Designated Roth Account (Roth 401(k)) Distributions

In a previous post we discussed the general information surrounding Designated Roth Accounts – eligibility, tax treatment, and contributions.  In this post we’ll go over the nuances involved in distributions from a Designated Roth Account under a 401(k).  Distributions are a little different from most other retirement plans, as you might guess…

Required Minimum Distributions

One of the first things that is different about a Roth 401(k)’s distributions is that the Required Minimum Distribution (RMD) rules apply to these accounts.  This is different from the Roth IRA, as RMD is not required under present law.  RMD for a Designated Roth Account is the same as the RMD rules for all other accounts to which the RMD rules apply.

The way to get around the RMD rule is to roll over your Designated Roth 401(k) account balance to a Roth IRA.  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.

Qualified Distributions

Another difference for the Designated Roth 401(k) 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.  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 401(k) account to a Roth IRA in a non-qualified distribution, ordering rules 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.

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 401(k) – 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 401(k) 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 401(k) 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 would be a tax-free event.

Here’s an example:  your Roth 401(k) 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 401(k) 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, and 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 pre-tax 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 401(k) or Roth 403(b)

The last nuance about Designated Roth 401(k) accounts that we’ll talk about 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 401(k) account, the “5-year” starting date will follow your account – or rather, whichever account was established earlier will apply to those funds going forward.

If you do a 60-day (again, either qualified or non-qualified) rollover to a new Roth 401(k), the age of the new account will apply, even if the funds had been in the old Roth 401(k) for a significant period of time.  Only the taxable or earnings component will be allowed to rollover in a 60-day rollover, so the age of the account is a moot point.

Rollover to a Roth IRA

For the same situations as in the paragraphs above, but the transfers are to a Roth IRA, no matter what kind of rollover is done, direct (trustee-to-trustee) or 60-day, qualified or non-qualified, the results are the same – the 5-year holding period will be that of the receiving Roth IRA account, no matter how long the funds were held in the Roth 401(k) account.  However, each individual conversion or rollover to a Roth IRA has its own 5-year period.  This is a good reason to establish a Roth IRA immediately, to have a vehicle to receive such transfers if the situation arises.

The one wrinkle with rollovers into Roth IRA accounts has to do with taxability of the rolled over funds:  If the distribution is qualified, then all of the funds rolled over are considered basis, and when distributed for any reason the basis is tax-free (no matter the holding period).  If the distribution is non-qualified, the funds retain their original characterization from before the rollover – part is contributions (basis) and part is earnings (taxable until qualified).

So you can see some of the great benefits of doing a trustee-to-trustee transfer over the 60-day transfer – especially if the rollover is to be non-qualified.  As always, consult your financial advisor before doing any of these, just to make sure you don’t make a mistake!

* 1000 extra points to the first person who can correctly name the 3 Rothsketeers famous Roths that I’ve depicted as “hosts” for my Roth IRA articles.

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Jim Blankenship, CFP®, EA, is an expert in personal retirement, IRAs, and tax issues, with more than 20 years of experience in the industry.  . Read more from this author