Five-Year Rule

One of the most common ways people plan for their retirement is by putting money into an Individualized Retirement Account, or IRA. IRAs exist to "force us" to pretty much just leave the money alone once it’s in there; if we try to take it out and use it before we hit the magical age of 59 ½ years old, we pay big penalties–-like ten-percent-of-the-amount-we-withdrew big-–for doing so.

No, seriously, the penalties can be yuuuge. If we take ten grand out of our IRA to, say, pay off our credit cards, we’re going to have to pay an extra $1,000 in fees. So, basically, we’re paying $11,000 to use $10,000 of our own future money–-and we’re losing all the interest that money would have gained if we’d just let it be. And to add insult to injury, we’d also have to pay income tax on the money we take out.

But what happens if someone with an IRA passes away before they turn 59 ½? What do the IRA’s beneficiaries do? Well, they invoke the five-year rule, which allows them to go ahead and start withdrawing money from that account, or rolling it into their own retirement account, without facing any withdrawal penalties.

They can also put money into the account, if they want, but with one caveat: within five years of the original accountholder’s death, the money in the account has to be completely distributed. So if we choose to put money into an inherited IRA, we’re going to have to close it out or roll it into something else within five years. Hence the name of the rule.