The five-year holding rule begins on the first day of the year for which you made your initial Roth IRA contribution (or converted a traditional IRA to a Roth). Once you’ve held your Roth funds for five years and have reached age 59 1/2, all funds you withdraw from your Roth will be tax- and penalty-free whenever you withdraw them.
For example, if 2016 was the first year you made a contribution to your Roth IRA, then on Jan. 1, 2021, you would have satisfied your five-year holding period and any funds you withdrew from your Roth (even if you withdrew the entire account) would be tax- and penalty-free.
But let’s say you first opened your Roth for the 2019 year. It’s still likely you won’t pay any taxes on funds withdrawn because there are ordering rules on withdrawals from your IRA. Yes, you will not satisfy your five-year holding period until 2024, but that applies only to the earnings on your Roth funds, and those funds are deemed to be distributed last, after you’ve withdrawn all your Roth contributions and conversions.
Under the tax law, Roth funds are deemed to come out in a certain order, called ordering rules, based on three baskets of funds. The first basket of funds deemed to be distributed is your original Roth IRA contributions. The next basket is your converted Roth funds. The third basket is earnings on your Roth funds. These ordering rules apply to all your Roth IRA funds together, no matter how many Roth IRAs you may have. Under the tax law, all your Roth funds are considered one pot.
Your original Roth contributions and converted funds (if any) will come out tax-free. If you do withdraw so much that you reach the earnings basket (after your Roth contributions and conversions are fully withdrawn), then the next funds you take out will be deemed to come from your earnings, and those will be taxable if you withdraw them before 2024, but you still won’t face a 10 percent penalty, because that can never apply to you.
Here is an example: Let’s say you first contributed to your Roth for 2019 and you contributed the maximum allowed, which was $7,000. Then in 2020 you converted $30,000 from your IRA to your Roth IRA. Let’s assume that the earnings on that $37,000 total was $6,000, so now you have a total of $43,000 in your Roth IRA. The first $37,000 (the total of your Roth contributions and converted funds) is tax-free whenever it’s withdrawn, and the $6,000 in earnings will be taxable if it’s withdrawn before 2024.
Let’s say you’d like to withdraw $15,000 from your Roth right now (in 2021). There will be no tax on that withdrawal because the first $7,000 is deemed to come from your 2019 Roth IRA contribution and the next $8,000 is deemed to come from your converted funds. Withdrawals from both baskets are tax-free. You won’t reach the earnings basket until all the remaining converted funds are withdrawn. If you need to withdraw all your Roth funds now, then there will be a tax, but only on the $6,000 in earnings. But again, that won’t happen until you’ve withdrawn more than $37,000.