Roth IRAs

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

The Roth IRA five-year rule is often misunderstood as an ironclad edict that locks your money away, out of your reach. In reality, it’s not the scary impediment that investors might fear.

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.

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 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.

Please remember that converting an employer plan account to a Roth IRA is a taxable event. Increased taxable income from the Roth IRA conversion may have several consequences including (but not limited to) a need for additional tax withholding or estimated tax payments, the loss of certain tax deductions and credits, and higher taxes on Social Security benefits and higher Medicare premiums. Be sure to consult with a qualified tax advisor before making any decisions regarding your IRA.
 Investment advisory services made available through AE Wealth Management, LLC (AEWM). AEWM and  Miller retirement group are not affiliated companies."
Neither the firm nor its agents or representatives may give tax or legal advice. Individuals should consult with a qualified professional for guidance before making any purchasing decisions.

About the Author

Nate Miller, Investment Adviser Representative

President, Miller Retirement Group

Nate Miller is president of Miller Retirement Group. Miller has more than two decades of experience in the financial industry and holds insurance licenses in Kansas and Missouri. He also has passed the Series 65 exam and is registered as an Investment Adviser Representative in those same states. Miller also is the author of "The CPR Retirement Rescue Roadmap: Your Guide to Breathing Life Into Any Portfolio."

The appearances in Kiplinger were obtained through a PR program. The columnist received assistance from a public relations firm in preparing this piece for submission to Kiplinger was not compensated in any way.

Most Popular

The 11 Most Expensive Cities in the U.S.
real estate

The 11 Most Expensive Cities in the U.S.

From metro areas on both coasts to the middle of the Pacific Ocean, these are the priciest cities in the U.S. to call home.
August 9, 2022
Your Guide to Roth Conversions
Special Report
Tax Breaks

Your Guide to Roth Conversions

A Kiplinger Special Report
February 25, 2021
You'll Save More on Green Home Improvements Under the Inflation Reduction Act
Tax Breaks

You'll Save More on Green Home Improvements Under the Inflation Reduction Act

Tax credits for energy-efficient home improvements will be extended and expanded by the Inflation Reduction Act.
August 12, 2022


5 Things to Consider When Weighing a Job Change

5 Things to Consider When Weighing a Job Change

Financially speaking, the decision to stay or go is about more than just salary. Take a holistic look at your offer before deciding to take the leap t…
August 14, 2022
2 Risks People Face If They Retire in Tough Economic Times

2 Risks People Face If They Retire in Tough Economic Times

You’ve reached your retirement age, but our economy is on the rocks. What should you do?
August 13, 2022
Are You Rich?
personal finance

Are You Rich?

You might be surprised. It depends on how you measure it, and the bar is changing.
August 12, 2022
How to Steer Your Retirement Portfolio Through the Storm
retirement planning

How to Steer Your Retirement Portfolio Through the Storm

Right now, it feels like there’s an economic challenge around every corner. But the good news is you can still protect your nest egg.
August 12, 2022