The Next Lesson: ROTH 401(k) Rollovers

Financial publications, mainstream media, bloggers, etc. have done a pretty good job covering ROTH contributions (both IRA and 401(k)) and related topics the past few years.  By now the average investor can at least tell you that ROTH contributions are treated on an after-tax basis and their withdrawals are tax-free in retirement.

Just when we think we have it all figured out, it’s on to the next lesson…..ROTH 401(k) Rollovers

The Economic Growth and Tax Relief Reconciliation Act of 2001 allowed for ROTH contributions in 401(k) plans, but the first contributions were not allowed until January 1st, 2006.  Just because these contributions were allowed it doesn’t mean that every company plan adopted the provision.  Right now around one-third of companies allow for ROTH contributions inside of their 401(k) plan, but the number is growing every day. 

Because of the young nature of this provision there haven’t been a large number of rollover transactions involving ROTH 401(k) dollars and very few articles, posts, etc. written on the subject.

Here are a few of bits of information to get us started:

Earnings vs. Contributions

Traditional 401(k) salary deferrals, matching contributions, profit sharing contributions and earnings associated with any of these are all treated the same when it comes to taxes.  These dollars are all considered pre-tax and are subject to ordinary income taxes when withdrawn.  On the flip side, ROTH 401(k) salary deferrals are tracked and treated separately than the earnings associated with those deferrals. 

Because of this separate treatment you are not allowed to rollover assets to a ROTH IRA and then back into a new employer‘s 401(k).  You can however move ROTH 401(k) dollars directly from one employer’s plan to the next (assuming your new employer’s plan allows for ROTH dollars and rollovers).

5-year rule

A qualified distribution from a ROTH 401(k) is one where the full distribution, including earnings, is free from taxes and penalties.  If a distribution is not qualified then the earnings may be subject to taxes and penalties.  A distribution of ROTH dollars from a 401(k) are considered qualified if it has been five years since the first ROTH contribution and you are age 59.5.  Death and disability are notable exceptions to the 59.5 rule.

If you rollover ROTH dollars to a ROTH IRA you take on that IRA’s characteristics for the purpose of the 5-year rule.  If your ROTH IRA had been opened for more than five years then any rollover dollars are considered to have met the 5-year rule once they are comingled in the IRA.  If a new ROTH IRA is opened with ROTH 401(k) dollars then a new 5-year period starts with the date of the rollover, regardless of how long you were making ROTH contributions in the 401(k) Plan.

60-day rollover option

This is best explained by an example:

Your 401(k) balance is $50,000 and consists of:

                -$25,000 in pre-tax dollars from employer matching contributions and earnings

                -$20,000 is from ROTH deferrals you made into the plan

                -$5,000 is from earnings on your ROTH deferrals

You leave your job and decide you will rollover your pre-tax dollars to an IRA but take the ROTH dollars out as a distribution.  Your check with be for $24,000.  Taxes of 20% ($1,000) will be automatically withheld on the earnings part of your distribution ($5,000).

You decide that you don’t need all of the money and decide to put $10,000 back into a ROTH IRA.  This is allowed within 60 days of the original distribution.   If a partial rollover occurs such as this, the portion that is rolled over is treated as consisting first of the amount of the distribution that would otherwise be taxable income.  In this case the rollover would consist of $5,000 of earnings and $5,000 of contribution.  The remaining $14,000 that you kept is not subject to taxes or penalties. 

The only drawback in this case is that 20% was withheld and sent to the IRS.  You can get this money back on your taxes assuming no other tax liability is owed.

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