Roth IRA v. Roth 401(k)? Maximizing Distributions
Roth IRAs and Roth 401(k)s are two incredibly similar types of savings account—each designed to provide a source of tax-free income during retirement. Of course, as with any type of tax-preferred, IRC-governed account, the rules are more complicated than they initially appear.While individually established Roth IRAs and employer-sponsored Roth 401(k)s are similar animals, they're by no means identical.Each type of account is governed by its own set of rules when it comes to distributions. Contrary to widespread belief, distributions aren't automatically tax-free (at least not entirely). Understanding the rules applicable to the specific type of account is critical when it comes time to take a distribution. Without understanding the nuances that apply, the risk of incurring taxes and penalties upon distribution remains very real—even when you're dealing with a Roth.
Roth Distribution Rules: The Basics
Roth IRAs and Roth 401(k)s start out similarly—each type of account is funded with after-tax dollars.Amounts that are contributed to either type of account can always be withdrawn tax-free (because they've already been taxed). It is, however, possible that earnings on contributions may be taxable if the account owner hasn't owned the Roth for at least five years.
Here's where understanding the distribution rules becomes particularly important.Roth funds are always divided into three buckets: direct contributions, converted dollars and earnings. Roth IRAs follow an ordering rule. When the owner takes a distribution, it's treated first as though it comes from the direct contribution bucket. Once that direct contribution bucket is "empty", the remaining distribution is then treated as though it comes from converted dollars. Only once all contributions and converted dollars are withdrawn will the earnings bucket be touched.
Roth 401(k)s use a pro rata rule. Distributions from Roth 401(k)s are treated as a pro rata mix of direct salary deferral contributions, converted dollars and earnings.
Understanding the Tax Implications
The tax treatment that applies to distributions will first hinge on whether the Roth 401(k) distribution was qualified or not qualified. A Roth 401(k) distribution is qualified if (1) the owner was at least 59 1/2 or disabled and (2) at least five years have passed since January 1 of the year the owner made their 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 account owner is at least 59 ½ years old and the account has been held for at least five years, the difference in distribution rules isn't important. Any distribution will be entirely tax-free. If the Roth 401(k) is rolled into a Roth IRA, all of the amounts rolled over are treated as direct contributions from day one.
Taxes and penalties may apply if the distribution is a non-qualified distribution. When a Roth 401(k) owner takes a non-qualified distribution, they can't take only from the non-taxable direct contributions bucket. Any distribution will be a pro rata mix—and the non-qualified earnings will be taxable if they are not rolled over.After the Roth 401(k)-to-Roth IRA rollover, every dollar keeps its pre-rollover character.
Note that it's also possible for a Roth 401(k) distribution to become qualified if an exception applies—such as the account owner has become disabled or is withdrawing no more than $10,000 to buy their first home. With respect to direct distributions from a Roth IRA, all accounts are aggregated for determining whether the owner has exhausted distributions from the non-taxable direct contributions bucket. The potentially taxable earnings portion won't be touched until all non-taxable contributions have been withdrawn.
Conclusion
The rules governing Roth accounts are similar—but they're by no means identical. It's important to remember that the two types of accounts are not interchangeable when it comes time to determining which account is best to tap for distributions first.