08/17/07 - Roth 401(k) Distribution Rules
By: Ana Maria Martinetti-Katz, CPA, MBA
The advent of the Roth 401(k) has been very well received for obvious reasons. The Roth 401(k), a hybrid of the traditional 401(k) and the Roth IRA, shares characteristics from each of these types of accounts such as limits on deferrals and taxability of contributions. But because it hasn't been around all that long, most individuals are uncertain about how distributions from this type of account are handled. Before we learn more about the rules for Roth 401(k) distributions, let's discuss rollover strategies for funds in Roth 401(k)s.
At the time an individual retires or leaves his/her place of employment for another, three options may exist for the funds in that employee's employer sponsored plan. The individual can:
(1) keep the monies in the account
(2) transfer the monies to an IRA or
(3) transfer the monies into the new employer's plan
Because of the limited investment choices available within most employer sponsored plans, leaving the funds in the previous employer's plan is usually not the optimal strategy. If the new employer allows for plan transfers and the investment choices are high-quality, a rollover to the new employer's plan may be suitable. However, more likely than not, the best option will be to roll the funds to an IRA account.
But investment choices are not the only option to consider when deciding whether to leave or where to roll over plan assets to. Another equally important decision to weigh is how distributions from either of these accounts will be treated when you are ready to withdraw the funds.
A qualified distribution from a Roth 401(k) is one that is income tax and penalty free and follows two basic requirements. The first is that the distribution must satisfy a five taxable year requirement. The second is that it not be made before the employee reaches the age of 59 ½. The age requirement is obvious, but, the five year rule can be a bit more complicated. Let's talk about that.
For purposes of the Roth 401(k), the five year holding period begins on the first day in which the individual made a contribution and ends five years from that date. If the individual decides to roll over their Roth 401(k) to a Roth IRA, the five year period begins with the first year for which the individual made a contribution to any Roth IRA account. So far, the rules are fairly straightforward. However, if you have rolled over a Roth 401(k) into an account from which you are now taking distributions, the rules get complicated. In this case, the following rules apply:
If a direct rollover (from trustee to trustee) has taken place between two Roth 401(k) accounts and if the start date of the distributing plan is earlier than the date of the receiving plan, the date of the distributing plan will carry over.
The rules are different when an employee receives a check for the funds within the 401(k) plan and subsequently redeposits these into the new 401(k) account within 60 days (employee rollover). In this case, the five year period begins on the start date of the receiving plan.
If, however, we have an employee or a direct rollover from a Roth 401(k) to an existing Roth IRA, the period begins in the year the Roth IRA was opened. The same is also true if the rollover is to a new Roth IRA.
Being aware of when the five year holding period takes effect is critical for all investors as failure to reach the five year period will result in taxation, at ordinary income tax rates, of the earnings of this nonqualified distribution.
But investor BEWARE! Unlike Roth IRAs, funds held in a 401(k) account, whether traditional or Roth, are subject to required minimum distributions upon the attainment of 70 ½ years of age. This is yet another sound reason to ensure that funds held in a Roth 401(k) are rolled over to a Roth IRA before the age requirement has been attained.
If you find yourself at the crossroads of a job change or retirement and have a Roth 401(k) in place, contact your financial advisor for advice on what strategy is best for you.
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