Many retirement investors are turning to Self-Directed Roth IRAs because of the tax-free withdrawals they are allowed, even before retirement. If you’re already contributing to a Roth or are thinking about converting your current traditional pre-tax account to a Roth, you need to understand the “Five Year Rule.”
Here are the basics of how this rule will affect your IRA distributions:
What is the Five-Year Rule for Self-Directed Roth IRAs?
This Roth rule denotes a five-year period in which tax-free distributions on the earnings and gains in a Self-Directed Roth IRA are restricted. The rule also limits the distribution of funds that were converted to a Roth IRA. If a Roth IRA realizes gains on top of the contribution amount, withdrawals of those gains before the five-year waiting period will be taxable.
Also, funds that were converted from a pre-tax retirement plan, such as a Traditional IRA, to a Roth IRA must wait five years to be distributed tax-free. The five-year period starts when an individual opens a Self-Directed Roth IRA and makes the initial contribution. It also begins when a Roth conversion is completed.
Keep in mind that the actual effective date of the five-year Roth rule is always January 1st of the tax year for which the contribution or conversion was made. This means that the waiting period could be reduced substantially with the proper timing.
How is the five-year period determined?
Here is an example: If you opened a Self-Directed Roth IRA in March of 2019 and made a contribution for the 2018 tax year, your five-year period would have begun on January 1, 2018, and will end on January 1, 2023, which means your waiting period was actually less than four years instead of a full five.
What about a conversion? Well, if you now have a Traditional IRA and want to convert it to a Roth IRA, you are required to pay the tax on the converted amount. Conversions must be completed before December 31st for an effective date of January 1st of the tax year.
Let’s say you completed a Traditional-to-Roth conversion on December 20, 2018. Your five-year period starts on January 1, 2018 and ends on January 1, 2023—around four years since you made the actual conversion.
Remember, conversions you make between January 1st and April 15th cannot be backdated to represent conversions in the prior tax year even though the filing deadline is April 15th.
What effect does the Five-Year Rule have on my distributions?
The five-year rule states that distributions that are above and beyond the amount contributed or converted, and are taken before the five-year waiting period, are not tax-free. Here is one example:
Jennifer is 57 years old and makes a contribution of $6000 to her Self-Directed Roth IRA on April 15, 2015, for the tax year of 2014. On January 1st, 2019, she decided to withdraw $8000 from her Roth IRA. Of the $8,000 that Jennifer withdrew, $6,000 is her contribution, and $2,000 is her earnings.
Because Jennifer is now older than 59 ½, and her five-year period has expired (January 1, 2014, to January 1, 2019), the entire distribution qualifies as a tax-free distribution and nothing is included as taxable income.
If Jennifer had made those same contributions on the same dates but had taken her $8,000 distribution on January 1, 2018, she would have withdrawn her earnings before the five-year rule had expired, which would have triggered a tax on the $2,000 of earnings. So even though she was now over 59 ½ years of age, she could not remove the earnings tax-free since she took a distribution after only four years of participating in her Roth IRA.
And remember that each conversion from a pre-tax IRA to a Self-Directed Roth IRA will have its own individual five-year waiting period.