The 5 Year Rule for Roth IRA Qualified Distributions

The basics of the Roth IRA include the phrase "Tax Free Money". That phrase makes the Roth IRA the most attractive retirement planning tool of our time. When it comes to the intricacies of the Roth IRA, in regards to how it works, some confusion can set in. One provision of the Roth IRA that can leave many scratching their heads is the Five Year Rule. The Five Year Rule pertains to when you can take qualified distributions from your Roth IRA tax and penalty free. Nobody wants to pay tax and penalties, right? That's why it's important to know how this rule works.

Just to add more fun to the mix, you need to first know that there are two sets of Five Year rules. One pertains to Roth IRA contributions and the other pertains to Roth IRA conversions. We'll begin with Roth IRA contributions.

Roth IRA Contributions and Five Year Rule

In order for you to take money from the Roth IRA tax and penalty free, it has to be considered a "qualified distribution". We'll get to what a qualified distribution is in one moment. First thing I need to remind you is that all contributions can be taken at any time, tax and penalty free. That means what you put into the Roth IRA (contribution) can be taken out the following day without consequence (not factoring sales charges and market risk). Let me illustrate:
Example 1 You open a Roth IRA at your bank and decide to put $5000 into a money market account inside the Roth. A month goes by and something happens where you need to withdraw your money. You can withdraw the original $5000 tax and penalty free. What has to stay is the earnings or, in this case, the interest that you made off the $5000 (which should be minimal considering you didn't have it that long). Now keep in mind, the bank may charge you some cancellation fee of some kind, so read the fine print. But as far as the IRS is concerned, you are in the clear.
Example 2 Just to illustrate another side of the first example, let's say this time you decide to invest at a brokerage firm and choose an investment more tied to the stock market. After a month goes by, your original $5000 investment now plummets to $3000. (I think a lot of people can relate to that). All you are allowed to withdraw is the $3000. That's it! Sometimes that gets overlooked. Also, if you paid a sales charge or commission on that investment, that's not being refunded to you either.

What is a Qualified Distribution for Roth IRA?

What's so important about a qualified distribution? If it's deemed qualified, you then avoid taxes and the 10% early withdraw penalty. Taken directly from IRS pub 590 this defines what qualified distribution is:
A qualified distribution is any payment or distribution from your Roth IRA that meets the following requirements.
  1. It is made after the 5-year period beginning with the first taxable year for which a contribution was made to a Roth IRA set up for your benefit, and
  2. The payment or distribution is: