While Roth 401(k)s have been around for almost 20 years, it’s widely expected that many more employers will start offering the retirement plan option given the Secure 2.0 Act’s mandate that higher-income taxpayers classify catch-up contributions as Roth contributions.
And that means that advisors should expect an uptick in questions surrounding the savings vehicle — namely, questions regarding rollovers and conversions. Today’s high-inflationary environment may be a great time to execute a Roth conversion and create a source of tax-free retirement income. Clients with Roth 401(k) balances may also wish to roll those balances into Roth individual retirement accounts when leaving employment.
The rules governing Roth 401(k)s are nuanced and can be incredibly challenging. These accounts are also extremely valuable in giving individuals an option for controlling their tax rates, and it’s important for clients to understand how to maximize these planning opportunities.
Tax Treatment of Roth 401(k) Rollovers
Roth 401(k)s and individually maintained Roth IRAs share the same tax treatment, so it would seem fairly simple to roll Roth 401(k) funds into a Roth IRA. In reality, there are several often-misunderstood rules that apply.
The tax treatment that applies to distributions first hinges on whether the Roth 401(k) distribution was qualified. A Roth 401(k) distribution is qualified if (1) the owner was at least 59.5 years old or disabled and (2) at least five years have passed since Jan. 1 of the year that the owner made the first Roth contribution to the employer’s plan, whether via direct contribution, in-plan conversion or rollover. Contributions to other Roth accounts don’t start the clock with respect to any other account.
If the distribution is qualified, the entire amount that was rolled over can be withdrawn tax-free. Earnings after the rollover are tax-free only if a separate five-year holding period is met. The IRA holding period requirement is satisfied when five years have passed since the date that the owner made a contribution to any Roth IRA. If the five-year Roth IRA holding period is not satisfied, the earnings generated after the rollover are taxable.
If the original Roth 401(k) distribution is not qualified, both pre- and post-rollover earnings can be withdrawn tax-free only if the Roth IRA distribution is qualified. For that, (1) the owner was at least 59.5, disabled or using the funds for a first-time home purchase and (2) five years have passed since the first Roth contribution. It’s also possible that a 10% early withdrawal penalty may apply.
Timing to Execute a Roth Conversion
When traditional retirement funds are converted to a Roth account, the entire amount converted is subject to ordinary income taxes. Many individuals attempt to time Roth conversions based on projections about their future income levels and changing tax rates. Of course, tax rates are at a historic low, and there’s no certainty to those rates being extended past 2025. Additionally, prolonged inflation is putting a strain on many individuals.
That said, a high-inflation environment is positive from a tax standpoint. Every year, the tax brackets expand, while the tax rates remain the same. When inflation is high, these cost-of-living adjustments are more substantial. Many lower tax brackets are now much wider than they were just a few years ago.
Because of the marginal nature of the tax code, that means that more of a taxpayer’s income is taxed at the lower rates. In the context of Roth conversions, that means it may be possible for a taxpayer to convert more funds at the lower rates.
For example, in 2025, the 24% tax rate applies to income between $206,701 and $394,600 for joint filers. A couple with a $300,000 income level would have $94,600 left in the 24% bracket. The couple may wish to execute a Roth conversion to “use up” the rest of their 24% bracket. Waiting until a future year to convert could mean that more of the converted amount would be taxed at a higher rate.
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