Despite being 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.

Key Takeaways

  • Contributions and earnings in a Roth 401(k) can be withdrawn without paying taxes and penalties if the account owner at least 59½ and has held their Roth 401(k) account for at least five years.
  • Withdrawals can also be taken without penalty if the account owner becomes disabled or by a beneficiary after the account owner's death.
  • Rollovers to a Roth IRA allow an account holder to avoid taxes on Roth 401(k) earnings.
  • Taking a loan from a Roth 401(k), if allowed, let's an account owner avoid taxes and penalties, provided rules for paying the money back are followed.

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. While not all companies with employer-sponsored retirement plans offer a Roth 401(k), they are becoming 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. In 2019, you can contribute up to $19,000 per year or $25,000 if you are age 50 or older.

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. In addition, withdrawals can be taken 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 70½. If you're still working at age 70½, you don't have to take RMDs. But if you own a 5% or larger share of the employing company, the distribution must begin at age 70½ regardless of employment status.

Unlike Roth 401(k)s, Roth IRAs are not subject to required minimum distributions.

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.

Taxes on Unqualified Withdrawals

If a withdrawal is made from a Roth 401(k) account that does not meet the above criteria, it is considered early or "unqualified." You can withdraw contributions from a Roth 401(k) without paying a penalty (or taxes, since Roth contributions are made with after-tax dollars). However, if the withdrawal is not qualified, you’ll pay taxes on any earnings you withdraw and potentially be subject to a 10% early withdrawal penalty.

Early withdrawals are prorated between nontaxable contributions and 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 $1,000 / $10,000, or 0.10. 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.

Rolling Over Funds in a Roth 401(k)

You can also avoid taxation on your earnings if your withdrawal is for the purposes of a rollover. If the funds are simply being moved into another retirement plan or into a spouse's plan via direct rollover, no additional taxes are incurred. If the rollover is not direct, meaning 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.

In addition, when you do an indirect rollover, the portion of the distribution attributable to contributions cannot be transferred to another Roth 401(k), according to the IRS, 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 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 being funded with after-tax dollars.

Advisor Insight

Scott Bishop, CPA, PFS, CFP®
STA Wealth Management, LLC, Houston, TX

Assuming that you are no longer working for the 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.