Roth IRAs are individual retirement accounts which you fund with after-tax income. While these types of retirement accounts may sound appealing, there’s one factor that’s often overlooked: the five-year rule.
The 5-year rule
If you’ve made contributions to a Roth IRA, this is considered a long-term investment. For this reason, the IRS has rules about when you can start withdrawing earnings.
You’ll need to wait at least five years after you made your first contribution to withdraw without penalty. It’s important to remember the IRS calculates the five years based on the tax year you first contributed, not the calendar year.
If you make your first contribution near the end of the tax year, you’ll likely only have to wait about four years instead of the full five.
Penalties for withdrawing early
A major benefit of Roth IRAs is that you won’t have to pay tax on earnings. Although, if you can’t wait five years before withdrawing, say goodbye to that perk.
Penalties for withdrawing from Roth IRAs before five years include a 10% penalty, as well as mandatory income tax on all earnings. This could translate to as much as a 40 percent penalty on earnings. Ouch.
The easiest way to avoid these penalties is to plan your financial future. If you don’t plan on touching Roth IRA earnings in five years, go ahead and start contributing. However, if you’re financial future isn’t so certain, it’d be best to postpone opening a Roth IRA account until you’re more financially stable.
As with anything, there are a few ways to get around the five-year rule.
For instance, if you’re a planning on buying your first home, the IRS will allow you to withdraw Roth IRA funds without penalty. In addition, you can withdraw early if you become seriously ill.
Yes, these are exceptions. But again, you shouldn’t be contributing to a Roth IRA account if you can’t wait five or more years to reap the rewards.