CLIENT EDUCATION
If you’ve considered opening a Roth IRA but haven’t yet made the move, there’s one very compelling reason to get started now – and it goes beyond the customary tax and investment benefits that a Roth IRA may offer.
Sometimes referred to as the Roth “five-year rule,” it limits your flexibility in using earnings from your Roth IRA until five yearsi after your first contribution.
That’s why it’s important to open a Roth IRA sooner rather than later – even if you start with a minimal contribution – just to get the clock running.
While your contributions – the money you deposit into your Roth IRA – can be withdrawn at any time for any reason without taxes or penalties, the five-year rule applies to any money you may have earned on your investments within the Roth IRA. However, it’s up to you to monitor your account to determine whether you are tapping into your contributions or actually withdrawing earnings from your Roth IRA.
So, if you’d like the option of using your Roth IRA earnings without incurring taxes or penalties to cover important expenses such as retirement costs (after 59½), a first-time home purchaseii, or to provide tax-free income to your beneficiaries, the sooner you open a Roth IRA, the sooner you would be able to take advantage of those options.
The five-year period starts with the tax year of your first contribution, but you can make that contribution as late as the mid-April tax filing deadline in the following year. In other words, a tax time Roth IRA contribution in April 2020 could be credited as a 2019 contribution, which would slice a year off the wait. Be aware that this must be designated as a carryback contribution; otherwise an April contribution would be credited to the current year.
A tax-year-2020 account start would mean that the earnings from your Roth IRA could be used for qualified purposes beginning in 2025.
If, over time, you open multiple Roth IRAs in addition to your original account, the 5-year period start date for all of them would revert back to that of your first account. If you’ve had a Roth IRA since 2017, and then open another in 2022, you wouldn’t have to wait to start making qualified withdrawals of the earnings in your 2022 account (assuming you are age 59 ½ or meet one of the other requirements). Your five-year waiting period would have already elapsed. (Roth IRA conversions made prior to age 59½ have a separate 5-year holding period related to the 10% penalty being applied if you withdraw the conversion amount from the Roth IRA). For more on the five-year rule, see the IRS Publication 590-B.
There are two types of IRAs – traditional and Roth IRAs. More than a third of U.S. households have one or the other – and sometimes both – although relatively few account holders make regular contributions. Only about 12% of American households contribute to an IRA each year, even though most wage-earners would qualify to make annual contributions.iii
Regardless of which type of IRA you choose, you would typically have the flexibility of allocating your contributions to a variety of investments, including a wide range of mutual funds and other securities that may offer the potential for long-term appreciation. However, keep in mind, not all investments increase in value, and may in fact lose money. While past performance is no guarantee of future returns, historically stock and bond markets have been volatile in the short term, but their performance has tended to even out over the long term as the economy moved through its various cycles.
For IRA contribution limits go to IRA contribution rules and limits.
Which type of IRA is right for you? There are several distinctions between the two, as well as some similarities. Both are designed to encourage Americans to save and invest for retirement, and both provide tax-deferred growth on investment gains within the account.
Before you make your choice, you may want to compare the primary benefits and drawbacks of each:
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Traditional IRA |
Roth IRA |
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Contributions may be deductible from your annual income, helping reduce your current taxes. |
Contributions are made with after tax dollars and provide no tax benefit for the current year. |
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Withdrawals of both contributions and earnings are taxed at your ordinary income tax rate. |
Withdrawal of earnings at age 59½ or later (or if you meet any of the other requirements) and after your Roth has been open for the 5-year period, are tax-free. |
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Required Minimum Distributions (RMDs) are mandatory beginning the year you turn 72, and each year thereafter. However, individuals who turned 70 ½ in 2019, must take RMDs in 2019, 2020 and beyond. (See: Required Distributions) |
There are no RMDs for a Roth IRAiv. |
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Working individuals may continue to contribute to their IRA for as long as they have earned income. This represents a change in the tax law as part of the SECURE Act. However, this applies to taxable years after December 31, 2019. For the 2019 tax year, individuals who were 70 ½ or over would not be allowed to contribute to a traditional IRA for 2019. |
There are no age limits on contributing to a Roth IRA. |
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You may roll over a traditional 401(k) to a traditional IRA tax-free, but to roll over a traditional 401(k) to a Roth IRA, you must pay taxes at your ordinary income tax rate. |
You may roll over a Roth 401(k) to a Roth IRA tax-free. (See: Changing Jobs? What to Do with Your 401(k)) |
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Contributions withdrawn face taxes, and penalties will apply if withdrawn before 59 ½ (with certain exceptions). (See: Traditional IRAs for Retirement) |
Although your contributions are withdrawn first without tax or penalty, if investment earnings are withdrawn earlier than five years after the account start date, taxes, and possibly penalties, will apply. (See: Roth IRAs) |
If you’re leaning toward opening a Roth IRA – and you hope to tap into the earnings from your investments at some point in the next several years – the best time to take the leap and start the clock may be right now. (See: Benefits of Roth IRAs Go Well Beyond Retirement)
i IRS Publication 590-B Distributions from IRAs.
ii Maximum $10,000 life time limit for first time home purchase if you or your spouse haven't owned a home in the prior two years.
iii Investing Company Institute, "The Role of IRAs in US Households' Saving for Retirement, 2017."
iv Your beneficiaries would be subject to required minimum distributions.
The concepts in this article are intended for educational purposes only. Check with your organization for any specific policies or procedures they have related to these activities.
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