What Is the 5-Year Rule?
Let me explain the 5-year rule in the context of individual retirement accounts, or IRAs. It usually means a waiting period you have to observe before pulling funds from a Roth IRA without facing penalties. I'll cover the different ways this rule shows up and how it might affect you directly.
Key Takeaways
You need to know that the 5-year rule deals with withdrawals from IRAs. For Roth IRAs, it sets a waiting time before you can take out earnings or converted funds without penalties. Specifically, hold the account for at least five tax years to withdraw those earnings without taxes or penalties.
How the 5-Year Rule Works
You can pull your contributions from a Roth IRA anytime without issues. But for earnings— that's interest, dividends, capital gains, or other income from your investments— you must have held the account for five years to avoid taxes and penalties. Plus, you need to be at least 59½.
Remember, this rule only restricts earnings, not your original deposits, since those were already taxed. The clock starts with your first contribution to any Roth IRA, even if it came from converting a traditional IRA.
There's another 5-year rule for converting a traditional IRA to a Roth. Wait five years after each conversion to withdraw those funds without penalties. Each conversion has its own timer, but the IRS says you withdraw the oldest conversions first. The withdrawal order is contributions, then conversions, then earnings.
If you ignore the rule and withdraw earnings or converted funds too early, you'll pay taxes at your ordinary income rate plus a 10% penalty. For example, if you're in the 24% bracket, that's 34% gone from your earnings just because you didn't wait five years.
Inherited IRAs vs. Traditional IRAs vs. Roth IRAs
Let's break this down by type, starting with inherited IRAs. A different 5-year rule applies to distributions from an inherited IRA if the owner died before 2020. For both traditional and Roth, beneficiaries take required minimum distributions, or RMDs.
You can distribute contributions or earnings from an inherited IRA without penalties, but taxes might apply based on the IRA type and your relation to the deceased. If the original owner didn't hold it for five years, earnings distributions get taxed.
Since the SECURE Act in 2020, non-spousal beneficiaries generally empty the account within 10 years of the death. Before that, you could stretch distributions over time to delay taxes—that was called a stretch IRA.
Eligible designated beneficiaries, like spouses, those not 10 years younger than the decedent, minor children, disabled, or chronically ill people, get more options. They can transfer the IRA to their name and defer distributions.
For traditional IRAs, as a beneficiary, you avoid the 10% early withdrawal penalty even if under 59½, but you pay income taxes on distributions. You can roll funds over, cash out, or combine them. Within five years, you can add contributions, but after that, withdraw everything.
Inherited Roth IRAs follow a 10-year rule for deaths in 2020 or later. You must liquidate by December 31 of the tenth year after death, unless you're an eligible designated beneficiary. No RMDs during those 10 years, or you could base distributions on your life expectancy.
If the inherited Roth has been around over five years, all distributions are tax-free, whether earnings or principal. If not, earnings are taxable, but principal isn't.
Frequently Asked Questions
What is the 5-year rule for Roth IRA? It means you can't withdraw earnings from your Roth without five years since your first contribution.
What about for inherited IRA? To withdraw earnings tax-free, the account needed to be open five years at the original owner's death.
Does it apply if you're 59½ or older? Yes, even then, the account must be five years old for tax- and penalty-free earnings withdrawals.
What's the 2 out of 5 year rule? That's for homeowners: live in your home two of the last five years to avoid capital gains taxes on sale.
The Bottom Line
The 5-year rule pops up in various IRA scenarios, mostly about withdrawing funds. For advice on handling your tax-advantaged accounts, talk to a financial advisor.
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