What Is the 5% Rule for Retirement Accounts?

The “5% rule” in retirement discussions refers not to a single regulation, but to several distinct financial guidelines. These rules primarily relate to distributions and tax treatment of retirement savings. Understanding which “5% rule” applies is important for individuals managing or inheriting retirement assets, as they ensure funds are distributed and taxed according to federal regulations.

The Five-Year Rule for Inherited Retirement Accounts

The five-year rule for inherited retirement accounts mandates that certain beneficiaries fully withdraw assets from an inherited Individual Retirement Account (IRA) or 401(k) plan within five years of the original owner’s death. This rule primarily applies to beneficiaries not considered “eligible designated beneficiaries” under IRS regulations. Eligible designated beneficiaries include surviving spouses, minor children of the deceased, disabled or chronically ill individuals, and beneficiaries not more than 10 years younger than the deceased. These eligible beneficiaries often have different distribution options, such as over their life expectancy or a 10-year period.

For beneficiaries subject to the five-year rule, the entire account balance must be distributed by December 31st of the fifth year following the original owner’s death. For example, if an account holder passed away in 2024, funds must be withdrawn by December 31, 2029. Beneficiaries have a defined window to manage tax implications, as all withdrawals are typically subject to income tax. The rule requires complete liquidation by the deadline, not a minimum annual distribution.

Failure to fully distribute the inherited retirement account balance within the five-year timeframe can lead to significant penalties. The IRS may impose an excise tax of 50% on the undistributed amount. Beneficiaries should consult a financial advisor to navigate these rules and plan distributions to minimize tax liabilities and avoid penalties.

The SECURE Act of 2019 eliminated the “stretch IRA” for most non-spouse beneficiaries, introducing a mandatory 10-year distribution period. However, the five-year rule still applies to certain non-designated beneficiaries, such as estates or some trusts. For these beneficiaries, the five-year rule typically applies if the original account owner died before their Required Beginning Date (RBD) for Required Minimum Distributions (RMDs). If the owner died on or after their RBD, funds must generally be distributed over the deceased owner’s remaining life expectancy.

Understanding the beneficiary type and the original owner’s RMD status at death is crucial for determining the applicable distribution rule. The rules for inherited IRAs and 401(k)s can be complex, especially when trusts are involved. Professional guidance is recommended to ensure compliance and optimize financial outcomes for beneficiaries.

The Five-Year Rule for Roth IRA Contributions and Conversions

The five-year rule for Roth IRAs governs the tax-free and penalty-free nature of “qualified distributions.” This rule is distinct from the inherited account rule and applies to direct contributions and conversions of traditional IRA funds into a Roth IRA. To be qualified, funds must be withdrawn after a specific five-year period and meet at least one other condition.

For Roth IRA contributions, the five-year period begins on January 1st of the tax year an individual made their first contribution to any Roth IRA. The clock starts at the beginning of that year, regardless of when the contribution was made. For example, a first contribution in December 2020 means the five-year period began January 1, 2020, and is satisfied on January 1, 2025. This single five-year clock applies to all Roth IRA contributions across all accounts.

A separate five-year period applies to Roth IRA conversions. For each conversion, a new five-year clock begins on January 1st of the conversion year. For example, funds converted in 2023 are subject to a five-year holding period beginning January 1, 2023, and ending January 1, 2028. If multiple conversions occur over several years, each has its own independent five-year period for penalty-free withdrawal of the converted principal.

For a Roth IRA distribution to be qualified (tax-free and penalty-free), two conditions must be met: the five-year waiting period, and the distribution must occur after the owner reaches age 59½, becomes disabled, or uses funds for a qualified first-time home purchase (up to $10,000). Distributions to a beneficiary after the owner’s death are also qualified. Meeting both the five-year rule and one of these conditions ensures contributions and earnings can be withdrawn without tax or penalties.

If withdrawals are made from a Roth IRA before both the five-year period and a qualifying condition are met, the distribution is generally non-qualified. Contributions can typically be withdrawn tax-free and penalty-free, as they are made with after-tax dollars. However, any earnings withdrawn before meeting qualified distribution requirements may be subject to ordinary income tax and a 10% early withdrawal penalty, unless an exception applies.

The 5% Owner Rule for Qualified Plan Distributions

The 5% owner rule in qualified retirement plans historically influenced when highly compensated individuals began taking distributions, even while employed. This rule applies to individuals owning more than 5% of the business sponsoring the plan, such as a 401(k). The 5% ownership determination includes direct and indirect ownership through family attribution rules, where stock owned by a spouse, children, grandchildren, or parents is considered owned by the individual.

Historically, a 5% owner was generally required to begin taking Required Minimum Distributions (RMDs) from their qualified plan by April 1st of the year following the calendar year they reached age 70½, even if still employed. This differed from non-5% owners, who could typically delay RMDs until April 1st of the year following their retirement from the plan-sponsoring employer. The rationale was to prevent highly compensated individuals from indefinitely deferring taxes on large retirement accounts.

The SECURE Act changed the RMD age from 70½ to 72, and the SECURE 2.0 Act further increased it to 73 in 2023, and to 75 starting in 2033. Despite these changes, the distinction for 5% owners regarding RMDs while still working largely remains. Non-5% owners employed by the plan sponsor can typically delay RMDs until retirement, but 5% owners are generally still required to begin RMDs once they reach the applicable RMD age, even if continuously employed.

A 5% owner cannot indefinitely delay RMDs past their required beginning date, even if actively working for the company sponsoring the plan. This ensures these owners begin drawing down retirement funds and paying income tax, preventing excessive tax deferral. The rule aims to ensure retirement plans serve as income vehicles, not indefinite tax shelters.

Understanding this rule is important for business owners participating in their company’s qualified retirement plans, as it impacts their tax planning and distribution strategies. Failure to take required RMDs can result in a 25% excise tax on the undistributed amount, potentially reduced to 10% if corrected promptly. 5% owners should monitor RMD obligations and plan distributions to avoid penalties.