What The Roth IRA 5-Year Rule Stipulates

Understanding how to best utilize a Roth IRA takes some patience and a little bit of research. Of course, this account is an investment vehicle that allows you to buy and sell stock. It's not a savings account that accrues interest, but rather an active, evolving investment portfolio that requires care and maintenance. This means anyone relying on their Roth IRA to fund a portion of their retirement will need to understand how stock investing works. Fortunately, the stock market isn't an unfriendly place for beginners who are learning to trade for the first time. (Here are 10 tips for investing in stocks as a beginner.)

After you've started to make strides with your portfolio, you might consider other avenues for your funding. For example, 401(k) owners who have been dutifully contributing with the help of employer matched funds might be interested in rolling over their investment into their Roth. And the opposite might apply for some investors as well. This said, one thing that is often considered a mistake with your retirement accounts is an early withdrawal. These all might seem like varied and unique needs and decisions, but they actually all play by the same, very important rule that governs the Roth IRA landscape. Roth owners must adhere to the five-year rule when doing just about anything with their funding other than making deposits and trading shares.

Essentially, this five-year rule (imposed by the IRS) governs your tax liability, among other things. If you've owned the account for five years, it's able to offer the tax advantages outlined in its general benefits. Specifically, a Roth IRA is funded with money that's already been taxed. When you withdraw those funds, they're treated as yours, including the earnings, which grow tax-free. But if you haven't maintained the account for a minimum of five years before you begin to withdraw funds, then this exemption no longer applies. There are other rules to consider as well, but this one's the easiest to overlook, potentially sinking an individual's retirement planning.

Fortunately, the five-year rule doesn't really come into play for those who've been planning their retirement since they were young. If you've been diligently contributing to your Roth throughout your working years, you're almost certainly not going to need to worry about a five-year minimum. Instead, you'll be primarily bound by the need to wait until you turn 59 ½ to access the earnings penalty- and tax-free.

This said, the five-year rule applies to conversions from a Roth IRA to another type of account as well, so it can come into play if you're thinking of changing your savings tactics earlier in life. All you need to remember is that waiting until your account has been around for five years will help you to avoid any potential penalties or complications, regardless of whether you're planning on moving the money or withdrawing it. (On a related retirement-account note, this is why cashing out your 401(k) early can come with major consequences.)

While the rule might seem straightforward, there are some additional quirks that Roth IRA owners will want to keep in mind. First, the five-rule doesn't reset the clock if you choose to move your funds from one broker to another. For instance, some savers will begin their retirement planning with the help of an investment professional who will handle your trading and investment decision-making for you — for a fee, of course. Later on, however, you might decide to move the funds under your direct control. The five-year rule relates to the account's total history, not the body managing the money. You therefore will not need to wait five years from the time you move the account to begin using it. (Learn if you can contribute to a Roth IRA after retiring.)

It's also worth noting that a contribution counts for the entire year, and isn't calculated by calendar date. Your first year of use is counted as a full year, regardless of whether you made your deposit in January or December. Beneficiaries also feature in this conversation. In order to distribute funds to a beneficiary without penalties, the account must have existed for five years (owned by the original contributor, not five years from when a beneficiary takes ownership).