Roth IRA 'five-year rule' can trigger an unexpected tax bill: Here's what you need to know

LTC Eugene Chu
..."Your initial Roth IRA contribution starts the clock on something called the "five-year rule," said Ed Slott, a certified public accountant and IRA expert based in Rockville Centre, New York. In basic terms, that rule requires Roth IRA owners have their account for five or more years to avoid paying income tax on any withdrawn investment earnings.

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"That's what we call a 'forever clock,'" Slott said. "Once it starts, it never stops."

Here's how it works, and why it's smart to watch the clock on your Roth IRA.

Flouting the '5-year rule' can mean earnings are taxable
Roth IRAs are 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 earnings — free of tax and penalties in old age.

But retirement accounts come with many rules to prevent potential tax dodges — 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 because you've already paid income tax on those funds.

However, the same isn't always true for investment earnings on those contributions.

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Avoid this investing mistake with your Roth IRA
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In tax lingo, a Roth IRA withdrawal must be a "qualified distribution" to avoid taxes or penalties. Taxes on investment earnings are at "ordinary income" tax rates, not the preferential tax rates for capital gains.

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

Age: You may be hit with a 10% tax penalty and income taxes on any investment earnings you withdraw before age 59½. (There are some exceptions to this "early withdrawal" penalty.)
Time: Here's where the "five-year rule" comes into play. Roth IRA owners must have their account for at least five years to avoid paying income tax on any withdrawn investment earnings.
Here's a simple example: Let's say a 60-year-old contributed $6,000 to a Roth IRA in January 2020. It's the saver's only Roth IRA and the first time they've contributed money to such an account. The investment has earned about $1,500. In 2023, the saver, now 63 years old, decides to withdraw the full $7,500."...

Good info.