This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters.Please also refer to the Disclaimer & Warning section found here.
New Year’s Eve is an important day if you do a Backdoor Roth IRA. Read below to find out why.
The Backdoor Roth IRA
I’ve written before about the Backdoor Roth IRA. It is a two step process whereby those not qualifying for a regular Roth IRA contribution can qualify to get money into a Roth IRA. Done over several years, it can help taxpayers grow significant amounts of tax free wealth.
One of the best aspects of the Backdoor Roth IRA is that it does not forego a tax deduction. Most taxpayers ineligible to make a regular Roth IRA contribution are also ineligible to make a deductible traditional IRA contribution. In the vast majority of cases, the choice is between investing money in a taxable account versus investing in a Roth account. For most, a Roth is preferable, since Roths do not attract income taxes on the interest, dividends, and capital gains investments generate.
The Basic Backdoor Roth IRA and the Form 8606
Let’s start with a fairly basic example.
Example 1
Betsy, age 40, earns $300,000 from her W-2 job in 2021, is covered by a workplace 401(k) plan, and has some investment income. Betsy has no balance in a traditional IRA, SEP IRA, or SIMPLE IRA.
At this level of income, Betsy does not qualify for a regular Roth IRA contribution, and she does not qualify to deduct a traditional IRA contribution.
Betsy contributes $6,000 to a traditional IRA on May 20, 2021. The contribution is nondeductible. Because the contribution is nondeductible, Betsy gets a $6,000 basis in her traditional IRA. Betsy must file a Form 8606 with her 2021 tax return to report the nondeductible contribution.
On June 5, 2021, Betsy converts the entire balance in the traditional IRA, $6,003, to a Roth IRA. As of December 31, 2021, Betsy has no balance in a traditional IRA, SEP IRA, or SIMPLE IRA.
Betsy has successfully executed a Backdoor Roth IRA. Here is what page 1 of the Form 8606 Betsy should file with her 2021 income tax return should look like.
Notice here that I am using the 2020 version of the Form 8606 for this and all examples. The 2021 Form 8606 is not yet available as of this writing.
The most important line of page 1 of the Form 8606 is line 6. Line 6 reports the fair market value of all traditional IRAs, SEP IRAs, and SIMPLE IRAs Betsy owns as of year-end. Because Betsy had no traditional IRAs, SEP IRAs, and SIMPLE IRAs as of December 31, 2021, her Backdoor Roth IRA works and is tax efficient. This important number ($0) on line 6 of the Form 8606 is what ensures Betsy’s Backdoor Roth IRA is tax efficient.
Note that Betsy’s Backdoor Roth IRA creates an innocuous $3 of taxable income, which is reported on the top of part 2 of the Form 8606.
The Pro-Rata Rule and December 31st
But what if Betsy did have a balance inside a traditional IRA, SEP IRA, or SIMPLE IRA on December 31, 2021? Would her Backdoor Roth IRA still be tax efficient? Probably not, due to the Pro-Rata Rule.
The Pro-Rata Rule tells us just how much of the basis in her traditional IRA Betsy can recover when she does the Roth conversion step of the Backdoor Roth IRA. Betsy’s $6,000 nondeductible traditional IRA creates $6,000 of basis. As we saw above, Betsy was able to recover 100 percent of her $6,000 of basis against her Roth conversion.
But the Pro-Rata Rule says “not so fast” if Betsy has another traditional IRA, SEP IRA, or SIMPLE IRA on December 31st of the year of any Roth conversion. The Pro-Rata Rule allocates IRA Basis between converted amounts (in Betsy’s case, $6,003) and amounts in traditional IRAs, SEP IRAs, and SIMPLE IRAs on December 31st. Here’s an example.
Example 2
Betsy, age 40, earns $300,000 from her W-2 job in 2021, is covered by a workplace 401(k) plan, and has some investment income. Betsy has no balance in a traditional IRA, SEP IRA, or SIMPLE IRA.
Betsy contributes $6,000 to a traditional IRA on May 20, 2021. The contribution is nondeductible. Because the contribution is nondeductible, Betsy gets a $6,000 basis in her traditional IRA. Betsy must file a Form 8606 with her 2021 tax return to report the nondeductible contribution.
On June 5, 2021, Betsy converts the entire balance in the traditional IRA, $6,003, to a Roth IRA.
On September 1, 2021, Betsy transfers an old 401(k) from a previous employer 401(k) plan to a traditional IRA. On December 31st, that traditional IRA is worth $100,000. The old 401(k) had no after-tax contributions.
This one 401(k)-to-IRA rollover transaction dramatically changes both the taxation of Betsy’s Backdoor Roth IRA and her 2021 Form 8606. Here’s page 1 of the Form 8606.
Line 6 of the Form 8606 now has $100,000 on it instead of $0. That $100,000 causes Betsy to recover only 5.67 percent of the $6,000 of basis she created by making a nondeductible contribution to the traditional IRA. As a result, $5,663 of the $6,003 transferred to the Roth IRA in the Roth conversion step is taxable to Betsy as ordinary income. At a 35% tax rate, the 401(k) to IRA rollover (a nontaxable transaction) cost Betsy $1,982 in federal income tax on her Backdoor Roth IRA. Ouch!
Quick Lesson: The lesson here is that prior to rolling over a 401(k) or other workplace plan to an IRA, taxpayers should consider the impact on any Backdoor Roth IRA planning already done and/or planned for the future. One possible planning alternative is to transfer old employer 401(k) accounts to current employer 401(k) plans.
There is an antidote to the Pro-Rata Rule when one has amounts in traditional IRAs, SEP IRAs, and SIMPLE IRAs. It is transferring the traditional IRA, SEP IRA, or SIMPLE IRA to a qualified plan (such as a 401(k) plan) before December 31st. Here is what that might look like in Betsy’s example.
Example 3
Betsy, age 40, earns $300,000 from her W-2 job in 2021, is covered by a workplace 401(k) plan, and has some investment income. Betsy has no balance in a traditional IRA, SEP IRA, or SIMPLE IRA.
Betsy contributes $6,000 to a traditional IRA on May 20, 2021. The contribution is nondeductible. Because the contribution is nondeductible, Betsy gets a $6,000 basis in her traditional IRA. Betsy must file a Form 8606 with her 2021 tax return to report the nondeductible contribution.
On June 5, 2021, Betsy converts the entire balance in the traditional IRA, $6,003, to a Roth IRA.
On September 1, 2021, Betsy transfers an old 401(k) from a previous employer to a traditional IRA. The old 401(k) had no after-tax contributions.
On November 16, 2021, Betsy transfers the entire balance in this new traditional IRA to her current employer’s 401(k) plan in a direct trustee-to-trustee transfer.
Here is Betsy’s 2021 Form 8606 (page 1) after all of these events:
Betsy got clean by December 31st, so her Backdoor Roth IRA now reverts to the optimized result (just $3 of taxable income) she obtained in Example 1.
Pro-Rata Rule Clean Up
Implementation
From a planning perspective, it is best to clean up old traditional IRAs/SEP IRAs/SIMPLE IRAs prior to, not after, executing the Roth conversion step of a Backdoor Roth IRA. I say that because things happen in life. There is absolutely no guarantee that those intending to roll amounts from IRAs to workplace qualified plans will get that accomplished by December 31st.
Further, transfers from one retirement account to another are usually best done through a direct “trustee-to-trustee” transfer to minimize the risk that the money in the retirement account accidentally is distributed to the individual, causing potential tax and penalties.
Before cleaning up old traditional IRAs, SEP IRAs, and SIMPLE IRAs, one should consider the investment choices and fees inside their employer retirement plan (such as a 401(k)). If the investment options are not good, and/or the fees are high, perhaps cleaning up an IRA to move money into less desirable investments is not worth it. This is a subjective judgment that must weigh the potential tax and investment benefits and drawbacks.
Tax Issues
Amazingly enough, the Pro-Rata Rule is concerned with only one day: December 31st. A taxpayer can have a balance in a traditional IRA, SEP IRA, or SIMPLE IRA on any day other than December 31st, and it does not count for purposes of the Pro-Rata Rule. Perhaps December 31st should be called Pro-Rata Rule Day instead of New Year’s Eve. 😉
Extra care should be taken when cleaning up (a) large amounts in any type of IRA and (b) any SIMPLE IRA. While it is fairly obvious that significant sums should be moved only after considering all the relevant investment, tax, and execution issues, the SIMPLE IRA provides its own nuances. Any SIMPLE IRA cannot be rolled to an account other than a SIMPLE IRA within the SIMPLE IRA’s first two years of existence. Thus, SIMPLE IRAs must be appropriately aged before doing any sort of Backdoor Roth IRA clean up planning.
Spouses are entirely separate for Pro-Rata Rule purposes, even in community property states. Cleaning up one spouse, or failing to clean up one spouse, has absolutely no impact on the taxation of the other spouse’s Backdoor Roth IRA.
Lastly, non spousal inherited IRAs do not factor into a taxpayer’s application of the Pro-Rata Rule. Each non spousal inherited IRA has its own separate, hermetically sealed Pro-Rata Rule calculation. The inheriting beneficiary does a Pro-Rata Rule calculation on all IRAs he/she owns as the original owner, separate from any inherited IRAs. In addition, non spousal inherited IRAs cannot be rolled into a 401(k).
Mega Backdoor Roth
Good news: the concerns addressed in this blog post generally do not apply with respect to the Mega Backdoor Roth (sometimes referred to as a Mega Backdoor Roth IRA, though a Roth IRA does not necessarily have to be involved). Qualified plans such as 401(k)s are not subject to the Pro-Rata Rule.
While 401(k)s are not subject to the Pro-Rata Rule, amounts within a particular 401(k) plan’s after-tax 401(k) are subject to the “cream-in-the-coffee” rule I previously wrote about here. Thus, if there is growth on Mega Backdoor Roth contributions before they are moved out of the after-tax 401(k), generally speaking either the taxpayer must pay income tax on the growth (if moved to a Roth account) or the taxpayer can separately roll the growth to a traditional IRA (which could then create a rather small Pro-Rata Rule issue with future Backdoor Roth IRAs). Fortunately, the cream-in-the-coffee rule has a much narrower reach than the Pro-Rata Rule.
Backdoor Roth IRA Tax Return Reporting
Watch me discuss Backdoor Roth IRA tax return reporting.
Conclusion
Get your IRAs in order so you can enjoy New Year’s Eve!
December 31st is an important date when it comes to Backdoor Roth IRA planning. It is important to plan to have no (or at a minimum, very small) balances in traditional IRAs, SEP IRAs, and SIMPLE IRAs on December 31st when planning Backdoor Roth IRAs.
None of what is discussed in this blog post is advice for any particular taxpayer. Those working through Backdoor Roth IRA planning issues are often well advised to reach out to professional advisors regarding their own tax situation.
Further Reading
I did a blog post about Backdoor Roth IRA tax return reporting here.
I did a deep dive on the taxation of Roth IRA withdrawals here.
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
Is the backdoor closing? If a recently released proposal from the House Ways & Means Committee is enacted, then yes it is.
My analysis and commentary below is just my initial take on the proposed new laws: it is subject to revision.
UPDATE December 18, 2021
The update as of December 18, 2021 can be read here. Turns out that as of now (December 18th) my predictive analysis offered in November appears rather spot on. But remember, things can change.
Here’s what I wrote in November: On November 19, 2021, the House of Representatives passed the proposals discussed below. To my mind, the passage of this legislation is a 26.2 mile marathon: Passage in the House is the first mile, and passage in the Senate is the next 25.2 miles. There are absolutely no guarantees as to whether the proposals ultimately become law. My view is that passage in the Senate is going to be much more difficult than passage in the House.
Backdoor Roths
The Backdoor Roth IRA has been a popular transaction for over a decade. It allows those unable to make a direct Roth IRA contribution to get an annual contribution into a Roth IRA through a two-step process. There is a 401(k) version popularly referred to as the Mega Backdoor Roth IRA, which allows taxpayers to move significant amounts into Roth accounts using after-tax 401(k) contributions.
House Ways & Means Proposal
On September 13, 2021, the House Ways and Means committee released legislative text and an explanation of proposed new rules that would change the Roth landscape.
Elimination of Backdoor Roth IRAs and Mega Backdoor Roth IRAs
Effective in 2022, after-tax amounts in IRAs could not be converted to Roth IRAs. This rule would apply to all taxpayers regardless of their level of adjusted gross income. This rule would eliminate the Backdoor Roth IRA, as amounts contributed to a nondeductible traditional IRA (the first step of a Backdoor Roth IRA) could not be converted to a Roth IRA.
The bill would also eliminate after-tax contributions to qualified plans. As a result, workplace plans such as 401(k)s could no longer offer the Mega Backdoor Roth.
Effect on 2021 Backdoor Roth IRAs
In a twist, the new rule would effectively impose a deadline on all 2021 Backdoor Roth IRA planning: December 31, 2021. If the new law is passed, both the nondeductible traditional IRA contribution step and the Roth conversion step for a Backdoor Roth IRA would need to be completed by 2021 in order to do a 2021 Backdoor Roth IRA.
Usually, the deadline to worry about from a Backdoor Roth IRA perspective is the deadline to make the nondeductible traditional IRA contribution, usually April 15th of the following year. There is no particular deadline to complete the Roth conversion step. By prohibiting Roth conversions of after-tax money in traditional IRAs beginning January 1, 2022, Congress effectively makes December 31, 2021 the deadline to execute the Roth conversion step of a 2021 Backdoor Roth IRA.
I wrote about how the legislative proposal impacts the approach to 2021 Backdoor Roth IRA planning and deadlines here.
I have previously written about late or “split-year” Backdoor Roth IRAs under current law here.
Update on Legislative Proposals (As of November 4, 2021)
On October 28th, a new tax proposal came out which did not have the Backdoor elimination proposals. However, a second new tax proposal issued on November 3rd did contain the Backdoor Roth elimination proposals. Based on the current political landscape, there is significant doubt as to whether any tax proposal is enacted during this Congress. However, there is at least some chance the Backdoor Roth proposals are enacted.
Elimination of Roth Conversions for High Income Taxpayers Beginning in 2032
The legislative proposal also eliminates Roth conversions in any year a taxpayer’s adjusted taxable income is $400K (single filers) or $450K (married filing joint) starting in the year 2032.
A couple of observations about this rule. First, this rule would have no practical effect on the FI community. Usually, those in the FI community avoid taxable Roth conversions during high income years. Taxable Roth conversions (such as the so-called Roth Conversion Ladder strategy) are usually executed during early retirement before collecting Social Security. Those years often have artificially low taxable income, so a high income cap on the ability to do a Roth conversion is a rule without consequence for the FI community.
Second, you might be wondering: why the heck are they changing the tax law 10 years in the future? Why not now? The answer lies in how Congress “scores” tax bills. Taxable Roth conversions, particularly in the near term, increase tax revenue. An immediate repeal of Roth conversions would “cost” the government money in the new few years. But by delaying implementation for 10 years, Congress is able to predict that taxpayers, facing a future with no Roth conversions, will increase Roth conversions in 2030 and 2031, increasing tax revenues in those years.
Outlook
Congress is closely divided. There is absolutely no guarantee this bill will pass both houses of Congress and be signed by the President. That said, these proposed rules are now “out there” and being “out there” is the first step towards a tax rule becoming law.
I will Tweet and blog about any future developments in this regard.
FI Tax Guy can be your financial advisor! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters.Please also refer to the Disclaimer & Warning section found here.
The Roth IRA: tax free retirement income. What’s not to love?
But wait a minute. What Congress gives Congress can take away, right? Might Congress, looking for tax revenues to pay off the debt, simply make Roth distributions in retirement taxable? Not very likely.
While I have no evidence to support this proposition, my guess is that Roth account owners vote at very high rates. Voting to tax Roth withdrawals in retirement seems to be a good way to create a motivated constituency to deny members of Congress re-election. I’m hardly the first person to argue that it is very unlikely that Congress will ever subject Roth withdrawals to income taxation.
The Value Added Tax
There are indirect ways for Congress to attack Roths and tax some of that otherwise tax free account value. One way some worry about is the value-added tax, otherwise known as the VAT. The VAT is a consumption tax on goods and services. The EU has a website here describing the VAT in the European Union. A VAT functions like a sales tax and can be added at any or all levels of production. Many developed countries have a VAT, but the United States does not.
Roths and the VAT
A VAT has the potential to increase the price of goods and/or services, and thus, to potentially eat away at value inside Roth accounts.
Here is a simplified example of how that would work.
Maria is retired. Her annual consumption is approximately $95,000, $5,000 of which is property taxes. She lives off $25,000 a year in Social Security income and $70,000 a year in withdrawals from her Roth IRA. She pays no income taxes on those withdrawals. If a 10 percent VAT were enacted on retail sales, she would need to withdraw approximately $9,000 (10 percent of her current $90,000 non-property tax annual consumption) more from her Roth IRA to pay for her current level of consumption. Instead of using an income tax, the government collects $9,000 from her Roth IRA annually by imposing a VAT.
The VAT functions as a tax on a Roth IRA. As Maria has to withdraw more from her Roth to maintain the same level of consumption, the VAT also reduces the value of amounts inside a Roth IRA. Does this mean a Roth IRA is less desirable?
For the reasons argued below, I believe that the answer is No. First, it should be remembered that were a VAT to be implemented, is almost certain to be implemented in addition to the current federal income tax. Sure, if the United States were to switchfrom an income tax to a VAT traditional IRA owners would win big (having previously received an income tax deduction without a later income tax charge) and Roth IRA owners would lose big. But a switch from an income tax to a VAT is almost certainly not happening.
Second, when assessing the value of Roth accounts in a United States with a VAT, one must compare them to the alternatives: traditional retirement accounts and taxable accounts.
Traditional Versus Roth with a VAT
Let’s start out by examining the difference between a Roth IRA and a traditional IRA if there is a federal VAT. Here is an example.
Joe is 65 years old and retired. He is a lifelong New York Jets fan, and decides he wants to go Super Bowl LVI, to see his Jets, presumably the AFC representatives in the game. One ticket costs $10,000 and Joe’s only source of funds for the purchase is his retirement account. Joe’s marginal federal income tax rate is 22 percent. Here are the results if Joe has a traditional IRA and a Roth IRA both without a federal VAT on the ticket and with a 5 percent federal VAT on the ticket:
No VAT
No VAT
5% VAT
5% VAT
IRA Type
Amount Needed
Income Tax Due
Amount Needed
Income Tax Due
Traditional
$12,821
$2,821
$13,462
$2,962
Roth
$10,000
$0
$10,500
$0
Hopefully you can see what is going on in the table. With a traditional IRA, one cannot simply withdraw $10,000 to pay for a $10,000 expense. There will be income tax due on the withdrawal. In order to net out $10,000 to pay for the ticket, Joe must withdraw $12,821, which covers the cost of the ticket and the 22 percent federal income tax (assume Joe lives in Florida so there’s no state income tax). This is computed as the amount needed ($10,000) divided by 1 minus the tax rate (1 minus .22), which equals $12,821.
With a 5 percent VAT, Joe must pay $10,500 for the Super Bowl ticket. From his traditional IRA, he must withdraw $13,462, computed as the amount needed ($10,500) divided by 1 minus the tax rate (1 minus .22).
As we are about to learn, paying a VAT with a traditional IRA creates a new tax: income tax on the VAT. Paying a VAT with a Roth IRA avoids this new tax.
If Joe pays for his Super Bowl ticket with a traditional IRA, he needs $641 more from his traditional IRA in a VAT environment to pay for the Super Bowl ticket. He must pay $141 in additional income tax to cover this additional withdrawal. The income tax on the VAT is $110 (22 percent of $500), the income tax on the income tax on the VAT is $24 (22 percent of $110), and there is approximately $7 of income tax on the remainder of the income tax required.
See this spreadsheet for the income tax calculation. Incredibly, it is possible to pay income tax on the income tax on the income tax on the income tax on the VAT if you pay the VAT from a traditional IRA. It will get much worse as expenses increase beyond the $10,000 tackled in this example.
The first lesson: a VAT hurts those with traditional IRAs, since they will have to increase their taxable withdrawals to pay for goods and services subject to the VAT. When paid with a traditional retirement account, VAT creates several new taxes: the VAT itself, the income tax on the VAT, the income tax on the income tax on the VAT, etc.
The second lesson: if a VAT is enacted, the Roth protects retirees from the income tax payable on the VAT. The 5 percent VAT increases the total tax cost of the $10,000 ticket by $641 if one uses a traditional IRA but only by $500 if one uses a Roth IRA. Having a Roth protects against income tax on the VAT itself. This makes a Roth an even more desirable planning alternative if there is a VAT than if there is no VAT.
The income tax on the VAT is another tax villain the Roth can successfully defeat.
Roth Versus Taxable with a VAT
I believe the logic applied in the Roth versus Traditional VAT environment applies in assessing Roths versus taxable accounts in a VAT environment. To fund consumption, retirees will have to sell more of their taxable brokerage accounts to pay for the now increased price of goods and services, resulting in higher capital gains (and thus, more capital gains taxes) in many cases. Using a Roth withdrawal to pay a VAT protects against those additional capital gains taxes.
Planning
If one believes that a VAT is coming, there is not much, to my mind, to be done from a financial planning perspective, other than increasing amounts in Roth accounts. One might purchase durable goods in advance of the enactment of a VAT, but that sort of planning is of limited value. How many refrigerators can you stockpile for your future use? For those worried about a VAT, the tactics that appear effective are to increase Roth contributions and/or conversions.
While a VAT would not be good news, it makes the Roth planning decision more likely to be the advantageous planning decision.
Paying a VAT out of a Roth avoids the income tax on the VAT (and the resulting additional income taxes) retirees incur when paying the VAT out of a traditional IRA. A Roth also avoids increased capital gains taxes resulting from using taxable brokerage accounts to pay a VAT.
Conclusion
A VAT is not good news for Roth IRA owners, but it is worse news for traditional IRA owners. Roths limit the tax damage of a VAT to the VAT itself in a way neither traditional retirement accounts nor taxable accounts are capable of. In the age-old traditional versus Roth debate, the possibility of a future VAT moves the needle (if ever so slightly) in the direction of the Roth.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
As always, the discussion is general and educational in nature and does not constitute tax, investment, legal, or financial advice with respect to any particular individual or taxpayer. Please consult your own advisors regarding your own unique situation.
FI Tax Guy can be your financial advisor! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters.Please also refer to the Disclaimer & Warning section found here.
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters.Please also refer to the Disclaimer & Warning section found here.
Really enjoyed this year-end tax planning conversation with Doc G on the Earn & Invest podcast. Stay tuned to the end for some candid behind the scenes podcast recording.
This post (and this podcast episode) is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
The Roth IRA is 25 years old as of 2023 (its birthday was January 1st). Yet there is still confusion about the rules applicable whenever someone withdraws money from a Roth IRA prior to turning 59 ½. This blog post attempts to correct some misconceptions on the taxation of nonqualified Roth IRA withdrawals.
Watch me discuss Roth IRA withdrawals.
Roth IRAs: The Basics
A Roth IRA is a tax-advantaged account that generally offers tax-free growth for invested amounts. Taxpayers receive no upfront tax deduction for putting money into a Roth IRA. If properly executed, taxpayers can withdraw money from a Roth IRA entirely tax and penalty free, and can enjoy years of tax-free growth on the amounts invested in a Roth IRA.
I have previously blogged about why I believe the Roth IRA is a great tax-advantaged account in my An Ode to the Roth IRA.
Roth IRA Funding
How does one move money into a Roth IRA? There are three ways.
Annual Contributions
Generally speaking, if your income is below certain limits, you can contribute up to the lesser of $6,500 or your earned income (2023 limits) to a Roth IRA. If you are aged 50 or older, the limits are the lesser of $7,500 or earned income (2023 limits).
I discussed Roth IRA annual contributions, including the income limits on the ability to make Roth IRA contributions, in this post.
Conversions
Amounts can be converted from traditional retirement accounts into a Roth IRA. Any taxpayer can convert amounts from a traditional retirement account to a Roth IRA. There are no restrictions based on level of income and/or having had earned income.
Conversions are taxable in the year of the conversion.
There are several reasons you might want to do a Roth IRA conversion. One might be the anticipation of paying tax at a higher rate in the future. The planning concept is to “lock in” the lower tax rate in the year of the conversion rather than tomorrow’s (anticipated) higher tax rate, and to get all of the earnings on the contribution out of income taxation.
Unlimited Roth IRA conversions form the backbone of the Backdoor Roth IRA planning concept.
Note that inherited traditional IRAs cannot be converted to Roth IRAs.
Transfers from Workplace Retirement Accounts
A third way to get money into a Roth IRA is by using workplace retirement accounts. Amounts in Roth 401(k)s and other workplace Roth accounts can be transferred into a Roth IRA. Generally, it is best to use direct “trustee-to-trustee” transfers to accomplish this.
Further, after-tax contributions in workplace retirement plans can be directly transferred to Roth IRAs, as discussed in Notice 2014-54. The ability to transfer after-tax contributions into a Roth IRA has facilitated the use of the Mega Backdoor Roth IRA planning technique.
Roth IRA Withdrawals: The Confusion
You may have heard that you cannot take money out of a Roth IRA if the account is not 5 years old without paying tax and a penalty. Not true!
There are not one, but two, five (5) year rules applicable to Roth IRAs. But neither one of them prohibit you from taking money out of a Roth IRA you have previously contributed through annual contributions. First, I will illustrate the default Roth IRA withdrawal rules, and then I will discuss the two 5 year rules.
Quick Thought: Most of this blog post addresses situations where the taxpayer does not qualify for a qualified distribution. Generally, a taxpayer fails to qualify for a qualified distribution if he or she has not attained the age of 59 ½, and/or if he or she has not owned a Roth IRA for 5 years. The advantage of a qualified distribution is that it is automatically tax and penalty free.
Roth IRA Withdrawals: The Layers
Here is the default order of distributions that come out of a Roth IRA. These are the rules that apply in cases where the taxpayer does not qualify for a qualified distribution. All Roth IRAs (other than inherited Roth IRAs) the taxpayer owns are aggregated for purposes of determining his or her Roth IRA layers.
First Layer: Tax-free return of Roth IRA contributions
Second Layer: Roth IRA conversions (first-in, first-out)
Third Layer: Roth IRA earnings
Each layer must come out entirely before the subsequent layer is accessed.
Here’s a brief example:
Example 1: Samantha opened her only Roth IRA in 2018. Samantha has made three prior $5,000 contributions to her Roth IRA (one for each of 2018, 2019, and 2020). She also made a $5,000 conversion from a traditional IRA to a Roth IRA in 2018. In 2021, at a time when her Roth IRA is worth $30,000 and Samantha is 50 years old, she takes a $10,000 withdrawal from her Roth IRA. All $10,000 will be a recovery of her previous contributions (leaving her with $5,000 remaining of previous contributions). Thus, the entire $10,000 distribution from the Roth IRA will be tax and penalty free.
The Roth IRA contributions come out tax and penalty free at any time for any reason! The 5 year rules have nothing to do with whether a taxpayer can recover their previous Roth IRA contributions tax and penalty free!
For those wanting to dig deeper into the tax law, please refer to this technical slide deck discussing why the Roth IRA contributions are distributed tax and penalty free regardless of the 5 year rules.
Note that aggregation rules always apply. In making an analysis like the one provided in Example 1, one must account for all their Roth IRAs and treat all of their Roth IRAs as a single Roth IRA to determine their own Roth IRA layers. Roth 401(k)s and inherited Roth IRAs are not included in the analysis.
5 Year Rule for Roth IRA Earnings
The first five-year rule for Roth IRAs applies only to a withdrawal of earnings from a Roth IRA. If the account owner has not owned a Roth IRA for at least 5 years, the earnings withdrawn from the account are subject to ordinary income tax (and possibly a penalty).
Example 2: Joe is 62 years old in 2024. He has owned a Roth IRA since 2021. In 2024, after having made $14,000 in prior annual contributions to his Roth IRA, he withdrew $17,000 from the Roth IRA. Because Joe has not owned a Roth IRA for 5 years, the withdrawal is not a qualified distribution. Joe recovers his first $14,000 tax free as a return of contributions. The next $3,000 of earnings is taxable to Joe as ordinary income (because of the first five-year rule). Because Joe is over age 59 ½, he does not owe the ten percent penalty on the distribution. If Joe had not attained the age of 59 ½, he would owe the 10 percent penalty on the $3,000 of earnings he received.
5 Year Rule for Roth IRA Conversions
There is a five-year rule applicable to taxable money converted from a traditional retirement account to a Roth IRA (what I will colloquially refer to as the “second five-year rule”). The idea behind the second five-year rule is to protect the 10% early withdrawal penalty applicable when someone has a traditional retirement account. Here is an illustrative example.
Example 3: Milton has $100,000 in a traditional IRA, no basis in any IRA, and is age 50. If he were to withdraw $1,000 from his traditional IRA (assuming no penalty exception applies), he would owe (in addition to ordinary income tax) a $100 penalty (ten percent) on the withdrawal.
Okay, but what if Milton first converts that money from a traditional IRA to a Roth IRA (assume Milton has no other balance in a Roth IRA)? Would that get him out of the 10 percent penalty? No, it won’t, because of the second five-year rule.
Example 4: Milton has $100,000 in a traditional IRA, no basis in any IRA, has no Roth IRAs, and is age 50. In September 2024, he converts $1,000 to a Roth IRA. In October 2024, he withdraws $1,000 from that Roth IRA. Because of the five-year rule applicable to Roth IRA conversions, Milton will still owe the $100 penalty on the withdrawal from the Roth IRA.
Had Milton waited until 2029 or later, he would not have owed the penalty on the withdrawal of that $1,000.
The 5 Year Rule for Roth IRA Conversions and the Backdoor Roth IRA
The Backdoor Roth IRA is subject to the second five-year rule, but the penalty effect turns out to be very minor (or non-existent) if the Backdoor Roth IRA has been properly executed.
Conversions, the second layer of the Roth IRA stack, come out first-in, first out. Further, the taxable amount (potentially subject to the 10 percent penalty upon withdrawal) of any one particular Roth IRA conversion comes out first within the conversion amount. Thus, the second layer (the conversion layer) can be composed of several mini-layers.
Here is a quick example:
Example 5: Denzel made $6,000 nondeductible traditional IRA contributions on January 1, 2019 and January 1, 2020. On February 2, 2019 and February 2, 2020, Denzel converted the entire balance of the traditional IRA ($6,010 each time) to a Roth IRA. As of December 31, 2019 and December 31, 2020, Denzel had $0 balances in all traditional IRAs, SEP IRAs, and SIMPLE IRAs.
In 2021, at a time when Denzel is 35 years old and has made no other contributions or conversions to a Roth IRA, he withdraws $3,000 from his Roth IRA. The first $10 of the withdrawal will be from the taxable amount of his 2019 Roth conversion, and thus, will be subject to the 10 percent penalty as it violates the second five-year rule (Denzel will owe $1 in penalties). The next $2,990 is attributable to the non-taxable portion of his 2019 Roth conversion, and as such, will not be subject to the 10 percent penalty. None of the $3,000 will be subject to ordinary income tax.
Penalty Exceptions
From time to time you will hear things such as “you can withdraw only $10,000 from a Roth IRA for a first-time home purchase.” Does that mean everything else discussed above does not apply?
Fortunately, the answer is no!
So what is the $10,000 rule getting at? It is getting at amounts withdrawn from a Roth IRA that would otherwise be subject to the penalty (and possibly income taxes — see The Super Exceptions below).
There are several penalty exceptions applicable to taxable converted amounts and earnings that are withdrawn from a Roth IRA in a nonqualified distribution. But the penalty exception rules generally apply on top of the usual layering rules, not instead of the usual Roth IRA layering rules.
In a discussion on social media, I used a version of the following example.
Example 6: Jane Taxpayer, age 30, has had a Roth IRA since 2017. In 2020, she withdraws $30,000 from her Roth IRA to acquire her first home, and has never used traditional IRA and/or Roth IRA money for such a purchase. She has previously made $20,000 in annual contributions to the Roth IRA. The first $20,000 of the withdrawal is a tax-free return of those contributions (see the layers above). The next $10,000 is out of earnings (see the layers above). This $10,000 is taxable to her as ordinary income. But, because of the $10,000 “qualified first-time homebuyer distribution” exception, she does not owe the 10 percent penalty on the withdrawal of those earnings.
In this case, withdrawals used to fund certain home purchases can qualify for a penalty exception (the first-time homebuyer exception is subject to a $10,000 cap). Please visit this website for a list of the possible penalty exceptions applicable to withdrawals from a traditional IRA and a Roth IRA.
The Super Exceptions
If the taxpayer is relying on the disability, age 59 ½, death, or qualified first-time home purchase penalty exceptions, the earnings also come out income tax free so long as the taxpayer has owned a Roth IRA for five years. See slide 5 of the above referenced technical slide deck.
As applied to Jane Taxpayer in Example 6 above, if she had owned a Roth IRA since any time in 2015 or earlier, the distribution of $10,000 of earnings would not only have been penalty free, it would have also been income tax free.
60 Day Rollovers
A taxpayer might take money out of a Roth IRA and then reconsider. Perhaps he or she wants the money to grow tax-free. Or perhaps the taxpayer dipped into earnings and the distribution is not a qualified distribution, meaning that it will likely be subject to both ordinary income and a ten percent penalty.
He or she might be able to roll the money back into the Roth IRA. However, the tax rules allow only one 60 day rollover every 12 months. The IRS has a website here discussing some of the issues.
Because of the one-rollover-per-year rule, I generally advise against doing 60 day rollovers unless you need to. Generally, it is best to avoid them, and then have the option available as a life raft if money somehow comes out of a Roth IRA (or other IRA) when it should not have.
Required Minimum Distributions
There are no required minimum distributions from a Roth IRA! Every other non-HSA tax-advantaged retirement account, including the Roth 401(k), has required minimum distributions.
Note that required minimum distributions are generally required once the Roth IRA becomes an inherited Roth IRA (in the hands of anyone but certain surviving spouses).
Tax Planning
Okay, so taxpayers always have tax and penalty free access to old Roth IRA annual contributions. So what of it? As a practical matter, maybe nothing.
In most cases, it makes sense to simply keep the money in the Roth IRA and let it grow tax free!
That said, there can be instances where, as part of a well crafted financial plan, it can make sense to withdraw previous Roth IRA contributions prior to age 59 ½. Further, it is good to know that, in an emergency situation, those old Roth IRA contributions are accessible.
Of course, prior to taking an early withdrawal from a Roth IRA, it is usually best to consult with your own financial advisor and/or tax advisor.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
Roth 401(k)s are gaining prominence as a tax-advantaged workplace retirement account. This post provides introductory information regarding Roth 401(k)s and their potential benefits as a retirement savings account.
Two important introductory notes. First, not all 401(k) plans offer a Roth option, so for some employees, a Roth 401(k) contribution is not an option. Second, this post is for educational purposes only and is not advice for any particular taxpayer.
Traditional 401(k) versus Roth 401(k)
In an ideal world, contributions by an employee to a traditional 401(k) result in a tax deduction when contributed, and taxable income when withdrawn.
Example 1: Tony makes $100,000 from his employer in W-2 wages in 2021. Tony contributes $15,000 during the course of 2021 to his employer’s traditional 401(k). Tony will receive a W-2 from his employer reporting $85,000 of taxable W-2 wages for 2021.
In an ideal world, contributions by an employee to a Roth 401(k) result in no tax deduction when contributed, and no taxable income when withdrawn.
Example 2: Rudy makes $100,000 from his employer in W-2 wages in 2021. Rudy contributes $15,000 during the course of 2021 to his employer’s Roth 401(k). Rudy will receive a W-2 from his employer reporting $100,000 of taxable W-2 wages for 2021.
Roth 401(k) Contributions
Employees can contribute the lesser of their earned income or $19,500 (2021 limit) to a Roth 401(k) in “employee deferrals.” For those 50 years old or older, the 2021 limit is the lesser of earned income or $26,000.
The employee deferral limit factors in both traditional 401(k) employee contributions and Roth 401(k) employee contributions. Here’s an illustrative example.
Example 3: Sarah, age 35, earns $100,000 in W-2 income in 2021 at Acme Industries, Inc. Sarah contributes the maximum to her 401(k) plan. Assuming Acme offers both a traditional 401(k) and a Roth 401(k), that maximum $19,500 contribution can be split up however Sarah chooses ($13,000 to the traditional 401(k) and $6,500 to the Roth 401(k), $5,000 to the traditional 401(k) and $14,500 to the Roth 401(k), etc.).
Any combination (including all in the traditional or all in the Roth) is permissible as long as the total does not exceed $19,500 (using 2021’s limits).
Roth 401(k) Contributions: Income Limits
There’s good news here. Unlike their Roth IRA cousins, Roth 401(k) contributions have no income limits. In theory, one could make $1 billion annually in W-2 income and still contribute $19,500 to a Roth 401(k).
Matching Contributions
Employer matching contributions are one of the best benefits of 401(k) plans.
Example 4: Elaine, age 35, works at Perry Publishing. She earns a salary of $50,000. Perry matches 50% of the first 6% of salary that Elaine contributes to her 401(k). Elaine decides to contribute $3,000 (6 percent) of her salary to the 401(k) as a Roth contribution. Perry contributes $1,500 as a matching contribution. The $1,500 employer match goes into the 401(k) as a traditional contribution. The $3,000 and its growth are treated as a Roth 401(k), and the $1,500 and its growth are treated as a traditional 401(k).
Matching contributions may be subject to vesting requirements, as described in this post. Employee contributions to a 401(k) (whether traditional or Roth) are always 100% vested.
Roth 401(k) Withdrawals
The greatest benefits of a Roth 401(k) are tax-free growth and tax-free withdrawals. Tax-free withdrawals are generally the goal, but they are not automatic. Recently, I wrote a post on Roth 401(k) withdrawals.
One important consideration regarding Roth 401(k) withdrawals: Roth 401(k)s are subject to the required minimum distribution rules starting at age 72. Thus, you must start withdrawing money from a Roth 401(k) at age 72. As a result, you will have less wealth growing tax-free. For this reason, many consider rolling Roth 401(k)s to Roth IRAs prior to age 72.
Conclusion
Roth 401(k)s provide a great opportunity to save and invest for retirement. Taxpayers should consider their own circumstances, and often consult with tax professionals, in deciding their own investment program.
Further Reading
For more information about 401(k) plans, please read this post.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters.Please also refer to the Disclaimer & Warning section found here.
We live in a Roth IRA world (or, at least I wish we did). We also live in a world where increasing numbers of people invest through a Roth 401(k).
The Roth 401(k) is still a relatively new account. Taxpayers and practitioners alike are still learning its contours. Things get even more complicated when you roll money from a workplace Roth 401(k) to a Roth IRA.
To get our feet wet, first I will illustrate the ordering rules for withdrawals from a Roth IRA. Then we will explore withdrawals from a Roth 401(k).
Note that much of this post discusses withdrawals before age 59 ½. In most cases, it is not wise to take a withdrawal from a retirement account before age 59 ½ unless (a) there is an emergency or (b) it is part of a well crafted financial plan.
Watch me discuss Roth 401(k) withdrawals.
Default Rule for Roth IRA Withdrawals: The Layers
Unless the distribution qualifies as a “qualified distribution” (see below), amounts come out of Roth IRAs in layers. Only after one layer has been exhausted can the next layer come out.
Here is the order of distributions that come out of a Roth IRA:
Second Layer: Roth IRA conversions (first-in, first-out)
Third Layer: Roth IRA earnings
Here’s a brief example:
Example 1: Steve has made five $5,000 contributions to his Roth IRA in previous years. He also made a $10,000 conversion from a traditional IRA to a Roth IRA in 2014. In 2021, at a time when his Roth IRA is worth $60,000 and Steve is 45 years old, he takes a $10,000 withdrawal from his Roth IRA. All $10,000 will be a recovery of his previous contributions (leaving him with $15,000 remaining of previous contributions). Thus, the entire distribution from the Roth IRA will be tax and penalty free.
The Roth IRA contributions come out tax and penalty free at any time for any reason!
A qualified distribution from a Roth IRA is usually one where the account holder both (i) has owned a Roth IRA for at least 5 years and (ii) is at least 59 ½ years old. If either condition is not satisfied, the default layering rules described above apply. Qualified distributions from a Roth IRA are tax and penalty free regardless of the layers inside the Roth IRA.
See page 31 of IRS Publication 590-B for more information about qualified distributions from Roth IRAs.
Roth 401(k) Withdrawals
First, a practical note: employers may restrict in-service Roth 401(k) withdrawals before age 59 1/2. Consider that before thinking about how the tax rules apply to withdrawals.
Default Rule: Cream-in-the-Coffee
Generally speaking, Roth 401(k)s have (1) investment in the contract (“IITC”), which is generally previous contributions and conversions and (2) earnings.
Unlike the sequenced layering of Roth IRA withdrawals, Roth 401(k) withdrawals generally default to what Ed Slott refers to as the “cream-in-the-coffee” rule (see Choate — discussed below, page 140).
As a result, withdrawals default to carrying out both some IITC and some earnings. Here’s an example:
Example 2: Lilly has made five $6,000 contributions to her Roth 401(k) in previous years. She also made a $10,000 conversion from a traditional 401(k) to her Roth 401(k) in 2014. In 2021, at a time when her Roth 401(k) is worth $60,000 and Lilly is 45 years old, she takes a $10,000 withdrawal from her Roth 401(k). Two-thirds ($6,667, computed as the fraction $40,000 divided by $60,000 times the withdrawal) of the $10,000 will be a recovery of her IITC (entirely tax and penalty free), and one-third ($3,333, computed as the fraction $20,000 divided by $60,000 times the withdrawal) of the $10,000 will be earnings, which are subject to both ordinary income taxation and a 10 percent penalty.
Quick Thought: Had Lilly’s Roth conversion occurred in 2017 or later, the portion attributable to the conversion ($1,667) would be subject to the 10 percent early withdrawal penalty (but not to ordinary income taxation).See Section 402A(c)(4)(D) and Section 408A(d)(3)(F). Note an earlier version had “2018 or earlier” where the bolded words are in error. I regret the error.
Quick Thought: The cream-in-the-coffee rule does not factor in amounts in traditional 401(k) accounts, even if they are within the same 401(k) plan.
Solving the Cream-in-the-Coffee Issue
We see that the cream-in-the-coffee rule has bad effects. It does not allow exclusive access to tax-favored amounts when there are non-tax favored amounts in an account. So what to do? There are three primary exceptions to the cream-in-the-coffee rule.
Exception 1: Wait for a Qualified Distribution
The cream-in-the-coffee rule can be waited out.
A qualified distribution from a Roth 401(k) is a withdrawal that occurs when the owner is age 59 ½ (see Treas. Reg. Sec. 1.402A-1 Q&A 2(b)(2)) and has had that particular Roth 401(k) account for five years (see Treas. Reg. Sec. 1.402A-1 Q&A 2(b)(1) and Q&A 4). Other qualified distributions can occur upon death or disability (if the 5 year test is satisfied), but for our purposes, we will assume for the rest of the article that any qualified distributions are qualified distributions occurring at or after age 59 ½ and after five years of ownership.
The owner of a Roth 401(k) who qualifies for a qualified distribution does not need to roll the Roth 401(k) to a Roth IRA to take a tax free withdrawal. Once the owner qualifies for a qualified distribution he or she can simply withdraw amounts from the Roth 401(k) tax-free.
However, as a practical matter, it is often the case that Roth 401(k)s are rolled into Roth IRAs (for several reasons). If the rollover from the Roth 401(k) to the Roth IRA would qualify as a qualified distribution if taken directly, then the entire amount in the Roth 401(k) (IITC and earnings) goes into the Roth IRA as a contribution. Ian Berger discussed this issue in an August 11, 2022 response to a question. His answer applies the rule in Treas. Reg. Sec. 1.408A-10 Q&A 3 (the sentence beginning with “Thus,”).
Up to the amount rolled into the Roth IRA can be distributed tax and penalty free. So long as the taxpayer has met the 5 year rule with respect to any Roth IRA, any future earnings beyond the amount rolled in can be withdrawn tax free at any time.
Quick Thought: I would be remiss if I didn’t insert the standard tax planner advice that rollovers from Roth 401(k)s to Roth IRAs are best accomplished through a direct trustee-to-trustee transfer.
There is one five year rule nuance to consider. If the taxpayer has never had a Roth IRA, he or she must wait 5 years (regardless of their age) to access later earnings generated by rollover contribution tax free. Here’s a quick example:
Example 3: John is 60 years old. He has never had a Roth IRA. He has had a Roth 401(k) with his employer for over five years. He has made $100,000 of contributions to the Roth 401(k) which has grown to $200,000. He does not need to roll his Roth 401(k) into a Roth IRA to take out money entirely tax and penalty free.
If John chooses to roll all $200,000 in his Roth 401(k) into a Roth IRA, all $200,000 goes into the Roth IRA as a contribution. If John withdraws more than $200,000 from the new Roth IRA before the Roth IRA turns 5 years old, those withdrawals of new earnings would be subject to income tax (though, of course, penalty free since John is over 59 ½ years old).
As a practical matter, as long as the taxpayer does not plan on withdrawing more than the rolled over amount in the first five years, this nuance is not likely to be a gating issue in determining whether the Roth 401(k) should be rolled over to a Roth IRA.
Exception 2: Roth 401(k) Rollover then Withdraw
The second strategy to overcome the cream-in-the-coffee rule is to rollover the Roth 401(k) to a Roth IRA without waiting.
If either the taxpayer is less than 59 ½ years old and/or has not held that particular Roth 401(k) for at least five years, the nonqualified distribution rules apply to the rollover. The Roth 401(k) goes into the Roth IRA as “contributions” to the extent of the IITC in the Roth 401(k), and as “earnings” to the extent of growth in the Roth 401(k).
Recall the example of Lilly above. Here is how it changes if she rolls the Roth 401(k) into a Roth IRA and then takes the withdrawal.
Example 4: Lilly has made five $6,000 contributions to her Roth 401(k) in previous years. She also made a $10,000 conversion from a traditional 401(k) to her Roth 401(k) in 2014. In 2021, at a time when her Roth 401(k) is worth $60,000 and Lilly is 45 years old, she rolls her Roth 401(k) over to a Roth IRA (her first ever). A month later, Lilly takes a $10,000 withdrawal from her Roth IRA. All $10,000 will be a recovery of her previous contributions (leaving her with $30,000 remaining of previous contributions). Thus, the entire withdrawal will be tax and penalty free.
While rollovers of nonqualified distributions do not eliminate Roth 401(k) earnings, they do eliminate the cream-in-the-coffee rule. As a result, Roth 401(k) to Roth IRA rollovers often make sense.
The Five Year Roth Earnings Rule
Where such rollovers can be disadvantageous is the five year rule as applied to earnings. Recall that being age 59 ½ is a necessary, but not sufficient, condition to withdrawing Roth earnings tax free. You also need to meet a 5 year rule.
If you have a Roth 401(k) that is 5 years old but have never had any Roth IRA, and you are less than 5 years away from attaining age 59 ½, rolling into a Roth IRA could subject withdrawals of earnings (after age 59 ½) in excess of IITC to ordinary income taxation. That said, often withdrawals do not exhaust contributions in the first five years after a rollover. Thus, often this will not be a gating issue.
Exception 3: Roth 401(k) Withdrawal then Rollover
There is a third way to overcome the cream-in-the-coffee rule. It is to take a withdrawal from the Roth 401(k) and then rollover the earnings component to a Roth IRA. Let’s see how that would affect Lilly:
Example 5: Lilly needs $10,000 and has decided to access it from her Roth 401(k). Lilly has made five $6,000 contributions to her Roth 401(k) in previous years. She also made a $10,000 conversion from a traditional 401(k) to her Roth 401(k) in 2014. In 2021, at a time when her Roth 401(k) is worth $60,000 and Lilly is 45 years old, Lilly takes a $15,000 withdrawal from her Roth 401(k). Based on her Roth 401(k) consisting of two-thirds IITC and one-third earnings, $5,000 of the withdrawal is taxable and subject to an early withdrawal penalty. However, Lilly can, within 60 days, rollover the $5,000 of earnings into a Roth IRA. The earnings will go into the Roth IRA as earnings, and Lilly avoids the tax and penalty on the withdrawal.
Note that if Lilly does this partial rollover, the rollover piece is not subject to the cream-in-the-coffee rule. The partial rollover attracts earnings before attracting any IITC (see Treasury Regulation Section 1.402A-1 Q&A 5).
Note further that if Lilly has no other Roth IRAs, she now has a Roth IRA that consists only of earnings. She will not (generally speaking) be able to touch this Roth IRA without ordinary income tax and a penalty until age 59 ½.
As a practical matter, the “withdraw then rollover” strategy may not be available to Lilly. The 401(k) plan may not allow partial distributions pre-age 59 1/2 after separation from service.
Coordination with the Rule of 55
Many like the Rule of 55, which is a rule that allows taxpayers to take amounts from workplace retirement plans such as 401(k)s without the early withdrawal penalty. It applies when a taxpayer separates from service at age 55 or older (up to age 59 ½, when withdrawals become penalty free), and the plan allows partial withdrawals.
So the question becomes, if you are in the 4.5 year Rule of 55 window (ages 55 to 59 ½) and you separate from service, should you leave a Roth 401(k) in the plan or roll it into a Roth IRA if you need to withdraw from it? Let’s consider an example.
Example 6: James is 56 years old and leaves his employment. He has contributed $100,000 over more than five years to his Roth 401(k), and it is currently worth $200,000. If he keeps the amounts in the Roth 401(k), every dollar he takes out will be half recovery of IITC (tax-free) and half a withdrawal of earnings (taxable, but qualifies for a penalty exception). If, instead, James follows the “rollover then withdraw” strategy and rolls his Roth 401(k) to a Roth IRA, the first $100,000 he withdraws before age 59 ½ will be a return of contributions, and only if he exceeds $100,000 in withdrawals will he have ordinary income and a penalty. A second option for James would be to do the “withdraw then rollover” strategy whereby James would direct half of each distribution (the earnings half) to a Roth IRA in order to avoid ordinary income taxation on the earnings portion.
This illustrates that numbers matter in this regard. It also shows that as long as the pre-age 59 ½ withdrawals will be less than the previous Roth 401(k) contributions, it is generally better to take the withdrawals from a rollover Roth IRA than from a Roth 401(k) penalty protected by the Rule of 55.
However, if one employs the “withdraw then rollover” strategy, keeping money in the Roth 401(k) can work as effectively as rolling over to a Roth IRA.
A Note on Rollovers
Any designated Roth account (401(k), 403(b), and/or 457) can be rolled into a Roth IRA. Designated Roth accounts can be rolled into other designated Roth accounts, though note there can some be some complexity in this regard.
Roth IRAs cannot be rolled into a designated Roth account, including a Roth 401(k).
The IRS has a handy rollover chart accessible here.
SECURE 2.0 Update
SECURE 2.0 makes three changes relating to Roth 401(k)s. First, it eliminates required minimum distributions (“RMDs”) from Roth 401(k)s during the owner’s lifetime. This change has little practical effect, as many Roth 401(k)s will ultimately be rolled to Roth IRAs anyway in order for the owner to obtain more investment choice and control of the account.
Second, SECURE 2.0 mandates that beginning in 2024, employee catch-up contributions to 401(k) accounts must be Roth contributions if the employee made more than $145,000 in wages the prior year.
Third, SECURE 2.0 allows employer contributions to Roth 401(k)s.
I suspect that based on the second and third changes, more employers may offer Roth 401(k)s in addition to traditional 401(k)s.
Further Reading
For those interested in seeing more information on distributions out of Roth IRAs after rollovers of Roth 401(k)s, please see Treasury Regulation Sec. 1.408A-10. For more information on rollovers of distributions from Roth 401(k)s into Roth IRAs, please see Treasury Regulation Sec. 1.402A-1.
The rules around Roth 401(k)s are complex, and different than those applicable to Roth IRAs. This blog post only presents an educational introduction to those rules. Taxpayers should exercise extra caution, and often consult with tax professionals, before moving money out of a Roth 401(k).
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters.Please also refer to the Disclaimer & Warning section found here.
