Understanding the "Five-Year Clock" to Avoid Roth Distribution Penalties

Both Roth IRA and Roth 401(k) accounts are rising in popularity due to their benefit of tax-free retirement income. Our previous two-part series explained important information about these two accounts: The first article explained basic differences in their features, and the second covered contribution and distribution differences. Based on some reader questions we received, in this article we delve a bit deeper to cover the all-important five-year holding rule.

Understanding the five-year rule for Roth IRAs and Roth 401(k)s ensures that individuals avoid taxes and/or penalties on their retirement investments and successfully reap the full financial benefits of a qualified distribution. 

Requirements of the Five-Year Rule
“Qualified distributions” from a Roth account are income tax free. Whereas non-qualified Roth distributions may or may not be tax free. A qualified distribution requires the following:

1.  An individual must hold the account for five years prior to receiving the distribution, and

2. The distribution must take place on or after the date the account owner turns age 59 ½. 

The exception to this rule occurs when an account holder suffers total disability or death before an account meets these requirements. For Roth IRAs only, a distribution up to $10,000 for the purchase of a “first home” qualifies for tax-free distribution.

The Five-Year Rule for Roth IRA Contributions

To be deemed “qualified” to receive tax-free distributions from a Roth IRA, the account holder must meet the requirements of the five-year rule. The five year “clock” begins the first time funds (whether through contributions or conversion) are deposited into any Roth IRA, regardless of where an individual establishes the account. Again, for an account holder’s distributions to qualify as tax free, they must, regardless of age, have at least one Roth IRA in their name for five years. (All examples provided herein are hypothetical and do not reflect actual client experiences.)

Example 1: Amy made her first Roth IRA contribution on August 1, 2015. Now, in 2022, Amy is age 60. Since she is over 59 ½ and established her Roth IRA account more than five years ago, she now qualifies for tax-free distributions.

The five-year hold period is measured from the beginning of the tax year for which it applies. Therefore, Amy’s hold period begins January 1, 2015. Her hold period is satisfied on January 1, 2020. 

Practice Tip: The five-year clock does not restart for each Roth contribution or new account owned. Instead, all an individual’s Roth IRAs are aggregated, allowing for an owner to roll over or transfer their Roth IRA to a new IRA custodian without restarting the five-year requirement. The only exception to this rule applies to inherited Roth IRAs or Roth 401(k)s.

The Five-Year Rule for Roth IRA Conversions

The 10% early withdrawal penalty is waived when a person under the age of 59 ½ makes an in-plan Roth 401(k) or Roth IRA conversion. Then, they must wait five years before withdrawing these converted funds. Should a person make a withdrawal before the end of this five-year period, the 10% penalty (known as the IRS 10% recapture tax), will apply. There is also a separate five-year clock for qualified distributions.

Example 2: In 2020, Bari converted $50,000 to her Roth IRA. This is the only Roth IRA she owns, and it consists only of converted funds. In 2022, Bari withdraws $50,000 at the age of 42. She will be subject to the 10% IRS recapture tax due to early withdrawal, which amounts to $5,000 because the five-year rule was not satisfied. 

Practice Tip: Each Roth conversion starts its own five-year clock. When owners complete more than one conversion, they may acquire different five-year waiting periods before receiving qualified distributions. To minimize this occurrence, make conversions at the same time whenever possible.

The Five-Year Clock and Multiple Roth 401(k) Plans

Participants in a 401(k) plan, upon separating from service, have a decision to make—what to do with their 401(k) account, including Roth 401(k) funds. Their decision consists of leaving the assets in the plan, rollover to a new employer’s retirement plan (that offers a Roth option), rollover to a Roth IRA, or cash out—leading to questions around the Roth five-year rule and rollovers. Notably, a conversion to a Roth IRA is not relevant as the assets are already Roth funds. Moreover, Roth employer plan funds are not permitted to be rolled over to a traditional, SEP, or SIMPLE IRA.

There are variables moving employer Roth funds—the distribution will be either (1) qualified or (2) non-qualified. Furthermore, the rollover will be either (1) a direct rollover or (2) a 60-day rollover. Each variable has its own set of rules (see chart below).

Notably, a participant who owns a Roth plan account (across multiple employers) has a separate five-year clock toward a qualified distribution.  However, the existing plan holding period can be rolled over to a new employer’s Roth 401(k). However, the existing holding period can be directly attributed to the new employer’s Roth 401(k) plan, but only in an instance where the funds are moved via a direct transfer. Whereas if the funds are moved via a 60-day rollover, the existing holding period, instead, becomes that of the new employer’s Roth 401(k). 

Example 3: George, age 63, worked at PNQ Inc. from 2008 to 2017 and had a Roth 401(k). He can take a qualified distribution from his Roth 401(k) at PNQ because that Roth account has been held for more than five years, and George is over 59 ½.

From 2018 to 2021, George then worked for XYZ Inc. where he had a separate Roth 401(k). In this case, he cannot take a qualified distribution from this Roth account as it does not satisfy the five-year requirement. The time accrued from the PNQ Roth 401(k) plan does not count toward his Roth account held in XYZ’s plan.

However, George can now complete a direct rollover from his PNQ 401(k) to XYZ (only if XYZ Inc. allows for rollovers), while also transferring the time accrued from PNQ’s Roth 401(k). This will allow George to take qualified distributions from his Roth account held at XYZ.

If George instead opted for a 60-day rollover, the rollover would not be allowed. Because only pre-tax funds can be rolled over. A qualified Roth distribution consists of all after-tax money!

Rollovers from a Roth 401(k) to a Roth IRA

Roth 401(k) funds rolled over to a Roth IRA will always use the five-year holding period associated with the Roth IRA (assuming an account has been established). Any holding time in the 401(k) plan is lost. 

Example 4: Anthony worked at A Life’s Dream Inc. for 25 years and first participated in the company’s Roth 401(k) plan in 2010. Now, in 2022, at the age of 65, he is retiring. Anthony can take a qualified distribution since he is over age 59 ½ and has held his Roth 401(k) for more than five years.

Anthony (now retired) elects to roll over his Roth 401(k) funds into a Roth IRA—the first Roth IRA he has ever established. Because the “clocks” relating to his Roth 401(k) and Roth IRAs are not aggregated, the Roth 401(k) funds will not be eligible for a qualified distribution from his Roth IRA. In other words, Anthony loses the time he held the funds in his Roth 401(k) plan. Importantly, if Anthony had had a Roth IRA for five years prior to this rollover, the funds would then meet the requirements of a qualified distribution. 

Practice Tip:  Participants that have Roth employer plan (401(k), 403(b), 457(b)) funds should establish a Roth IRA (through direct contributions, conversion, or back-door”) as soon as possible—any of these funding methods start the five-year clock. 

Roth accounts, given the option of tax-free income, are very attractive. It’s critical the account owner is familiar with the rules that must be satisfied to generate tax- and penalty-free income. We strongly urge individuals, prior to taking income from a Roth account (IRA or 401(k)), to have a thorough discussion with their tax and financial professional.

Key Takeaways:

·  Roth 401(k)s and Roth IRAs offer the ability to receive tax-free income in retirement. To avoid taxes and or penalties, accounts must be held for five years, and the individual must be at least age 59 ½, disabled, or have died.

·  Each of the five-year rules are measured from the beginning of the tax year for they apply.

·  To satisfy the five-year rule, account holders should know that the total holding period of all Roth IRAs in their name is aggregated. The five-year period begins the first time any contributions or conversions are made into a Roth IRA.

·  The 5-year hold period for Roth employer plan funds is determined separately

·  A separate five-year clock applies to an inherited Roth IRA.

The five-year Roth holding rule is a tricky subject, so it’s wise to consult with experts. To learn more, contact your financial or tax professional.