Although funded in dollars after tax, a Roth 401 (k) account is not immune to taxes and potential penalties if you don’t know how the withdrawal rules work. Understanding the requirements will prevent you from losing part of your retirement savings. These taxes and penalties are another reason to avoid withdrawal in anything other than a serious emergency. Here’s how it works
Key to take away
- Contributions and earnings in Roth 401 (k) can be withdrawn without paying taxes and penalties if the account holder is at least 59½ and has kept his Roth 401 (k) account for at least five years.
- Payment can also be made without penalty if the account holder becomes disabled or the user after the death of the account holder.
- Transfers to the Roth IRA allow the account holder to avoid the Roth 401 (k) earnings tax.
- Taking a loan from Roth 401 (k), if allowed, allows the account holder to evade taxes and penalties, provided the refund policy is followed.
Roth 401 (k) s: Fundamentals
The Roth 401 (k) includes a combination of the features of the traditional 401 (k) and the Roth IRA. While not all companies with pension plans sponsored by employers offer Roth 401 (k), they are becoming increasingly popular.
Unlike the traditional 401 (k), contributions are paid in dollars after tax and cannot be deducted, but you do not pay withdrawal tax when you withdraw.UFor 2020 and 2021, you can contribute up to $ 19,500 per year or $ 26,000 if you are 50 years old or older.UU
Roth 401 (k) Withdrawal Rules
In order to make a “qualified” withdrawal from a Roth 401 (k) account, retired savers had to contribute 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 the account holder, in which case the funds will go to the account users.UU
The terms of the Roth 401 (k) account also stipulate that minimum allocations (RMDs) must begin by year 72. That distribution age is 70½ if you have reached that age by 1 January 2020. If you are still working at 70 70, you do not have to take RMDs from the account of the employer you currently work for. But if you own a 5% or higher stake in the employer company, distribution must begin at age 72, regardless of employment status.UU
Penalties for those under the age of 59 who withdraw money from traditional or Roth IRAs or 401 (k) have re-enacted beginning January 1, 2021. On March 27, 2020, President Trump signed an emergency incentive law for coronavirus in the amount of 2 billion dollars by which these suspended fines, but only for 2020.UU
Unlike Roth 401 (k) s, Roth IRAs are not subject to minimal distribution. Because contributions to the Roth Plan are given in dollars after tax, you do not have to pay income tax on qualified distributions, although you must report them to the IRS on Form 1099-R when filing taxes.UU
On March 27, 2020, President Trump signed the $ 2 trillion coronavirus promotion law, known as the Relief, Assistance and Economic Security Act (CARES). In 2020 alone, up to $ 100,000 is allowed to be withdrawn from the traditional or Roth 401 (k) without a 10% penalty for those under 59.
Tax on unqualified withdrawals
If the withdrawal is made from a Roth 401 (k) account that does not meet the above criteria, it is considered premature or “unqualified”.UYou can retire contributions of Roth 401 (k) without paying a fine (or tax, because Roth contributions are paid in dollars after tax). However, if the withdrawal is not qualified, you will pay tax on either earnings you withdraw and are potentially subject to a 10% penalty for early withdrawal.UU
Early withdrawals are proportional between non-taxable contributions and earnings. To calculate the portion of the withdrawal that can be attributed to earnings, simply multiply the amount of the withdrawal by the ratio of your total account earnings to your account balance. If your account balance is $ 10,000, consists of a $ 9,000 contribution and $ 1,000 earnings, then your earnings ratio is 0.10 ($ 1,000 / $ 10,000).
In this case, a $ 4,000 withdrawal would include $ 400 of taxable earnings, which should be included in the gross annual income reported to the IRS on your taxes.
Overturning funds in Roth 401 (k)
You can also avoid taxing your earnings if your withdrawal relates to a rollover. If the funds are simply transferred to another pension plan or to the spouse’s plan through direct recovery, no additional taxes will be incurred. If the transfer is not direct, which means that the funds are distributed to the account holder and not between one institution to another, the funds must be deposited in another Roth 401 (k) or Roth IRA account within 60 days to avoid taxation.UU
Also, when you perform an indirect rollover, the portion of the allocation that can be attributed to contributions, according to the IRS, cannot be transferred to another Roth 401 (k), but can be transferred to the Roth IRA. Part of the earnings in the distribution can be deposited in any type of account.
Borrowing from Roth 401 (k)
Although there is no non-taxable way to withdraw non-taxable money from your Roth 401 (k) before age 59, taking a loan from your account is a way to use the funds for current needs without reducing your retirement savings. Many 401 (k) plans, Roth or traditional, allow the account holder to take out a loan of $ 10,000 or 50% of the account balance, whichever is greater, but loans must not exceed $ 50,000.UU
Loans must be repaid within five years in generally equal installments at least quarterly.UThe advantage is that you borrow money from yourself, and all charges and interest are returned directly to your pension account. Failure to repay the loan as provided, however, may result in it being considered a taxable distribution.
The bottom line
When household bills start to pile up or unexpected expenses arise, coming to your retirement savings can look appealing in the short term. Retirement accounts like Roth and traditional IRAs and 401 (k) plans are not designed for easy access.
If you break into your pension funds without knowing the rules, you run the risk of losing part of your savings due to penalties and paying taxes. The Roth 401 (k) account is not immune to these problems, although it is funded in dollars after tax.
Scott Bishop, CPA, PFS, CFP®
STA Wealth Management, LLC, Houston, Texas
Assuming you no longer work for the company, your account statements should indicate whether you are five years old, but if not, you can find out from the plan administrator. The first year Roth 401 (k) became available was in 2006, and if your first contribution was before 2014, your plan is now fully exempt from distribution taxes.
If you are still employed and eligible for withdrawal, it is best to hand it over to the Roth IRA. If your trade generates gains in a taxable account, you will owe annual gains taxes, but if you trade a Roth IRA, all gains are tax deductible until you have a Roth IRA for five years.
Even if you do not currently have a Roth IRA, crossing a qualified Roth 401 (k) will be treated as a regular contribution of the Roth IRA.