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Understanding the Roth IRA 5-Year Rule

Roth IRAs offer the advantage of tax-free withdrawals during retirement, provided IRS rules are followed. One key rule is the five-year rule, which requires you to wait at least five years before withdrawing earnings from a Roth IRA to avoid penalties.

How Does the Roth IRA 5-Year Rule Work?

A Roth IRA allows for tax-free withdrawals, but with a caveat. While you can withdraw your contributions anytime without penalty or taxes, earnings are subject to a holding rule. Under the five-year rule, the account must be open for at least five years from the tax year of your first contribution before you can withdraw earnings without penalties.

When Does the 5-Year Rule Start?

The five-year period starts on January 1 of the tax year of your initial contribution, not the actual date you made the contribution. For example, if you contributed on July 22, 2022, you could make a penalty-free withdrawal of earnings starting on January 1, 2027.

Conversions and inherited Roth IRAs also fall under the five-year rule. Each conversion has its own five-year waiting period, separate from the five-year period for contributions. Following the IRS’ ordering rules can help you avoid breaking the five-year rule.

When Can You Withdraw Money From an IRA Without Penalties?

You can withdraw regular Roth IRA contributions at any time tax-free and penalty-free since you’ve already paid taxes on contributions. However, whether you pay penalties on other withdrawals depends on if the funds meet the five-year rule.

Qualified Distributions

After meeting the five-year rule, any distribution is considered qualified if you meet at least one of the following conditions:

• You’re at least age 59½.
• You’ve become permanently disabled.
• You are the beneficiary of a deceased IRA owner.
• You’re using the funds to purchase, build, or rebuild a first home (up to a $10,000 lifetime maximum).

Non-Qualified Distributions

Non-qualified distributions do not meet the conditions of a qualified distribution and are subject to regular income tax and a 10% early withdrawal penalty, unless one of the following exceptions applies:

• Paying for qualified higher educational expenses.
• Covering unreimbursed medical expenses exceeding 7.5% of your adjusted gross income.
• Covering health insurance premiums during unemployment.
• Part of a series of substantially equal payments.
• Due to an IRS levy of the IRA or retirement plan.
• Qualified reservist called to active duty for more than 179 days.

How to Get the Most out of Your Roth IRA

Having a Roth IRA as part of your retirement strategy provides tax advantages, allows you to diversify your retirement savings, and offers additional withdrawal options. Here are some tips for maximizing your Roth IRA:

• Contribute the maximum amount each year.
• Start contributing as early as possible to benefit from compound interest.
• Diversify your investments to balance risk and growth potential.
• Choose low-cost investments to avoid high fees eating into your returns.
• Avoid early withdrawal of earnings to prevent taxes and penalties.

Roth IRA vs. Traditional IRA vs. 401(k)

Before contributing to a Roth IRA, it may be beneficial to max out your 401(k) or traditional IRA contributions, especially if your employer offers a 401(k) match. These contributions reduce your taxable income. If you expect to be in a lower tax bracket during retirement, contributing to a 401(k) or traditional IRA can help you defer taxes.

Contributing to a Roth IRA may be more beneficial if you expect to be in a higher tax bracket during retirement. You’ll pay lower taxes on your contributions now, and your retirement withdrawals will be tax-free. Roth IRAs also allow you to withdraw your contributions anytime without incurring taxes or penalties, giving you more control over your withdrawals since distributions aren’t required during retirement.

The Bottom Line

Before making a withdrawal from your Roth IRA, ensure you’re following the five-year rule and other guidelines to make your withdrawal both tax-free and penalty-free. Saving for retirement is crucial for a solid financial plan. Keeping an eye on your credit as you head for retirement is also important, especially if you anticipate needing to borrow money.

For any mortgage-related needs, call O1ne Mortgage at 213-732-3074. We’re here to help you navigate your financial journey with confidence.

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