The IRA 5-Year Rule: How Does It Work?

An Individual Retirement Arrangement (IRA) is a tax-advantaged savings plan with specific regulations governing when and how money can be withdrawn. Among these are the “5-year rules,” a set of timing requirements that can affect the tax treatment of distributions. The term is a source of confusion because it refers to several distinct rules that apply in different circumstances. Understanding these rules is an important part of managing retirement assets, as they determine whether withdrawals are subject to taxes and penalties.

The 5-Year Rule for Roth IRA Withdrawals

Two separate 5-year rules govern withdrawals for Roth IRA owners. The first rule relates to the tax-free withdrawal of investment earnings. For a distribution of earnings to be free from federal income tax, a 5-year holding period must be satisfied. This clock starts on January 1 of the tax year for which the first contribution was made to any of the owner’s Roth IRAs. All subsequent Roth IRAs are covered by this initial 5-year period.

Meeting this 5-year holding period is just one requirement for taking tax-free earnings. The account owner must also be at least age 59½ or meet an exception, such as death or disability. If an owner who is over 59½ takes out earnings before the 5-year clock is satisfied, those earnings will be subject to ordinary income tax.

A second, separate 5-year rule applies to funds moved into a Roth IRA from another retirement account, such as a Traditional IRA or 401(k). Each of these “conversions” has its own 5-year holding period. This rule determines whether a 10% early withdrawal penalty applies to the converted amount if withdrawn before the owner reaches age 59½. The clock for each conversion starts on January 1 of the calendar year it was made.

This rule is about avoiding the 10% penalty, not income tax, as the tax on the conversion is paid in the year it occurs. For example, if a 45-year-old converts $50,000 from a Traditional IRA to a Roth IRA, they must wait five years to withdraw that amount without a penalty. If they withdraw it in year four, the 10% penalty would apply even though the income tax was already paid.

The 5-Year Rule for Inherited IRAs

A different 5-year rule can apply to inherited IRAs, dictating how quickly the account must be depleted. This rule applies if the deceased owner passed away before their required beginning date for taking Required Minimum Distributions (RMDs). It primarily affects “non-designated beneficiaries,” such as the decedent’s estate, a charity, or certain trusts.

The beneficiary must withdraw the entire IRA balance by December 31 of the fifth year following the owner’s death. For example, if the owner died in 2024, the deadline is December 31, 2029. The funds can be withdrawn at any time, as long as the account is empty by the deadline.

This rule contrasts with the 10-year rule that applies to most individual “designated beneficiaries,” which gives them a decade to empty the account. The 5-year rule is more restrictive, reserved for beneficiaries that are not people or for trusts that do not meet specific IRS criteria. This distinction is important for estate planning and for beneficiaries to understand their obligations.

Tax Consequences of Non-Compliance

Failing to adhere to the 5-year rules can lead to significant financial penalties. The specific consequence is directly tied to the rule that was broken, underscoring the importance of careful planning.

Withdrawing Roth IRA earnings before satisfying the 5-year holding period for contributions will subject the earnings to ordinary income tax. If the owner is also under age 59½ and does not qualify for an exception, a 10% early withdrawal penalty will also be assessed on those earnings.

If an individual under age 59½ withdraws converted funds before that conversion’s 5-year period has passed, a 10% early withdrawal penalty applies. This penalty is levied on the portion of the withdrawal that was taxable at the time of conversion. For example, withdrawing a $40,000 taxable conversion early would trigger a $4,000 penalty, even if income tax was already paid.

Beneficiaries who fail to comply with the 5-year rule for an inherited IRA face a 25% excise tax on the amount that should have been withdrawn. This penalty can be reduced to 10% if the beneficiary corrects the mistake in a timely manner.