Despite the fact that it's funded with after-tax dollars, a Roth 401(k) account is not immune to taxes and potential penalties if you don't know how rules regarding withdrawals work. Understanding the requirements will keep you from losing part of your retirement savings. These taxes and penalties are one more reason to avoid making withdrawals for any reason but a serious emergency. Here's how it works:
- Understanding the rules about Roth 401(k) accounts can keep you from losing part of your retirement savings
- Contributions and earnings in a Roth 401(k) can be withdrawn without paying taxes and penalties if you are at least 59½ and had your account for at least five years.
- Withdrawals can be made without penalty if you become disabled or by a beneficiary after your death.
- Rollovers allow you to avoid taxes on Roth 401(k) earnings.
- You can avoid taxes and penalties by taking a loan from your Roth 401(k) as long as you follow the repayment rules.
Roth 401(k)s: The Basics
A Roth 401(k) includes a combination of the features of a traditional 401(k) and a Roth IRA. Though not all companies with employer-sponsored retirement plans offer a Roth 401(k), they are increasingly popular.
Unlike a traditional 401(k), contributions are made with after-tax dollars and are not deductible, but you don't pay taxes on withdrawals when you retire. For 2022, you can contribute up to $20,500 per year ($19,500 per year in 2021), or $27,000 if you are age 50 or older ($26,000 in 2021).
Roth 401(k) Withdrawal Rules
To make a qualified withdrawal from a Roth 401(k) account, retirement savers must have been contributing to the account for at least the previous five years and be at least 59½ years old. Also, withdrawals can be made if the account holder becomes disabled, or after the death of an account owner, in which case the funds would go to the beneficiaries of the account.
The terms of Roth 401(k) accounts also stipulate that required minimum distributions (RMDs) must begin by age 72. That distribution age is 70½ if you reached that age by Jan. 1, 2020. If you're still working at age 70½, you don't have to take RMDs from the account of the employer for which you currently work. But if you own a 5% or larger share of the employing company, the distribution must begin at age 72 regardless of employment status.
Unlike Roth 401(k)s, Roth IRAs are not subject to RMDs. Because contributions to a Roth plan are made with after-tax dollars, you do not need to pay income tax on qualified distributions, though you still have to report them to the IRS on Form 1099-R when filing your taxes.
If a withdrawal is made from a Roth 401(k) account that does not meet the above criteria (if you're at least 59½ and the account is at least five years old), it is considered early or unqualified. And that means you may have to pay income taxes and a 10% IRS tax penalty on some but not all of the amount you take out.
Basically, you can withdraw a sum equivalent to the contributions from a Roth 401(k) without paying a penalty or taxes, because Roth contributions are made with after-tax dollars. Any distributed earnings, though, are liable for taxes and penalties.
There is one catch, though. Early withdrawals have to be prorated between (nontaxable) contributions and (taxable) earnings. To calculate the portion of the withdrawal attributable to earnings, simply multiply the withdrawal amount by the ratio of total account earnings to account balance. If your account balance is $10,000, made up of $9,000 in contributions and $1,000 in earnings, then your earnings ratio is 0.1 ($1,000 ÷ $10,000).
In this case, a $4,000 withdrawal would include $400 in taxable earnings, which would need to be included in the gross annual income reported to the IRS on your taxes. There'd also be a 10% tax penalty on the $400, or $40.
On March 27, 2020, former President Trump signed the $2 trillion Coronavirus Aid, Relief, and Economic Security (CARES) Act. It allowed withdrawals of up to $100,000 from traditional or Roth 401(k) for 2020 only without the 10% penalty for those under age 59½. Penalties for those under age 59½ who withdraw money from traditional or Roth IRAs or 401(k)s went back into effect starting Jan. 1, 2021.
Rolling Over Funds in a Roth 401(k)
You can avoid taxation on your earnings if your withdrawal is for a rollover. If the funds are simply moving into another retirement plan or a spouse's plan via direct rollover, no additional taxes are incurred.
If the rollover is not direct (the funds are distributed to the account holder rather than from one institution to another), the funds must be deposited in another Roth 401(k) or Roth IRA account within 60 days to avoid taxation.
When you do an indirect rollover, the portion of the distribution attributable to contributions cannot be transferred to another Roth 401(k) but it can be transferred into a Roth IRA. The earnings portion of the distribution can be deposited into either type of account.
Borrowing from a Roth 401(k)
Although there's no tax-free way to withdraw tax-free money from your Roth 401(k) before age 59½, taking a loan from your account is a way to use the funds for current needs without diminishing your retirement savings. Many 401(k) plans, Roth or traditional, allow for the account holder to take out a loan of $10,000 (or 50% of the account balance, whichever is greater), but loans cannot exceed $50,000.
Loans must be repaid within five years in generally equal payments made at least quarterly. The benefit is that you are borrowing money from yourself, and all payments and interest charged go directly back into your retirement account. Failure to repay the loan as stipulated, however, may result in it being considered a taxable distribution.
The Bottom Line
When household bills start piling up or unexpected expenses crop up, reaching into your retirement savings may seem appealing in the short term. Retirement accounts like Roth and traditional IRAs and 401(k) plans are not designed for easy access.
If you raid your retirement funds without knowing the rules, you risk losing part of your savings to penalties and tax payments. A Roth 401(k) account is not immune to these problems, despite the fact that it's funded with after-tax dollars.
Scott Bishop, CPA, PFS, CFP®
Avidian Wealth Management, LLC, Houston, TX
Assuming that you no longer work for your company, your account statements should indicate whether you have the five years completed, but if not, you can find out from the plan administrator. The first year the Roth 401(k) became available was 2006, and if your first contribution was before 2014, your plan is now fully qualified tax-free upon distribution.
If you are still employed and eligible for withdrawal, it’s best to roll it over to a Roth IRA. If your trades generate gains in the taxable account, you will owe annual taxes on the gains, but if you trade in a Roth IRA, all gains are tax-deferred until you have had a Roth IRA for five years.
Even if you do not have a Roth IRA right now, the rollover of a qualified Roth 401(k) will be treated as regular Roth IRA contributions.