here’s what you need to know

A Roth IRA is a type of after-tax retirement account. Since Roth IRA owners pay income tax on contributions, they can generally withdraw their savings — and any investment income — tax- and penalty-free into old age.

But retirement accounts come with a number of rules to prevent potential tax evasion — and Roth IRAs are no exception.

Contributions to a Roth IRA are always tax- and penalty-free. You can withdraw them at any time and at any age as you have already paid income tax on those funds.

However, those contributions don’t always translate to investment income.

In tax lingo, a Roth IRA withdrawal must be a “qualified distribution” in order to avoid taxes or penalties. Investment income is taxed at “ordinary income” tax rates, not at the preferential tax rates for capital gains.

There are two requirements for a withdrawal to count as a qualified distribution:

• age: You may be subject to a 10% tax penalty and income tax on any investment earnings you withdraw before age 59½. (There are some exceptions to this “early withdrawal” penalty.)
• Time: Here is where the “five-year rule” comes into play. Roth IRA owners must have had their account for at least five years to avoid paying income tax on any withdrawn investment income.

Here’s a simple example: Let’s say a 60-year-old contributes $6,000 to a Roth IRA in January 2020. This is the saver’s only Roth IRA and the first time they have contributed money to such an account. The investment has earned approximately $1,500. In 2023, the saver, who is now 63, decides to withdraw the entire $7,500.

You might think that this person is in the clear, since they are over 59½ years old. However, this person will owe income tax on $1,500 of the earnings because the account hasn’t been open for five years. This would not be an eligible distribution.

If you don’t mind doing some advance planning, an easier solution is to stick to the Roth IRA’s five-year rule, Sloat said.

If that same 63-year-old person had contributed to a Roth IRA any time over five years in the past — even if it was just $1 in 1990, for example — their investment income would be tax-free if withdrawn today. (One caveat: Anyone under age 59½ may still have to pay a 10% tax penalty on the income withdrawn, with some exceptions.)

That’s because the five-year holding period “begins with the first tax year for which contributions to the Roth IRA were made for your benefit,” according to the IRS.

In other words, the initial Roth IRA contribution starts the five-year clock, Slott said. It begins on January 1 of the year in which the first dollar is contributed. Slot said that clock runs forever and is not reset if future contributions are made, or if the account is closed and re-opened.

Slott said savers who are eligible to contribute to a Roth IRA should open one now to start the clock to avoid any pitfalls later.

Of course, not everyone is eligible to contribute to a Roth IRA. There are income limits: A single tax filer cannot contribute any money to a Roth IRA in 2023 if their modified adjusted gross income exceeds $153,000. Married couples filing a joint tax return have a MAGI limit of $228,000.

A Roth IRA conversion is one way to circumvent these income limits. And there’s another way to start the five-year clock for qualified distributions, Slott said — though he advised that there’s a separate five-year rule for converted money that could trip taxpayers under 59½.

Another important note: The five-year clock may still apply if you inherit a Roth IRA from the deceased account holder.

Ultimately, though, retirement savers who use their accounts as envisioned by the tax code — as a vessel of savings for the long term and for use in old age — have little to fear from any of these tax rules. Not there.

“If you use the Roth the way it’s intended, you won’t need to know the five-year rule,” Slott said.