Guy Hockerman, CPA, CFP®, Financial Planning Manager, Commerce Trust Company
The Roth IRA is a unique investment vehicle that offers significant tax advantages for long-term investors with the ability to defer distributions of accrued income and gains. Roth contributions are taxed upfront, so the money investors contribute to their accounts generally can be withdrawn without the worry of taxes or penalties. However, it’s a different story for investment income generated from those contributions.
There are requirements regarding Roth IRA withdrawals of earnings or “qualified distributions.” The first is age-based, which requires earnings generally cannot be withdrawn by the account owner before age 59 ½.
The second rule requires owning the account for at least five years to avoid taxes or penalties on Roth earnings. Known as the five-year rule, these stipulations often supersede the age requirement and can cause investors confusion, or worse, an adverse and costly consequence to one’s retirement strategy.
How Does the Roth IRA Five-Year Rule Work?
There are generally three types of five-year rules investors should understand.
The second rule requires owning the account for at least five years to avoid taxes or penalties on Roth earnings. Known as the five-year rule, these stipulations often supersede the age requirement and can cause investors confusion, or worse, an adverse and costly consequence to one’s retirement strategy.
How Does the Roth IRA Five-Year Rule Work?
There are generally three types of five-year rules investors should understand.
- First Contribution – The five-year period starts on the first day of the tax year for which an investor makes an initial contribution to a Roth IRA. For example, if a participant contributes to an account for the first time during the 2023 tax year, the five-year period will end on Jan. 1, 2028.
- Inherited Roth IRAs – The first contribution five-year period also applies to a Roth IRA that a participant might inherit. So, if it’s been less than five years since the original owner made an initial Roth contribution, the earnings are taxable.
- Roth Conversions – Another type of five-year rule applies when investors convert other retirement accounts, such as a 401(k), into a Roth IRA. Like the first contribution provision, the five-period starts on the first day of the tax year of the conversion. However, this rule is slightly different in that each Roth conversion starts its own five-year clock.
Source: CCH AnswerConnect, Wolters Kluwer; Internal Revenue Service.
Past performance is no guarantee of future results, and the opinions and other information in the commentary are as of February 28, 2023. This summary is intended to provide general information only and is reflective of the opinions of Commerce Trust. This material is not a recommendation of any particular security, is not based on any particular financial situation or need and is not intended to replace the advice of a qualified attorney, tax advisor or investment professional.
Diversification does not guarantee a profit or protect against all risk. Commerce Trust does not provide tax advice or legal advice to customers. Consult a tax specialist regarding tax implications related to any product and specific financial situation. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. Commerce Trust does not provide advice related to rolling over retirement accounts.
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