unless you have reached age 59½ or qualify for another exception. This rule also applies to conversions from employer plans.2

If you’re not sure whether converting your 401(k) plan or Traditional IRA assets to a Roth IRA makes sense, a financial advisor can help you understand the implications of different conversion scenarios.

1You may also leave the money in your former employer's plan, roll the money into another employer's Roth account, or receive a lump-sum distribution. Income taxes and a 10% penalty tax may apply to the taxable portion of the distribution if it is not qualified.

2Withdrawals that meet the definition of a "coronavirus-related distribution" during 2020 are exempt from the 10% penalty.

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Chris Gullotti is a financial advisor and Partner located at Canby Financial Advisors, 161 Worcester Road, Framingham, MA 01701. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. He can be reached at 508.598.1082 or [email protected]

 

Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2020. Broadridge Investor Communication Solutions, Inc. does not provide investment, tax, legal, or retirement advice or recommendations. The information presented here is not specific to any individual's personal circumstances.