Roth IRAs are generally a retirement saver’s dream. Although the amount you contribute is limited and is contributed as after-tax money, when you withdraw from the account in retirement, you pay no tax on the withdrawal. It’s an amazing deal.

You invest your contribution in your Roth IRA with the hope that the assets will help support you in retirement. Because you put in after-tax dollars, you do not pay tax again on the withdrawals as long as you meet the requirements.

If you’re taking out money before you’re 59 ½, make sure you only take out what you put in. If you’re taking out money before you’ve had a Roth with contributions for 5 years, make sure you only take out what you put in, regardless of your age.

The 5-Year Rule, Part 1

This means you can’t touch the earnings on your contributions until you’ve had an account open for 5 years and you’re either over age 59 ½ or you meet special exceptions. These exemptions include: being disabled, using the funds to purchase a first home, or distributions made to a beneficiary or estate after the death of the original account owner.

There are a few other exceptions to paying the 10% tax penalty for early distributions but those are less common, so I refer you to the IRS website if you think you might qualify for an exception.

This 5-year rule seems to exist to prevent people contributing to a Roth, investing it, and immediately taking out the earnings tax-free, thus avoiding the capital gains tax. If you take out any earnings early, you must pay a 10% penalty on your withdrawal. Roths are supposed to be long-term investing tools, not a tax dodge.

The 5-year clock starts with the tax year of the first contribution, meaning that if you contributed between January 1, 2016 and April 18, 2017 for tax year 2016 (the deadline for 2016 contributions), the clock starts January 1, 2016. Additionally, you can aggregate Roth accounts, so if you opened an account at Vanguard and contributed for 2016 and two years later open one at Schwab, the clock for both accounts started January 1, 2016.

If you have a Roth 401(k) or other Roth option through your employer, the clock runs separately for those accounts; they are not aggregated with any accounts you personally own outside your employment.

You are still only allowed to contribute $5,500 per year ($6,500 if you’re age 50 or over) to all personal Roth accounts, so there’s no tax benefit to opening multiple accounts, and your income must fall between $5,500 – $186,000 if you’re married filing jointly and between $5,500 – $118,000 if you’re single to contribute the full amount (unless you do a backdoor Roth contribution).

The 5-Year Rule, Part 2

There is a second instance of the 5-year rule: if you convert money from an IRA to a Roth or you roll over money from an employer retirement plan (such as Roth 401(k)) into your personal Roth account, that money has its own 5-year clock before you can make withdrawals on it. The clock for conversion money starts January 1 of the year you made the conversion. While contributions can be made up until the April tax filing date for the previous year, conversions only count in the year you make them.

Whenever you take a distribution, this is the order the funds come from:

1. Regular Contributions (never taxed)
2. Conversion/ Rollover amounts (the first money in is considered to be the first money out; earlier conversion money comes out before later conversion money – or FIFO). Conversion/ Rollover money less than 5 years old is taxed as follows:
   1. Taxable portion (meaning the amount you’d include in gross income on your taxes because of the conversion or rollover)
   2. Nontaxable portion
3. Earnings on contributions

Roth IRAs are powerful tools with a good bit of flexibility, and this is why we’ve written many articles extolling their virtues. Where else can you get tax-free withdrawals from your investments? We even recommend contributing to your Roth if you can’t afford it because we firmly believe that by the time you’re withdrawing from your Roth in retirement, you’ll be glad you stored away money and invested for the long term.

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