The five-year holding rule begins on the first day of the year for which you made your first Roth IRA contribution (or converted a traditional IRA into a Roth). Once you’ve held your Roth balance for five years and are 59 1/2 years of age, any balance you withdraw from your Roth will be tax and penalty free when you withdraw them.
For example, if 2016 had been the first year you contributed to your Roth IRA, on January 1, 2021, you would have fulfilled your five-year holding period and any funds you withdrew from your Roth (even if you withdrew those would have the entire account) would be exempt from tax and penalties.
Let’s say you opened your Roth for the first time in 2019. It is still likely that you will not pay tax on funds withdrawn as there are ordering rules for withdrawals from your IRA. Yes, you will not meet your five-year holding period until 2024. However, this only applies to the income from your Roth funds. These funds are deemed to be last distributed after you withdraw all of your Roth contributions and conversions.
Under the Tax Act, Roth funds are assumed to be issued in a specific order called ordering rules, based on three money baskets. The first basket of funds to be deemed paid will be your original Roth IRA contributions. The next basket is your converted Roth balance. The third basket is the profit from your Roth fund. These ordering rules apply to all of your Roth IRA funds together, regardless of how many Roth IRAs you have. According to the tax law, all of your Roth funds are considered to be one pot.
Your original Roth contributions and converted funds (if any) will be issued tax-free. If you withdraw enough to hit the basket of winnings (after your Roth Contributions and Conversions are fully deducted), the next money you withdraw will be considered to be from your income and these will be taxable if you are they withdraw before 2024, but you still won’t face a 10 percent penalty because that can never apply to you.
Here’s an example: let’s say you contributed to your Roth for the first time in 2019 and made the maximum amount allowed, which was $ 7,000. Then in 2020 you converted $ 30,000 from your IRA to your Roth IRA. Let’s say the profit for this $ 37,000 total was $ 6,000. So now you have a total of $ 43,000 in your Roth IRA. The first $ 37,000 (the sum of your Roth contributions and converted funds) is tax-free on any withholding, and the $ 6,000 income is taxable if withdrawn before 2024.
For example, let’s say you want to withdraw $ 15,000 from your Roth now (in 2021). There is no tax on this payout as the first $ 7,000 will come from your Roth IRA contribution for 2019 and the next $ 8,000 will come from your converted funds. Withdrawals from both baskets are tax-free. You will only reach the basket when all remaining converted amounts have been withdrawn. Now if you need to withdraw all of your Roth funds a tax will be charged but only on the $ 6,000 revenue. But again, this won’t happen until you’ve withdrawn more than $ 37,000.