Everyone is freaking out about the Roth 5-year rule but there is no cause for alarm. In this quick read, we explain the 5-year rule in a straightforward manner that will leave you with no further questions.
The Roth 5-year rule applies to all Roth accounts such as Roth IRAs and Roth 401(k)s. The 5-year rule says that you must leave your earnings in a Roth account for at least 5 years or face a penalty for early withdrawal. Does that mean if you put money in a Roth account you can’t get to it for 5 years? No, it does not.
Contribution: Money placed into a retirement savings account; same as deposit.
Retirement Account: An account that has special tax treatment to help people save for retirement. Retirement accounts are typically held by financial institutions.
Financial Institution: A bank, credit union, or investment bank such as Vanguard or Goldman Sachs.
Special Tax Treatment: A method that provides legal tax avoidance on either a pre-tax or after-tax basis.
Pre-Tax: Special treatment given to tax-advantaged retirement accounts such as traditional 401(k)s and IRAs. It allows contributions to be made without paying any income tax on the money deposited at the time of deposit. When distributions are taken in retirement, taxes must be paid on both the contributions and any investment earnings.
After-Tax: Special treatment given to after-tax retirement accounts such as Roth IRAs and Roth 401(k)s. It allows distributions in retirement without paying tax on either the contributions or their investment earnings. Taxes are paid when contributions are made by funding the account with after-tax dollars (i.e., take-home pay).
Distribution: Money removed from a retirement savings account; same as withdrawal.
Earnings: It has two meanings: a) money made by working, and b) when used in the context of retirement savings and investing, it means money made in an account due to stock market advances, dividends, or interest.
If you put $100 in a Roth account, you can withdraw it one minute later and there would be no penalties. Suppose instead that you leave the $100 in the Roth account and invest it in a stock. Over the course of one year the stock increases in value and now you have $120 in your account. As mentioned, you can take your $100 contribution any time without penalty, but if you try to withdraw the entire $120 you will pay a penalty on the $20 in investment earnings. The $20 would be taxed as ordinary income, plus you would pay a 10% "penalty" tax on the $20 because you took the distribution before 5 years had expired.
As we said at the outset, the 5-year rule applies to Roth 401(k)s. While that is true, it happens in a roundabout way. Roth 401(k)s are typically rolled over into a Roth IRA at retirement. If you have not already established a Roth IRA, you will incur a 5-year waiting period. The best strategy is to open and fund a Roth IRA at least 5 years prior to your anticipated retirement date. That way you won’t have to wait 5 years to get to your money.
For those who believe higher taxes are on the horizon, Roth accounts are the way to go for retirement savings. There may never be another time when taxes are as low as they are today. It makes sense to pay taxes on your retirement savings now while tax rates are low rather than wait until you are retired when tax rates may be higher.Photo credit: Pixabay