How to be Sure Your Roth IRA Distributions are Tax Free

The general rule is that distributions from a Roth IRA are tax free to both the original account owner and beneficiaries who inherit.

But this is the tax law, so there are exceptions that could make a Roth IRA distribution taxable.

Roth IRA owners must be aware of the five-year rule. In fact, details about the five-year rule are one of the most-asked questions from readers, both directly to me and in our regular Retirement Watch teleforums.

Roth IRA distributions are tax free when they are “qualified distributions.”

Satisfying the five-year rule is the main requirement for a distribution to be qualified.

The five-year rule is confusing partly because there really are two five-year rules.

One five-year rule determines if a distribution from a Roth IRA avoids income taxes. The other five-year rule determines if a distribution taken before age 59½ avoids the 10% early distribution penalty tax. The two rules are easy to confuse or conflate, and that often happens.

Despite all the attention they receive, the five-year rules are irrelevant to most of my readers. I’ll explain why after discussing the two rules.

Keep in mind the five-year rules apply only to original owners of IRAs. Beneficiaries who inherit IRAs automatically avoid the 10% early distribution penalty and receive tax-free distributions.

The Five-Year Rule for Income Taxes

Two tests must be met for a distribution to be qualified and tax free. One test is that five tax years must have passed since the first contribution was made to any Roth IRA of the taxpayer.

This is a broad rule, according to the IRS regulations. The five-year period starts whenever money is put into any Roth IRA for the taxpayer. Under this rule, contributions include both direct contributions and converted amounts, also called rollover contributions.

Some people believe this five-year rule applies separately to each Roth IRA. That’s not the case; it applies per taxpayer. Others think the five-year rule is applied separately to each Roth IRA conversion. That’s also not the case.

Some worry that rolling over one Roth IRA to another, such as by changing IRA custodians, might restart the five-year period. Again, that’s not the rule.

The Roth IRAs of the taxpayer and the money flowing into Roth IRAs are aggregated to come up within one five-year period. Essentially, once you’ve satisfied this five-year rule for one Roth IRA, you’ve satisfied it for life for all Roth IRAs.

That’s why some advisors recommend opening and contributing to a Roth IRA as soon as you are able. An alternative is to convert a small amount of a traditional IRA to a Roth IRA.

Either action starts the five-year clock running. Maybe you aren’t ready to convert a significant part of a traditional IRA to a Roth IRA, but you might be in five or 10 years. If you open a modest Roth IRA now, if you’re ready for significant Roth IRA moves in the future, the five-year rule won’t be an obstacle.

The second test for qualified distributions is broader. The distribution must be made on or after at least one of the following events: the owner turned age 59½; the IRA owner passed away, so the distribution is made to the estate or a beneficiary; or the distribution is made for first-time qualified home-buyer expenses of up to $10,000.

You must satisfy both tests for a Roth IRA distribution to be income tax free. For example, if you are at least age 59½ and have had a Roth IRA for at least five years, you meet both tests and a distribution is qualified and tax free.

The Five-Year Rule for the 10% Penalty

The second five-year rule determines whether a distribution of principal from a converted IRA is subject to the 10% early distribution penalty.

This five-year rule states that the early distribution penalty isn’t imposed if at least five tax years have passed since the principal was converted.

This rule applies separately to each IRA conversion. If you’re doing conversions over a period of years, track the amount of principal converted each year.

But a distribution is an early distribution only if it is taken before age 59½. Most of my readers are older than that or soon will be. The early distribution penalty isn’t a risk for them, even if they converted part of a traditional IRA yesterday and want to take a distribution tomorrow.

Suppose Max Profits is 45 years old and converts a traditional IRA to a Roth IRA. At age 51, he needs the money from the Roth IRA and distributes the full account. The early distribution penalty doesn’t apply, because more than five years have passed since the conversion.

But the distribution of the earnings of the Roth IRA is taxable, because Max was younger than age 59½ and didn’t meet any other tests to exempt the earnings from income taxes. The distribution of the principal, or converted amount, isn’t taxable, because the taxes on that were paid when the conversion was done.

When you’re younger than 59½ and it’s been less than five years since you did the conversion, there are about 30 other exceptions to the 10% early distribution penalty. You might qualify for at least one of them.

Each five-year rule isn’t really a full five-year rule.

That’s because the rules consider tax years, or taxable years, not calendar years or 12-month periods. Under the tax code, a tax year starts on the first day of the year.

For example, you can make a contribution to a Roth IRA for tax year 2024 as late as April 15, 2025 (even later if the 15th falls on a weekend or holiday). Or you can convert an IRA as late as December 31, 2024. In either case, the five-year clock starts running on the first day of the tax year, January 1, 2024. So, the five-year period ends less than 60 months from the date of your action.

Why the Rules Usually Aren’t Relevant

As I said above, the second fiveyear rule for the early distribution penalty doesn’t apply to most of my readers and to people taking distributions during retirement, because it doesn’t apply to anyone older than age 59½.

The first five-year rule also won’t be relevant to most of my readers because of what are called the ordering rules for Roth IRAs.

After a period of time, your Roth IRA will hold at least two types of assets. There will of course be the principal, which will be either the amount you contributed to or rolled over to the Roth IRA via a conversion. You might have more than one type of principal, but most Roth IRAs don’t.

Then, there will be earnings on the principal, such as appreciation, capital gains, interest, dividends, and perhaps other types of earnings.

When you take a distribution from a Roth IRA that is less than the full IRA value, the ordering rules determine whether the distribution is of principal or earnings.

Under the ordering rules, the first distributions are principal. Only after all principal is distributed are accumulated earnings distributed.

Distributions of principal from the Roth IRA aren’t taxable, because you already paid taxes on them. The five-year rule doesn’t apply to principal distributions, because principal distributions are tax free regardless of when they are made.

Income taxes aren’t an issue until all the principal is distributed and earnings are distributed.

The ordering rules also state that contributions are distributed first, then converted amounts and finally earnings.

When there were conversions in different years, the conversions are considered to be distributed on a first-in, first-out basis. So, the first conversions are distributed first, and the most recent conversion is distributed last.

These details are only for Roth IRAs. For Roth 401(k)s the rules are a little different. I won’t go into them now.

You should see that the five-year rules don’t matter to most people who are in or near retirement. They’re older than age 59½.

They’re also likely to withdraw money gradually over time. They’ll withdraw principal first, which always will be tax free. Income taxes aren’t relevant until all the principal has been distributed.

When a Roth IRA distribution isn’t taxable, it also isn’t included in adjusted gross income or modified adjusted gross income for determining the amount of taxable Social Security benefits, the Medicare premium surtax, and other Stealth Taxes.