Roth IRAs are among the most useful tools you can use to save for retirement. In addition to the trait all IRAs share -- that is, letting you enjoy tax-deferred growth on the investments within your retirement account throughout your career -- a Roth IRA has the added benefit of letting you take distributions after you retire without having to worry about paying taxes on the withdrawals. (If that sounds like a good deal to you, the Fool happens to have a great section where you can learn about IRAs, and figure out which one is right for you.)
But two Roth IRA rules put limitations on your ability to get tax-free treatment for your investment income, as well as your right to take money out of your account without having to pay onerous penalties. Let's take a look at these two Roth IRA rules to learn how you can manage your retirement account in order to avoid nasty surprises.
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Roth IRA Rule No. 1: Waiting five years after you contribute
The first five-year rule deals with when you can withdraw money from your Roth IRA and have it treated as a qualified distribution for tax purposes. In the simplest terms, you must have had money in a Roth IRA for at least five tax years before any withdrawals qualify for favorable tax treatment.
The whole point of a Roth IRA is to avoid taxes on distributions, as you don't get an upfront deduction for your contributions as you would with a traditional IRA. So complying with this rule is important, because otherwise, you'll end up having to pay income tax on the earnings from your Roth investments.
In addition, if you're not at least 59 1/2 and you don't qualify for one of the penalty exceptions, you'll also pay a 10% penalty. By contrast, qualified distributions are tax-free and penalty-free.
For the purposes of the rule, the five-year clock starts on Jan. 1 of the tax year in which you make your initial Roth IRA contribution. Because you have until April 15 of the year following any given tax year to make a Roth contribution, in some cases, the five-year rule actually requires holding your assets within the Roth for less than four years. For instance, if you opened your first Roth IRA on April 15, 2014 and designated that contribution for the 2013 tax year, then the five-year period would expire on Jan. 1, 2018.
Interestingly, this five-year rule only applies to your first Roth IRA contribution. Future contributions don't start a new clock running, and once that initial five-year period passes, you don't have to worry about this rule any longer.
Moreover, there are ways around the five-year rule, at least to a limited extent. You can still withdraw your original contribution (but not any capital gains) from your Roth IRA without having to pay tax or penalties, even if the five-year period hasn't passed.
Roth IRA Rule No. 2: Waiting five years after a Roth conversion
A completely separate five-year rule applies when you convert money in a traditional IRA to a Roth IRA. Here, the rule says that until five years has passed after the conversion, you have to pay the 10% penalty if you withdraw money from the converted Roth and don't qualify for the usual penalty exceptions.
This rule works differently from the first Roth IRA rule in that a new five-year period starts for every Roth conversion you make. But the point of the rule is to prevent you from using Roth conversions to avoid a penalty that would apply to traditional IRA withdrawals. Without this rule, you could convert money to the Roth and then immediately withdraw it without paying the 10% penalty, because converted amounts are generally treated as tax-free when distributed because you included them in taxable income and paid tax at the time of the Roth conversion. This rule closes that loophole.
The five-year period starts running on Jan. 1 of the year of conversion, so, depending on when the conversion takes place during the year, the actual waiting period can be as little as four years and a day. If you turn 59-1/2 during the five-year period, then the penalty no longer applies after that date, even if the five years haven't elapsed.
Stay on top of the rules
Roth IRAs are valuable for your retirement planning, but keeping track of the Roth IRA rules can be tricky. By knowing the basics, you can avoid making big mistakes that can cost you in extra taxes and penalties.
Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
FAQs
A “backdoor” Roth IRA allows high earners to sidestep the Roth IRA's income limits by converting nondeductible traditional IRA contributions to a Roth IRA. That typically requires you to pay income taxes on funds being rolled into the Roth account that have not previously been taxed.
What is the best company to open a Roth IRA with? ›
The best Roth IRA accounts include Vanguard, Fidelity, Charles Schwab, Merrill Edge and E*TRADE. They stand out for their low costs and large selection of retirement investments.
What is the backdoor Roth 5 year rule? ›
Accessed Apr 8, 2022. You'll need the money in five years or less. Money converted from an IRA to a Roth IRA falls under a Roth five-year rule: If you don't wait five years to withdraw it, you could owe taxes and a 10% penalty. The withdrawal from your IRA will push you into a higher income tax bracket.
What are the exceptions to the 5 year rule for Roth IRAs? ›
If you're under age 59½ and your Roth IRA has been open five years or more, your earnings will not be subject to taxes if you meet one of the following conditions: You use the withdrawal (up to a $10,000 lifetime maximum) to pay for a first-time home purchase. You become disabled or pass away.
Is the backdoor Roth going away in 2024? ›
Yes. Backdoor Roth IRAs are still allowed in 2024. However, there has been talk of eliminating the backdoor Roth in recent years. And the future is, of course, difficult to predict.
How do I convert my IRA to a Roth without paying taxes? ›
The point of a Roth IRA is that it's already taxed money that grows tax-free. So, to convert your traditional IRA to a Roth IRA you'll have to pay ordinary income taxes on your traditional IRA contributions in the year of the conversion before they “count” as Roth IRA funds.
What is better than a Roth IRA? ›
The main difference between a Roth IRA and a traditional IRA is how and when you get a tax break. Contributions to traditional IRAs are tax-deductible, but withdrawals in retirement are taxable as income. In comparison, contributions to Roth IRAs are not tax-deductible, but the withdrawals in retirement are tax-free.
Who should not open a Roth IRA? ›
If you're now in one of the higher tax brackets, your tax rate in retirement may have nowhere to go but down. In this case, you're probably better off postponing the tax hit by contributing to a traditional retirement account.
How to become a millionaire through Roth IRA? ›
How to Become a Roth IRA Millionaire
- Open a Roth IRA account. The first step in becoming a Roth IRA millionaire is pretty obvious- you need to open up a Roth IRA account! ...
- Fund the maximum allowable contributions. Next, start funneling money into your Roth. ...
- Invest in low-cost index funds. ...
- Repeat every year. ...
- Be Patient.
To be clear, no converted funds would get double-taxed, but some circ*mstances can result in a taxable transaction. That's where the rules get more complicated. (And that's why it's a good idea to consult with a financial advisor when deciding whether a backdoor Roth makes sense for you.)
A mega backdoor Roth allows high-earning investors — who otherwise couldn't put money in a Roth account because of income restrictions — to move money from a 401(k) plan to a Roth IRA or Roth 401(k) plan.
Who is not eligible for backdoor Roth IRA? ›
The term “backdoor” reflects the indirect nature of this contribution method. As of 2024, single filers with modified adjusted gross income (MAGI) above $161,000 and married couples above $240,000 are ineligible to contribute to a Roth IRA directly.
Should I convert my IRA to a Roth after age 60? ›
Converting an IRA to Roth After Age 60. Retirement savers who convert pre-tax retirement accounts such as IRAs to after-tax Roth IRAs after reaching age 60 can keep growing funds tax-free and then make withdrawals in retirement without paying taxes.
What is the penalty for withdrawing from a Roth IRA? ›
The early withdrawal penalty for a traditional or Roth individual retirement account is 10% of the amount withdrawn. Keep in mind that you may also owe income tax in addition to the penalty. You can withdraw contributions (but not earnings) early from a Roth IRA without being subject to income tax and the penalty.
What is the best company to open a Roth IRA? ›
If you'd like to invest on your own in a Roth IRA, Fidelity offers the best all-around broker experience. Vanguard is best for low-cost mutual funds, Interactive Brokers is best for advanced capabilities and access to global markets, and E*TRADE has the best mobile apps for investors.
What is the downside of backdoor Roth? ›
Cons: All or part of a backdoor Roth IRA conversion could be a taxable event. You may have to pay federal, state, and local taxes on converted earnings and deductible contributions. Conversions could kick you into a higher tax bracket for the year.
Is backdoor Roth worth the hassle? ›
But once your federal income tax bracket hits 24%, you're at roughly a neutral state. If your federal income tax bracket is 32% or higher, doing a Backdoor Roth IRA is a terrible, terrible idea. It is highly unlikely you will be making more money, and thereby being in a higher tax bracket in retirement!
What is the income limit for a backdoor Roth IRA? ›
Understanding Backdoor Roth IRAs
The limits are as follows: For 2023: Between $138,000 and $153,000 for single filers and between $218,000 and $228,000 for joint filers. For 2024: Between $146,000 and $161,000 for single filers and between $230,000 and $240,000 for married couples filing jointly4.
