Roth IRA ‘five-year rule’ can trigger an unexpected tax bill: Here’s what you need to know

Roth IRAs are a type of after-tax account for retirement savings. Future withdrawals are tax-free if they are “qualified distributions.”

A $1 contribution today to a new Roth individual retirement account may not sound like much. But that seemingly small sum might save you a bundle in taxes down the road due to an under-the-radar timing requirement.

Your initial Roth IRA contribution starts the clock on something called the “five-year rule,″ said Ed Slott, a certified public accountant and IRA expert based in Rockville Centre, New York. In basic terms, that rule requires Roth IRA owners have their account for five or more years to avoid paying income tax on any withdrawn investment earnings.

“That’s what we call a ‘forever clock,’” Slott said. “Once it starts, it never stops.”

Here’s how it works, and why it’s smart to watch the clock on your Roth IRA.

Flouting the ‘5-year rule’ can mean earnings are taxable
Roth IRAs are a type of after-tax retirement account. Since Roth IRA owners pay income tax on contributions, they can generally withdraw their savings — and any investment earnings — free of tax and penalties in old age.

But retirement accounts come with many rules to prevent potential tax dodges — and Roth IRAs are no exception.

Contributions to a Roth IRA are always tax- and penalty-free. You can withdraw them at any time and at any age because you’ve already paid income tax on those funds.

However, the same isn’t always true for investment earnings on those contributions.

In tax lingo, a Roth IRA withdrawal must be a “qualified distribution” to avoid taxes or penalties. Taxes on investment earnings are at “ordinary income” tax rates, not the preferential tax rates for capital gains.

There are two requirements for a withdrawal to count as a qualified distribution:

Age: You may be hit with a 10% tax penalty and income taxes on any investment earnings you withdraw before age 59½. (There are some exceptions to this “early withdrawal” penalty.)
Time: Here’s where the “five-year rule” comes into play. Roth IRA owners must have their account for at least five years to avoid paying income tax on any withdrawn investment earnings.
Here’s a simple example: Let’s say a 60-year-old contributed $6,000 to a Roth IRA in January 2020. It’s the saver’s only Roth IRA and the first time they’ve contributed money to such an account. The investment has earned about $1,500. In 2023, the saver, now 63 years old, decides to withdraw the full $7,500.

You might think this person is in the clear, since they’re over age 59½. However, this individual would owe income taxes on the $1,500 of earnings because the account hasn’t been open for five years. It wouldn’t be a qualified distribution.

An easy way to start the 5-year clock

There’s an easy workaround to the Roth IRA five-year rule if you don’t mind doing some advance planning, Slott said.

If that same 63-year-old had contributed any money to a Roth IRA at any point beyond five years in the past — even if it was just $1 back in 1990, for example — their investment earnings today would be tax-free when withdrawn. (One caveat: Someone younger than age 59½ may still owe a 10% tax penalty on earnings withdrawn, with few exceptions.)

That’s because the five-year holding period begins “with the first tax year for which a contribution was made to a Roth IRA set up for your benefit,” according to the IRS.

In other words, the initial Roth IRA contribution is what starts the five-year clock, Slott said. It starts Jan. 1 of the year in which the first dollar is contributed. That clock lasts forever and doesn’t reset if future contributions are made, or if the account is closed and then reopened, Slott said.

Savers who qualify to contribute to a Roth IRA should open one to start the clock now to avoid any snags later, Slott said.

Who will ‘never need to know the 5-year rule’
Of course, not everyone is eligible to contribute to a Roth IRA. There are income limits: A single tax filer can’t contribute any money to a Roth IRA in 2023 if their modified adjusted gross income exceeds $153,000. Married couples filing a joint tax return have a MAGI limit of $228,000.

A Roth IRA conversion is one way to sidestep these income limits. And a conversion is another way to start the five-year clock for qualified distributions, Slott said — though he advised that there’s a different five-year rule for converted funds that could trip up taxpayers under age 59½.

Another important note: The five-year clock may still apply if you inherit a Roth IRA from a deceased accountholder.

Ultimately, though, retirement savers who use their accounts as envisioned by the tax code — as a pot of savings amassed over a long time and for use in old age — don’t need to fear tripping up any of these tax rules.

“If you use the Roth the way it’s intended, you’ll never need to know the five-year rule,” Slott said.