More and more 401(k) plans are making Roth employee contributions available, and employees leaving their jobs often want to roll over Roth 401(k) funds to a Roth IRA. What tax rules apply to distributions of amounts rolled over? Warning: The rules are complicated because they involve two five-year holding periods, one for the Roth 401(k) distribution and the other for the Roth IRA distribution.
If Your Roth 401(k) Distribution Is Qualified
Step one is to figure out if your Roth 401(k) distribution is qualified; that is, if you are age 59½ or older (or disabled) and have satisfied a five-year holding period. The holding period begins on January 1 of the year you made your first Roth contribution to the current plan (or did a rollover of Roth funds into the plan or an in-plan Roth conversion). Roth contributions made to other plans (or IRAs) don’t count.
If your Roth 401(k) distribution is qualified, you can immediately withdraw tax-free the entire rolled-over amount (both the Roth 401(k) contributions themselves and associated earnings) from your Roth IRA. What about earnings generated after the rollover? You can’t withdraw those earnings tax-free until the five-year holding period for your Roth IRA has been satisfied. The Roth IRA clock begins on January 1 of the year you made your first contribution (or conversion) to any Roth IRA. (That’s why it’s so important to make a Roth IRA contribution – no matter how small – as early as possible to get the clock ticking.) Importantly, you cannot carry over the Roth 401(k) holding period and use itto satisfy the Roth IRA holding period. But if your Roth IRA is distributed after the Roth IRA holding period has been met, then you’re all set: Everything comes out tax-free and penalty-free.
If the Roth IRA holding period hasn’t been met (because, for example, the rollover is your first Roth IRA), then you have to wait out five years before withdrawing your post-rollover earnings free of taxes. But, again, the original amount rolled over can always be withdrawn without tax or penalty.
If Your Roth 401(k) Distribution Is Not Qualified
What if your Roth 401(k) distribution is not qualified? In that case, you can immediately withdraw tax-free only the rolled-over Roth 401(k) contributions from your Roth IRA. Both the rolled-over Roth 401(k) earnings and any post-rollover earnings come out tax-free only if the Roth IRA distribution is qualified; that is, you’re age 59½ or older (or disabled or using the funds for first-time homebuyer expenses) and you’ve satisfied the Roth IRA five-year holding period (discussed above).
If the Roth IRA distribution is not qualified, then you’ll pay taxes (and possibly the 10% early distribution penalty) on both the rolled-over earnings and post-rollover earnings out of the Roth IRA. But the rolled-over Roth 401(k) contributions can always be distributed free of taxes and penalty.
I said it was complicated! Consulting with a knowledgeable financial advisor prior to any rollover is highly recommended.
If you have technical questions you would like to have answered, be sure to submit them to mailbag@irahelp.com, to be answered on an upcoming Slott Report Mailbag, published every Thursday.
Specializing in private wealth management, we provide education, guidance, and strategies to help you achieve a tax-efficient retirement income.
Specializing in private wealth management, we provide education, guidance, and strategies to help you achieve a tax-efficient retirement income.
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