It’s no secret that I am a big fan of Roth accounts and the income tax-free growth they offer. They can be excellent tools for both retirement planning and estate planning; but, it’s important to understand the rules before taking a distribution so you can reap the benefits without any penalty.
What is the 5-Year Rule?
The 5-year rule is one that often comes up in regard to Roth TSP and Roth IRAs. The 5-year rule states that the account has to be open for five years before withdrawals of earnings can be taken without a penalty. Keep in mind that a person must also retire in the year they turn age 55 to have penalty free access to TSP funds (but not Roth TSP), and for a Roth IRA and Roth TSP a person must be 591/2 to make withdrawals.
Here’s the tricky part: EACH must satisfy its own 5-year rule. This means that having funds in Roth TSP for five years doesn’t mean you can forego the requirement for a Roth IRA. They are independent of one another.
How the Five Years is Calculated
For the purpose of determining your timeline, Roth IRAs can be broken down into two types:
- Contributions
- Conversions
Contributions to the Roth IRA start the 5-year period on January 1st of the first year of funding. Below is an example.
Joe Federal funds his Roth on April 15th of 2022 for tax year 2021.
His 5-year period starts on 1/1/2021.
Penalty-Free Withdrawals in Retirement
There is one more important thing to know about Roth IRAs and the 5-year rule – you can take your contributions out at anytime without penalty. It is the growth on contributions (earnings) that cannot be accessed at any time without penalty.
Here’s an example:
Joe Federal has put $20,000 in his Roth IRA over the past 3 years. He retires at 57 and decides he wants to take some money from his Roth IRA. He is allowed to withdraw $20,000 with no penalty. Even if his account has grown to $30,000, he can always withdraw the $20,000 of contributions.
The ordering rules for Roth IRA distributions are:
- Principal contributions
- Roth IRA conversion
- Investment earnings
Roth TSP distributions
Roth TSP distributions are different. To start, account holders don’t have penalty free access to Roth TSP if they retire prior to 591/2. Unlike a Roth IRA, distributions from Roth TSP are prorated between principal and earnings.
If Joe Federal has $40,000 in Roth TSP and has contributed $30,000, then 75% of his distribution from Roth TSP will be contributions and 25% will be earnings.
If he takes a $10,000 distribution from Roth TSP, $7,500 of it will be contributions and therefore no taxes or penalty. However, the additional $2,500 will be subject to income taxes and the 10% IRS penalty.
Roth Conversions
Roth conversions have their own 5-year time period, and each individual Roth conversion starts a new 5-year waiting period. If you were to convert funds to a Roth IRA and try to access the funds prior to the end of the waiting period, you would incur a penalty.
But, there is an exception for Roth conversions: the accountholder is at least 591/2 years old.
Joe Federal decides to do a Roth conversion for $20,000 from his IRA at the age of 61. He has a Roth IRA that has been open for eight years. Since he has had a Roth IRA open for five years or longer and he is age 61 he will have immediate access to the $22,000 of funds in his Roth IRA.
If Joe Federal was under the age of 591/2, he would have a waiting period before being able to access his funds.
Implications of the holding period
While this may seem like a lot of rules to navigate, it doesn’t have to be that difficult. If you retire in your 50s and you plan to take withdrawals from TSP, there are two simple things that you can do.
- Only take withdrawals from traditional TSP and leave Roth TSP alone.
- Transfer your Roth TSP to your Roth IRA.
Each of the steps above will prevent you from paying unnecessary taxes and penalties on the Roth portion of your retirement. One other thing that you can do right now to limit your chances of having to pay any penalty on Roth IRA distributions is to start a Roth IRA.
I believe that Roth IRA and Roth TSP are both phenomenal retirement planning tools, but that doesn’t mean that there aren’t rules and obstacles you may need to navigate. This is just one of the retirement planning issues that we help our clients navigate at Bobb Financial. If you are at or near retirement and would like help navigating finances in retirement you can schedule an introductory phone call here.
Brad Bobb, CFP® is the owner of Bobb Financial Inc, and an expert in retirement planning for federal employees.