Hesitant About a Roth Because of the 5-Year Rule? Here’s Why You Shouldn’t Be

Recommend a Roth conversion to some people, and you may encounter a touch of financial skepticism.

“What if I need my money all of a sudden?” they ask. “Won’t it be off-limits to me for five years?”

The short answer is no, your money won’t be off-limits to you for five years. However, the longer answer is worth exploring because the question is a good one, even if it’s based on a misunderstanding about the Internal Revenue Service’s five-year rule that applies to Roth accounts.

From just $107.88 $24.99 for Kiplinger Personal Finance

Be a smarter, better informed investor.

CLICK FOR FREE ISSUE

Sign up for Kiplinger’s Free Newsletters

Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.

Profit and prosper with the best of expert advice - straight to your e-mail.

Sign up

But before we step into the thorny thicket involving those five years, let’s first review what a Roth is and why Roth conversions have become popular.

Tax-Deferred vs. Tax-Free

Traditionally, many Americans have saved for retirement with a traditional IRA, 401(k) or similar tax-deferred account. These retirement savers enjoyed a tax advantage when they made contributions to those accounts because the contribution amounts were subtracted from their taxable income. But the catch is that they are taxed when they withdraw money from the account in retirement.

As a result, plenty of people have learned much too late that they didn’t accumulate as much retirement savings as they thought they had because they failed to consider that the IRS is going to claim a large chunk of their money. In addition, when they reach age 72, something called a required minimum distribution (RMD) kicks in, which means they have to withdraw a certain percentage each year whether they want or need to do so.

Enter Roth accounts, which grow tax-free, have no RMDs and are not taxed when you make withdrawals. While there are several tax considerations to be made when thinking about a Roth conversion, let’s review some of the reasons they have been popular with consumers over the years. You don’t get any upfront tax advantage, but the long-term tax advantage usually is much better. That’s why many people with traditional IRAs convert to Roth accounts. They pay taxes when they make the conversion, but in most cases they are going to save on taxes in the long run.

Now, let’s take a look at that five-year rule that, admittedly, can be confusing.

The Ticking 5-Year Clock

Whenever you contribute to a Roth, a five-year clock starts ticking on any growth you experience with the money you put into the account. (That clock begins on Jan. 1 in the year you make the first contribution.) Any interest you gain from your Roth remains hands off until the five years pass. Withdraw that money and you will be taxed.

Withdraw those gains before you turn 59½ and a penalty is tacked onto the tax bill.

But notice that I stated that the five-year clock applies to growth. It does not apply to the money you contributed to the account. It’s important to note here that the IRS has an order of withdrawals that it considers when money is taken from a Roth. They consider the contributions you made first. Next are conversions. And finally comes the earnings — the growth on your money, which is the part subject to potential taxation under the five-year rule.

An Example to Illustrate

Let’s look at a hypothetical situation to better understand why the five-year rule might never come into play for you. Imagine you are 62 and have been contributing to a Roth IRA over several years and have $50,000 in the account. You also decided to convert a traditional IRA to a Roth and, after taxes, end up with $300,000 in that Roth account, bringing your Roth total to $350,000. Finally, you have some growth in these accounts – say $50,000 – bringing the new total to $400,000.

At that point, you retire and decide to begin taking out $25,000 a year to supplement your Social Security and pension. Remember that $350,000 of your Roth balance is your contributions, to which the five-year rule does not apply. So, at $25,000 a year, it will take 14 years before you have to take out any of the growth – long after that five-year clock has run out.

In other words, for most people, it would be hard to become a victim to that five-year rule, so if that’s the factor making you hesitate about a Roth conversion, don’t let it be.

Of course, the five-year rule isn’t the only factor to consider if you want to make a Roth conversion. A financial professional can help you decide whether a Roth conversion is the best move for you and can provide advice on how to make the move in the most tax-efficient manner for you.

Ronnie Blair contributed to this article.