In a previous post we discussed the general information surrounding Designated Roth Accounts (also known as a Roth 401k) – eligibility, tax treatment, and contributions. In this post we’ll go over the nuances involved in distributions from a Designated Roth Account under a 401k. Distributions are a little different from most other retirement plans, as you’ll see.
Required Minimum Distributions
One of the first things that is different about Roth 401k distributions is that the Required Minimum Distribution (RMD) rules DO apply to these accounts. This is different from the Roth IRA, as RMDs are not required by the original owner under present law. RMD for a Roth 401k are the same as the RMD rules for all other accounts to which the RMD rules apply.
Related: Risks Associated with Investing in Index Funds
There is, however, a way to get around the RMD rule: if you roll over your Designated Roth 401k account balance to a Roth IRA, RMDs no longer apply. Obviously this is a tax-free event, since both accounts are non-taxable in both contributions and earnings. As long as this is done before the first year of RMD, these rolled over funds will never (under current law) be subject to RMD rules to the original owner of the account. When inherited, Roth IRA and Roth 401k funds are subject to RMDs as inherited accounts – but that’s a topic for another day.
Qualified Distributions
Another difference for the Designated Roth 401k account is in the definition of qualified distributions. As with other retirement accounts, qualified distributions can occur when one of the following events occurs:
- account owner reaches age 59½; or
- account owner dies; or
- account owner becomes disabled (per IRS definition).
In addition to one of those events, in order for the distribution to be qualified (and therefore tax-free), the account must have been in existence for at least 5 years.
Non-Qualified Distributions
A non-qualified distribution is, as you might guess, when the rules for a qualified distribution (above) have not been met. Of course, there are complicated rules associated with any non-qualified distribution from a Designated Roth account.
Pro Rata Rule for Non-Qualified Distributions
A pro rata rule applies (instead of the ordering rules that apply to Roth IRA accounts) for non-qualified distributions from a Roth 401k. For example, if the account had received contributions of $5,000 and had grown to $10,000, when a distribution occurs before the account has been in existence for 5 or more years, 50¢ of every dollar will be taxable. This is different from the rule associated with a rollover, as you’ll see.
Ordering Rule
Just to confuse matters, when rolling over a portion of a Designated Roth 401k account to a Roth IRA in a non-qualified distribution, the ordering rules do apply, so that the first portion rolled over is the taxable amount (the earnings). If the rollover was a qualified distribution, all amounts are considered basis in the new account, and therefore non-taxed upon a qualified distribution.
Rollovers
Now, let’s see how the IRS has really muddied the waters: when rolling funds over from an existing employer to another employer’s Roth 401k – it’s a straightforward activity if you do a trustee-to-trustee transfer – same as for a transfer to a Roth IRA. However (and there’s always a however in life, right?) if you do a non-qualified 60-day rollover things really get complicated.
Complications With a 60-Day Rollover
Here’s what happens with the 60-day rollover to a new employer’s Roth 401k plan: first of all, only the growth (or earnings) from your old employer’s plan can be rolled over to your new employer’s Roth 401k plan. In addition, the earnings portion of the account will be subject to mandatory 20% withholding, even if you roll the entire amount into the new employer’s plan, which should be a tax-free event.
Here’s an example: your Roth 401k account has $20,000 in it, of which $5,000 is earnings. You decide to roll over this account to your new employer’s Roth 401k plan. If you don’t do a trustee-to-trustee transfer, you will only be allowed to put $5,000 (the earnings) into the new account. When you take the distribution, you’d receive a check for $19,000, which is your $15,000 basis plus the $5,000 earnings minus 20% ($1,000) mandatory withholding tax. You are allowed to put up to $5,000 into the new plan, plus up to $15,000 into your Roth IRA, all tax free, even though you were forced to have $1,000 withheld.
Of course, that amount that was withheld will be available to you as a credit against your tax obligation at the end of the year, or as a refund if it caused an overpayment.
If you did a trustee-to-trustee transfer, none of this withholding or earnings-only limitation would have applied, so it makes good sense to do the trustee-to-trustee transfer whenever possible, to avoid such a situation.
5-Year Rule
Rollover To Another Roth 401k or Roth 403b
The last nuance about Designated Roth 401k accounts covered here is the 5-year provision and how rollovers affect it. If you do a trustee-to-trustee (either qualified or non-qualified) rollover of funds to a new employer’s Roth 401k account, the “5-year” starting date will follow from your original account – or rather, whichever account was established earlier will apply to those funds going forward.