Roth 401(k) Distribution Regulations
MAY 2008 - On
April 30, 2007, the IRS published final regulations on the taxation
of distributions from designated Roth accounts, better known as
Roth 401(k)s and Roth 403(b)s. This article mentions only the Roth
401(k), but the information applies to Roth 403(b)s as well. These
final regulations for the taxation of Roth 401(k) distributions
are effective April 30, 2007, and generally apply to tax years beginning
on or after January 1, 2007. Similar regulations will apply to Roth
403(b) plans when the final 403(b) regulations are released.
of the Roth 401(k) Contribution Rules
regulations for Roth 401(k) contributions, dated December 30,
2005, have been effective since January 1, 2006, when these accounts
first became available.
401(k) option may be offered by an employer plan. It is not a
stand-alone retirement plan, and is governed by the same rules
as other 401(k) plans. It is subject to the same nondiscrimination
tests, contribution limits, and distribution restrictions as other
funds in a 401(k) plan. An employer is not required to offer a
Roth option to its employees, and there are no income limits for
employees’ Roth 401(k) contributions, although some highly
compensated employees may not be able to contribute the full amount,
just as they cannot contribute the full amount to a 401(k).
contributions are salary deferrals, but they are made after-tax.
The amount deferred to a Roth 401(k) is subject to the same income
tax withholding as the employee’s take-home pay, unlike
deferrals to a 401(k), which are not taxed.
Lou’s employer has a 401(k) plan and now offers a Roth 401(k)
option. Lou earns $50,000 a year and currently has 5% of his salary
deferred to the 401(k) plan.
The deferral of $2,500 is pre-tax. It reduces Lou’s take-home
pay by $2,500, and his employer does not withhold any federal
taxes out of the $2,500. It is as if Lou were earning only $47,500
a year, because he pays tax on only $47,500.
401(k). Lou decides to change his 5% deferral to the Roth
401(k). The deferral of $2,500 is now after-tax. His employer
must calculate federal withholding on Lou’s full salary
of $50,000. Lou pays tax on his full salary even though he receives
only $47,500. Lou is actually paying more taxes on the money he
takes home each year.
limits are the same as the elective contribution limits for the
employer plan. And, just as the contribution limits for a traditional
IRA and a Roth IRA are combined so taxpayers cannot contribute
more than $5,000 to all their IRAs if they are under age 50, the
Roth 401(k) and the 401(k) limits are combined. For 2008 the maximum
contribution amount is $15,500 plus a $5,000 catch-up contribution
if the employee is age 50 or older.
In 2008 Mike is under age 50 and does not qualify for catch-up
contributions. The 401(k) plan lets him defer $15,500 of his compensation,
and his employer also offers a Roth 401(k). The total deferral
to both plans cannot exceed $15,500. Mike decides to defer the
maximum to his retirement account and elects to defer $10,000
to the Roth 401(k) account and the balance of $5,500 to the 401(k)
contributing to a Roth 401(k) doesn’t limit one’s
ability to contribute to a traditional or Roth IRA, being covered
by a company plan could affect the ability to deduct a traditional
IRA contribution, depending on income. Those who qualify can contribute
to both Roth 401(k)s and Roth IRAs to quickly build their tax-free
John and Nancy are married and file a joint return. Their joint
income is $125,000, so they each qualify to make Roth IRA contributions.
They are also both over 50 years old, so they both qualify to
make catch-up contributions. If John and Nancy work for companies
that offer Roth 401(k)s, they can contribute a total of $53,000
to their Roth IRAs and Roth 401(k)s for 2008. Here is how they
get to the $53,000 total contribution amount for one year:
2008 Roth 401(k) contributions: $15,500 + $5,000 catch-up = $20,500
each 2008 Roth IRA contributions: $5,000 + $1,000 catch-up = $6,000
each Total = $26,500 each or $53,000 for both, all in one tax
salary deferrals or rollovers from other Roth employer plans can
go into a Roth 401(k), and the election to make Roth 401(k) contributions
(these are after-tax contributions) is irrevocable. Taxpayers
can’t change their minds and recharacterize. For example,
funds contributed to a Roth IRA can be recharacterized to a traditional
IRA, and funds contributed to a traditional IRA can be recharacterized
to a Roth IRA. But funds contributed to a 401(k) cannot be either
recharacterized as a Roth 401(k) contribution or transferred to
a Roth 401(k).
A Roth 401(k)
cannot be the only plan that an employer offers; it must be paired
with a 401(k) plan. The Roth 401(k) contributions are made in
lieu of elective pre-tax contributions that the employee is otherwise
eligible to make under the plan.
must maintain and account for Roth 401(k) contributions in a separate
account. Forfeitures and employer-match contributions cannot be
allocated to the Roth 401(k) account. The employer must keep track
of gains, losses, contributions, and distributions in the Roth
401(k) account, and must be able to determine the employee’s
basis in the account.
If the plan
allows Roth 401(k) rollover contributions, they can be accepted
only from another Roth employer account. The plan cannot accept
rollovers from an individual IRA or Roth IRA. Nor can the employee
convert amounts currently held in the 401(k) plan to the Roth
401(k) Required Minimum Distributions
from a Roth 401(k) will be subject to the plan distribution rules.
The plan participant cannot take the funds out unless the plan
allows it. The 401(k) required minimum distribution (RMD) rules
also apply to the Roth 401(k) when the plan participant reaches
his required beginning date. An employee can get around this by
rolling the Roth 401(k) monies into an individual Roth IRA, where
there are no RMDs. If the rollover is not done until the year
of the first RMD, the RMD will have to be distributed from the
plan before doing the rollover.
Ben has retired and left his retirement funds in the company plan.
He must take an RMD this year. Ben’s Roth 401(k) has $40,000,
and his 401(k) has $340,000. His RMD for the year will be based
on the total balance in both plans, $380,000. Had Ben rolled the
$40,000 Roth 401(k) balance over to a Roth IRA in a prior year,
his RMD for this year would be based only on his 401(k) balance
Roth 401(k) Distributions
distributions are not subject to taxes or penalties. A distribution
is qualified if the Roth 401(k) account is held for more than
five years and any of the following applies:
- The employee
is age 59 Qs or older;
- The employee
is deceased; or
- The employee
distribution is considered to consist entirely of basis. When
these funds are transferred to another employer’s Roth 401(k)
or to an individual Roth IRA, they go into the new account as
basis and are available for distribution income tax–free.
Rachel established her Roth 401(k) with her current employer 10
years ago. Now, at age 62, she is taking early retirement and
wants to supplement her income until she starts collecting Social
Security. Any distribution Rachel takes from her Roth 401(k) plan
will not be subject to income tax because the plan was established
more than five years ago and Rachel is past the age of 59 Qs .
that is not a qualified distribution is subject to the pro-rata
rule; it is not subject to the ordering rules used in a distribution
from an individual Roth IRA. The nontaxable amount of the distribution
is generally determined by dividing the employee’s deferrals
(basis) by the balance in the Roth 401(k) account and multiplying
the amount distributed by the result.
401(k). Kathy has deferred a total of $30,000 to
her Roth 401(k) and has a total balance in the account of $40,000.
She then takes a distribution of $12,000. A total of $9,000 of
the distribution will be tax-free ($30,000/$40,000 = .75) ($12,000
x .75 = $9,000).
from a Roth IRA, where ordering rules apply. Under the ordering
rules for Roth IRA distributions, the funds are deemed to come
out in this order:
from Roth IRA contributions. Roth IRA contributions can be withdrawn
at any time for any reason, tax- and penalty-free.
from Roth IRA conversions (taxable amounts first, then nontaxable
- The balance
of the distributions is deemed to come from earnings on Roth
contributions or conversions.
Roth IRA. Kathy also has a Roth IRA with $30,000
of contributions and a total account balance of $40,000. She then
takes a distribution of $12,000. Under the Roth IRA ordering rules,
the $12,000 is deemed to come first from contributions; Kathy’s
contributions total $30,000, so the distribution is tax-free to
accounts can be rolled over to individual Roth IRAs, but individual
Roth IRAs cannot be rolled over to Roth employer plans. Employee
deferrals to the Roth 401(k) are after-tax contributions and governed
by the rules applicable to after-tax contributions in an employer
plan. Roth 401(k) funds can be rolled over to another employer’s
Roth plan only if the receiving plan allows it. The amount rolled
over depends on whether the transfer was done as a direct rollover
(a trustee-to-trustee transfer) or a 60-day rollover.
rollover (trustee-to-trustee transfer). The entire plan balance
can go to an employer Roth plan or to an individual Roth IRA.
(60-day rollover). Only taxable amounts can be rolled over
to another Roth employer plan, or the entire plan balance can
go to an individual Roth IRA. The rollover must be completed within
If the employee
does a partial 60-day rollover of a nonqualified distribution
to an existing individual Roth IRA, the amount rolled into the
Roth IRA is deemed to come first from taxable amounts distributed
from the Roth 401(k). This means that the employee is rolling
the taxable earnings portion into the Roth IRA first, and the
balance of the distribution comes from the tax-free part.
Dave is changing jobs and wants to transfer his existing 401(k)
of $150,000 and his Roth 401(k) of $25,000 to his new employer’s
plan. His new employer plan allows him to transfer his 401(k)
and Roth 401(k) balances into the employer’s plan. The $25,000
Roth 401(k) balance includes $5,000 of earnings. The distribution
of the Roth 401(k) funds is not a qualified distribution because
the funds have not been held for five years.
rollover. Dave does a direct rollover of the total balance
from his previous employer into the current employer’s plan.
The total amount transferred is $150,000 into the 401(k) and $25,000
into the Roth 401(k).
rollover. Dave does a 60-day rollover of the total balance
from his previous employer. He receives a rollover check, but
because this is a 60-day rollover (as opposed to a direct rollover),
any pre-tax amount in the distribution is subject to mandatory
20% withholding, the same as any eligible rollover distribution
from a 401(k).
balance in Dave’s 401(k) can be rolled over, but Dave receives
only 80% of that amount ($120,000), because the distribution from
the 401(k) was subject to withholding. He receives only $24,000
from the Roth 401(k). Only $1,000 of the $25,000 Roth 401(k) rollover
needs to be withheld [20% of the $5,000 of Roth 401(k) earnings].
replace the withheld funds with other funds he has if he wants
to roll over the entire plan balance. Because he is doing this
transfer as a 60-day rollover, only the taxable amounts in the
Roth 401(k) (the $5,000 of earnings) can be rolled over to the
new Roth 401(k). To complete the rollover, Dave must roll over
the funds he received (plus funds to cover the withheld amounts)
to his new employer’s 401(k) and Roth 401(k) within 60 days.
Dave rolls over the net amounts into his current employer’s
amount that Dave can roll over to the new 401(k) is $150,000.
The amount that he actually rolls over is $120,000 ($150,000 less
the 20% mandatory withholding of $30,000).
amount that can be rolled over to the new Roth 401(k) is $5,000.
The amount that Dave actually rolls over is $4,000 ($5,000 less
the 20% mandatory withholding of $1,000).
that Dave has not rolled into his new employer plan can be rolled
over to his Roth IRA if he completes the rollover within 60 days.
This amount would include the after-tax amount of $20,000 from
his Roth 401(k) and the mandatory withholding amounts that he
didn’t roll over into his new employer’s plan [$30,000
from the 401(k) and $1,000 from the Roth 401(k)]. Funds that Dave
rolls over to his Roth IRA can continue to grow tax-free.
60-day rollover of the Roth 401(k). Dave does a direct rollover
of his 401(k)’s $150,000 balance into his new employer’s
plan. He takes a full distribution of the $25,000 Roth 401(k)
balance and does a 60-day rollover of only $10,000 to his Roth
IRA. Dave’s distribution from the Roth 401(k) will be subject
to mandatory 20% withholding, but only on the earnings of $5,000
($5,000 x 20% = $1,000) in the account. No withholding is required
on the tax-free portion of the distribution (the $20,000 of after-tax
contributions). Dave receives a check for $24,000 ($25,000 account
balance less $1,000 withholding). The
$10,000 deposited in the Roth IRA will be deemed to first be the
$5,000 taxable balance in the Roth 401(k), and the $5,000 remaining
will be added to the basis in the Roth IRA. The remaining $14,000
that Dave did not roll over will be treated as a tax-free distribution.
The end result is that Dave has executed a series of transactions
that are nontaxable (because his total taxable amount ends up
being rolled into his Roth IRA), but he has been forced to prepay
$1,000 in income tax withholding.
of the story: Do not take a nonqualified distribution from any
Roth account, particularly a Roth 401(k) account.
Clock for Qualified Distributions
have their own five-year holding rules. Unlike individual Roth
IRAs, where there is only a single five-year period that starts
with the establishment of the owner’s first Roth IRA, Roth
401(k)s have a separate five-year holding period for each employer’s
Roth account. Taxpayers who work for different companies and participate
in Roth 401(k) plans at more than one company will have a different
five-year period for each plan.
regulations (and the examples below) spell out how the five-year
holding period is determined in each situation, depending on how
the funds were transferred (direct or 60-day rollovers) and where
the funds were transferred to [Roth 401(k) or Roth IRA].
from Roth 401(k)s to new Roth 401(k)s. The rules
are different for 60-day rollovers and for direct rollovers, and
they are more favorable for direct rollovers. When funds are moved
to a new employer’s Roth 401(k) plan in a direct rollover,
the new plan will use the earlier start date of the five-year
holding period of the two plans.
Direct rollover (trustee-to-trustee transfer) to a new Roth 401(k).
Edna started contributing to her Roth 401(k) in 2006. In 2009
she gets a new job; that employer also has a Roth 401(k) plan.
She does a direct rollover of her entire Roth 401(k) to the new
employer’s plan. The beginning date of Edna’s holding
period in the old plan was January 1, 2006, and the beginning
date in the new plan is January 1, 2009. Because of the direct
rollover, Edna can use the earlier of the two dates as the beginning
date of her holding period. The beginning date for the new plan
will be January 1, 2006.
same funds are transferred as a 60-day rollover, the five-year
holding period cannot be carried over to the new plan. The employee
will use the holding period of the receiving plan.
60-day rollover to a Roth 401(k). Consider the same
scenario as above, except Edna did a 60-day rollover of the taxable
amount only, into the new employer’s Roth 401(k) plan. She
cannot carry over the beginning date of the holding period from
her old plan, so the new beginning date of the holding period
is January 1, 2009, the date applicable in the receiving plan.
from Roth 401(k)s to Roth IRAs. The five-year holding
period is never carried over to an individual Roth IRA. The Roth
401(k) funds will be governed by the five-year rule applicable
to the Roth IRA. If the Roth IRA has already satisfied the five-year
period, then the employer funds are deemed to have also met the
five-year period, even if they were in the Roth 401(k) for only
a year. This is just one more reason for qualifying individuals
to establish a Roth IRA. If they don’t qualify now, they
will qualify in 2010, when the restrictions on converting to a
Roth IRA are lifted and taxpayers can establish Roth IRAs by doing
Rollover to an existing Roth IRA. Consider the same
scenario as the direct rollover example, except Edna did a rollover
of the total amount from the Roth 401(k) in 2009, to her individual
Roth that she established in 2004. Because Edna cannot carry over
the beginning date of the holding period in the Roth 401(k) plan,
she must use the beginning date in the Roth IRA. In this case,
the Roth has been open for more than five years, so the Roth 401(k)
funds she rolled over are now considered to satisfy the five-year
holding period even though they were in the Roth 401(k) for only
three years. This is another reason for anyone who qualifies to
open a Roth IRA now, and get the five-year clock ticking.
Rollover to a new Roth IRA. Same scenario as the
direct rollover example, except Edna did a 60-day rollover of
the total amount from the Roth 401(k) to a Roth IRA that she first
establishes in 2009 at the time of the rollover. Because Edna
cannot carry over the beginning date of the holding period in
the old plan, she uses the beginning date in the Roth IRA. In
this case, the Roth IRA has just been established, so the five-year
holding period for the Roth 401(k) funds starts over as of 2009.
Edna loses the three years she had in the Roth 401(k).
Rollover of qualified distribution to a new Roth IRA. Returning
to the earlier example of Rachel, she established her Roth 401(k)
with her current employer 10 years ago. Now, at age 62, she is
taking early retirement and wants to supplement her income until
she starts collecting Social Security. Rachel never had a Roth
IRA, so she does a direct rollover of her entire Roth 401(k) balance
into a new Roth IRA. This Roth IRA will have to satisfy a five-year
holding period before Rachel can take a qualified distribution,
even though the funds rolled into it have been in the Roth 401(k)
for 10 years and she is over age 59 Qs . But the rollover funds
from her Roth 401(k) are considered basis in the Roth IRA because
they were a qualified distribution from the plan. Under the Roth
IRA ordering rules, any distribution Rachel takes is considered
to first come from her basis, and distributions of basis will
be income tax–free.
be required distributions to the Roth 401(k) beneficiary based
on the options available in the plan, but distributions will not
automatically be qualified distributions. A qualified distribution
has two parts: Death of the account owner satisfies one part;
the other part is the five-year holding period. If the Roth 401(k)
account owner has not satisfied the five-year holding period,
the beneficiary must hold the account for the balance of the holding
period before he has a qualified distribution.
George began making Roth 401(k) deferrals in 2007. He dies in
2010. Because the five-year holding period will not be satisfied
until 2012, George’s beneficiary will not receive a qualified
distribution from the plan until 2012, even though the beneficiary
must take required distributions beginning in 2011.
Roth 401(k) is an employer plan, nonspouse beneficiaries may not
be able to stretch distributions over their life expectancies.
Although the Pension Protection Act of 2006 allows a nonspouse
beneficiary to do a direct rollover of employer plan balances
to inherited IRAs, the employer plan must allow this option. If
the plan does not allow the direct rollover option, beneficiaries
will be limited to the distribution options available in the plan.
(Five years or a lump-sum distribution are common options for
nonspouse plan beneficiaries.)
Reporting of Roth 401(k) Distributions
A Roth 401(k)
plan must track the Roth assets in an account separate from the
401(k) assets. The plan administrator or other responsible party
must track deferrals to the plan (the after-tax amounts), earnings
in the plan (the pre-tax amounts), and distributions (nonqualified
distributions are pro rata distributions, so both pre-tax and
after-tax balances are affected by a distribution and the beginning
of the five-year holding period. When a direct rollover of Roth
401(k) funds is done, all of this information must be furnished
to the receiving plan. When a 60-day rollover is done, this same
information (except for the date of the beginning of the holding
period, because that cannot be transferred to the receiving plan)
must be provided to the employee when the employee requests it.
is required to issue a separate Form 1099-R to report distributions
from a Roth 401(k). Code B has been added to the list of explanation
codes to designate a nonqualified distribution from a Roth 401(k).
IRA Documents Must Be Amended
On May 31,
2007, the IRS released Announcement 2007-55 to remind Roth IRA
sponsors that Roth IRA documents will need to be amended if they
are to allow for the acceptance of rollover contributions from
Roth 401(k) or Roth 403(b) accounts. All advisors whose clients
are thinking of rolling over Roth 401(k) balances to Roth IRA
accounts should first be sure that the Roth IRA document allows
for this type of rollover. A Roth IRA that has already accepted
rollover contributions from a Roth 401(k) needed to be amended
by December 31, 2007 (Revenue Procedure 2002-10).
here to view Advisor Action Plan.
here to view Allowable Contributions to Roth 401(k)s.
here to view Allowable Rollovers From Roth 401(k)s.
Slott, CPA, Rockville Centre, N.Y., is a nationally recognized
IRA expert, speaker, and author of several IRA books, including
Your Complete Retirement Planning Road Map (Random House;
2007), and of the monthly newsletter Ed Slott’s IRA Advisor,
from which this article is adapted with permission from the author.
To order, call 800-663-1340 or go to www.irahelp.com.