Roth IRAs are a great retirement savings vehicle. You pay tax up front and then watch your money grow tax-free. However, they have a couple of confusing rules that unfortunately are lumped together as a “Roth 5-year rule” which generally leads people to think you need to wait a minimum of five years before you can withdraw money in a Roth IRA account.
There’s really two “Roth 5-year rules”. The first 5-year rule (and the one more likely to be applicable to lawyers) applies to Roth conversions and determines whether the withdrawal of converted principal will be penalty-free (the “5-year conversion rule”). The second 5-year rule applies to Roth contributions and determines whether the withdrawal of earnings will be tax-free (the “5-year contribution rule”).
So let’s take it one step at a time.
The 5-Year Contribution Rule
Roth contributions are direct “front door” deposits into your Roth account. Depending on your income, you may not be eligible to make direct Roth contributions. Roth contributions can be withdrawn at any time, with no penalties or taxes due. You can make a direct Roth contribution on January 1st and withdraw the contribution on January 2nd. This is one of the reasons why Roth IRA contributions can be used as an emergency fund. If you worked for a couple of years before law school, you could make direct Roth IRA contributions and then withdraw the money later should some type of personal disaster require access to the money. Some enterprising law students even make sure to contribute to a Roth IRA during law school, which you can do as long as you have enough earned income each tax year.
Just to emphasize: You can withdraw Roth IRA contributions at any time.
You cannot withdraw the earnings without meeting two tests: (1) it needs to be a qualified distribution, which generally means you must be over age 59 ½ (see IRC Section 408(d)(2)(A)); and (2) the earnings can’t be withdrawn during the 5-taxable-year period beginning with the first taxable year for which an individual made a contribution to a Roth IRA (see IRC Section 408(d)(2)(b)).
So this 5-year contribution rule only applies to earnings and not to the original principal contributions.
The strange quality of this rule is that the clock starts once any money is funded into your Roth IRA (whether by contribution or conversion). This is explained in detail in Treasury Regulation 1.408A-6, Q-2. So, if you’ve had your Roth IRA for longer than 5 years, this rule isn’t an issue for you, which I suspect is the case for the vast majority of readers of this site.
This 5-year-rule makes intuitive sense. The government wants you to use a Roth IRA for long-term retirement planning, so they’ve eliminated any possibility of opening up a new Roth IRA account and withdrawing the earnings during the first five years of the Roth’s existence. So long as you’ve opened up a Roth IRA account early in your investment career, this rule isn’t going to apply to you.
The 5-Year Conversion Rule
Now, let’s tackle Roth conversions. These are made when you convert money from a Traditional IRA to a Roth IRA, therefore it covers all “backdoor” Roth IRA contributions (which are really non-deductible contributions made to a Traditional IRA which are then converted to a Roth IRA). Roth conversions are subject to a separate 5-year rule. Under this rule, you cannot withdraw Roth IRA conversions until five taxable years have passed. Roth conversions are deemed to have occurred as of January 1st of the year in which the conversion happened (see Treasury Regulation 1.408A-6, A-5(b)).
This 5-year rule applies to each Roth conversion (see Treasury Regulation 1.408A-6, A-5(c)). So, if you’re making a backdoor Roth IRA contribution each calendar year, each backdoor contribution has a 5-year clock that starts running on January 1st. You cannot withdraw the contribution without penalty until five taxable years have elapsed. Thankfully, the IRS deems withdrawals to be on a first-in, first-out basis (see IRC Section 408A(d)(4)(B)(ii)(II)), so the oldest conversions are withdrawn first.
In practical terms, it’s ineffective to use backdoor Roth IRA contributions as an emergency fund since you have to wait five years before you can withdraw the funds.
It helps to understand the purpose of this rule by thinking through an example.
Example. Lawyer Larry has a $100,000 Traditional IRA balance. He cannot withdraw the balance because he’s not yet 59 ½. If Larry converts his Traditional IRA to a Roth IRA he will pay income taxes on the conversion. Without the 5-year conversion rule, Larry would then be free to withdraw his entire conversion amount. The result of this would be a complete circumvention of the 59 ½ age requirement. While the 5-year conversion rule doesn’t eliminate this loophole entirely, it means Larry will have to wait five years before he can withdraw his contribution. Note: This is one of the many ways to get access to retirement funds before hitting the age limits, so long as you can plan for the 5-year waiting period.
The bottom line here is that it’s important to understand that we have two 5-year rules. The 5-year conversion rule prevents you from taking a penalty-free withdrawal of converted principal. The 5-year contribution rule prevents you have taking a tax-free withdrawal of Roth earnings.
The 5-year conversion rule is more likely to impact you, although if you’re using your Roth IRA as a retirement vehicle, it won’t be a problem because you won’t be making withdrawals until many years in the future.
Further Reading: Understanding the Two 5-Year Rules for Roth IRA Contributions and Conversions by Michael Kitces.