Roth 401(k) Accounts – Some Distributions May Still be Taxable

Take-Away: With more qualified plans now accepting Roth 401(k) contributions in order to minimize income taxes in retirement years, it is important to become familiar with the distribution rules associated with a Roth 401(k) account.

Background: Like Roth IRAs, distributions from a Roth 401(k) accounts can either be qualified or non-qualified.

Qualified Distributions: If a qualified distribution is taken from a 401(k) account, it is tax-free and penalty-free. A distribution from the Roth 401(k) account is qualified if two conditions are met: (i) the participant must be at least 59 ½ (or the distribution must be on account of disability or death); and (ii) the participant must have held the Roth 401(k) account for more than five (5) years. The 5 year minimum holding period starts on January 1 of the first year that the participant made a contribution to the Roth 401(k) account.

Example: Paul started participating in his employer’s 401(k) plan ten years ago. Paul made his first contribution to his Roth 401(k) account six years ago. Paul, age 61, takes a distribution from his Roth 401(k) account. Since Paul is over the age 59 ½ and he made his first contribution to his Roth 401(k) account more than 5 years ago, the distribution taken by Paul from his Roth 401(k) account is both income tax and penalty tax-free.

Non-Qualified Distributions: If the distribution taken from a Roth 401(k) account does not satisfy the qualified distribution conditions, a portion of the distribution will be taxable, even though it comes from a Roth account. The IRS uses a pro rata rule to calculate the taxable portion of the distribution from the Roth 401(k) account. The amount of the distribution that is taxable is determined by dividing the amount of the Roth 401(k) contributions by the total Roth 401(k) account balance, i.e. contributions made plus earnings on those contributions. That fraction is then multiplied by the amount of the distribution, which amount is then subtracted from the gross distribution amount.

Example: Jim, age 45, takes a hardship withdrawal of $12,000 from his Roth 401(k) account. Over the years Jim has made $80,000 of Roth 401(k) deferral contributions. Jim’s total Roth 401(k) account balance (his Roth contributions plus earnings on those contributions) is currently $100,000. The fraction of Jim’s Roth 401(k) contributions to his total account balance is 80% ($80,000 divided by $100,000 = 80%.) Consequently, $9,600 of Jim’s $12,000 will be non-taxable ($12,000 withdrawal times 80%= $9,600.) The remaining $2,400 will be taxable to Jim unless a statutory exception applies. Note, too, that since Jim is under age 59 ½, his distribution will also be subject to the 10% penalty for an early distribution from a qualified plan.

Other 401(k) Accounts: In calculating whether a Roth 401(k) account distribution is subject to taxes, any other taxable amounts in the participant’s 401(k) account, such as accounts that hold pre-tax deferrals or employer matching contributions are ignored.

CARES Act Distribution: If the Roth 401(k) account participant is affected under the CARES Act and takes a coronavirus-related distribution, that participant can take up to $100,000 of distributions from the Roth 401(k) plan without an immediate tax and without the 10% early distribution penalty. The income tax is spread ratably over three years, starting with 2020. Moreover, the tax paid can be recouped if the distribution is re-contributed/repaid to the company plan within three years.

Example: Tonia, age 45, lost her job because of COVID-19. As a result, Tonia took a $12,000  Roth 401(k) distribution in 2020. The balance of Tonia’s Roth 401(k) account balance was $100,000. From the prior example, we know that Tonia will have to report $2,400 as part of her taxable income for 2020. Tonia will be exempt from the 10% early distribution penalty. In addition, Tonia could spread the $2,400 portion that is taxable income over three years. Tonia can also recover the income taxes that she paid on that $2,400 distribution by repaying all or part of the $2,400 in 2020 through 2022 to the Roth 401(k) plan.

Conclusion: These Roth 401(k) distribution rules are much the same as for a distribution from a Roth IRA, so there are not too many ‘traps’ to be concerned about. Making a Roth contribution (either to an IRA or a 401(k) account brings tremendous tax savings, e.g. no income taxes, no RMDs, etc, which gets almost all of the attention in making the decision, it makes sense to spend at least a few minutes discussing these restrictions on accessing the funds held in the Roth retirement accounts. 2020 will be (so far as we know today) the only year that the 10% penalty for an early distribution can be ignored.