From the October 2007 issue of Boomer Market Advisor • Subscribe!

Timing mistakes are taxing in Roth 401(k) distribution planning

The Roth 401(k) regulations were finalized by the IRS on April 30, 2007. Hopefully, you have persuaded your clients to contribute to a Roth 401(k) if the option is available to them. The next step is in educating your clients to contact you before withdrawing funds or initiating rollovers from the hybrid account. Making withdrawals from a Roth 401(k) account or completing a rollover into a Roth IRA at the wrong time can have unwanted and unintended tax consequences.

An important distinction exists between a qualified distribution and a nonqualified distribution from a Roth 401(k). A distribution is qualified (i.e., there are no tax consequences) if the account has been held for five years before the first distribution and if the distribution is either:

1. Made on or after the date the client reaches age 59 1/2 ,
2. Made after the client's death, or
3. Attributable to the client's disability.

A distribution for any other purpose from a Roth 401(k) account is a nonqualified distribution.

For example, suppose your client is a 60-year-old woman who starts contributing to a Roth 401(k) account in 2007 and retires from her job in 2010. When she retires, she has contributed $60,000 to the Roth portion of her 401(k) account, which has grown to $75,000. The traditional portion of her 401(k) account is worth $525,000. Since she has only held her Roth 401(k) account for three years, any distributions made from the account in 2010 will be considered nonqualified distributions. If your client thought she could withdraw her $60,000 of Roth contributions tax-free she would be mistaken. Unfortunately, the taxes on a nonqualified distribution from Roth 401(k) are calculated on a pro-rated basis between the traditional portion of the 401(k) account and the Roth portion of the 401(k) account. In this example, of the $600,000 in the account, 90 percent is considered taxable (the traditional portion of the 401(k) and the earnings on the Roth portion) and only 10 percent is considered tax-free (the contributions to the Roth portion of the 401(k) account). Thus, $54,000 (90 percent) of the $60,000 distribution from the Roth 401(k) account would be taxable.

This rule stands in sharp contrast to the Roth IRA rule which permits withdrawals of your contributions (the "basis") at any time without tax consequences.

But there is a way around this. Your client can withdraw the $60,000 tax-free if she does a direct rollover of the Roth 401(k) into a new Roth IRA. The $60,000 withdrawal would still constitute a nonqualified distribution because the Roth IRA would not have been held for five years. However, because the Roth IRA nonqualified distribution rules permit you to treat a distribution of your Roth contributions as a return of basis, the client would not be subject to any income tax on the distribution.

Although this outcome is not particularly onerous for this client, consider a client who had been contributing to his Roth 401(k) since his 30s. Then at age 58, he opens a Roth IRA. When he rolls his Roth 401(k) into his Roth IRA, should he decide to withdraw funds from the Roth IRA before satisfying the five year requirement, he would only have tax-free access to the basis, not the full account balance. This is why long-term planning for Roth 401(k) distributions is so important.

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