The Roth IRA – and the Roth 401(k) – are perhaps the most attractive retirement savings vehicles available. Unlike traditional IRAs which provide tax-deferred growth (you pay the tax eventually), Roth IRA assets grow tax-free. Because you pay the taxes upfront, this is a very favorable tax characteristic, especially considering the future state of tax rates is very uncertain.
The Roth 401(k) option has become more commonly offered in company 401(k) plans for just this reason: employees want to take advantage of tax-free growth. In addition, Roth 401(k)s provide higher earning individuals improved benefits, as contributions to a regular Roth IRA (one not associated with a company 401(k) plan) are not allowed if a married couple has an AGI over $199K (or $135K for an individual).
If you already participate in a company Roth 401(k), you should consider opening a Roth IRA on the side. Here’s why.
The Five-Year Rule Explained
Let’s start with the basics. Money you contribute to a Roth IRA can be taken out any time, tax- and penalty-free. Any growth in the account that you take will be subject to penalty and taxation, unless you’ve had the account for five years and are at least 59½ when taking the money out. However, there are special circumstances that allow you to take funds before age 59½, such as disability or for a first-time home purchase.
The 5-year rule for Roth IRA and Roth 401(k) distributions stipulates that 5 years must have passed before you can withdraw the earnings in the account tax-free, regardless if it is an otherwise qualified distribution. So even if you are using Roth IRA funds to purchase a home, for example, you cannot use the special exemption if the account is less than five years old. In this example, you would be taxed on your earnings, which could result in a hefty tax bill.
Applying The Five-Year Rule To Roth 401(k) Rollovers
Rolling over a Roth 401(k) retirement account into an Roth IRA is very common. In most cases this happens when an employee leaves an employer and wants to move the funds into their own name. The employee may have joined a firm that does not offer such a plan, or maybe they started their own business (which opens up different kinds of retirement account possibilities).
What many people don’t realize is that when you rollover your Roth 401(k) to a Roth IRA, the holding period of your Roth 401(k) does not carry over. This means that if you did not already have an existing Roth IRA account, the five-year period starts over when you request a rollover. All the years that you had been making contributions to your Roth 401(k) are no longer considered for the purposes of the Five-Year Rule. Your funds have become less flexible post-rollover.
The good news is that the holding period is based on the account receiving rollover funds, so you can easily prepare for a possible Roth 401(k) rollover in the future. If you have an existing Roth IRA that has been open for more than five years, you’d be in luck. As soon as the Roth 401(k) rollover goes into your existing Roth IRA, it would have the same holding period as those Roth IRA funds. Five-Year Rule passed!
If you have a Roth 401(k), you should highly consider opening a Roth IRA now so that you can start the clock ticking on your Five-Year Rule. You never know what will happen in the future, but by planning for all the potential scenarios, you will have the flexibility needed to continue forward with your financial and life goals.
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Sean Condon is a wealth advisor with more than a decade of industry experience. He specializes in helping entrepreneurs build a culture of financial confidence by offering their employees unprecedented access to a CERTIFIED FINANCIAL PLANNER™ professional. Taking an owner’s approach, Sean does his best to understand the many elements of clients’ entrepreneurial journeys. He works in a technically competent and caring manner to reduce clients’ anxiety about money issues and serves as a fiduciary by always putting his clients’ best interests first. Learn more about Sean by connecting with him on LinkedIn.
Perritt Capital Management, Inc. is the Registered Investment Advisor for Windgate Wealth Management accounts. Windgate does not provide tax advice. Consult your professional tax advisor for questions concerning your personal tax or financial situation.
Information here is obtained from what are considered reliable sources; however, its accuracy, completeness, or reliability cannot be guaranteed. The data above is based on current laws that may change.
First published September 2018.