Retirement Answers

Jacob: 00:00

Hey, friends, and welcome back to another episode of Retirement Answers. My name is Jacob Duke. I'm your host, as always. Today on the show, we are talking about the two different five year rules that relate to the Roth IRA. We're gonna talk about what they are, how they work, and then I'm gonna give you one big takeaway here at the end that might be something you had not thought about.

Jacob: 00:20

So what are these five year rules and how do they work? So there's two different ones. The first one has to do with distribution of earnings within the Roth IRA, whether or not those are early or late. So whenever you make a contribution to your Roth IRA, you can take out that contribution at any point for any reason, no tax, no penalty, okay? Because that is after tax money that you've put into the account.

Jacob: 00:42

Now, growth or earnings that have happened on that money that you've contributed, that is what is tied up based on two different stipulations. The first stipulation is you cannot take out your earnings out of that account until you are age 59.5, and then the second one is the account has been opened for five years. So the key here is, and I've heard this stated incorrectly, the key is that this is an and situation, not an or situation. And what I mean by that is, is you have to be 59 and a 0.5 and the Roth IRA has to have been open for at least five years. So both of those things have to be true in order for you to access any earnings that you have made on your money or your investments inside of your Roth IRA.

Jacob: 01:23

Now, something to know here regarding this early distribution penalty that would be 10% in addition to taxes paid on that earnings, if you decide to take the earnings out before 59.5 and the account has been over for five years, if you take money out before that, you'll pay that penalty. The order in which your money would be distributed out of your Roth IRA, should you decide to take money from the account, is what's really important. So here's how your money would actually be taken out should you decide to take something. The first thing to come out is always your contribution. So whatever money you have put into your Roth IRA, that is what's gonna come out first every single time, no questions, okay?

Jacob: 01:57

The second thing that would come out is any sort of conversion that you've done. You've any Roth conversions, any sort of converted dollars, those would come out second and we're to come back to this here in just a minute with the second five year rule. And then the third thing that would ever come out of your Roth IRA in terms of this order would be your earnings. So your earnings always come out last. So here's how that would actually play out.

Jacob: 02:19

Let's say you've got $50,000 in a Roth IRA, and you've put $30,000 into that account. So $30,000 is your contributions, and you need to take out $30,000 from the account to go do something with that money. Well, you can take out all 30,000 of your contribution since that's what would come out first, and the $20,000 that's different there, that's the that's the earnings, the growth that you've had in the account, that stays in the account, and you're you're not going to pay any taxes or any penalties on the 30,000 you're taking out because you're just giving your principal or your contributions back to yourself. Now, as soon as you go from 30,000 of a distribution to a $40,000 distribution, the first 30 is not going to be taxed or penalized, but the next 10 would be because that would be part of your earnings coming out before you are 59.5 and your account being open five years. So that's how that works.

Jacob: 03:08

Just know that your earnings come out last. And that's why I always emphasize the importance of having your 5498s on file. So that 5,498, that is a tax form that you're sent every single year that you make a contribution to an IRA. So if you don't keep track of those and then you distribute money from your Roth IRA before fifty nine and a half and five years, and then you get audited and you have to answer for these distributions out of your Roth IRA. If you don't have the form 5498s on hand to back up your distribution and prove that they were supposed to be tax free, then you could have to owe tax on that.

Jacob: 03:41

So it's important to hold on to those form 5,498, even though there's nothing to do with them per se, you just need to keep them on file. Because if you make any distributions that would technically be early, you have to be able to back that up and show that that was actually contributions that you sent out to yourself. So that's a few different nuances there on the rule around how you can take money from a Roth IRA and when you can do that and the penalties or taxes that might apply. Now, what's the second five year rule? The second five year rule has to do with Roth conversions.

Jacob: 04:10

So every single time that you do a Roth conversion, moving money from a traditional IRA to a Roth IRA, that starts a new five year clock. And that basically means that once you reach that five year clock, the money that you've converted becomes a contribution at that point, okay? So the idea there is you can't just move money from a traditional IRA to a Roth IRA to turn it into a contribution immediately, and then take that money out again tax free. You have to wait five years before that conversion amount technically becomes a quote contribution in the IRS's eyes. And so going back to the order of distribution here, contributions are first, your conversions are second, and then any earnings would be third.

Jacob: 04:52

So that's the second five year rule, it has to do with your any Roth conversions you do and just know, the five year clock starts January 1 of the year in which you do the conversion. So if you do a conversion, 12/30/2025, that's the year we're in right now. Technically, your five year clock started on 01/01/2025, and then 01/01/2030, that's whenever you would be free and clear to use that converted amount for whatever you would like without tax or penalty. Okay, so that's for every single conversion. Everyone has their own five year clock.

Jacob: 05:23

You can't do it one time and then all your subsequent following Roth conversions follow that same five year rule. It's a five year rule for each individual conversion. Now, here's a question that comes up sometimes. Jacob, what happens if I do a Roth conversion in retirement? Do I have to wait that five years in order to be able to take that money out without tax or penalty?

Jacob: 05:43

And the answer is no, you do not. Once you are 59.5 and the account has been open, the five year rule for conversions is eliminated because you have reached the age requirement and the account being open for five years, okay? So just know that in retirement, can touch and take out your conversions immediately. Once you are 59.5 and the account being open for five years, you can do that without any issues. Now, here's the big takeaway.

Jacob: 06:09

Here's the big bonus tip I've got for you. Many people don't have Roth IRAs open, number one, because they never saved to a Roth IRA, never thought to, didn't know it was going be a beneficial thing or were never able to, meaning they earned too much money, couldn't do it, they had money in a traditional IRA, did not do any backdoor Roths, and they also never saved any Roth money to their four zero one ks, okay? So what they've got here is they have no Roth IRA, and then they get to retirement without one, and they finally open one up because maybe they have some Roth dollars in their four zero one ks, whenever they do their rollover, it's going to go into a Roth IRA, so they have to open that account up for to have that money deposited into it correctly. So they open a Roth IRA right at retirement, so that all can happen, and they do a Roth conversion year one of retirement, and they wanna go take that money out of their Roth IRA to spend for whatever reason. Here's the problem.

Jacob: 06:57

The Roth IRA has not been open for five years, has it? It is not, because they just opened it so that they can roll over some money into that from their four zero one ks. So here's the bonus takeaway. Here's the bonus tip, the kind of next level thinking. If you do not have a Roth IRA open right now, open one today and get money in it somehow.

Jacob: 07:16

Whether you can contribute directly to it, whether you need to do a backdoor Roth contribution, whether you need to do a Roth conversion, I don't care how much, get $100 into it, just open the account and get $100 into it somehow, so that your five year clock can start, especially if you're getting closer to retirement and you do not have a Roth IRA open already. You could be in for a rude awakening if you do conversions in retirement, you have not met that five year window, that five year time retirement on the conversions, and you have to wait to be able to access any of your converted dollars, okay? So start the five year clock today so that when you get to retirement, you are free and clear, you're 59.5 or older and the five years has been met, you've got all that taken care of, so you don't have to worry about anything. So that's something that not many people know about or are aware of. They think that whenever they have a Roth IRA in retirement, any money in that, once they're 59.5, they can have that money and take it and do it tax free.

Jacob: 08:07

That is not the case relating to conversion specifically. So just know that you should do that. And again, this is something not many people know about, and I would encourage you to look at this for yourself and say, should I just go ahead and open a Roth? Should I just put $100 in it somehow, whether it be regular contribution backdoor or doing conversion to get something started there? And then that way you're ready to go when retirement comes.

Jacob: 08:30

So those are the two five year rules. I hope I've covered that in a way that makes it make sense. You've got two different ones. The first one is, is you cannot access your earnings or your capital gains inside of your Roth IRA until you're both age 59.5 or older, and the account has been open for five years. You can always access your contributions, no tax, no penalty.

Jacob: 08:49

And then the five year rule for Roth conversions is that each conversion has a five year time window before that money can be taken out without tax or penalty. And then again, once you are 59.5 and the account has been over five years, any money that you convert into a Roth at that point is free and clear immediately. You do not have to wait. Those are some different things there, a few different nuances for you. Hopefully that's helpful and beneficial as you continue to build out your tax strategy and understand your options around Roth IRAs and the different rules with them.

Jacob: 09:19

So let me know if you have any comments or questions, shoot an email over to me happy to have a conversation with you. Other than that, share this with somebody who might benefit from it and give a rating and review there on the podcast platform that you listen through. I hope you have a great rest of your day. We'll talk to you again next week. Hey, it's Jacob again, and I wanted to remind you that nothing discussed in today's episode is meant to be financial, legal or tax advice.

Jacob: 09:44

Retirement Answers is for educational purposes only. Thanks for tuning into this week's episode. I look forward to talking with you again next week.