While many investors understand that a Roth 401(k) is basically a hybrid of a regular 401(k) and a Roth IRA, if my email correspondence is any indication, many people are somewhat confused about the details. Specifically, many people have misunderstandings about either of two points:
- When you can take money out of the plan, and
- How withdrawals (technically referred to as “distributions”) are treated for tax purposes.*
When Can You Take Money Out?
With an IRA (whether Roth or traditional), you can take your money out of the account at any time. The only question is whether the money will be taxable and/or subject to the 10% penalty. In contrast, with a 401(k), you have to meet certain requirements before you’re even allowed to take money out of the account.
In this regard, a Roth 401(k) works like a regular 401(k). That is, if you are still working for the employer in question, you might not be able to take money out of the plan at all. (Possible options to look into would include a financial hardship distribution, an in-service distribution, or a 401(k) loan.)
Is the Distribution “Qualified”?
When trying to figure out how a distribution will be treated, the first thing to determine is whether or not the distribution will count as a “qualified distribution.” If a distribution is qualified, it will be free from tax and penalty. For a Roth 401(k) distribution to be qualified, it must occur:
- After you have reached age 59.5 (or died or become disabled), and
- At least 5 years after the first day of the calendar year in which you first made a Roth contribution to the retirement plan.
Note that this 5-year rule is on a per-Roth-401(k) basis. (In contrast, the 5-year rule that applies to Roth IRA distributions is not on a per-IRA basis — once you have met it for one Roth IRA, you have met it for all Roth IRAs.)
Example: Bob is employed by Employer A and has been making Roth contributions to Employer A’s retirement plan since 2010. In October of 2013, however, Bob takes a new position with Employer B and begins making Roth contributions to Employer B’s retirement plan. Bob will now have to satisfy a new 5-year period (in this case, he must wait until January 1, 2018) until Roth distributions from Employer B’s retirement plan can be considered qualified.
If, however, you roll money over from a prior Roth 401(k) into your new Roth 401(k), the 5-year rule for your new Roth 401(k) is considered to have started on January 1 of the year in which you first made a Roth contribution to the prior plan. (So, if Bob in our previous example rolled over his Roth 401(k) from Employer A into his Roth 401(k) with Employer B, his 5-year period with regard to Employer B’s plan would be satisfied as of January 1, 2015.)
How Are Nonqualified Distributions Treated?
If your distribution is a nonqualified distribution:
- The portion of the distribution that represents your contributions to the account will be nontaxable (and not subject to the 10% penalty), and
- The portion of the distribution that represents earnings (i.e., growth) will be taxable and potentially subject to the 10% penalty.
In determining what portion of the distribution is considered to come from contributions as opposed to earnings, each distribution is simply treated on a pro-rata basis. For example, if you currently have $10,000 in your Roth 401(k), of which $8,000 is from contributions and $2,000 is from earnings, any distribution will be considered to come 80% from contributions and 20% from earnings — meaning that 80% of the distribution will be nontaxable, and 20% will be taxable and possibly subject to a 10% penalty.
Any portion of a nonqualified distribution that comes from earnings will be subject to the 10% penalty unless one of the following requirements is met. (Note that these are the same requirements as for regular 401(k) distributions.)
- You are age 59.5 or older,
- You are disabled,
- You have died and the distribution is being made to your estate or your designated beneficiary,
- The distribution is part of a series of “substantially equal periodic payments” made based on the appropriate life expectancy table,
- The distribution is made after you have separated from service with your employer and that separation from service occurred in or after the year in which you reached age 55,
- The distribution is the result of an IRS levy on the plan,
- The distribution does not exceed the amount of medical expenses that you can claim as an itemized deduction for the year,
- The distribution is made pursuant to a qualified domestic relations order (e.g., in the event of a divorce), or
- The distribution is a qualified reservist distribution for a military reserve member called to active duty.
*For those interested in reading the actual reference material, Internal Revenue Code section 402A contains the rules for designated Roth contributions (i.e., what we typically refer to as Roth 401(k) contributions).