The Roth 5-year rule applies to all Roth accounts such as Roth IRAs and Roth 401(k)s. The Roth 5-year rule requires your investment earnings to remain in the Roth account for at least 5 years.

Roth accounts are uniquely positioned to benefit those who believe future tax rates will be higher. It’s the classic pay me now or pay me later. Paying later sounds better, but what if you could save money by paying now?

There is no guarantee that taxes will increase in the future, but it stands to reason that they will. Over the course of the last 25 years, our national debt has ballooned from $5 trillion to $35 trillion, and it shows no signs of slowing down. Somebody has to pay the bill, and that somebody is you and me, the American taxpayer.

Roth Retirement Accounts

Roth retirement accounts work differently than traditional IRAs or 401(k)s. With a traditional account, you don’t pay any taxes on the money you contribute to the account. Then in retirement when you take distributions from the account, you pay taxes on both your original contributions and any investment earnings.

Roth accounts work exactly the opposite. You pay taxes on the money you contribute to a Roth account, then in retirement when you take distributions you don’t pay any taxes on your original contributions or any investment earnings.

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If future tax rates go higher, you may be better off having your retirement savings in a Roth account. That way you pay taxes on your contributions now while tax rates are relatively low, rather than waiting until they may go higher.

Roth accounts have another even bigger advantage over traditional accounts. Because you don’t owe any taxes on your investment earnings in a Roth account, you can amass a small fortune in your account that you never have to pay taxes on.

The Roth 5-Year Rule

The Roth 5-year rule requires your investment earnings to remain in the Roth account for at least 5 years after you have established the account. However, that does not mean you can’t withdraw any money from the account during that period. You can withdraw your contributions, you just have to wait 5 years to withdraw any investment earnings. 

Let’s look at a quick example to illustrate the point. Suppose you open a Roth account and put $100 in it. You can withdraw that $100 one minute later with no penalties. Whoever you’re dealing with at the financial institution might think you’re crazy, but that’s a separate issue.

Now suppose instead that you leave the $100 in the Roth account and over the course of one year the investment increases in value and now you have $120 in your account. As mentioned, you can withdraw your original $100 contribution at any time without penalty, but if you try to withdraw the $20 in investment earnings before 5 years has elapsed you will pay a penalty.

Conclusion

For those who believe higher tax rates may be on the horizon, Roth accounts are the right choice. There may never be another time when tax rates 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 waiting until they may go higher in the future.

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