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

It’s especially important to understand how each type of IRA works when it comes to things like contributions, tax deductibility, and withdrawals, since these features can affect your finances now and down the road.

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

• A “five-year” rule for Roth individual retirement accounts may trigger an unexpected tax bill on investment earnings, even after age 59½.

• Contributing just $1 to a Roth IRA today can help you avoid a tax surprise later.

Your initial Roth IRA contribution starts the clock on something called the ‘five-year rule.

That rule requires Roth IRA owners have their account for five or more years to avoid paying income tax on any withdrawn investment earnings.

Roth IRAs are a type of after-tax retirement account.  Roth IRA owners pay income tax on their contributions, but 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 benefits 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 Roth IRA owners must have their account for at least five years to avoid paying income tax on any withdrawn investment earnings.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.

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

So, if you started the Roth IRA at age 50, you’d be in the clear to withdraw funds at 63 since your past the five-year clock.

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. 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.

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

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 have questions about how to best manage your investments and more importantly, how to manage your risk relative to your financial goals, please give me a call at 480-330-4878.  I am a fiduciary.  I act in your best interest.  I am a fee only investment advisor.  No commission sales.  No minimum investment balance necessary.  I work with all investors young and old no matter how much money they have.

Brad Singer, CFA is a local financial advisor and is owner of Vail Financial Advisors, a Registered Investment Advisor in the state of Arizona. This Content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice. Investment performance statistics were as of December 20, 2022, the date of this article.