One of the main attractions of having a Roth IRA is that once you reach the age of 59 1/2 and have had a Roth account opened for five years, you qualify for tax-free distributions. There are a few quirks involved – but when performed properly, these work to your advantage. An important factor depends on when your account was opened or when you converted your funds into a Roth from another account.
What is the Roth IRA five-year rule? Is there a catch? How does it work?
These are all valid and important questions individuals ask when considering Roth IRAs. The answers are critical but can sometimes be confusing so we’ll explain it here in easy terms.
What is the Roth IRA five-year rule?
The five-year rule refers to a specific time period that you must own your Roth IRA before you can begin taking tax and penalty-free withdrawals. What this means is that you have to own a Roth account for a period of five years, as determined by the IRS, before you can begin taking tax-free distributions on the earnings and/or converted funds in the account. Additionally, if you seek to take distributions of income earned within the Roth IRA during those first five years, the distributions of those gains are taxable. Remember though, that distributions of contributions only, are always tax-free.
Keep in mind that you are unable to take any tax-free distributions of earnings until you reach the age of 59 1/2 no matter how long you’ve owned your Roth IRA.
Reread the last sentence above, understand the key words here are “as determined by the IRS” and read on.
“As determined by the IRS:” The catch that works to your advantage.
The clock starts ticking depending on when you open your account and in which tax year you plan to report contributions to it. This is critical and also contingent on the day you open your account—because, you may gain a few extra months or even an entire year of ownership. How? The IRS allows Roth owners to open and make yearly contributions to new IRA accounts until April 15th of the following year and include contributions to the account on the previous year’s tax returns. Meaning you can open your Roth IRA on April 14, 2016 and declare contributions made to the account on your 2015 income tax report. So, if you do open and fund your account before April 15, 2016, and declare contributions to the account on your 2015 income tax report, the date of your ownership is “rolled back” to January 1, 2015 (which gives you an extra year and 3 ? months of ownership towards the five-year rule). If you open your account in August or even December of 2015, your ownership date is rolled back to January 1, 2015.
So, by IRS regulation, you can actually have owned the Roth IRA for a period of approximately four years but have it classified as five—depending on when you open it.
The process is a bit different with conversions to a Roth IRA. If you are converting funds from a pre-existing plan in to a Roth IRA, you have until December 31 of the tax year you want it to count towards. For instance, if you want your converted funds to be reported on your 2015 tax return, you must perform the conversion on or before December 31, 2015. Conversions made after that date—from January 1-April 15, 2016, are not allowed to be backdated to the previous year.
You can self-direct a Roth IRA.
The fact that Roth IRAs can be self-directed makes these retirement plans even more attractive to savvy investors. Self-direction provides plan owners the ability to control their own retirement funds and decisions. Additionally, investors gain access to many different types of alternative investments such as real estate, precious metals, oil and gas options, private lending opportunities—and much more—to build wealth for retirement.
Visit the Roth IRA section on our web site to learn more about how these plans work as well as the how tax-free withdrawals are distributed.
If you have questions about this article or want to learn more about self-directed Roth IRAs, please contact us.