By Andy Ives, CFP®, AIF®
IRA Analyst
The foundational premise of a Roth IRA and a Roth 401(k) is the same – after-tax dollars go into the Roth account (either via contribution or conversion), and eligible earnings are tax-free. Pretty easy. But when it comes to withdrawing dollars from a Roth IRA or Roth 401(k), there is a fork in the road. Roth distribution rules between Roth 401(k) plans and Roth IRAs do NOT work the same.
Roth IRAs follow strict distribution ordering rules. Contributions come out first, converted dollars come out next, and earnings are paid out last. It does not matter how many Roth IRAs a person has or if those Roth IRAs are held at different custodians. The IRS sees only one big, consolidated Roth IRA bucket.
Example: Jim, age 48, has a Roth IRA at Custodian A into which he makes annual contributions. Over the years, his total contributions into this Roth IRA are $50,000, and the account value is $100,000. Jim has a second Roth IRA at Custodian B worth $300,000 that was created when he did a full conversion of a traditional IRA. Jim has made no contributions to his “Roth Conversion IRA” at Custodian B. If Jim takes a distribution of $10,000 from the Roth IRA at Custodian B (the “conversion Roth”), the distribution is deemed to consist of contributed dollars. That’s because Jim’s two Roth IRAs are considered to be one consolidated bucket of Roth IRA money, consisting of contributions, conversions and earnings. Regardless of which Roth IRA Jim takes a distribution from, he would need to withdraw a total of $50,000 before his Roth IRA conversion dollars could be reached.
Roth 401(k) plans, on the other hand, do not follow the same distribution ordering rules. Dollars within the Roth portion of a plan can be a mix of salary deferrals (“contributions”), in-plan conversions and earnings. Any distribution from the Roth 401(k) bucket will come out based on a pro-rata mix of salary deferrals, conversions and earnings.
For plan participants who are age 59½ or older and who have held the Roth 401(k) for over 5 years, this is a non-issue. Any Roth 401(k) distribution to a person who meets these levels will receive a “qualified distribution.” That means the entire distributed amount is tax- and penalty-free. If a qualified distribution is rolled over to a Roth IRA, it all dumps into the “contributions bucket” within the Roth IRA and is immediately available for tax-free distribution.
But if a person is either under age 59½ or has not held the Roth 401(k) for 5 years (“non-qualified”), any distribution from the Roth portion of the plan will come out pro-rata. A non-qualified Roth plan participant cannot target only his Roth 401(k) salary deferrals for withdrawal. He must instead receive a proportionate blend of those deferrals (after-tax) and earnings on the deferrals – which will be taxable if not rolled over. If a non-qualified Roth 401(k) distribution is rolled over to a Roth IRA, the Roth dollars will “maintain their same character” when they go into the Roth IRA. Meaning, salary deferrals will go into the Roth IRA contributions bucket, conversions will go to conversions, and earnings will go into the Roth IRA earnings bucket.
While the basic principles of Roth IRAs and Roth 401(k) plans are the same, note that the distribution rules are not.
If you have technical questions you would like to have answered, be sure to submit them to mailbag@irahelp.com, to be answered on an upcoming Slott Report Mailbag, published every Thursday.
https://irahelp.com/roth-distribution-rules-iras-vs-plans/