Roth IRAs and 401(k)s are excellent retirement savings tools. They offer tax diversification from traditional IRA and 401(k) accounts and offer financial planning flexibility. Roths offer tax-free growth and tax-free distributions if the rules are followed.
Distributions from a Roth IRA account are tax free if:
- The money has been in a Roth account for at least five years; and
- The account owner is at least 59½.
While you can always withdraw your contributions, the five-year clock governs when earnings can be withdrawn tax free. The clock starts with the first Roth IRA contribution or conversion from a traditional IRA. The clock starts in January of the calendar year that the first contribution was made.
There are a number of special circumstances in which a qualified distribution (tax free for both earnings and principal) can be made. These include:
- Disability of the account holder.
- A beneficiary receiving the proceeds of the account due to the death of the account holder.
- A distribution of $10,000 or less that will be used to purchase or rebuild the account holder’s first home or that of qualified family members. Key to the definition is that this is a principal residence and that you or your spouse haven’t owned a principal residence in the past two years.
In the last case, just because you can withdraw up to $10,000 tax free doesn’t mean that this is a good idea. Do you have another source of funds that won’t entail raiding your retirement account?
Distributions of earnings that are not qualified are subject to ordinary income taxes and a 10% penalty if you are under 59½. There are some exceptions to the 10% penalty, and they include:
- The distributions are part of a series of substantially equal withdrawals for a minimum of five years or until you reach age 59½, whichever is longer.
- To cover unreimbursed medical expenses in excess of 7.5% of your adjusted gross income (AGI).
- To cover medical insurance premiums if you’ve lost your job.
- To cover qualified higher education expenses for you or a family member.
- The distribution is the result of an IRS levy.
- The distribution is a qualified military reservist distribution.
The Roth ordering rules will determine whether a distribution is taxable if it is not a qualified distribution. According to the IRS, there are set rules for the order in which contributions and earnings are distributed from a Roth account.
- Regular (non-conversion) contributions are first.
- Conversion and rollover contributions are next, on a first-in/first-out basis.
Required Minimum Distributions (RMDs)
One of the advantages of Roth IRAs is that they are not subject to annual required minimum distributions at age 70½ like traditional IRAs. This not only allows the account to continue to grow tax free but also offers some estate planning options.
If your beneficiary is your spouse, the same tax-free characteristics of the account stay in place if they make the account their own.
Non-spousal beneficiaries will also not be taxed on withdrawals, but they have two options for handling this account.
- They can take distributions over their lifetime as with an inherited traditional IRA. The distributions are not taxed (unless they are non-qualified), and the remainder of the account continues to grow tax free.
- Assuming the beneficiary is younger than the original account holder then this functions as a “stretch-IRA.”
- This money cannot be commingled with any other Roth IRA you might own.
- Liquidate the account within five years. Again, the distributions will not be taxable assuming they are qualified.
Roth IRA Conversions
Money converted from a traditional IRA to a Roth IRA is taxed in the year of the conversion.
There is a five-year clock on each conversion. For those who are under age 59½, a 10% penalty would apply to any funds withdrawn within that five-year window. This was a change in the rule to prevent people from doing the conversion and then immediately taking a distribution from the Roth, effectively circumventing the IRA early distribution penalties.
The rules for exceptions listed above still apply here as instances when the 10% penalty would not apply.
Roth 401(k) Distributions
A Roth 401(k) account can provide an opportunity for those interested in making Roth contributions if their income is too high to qualify for a Roth IRA contribution. Additionally, the contribution limits are the full $18,000 ($24,000 for those 50 and over) allowed for a 401(k) versus the $5,500/$6,500 for a Roth IRA.
A Roth 401(k) also grows tax free and allows tax-free withdrawals. However, the RMD rules for a Roth 401(k) are different than with a Roth IRA.
If you are retired and still hold money in a Roth 401(k) at age 70½, you will need to take RMDs from the account. They will not be taxed, but you will lose the tax-free growth the funds enjoyed while in the account.
An easy solution is to roll this money to a Roth IRA; then the money is not subject to RMDs as explained above.
Roth IRAs and 401(k)s are a great option for many retirement savers. They offer some planning alternatives as well as tax diversification into retirement, a plus in an era of uncertain future tax rates.
The distribution rules can be complex, and you should be sure to understand them so you don’t trigger an unwanted taxable event at some point.