An employer-sponsored 401(k) retirement savings plan is generally recognized as one of the easiest, and most practical ways to build towards a secure retirement. Employers often enroll employees automatically in a 401(k) plan, with a minimum contribution of 3%. Of course you can change the percent you contribute (or opt out of making deferrals) if you choose to. A traditional 401(k) allows you to enjoy tax-deferred growth on the deposits to your retirement account throughout your career.

What many taxpayers may not realize is that there are now two types of 401k(s): the traditional, tax-deferred version and the Roth 401(k) version. Similar to its counterpart — the Roth IRA — the Roth 401(k) is kind of a “best of both worlds” scenario. With a Roth 401(k), you get the benefits of a Roth IRA, with the “hassle-free” contributions of an employer-sponsored retirement account and none of the contribution limitations imposed on a Roth IRA.

If you have a traditional 401(k) and your employer offers the Roth 401(k) as well, consider using the Roth 401(k), or splitting your contribution between the two plans.  One offers tax deferral, the other offers the advantage of tax free distributions.  Both require that you start taking distributions at age 70 ½.  Since there is no distribution requirement in the Roth IRA, if you don’t need the money, you can rollover your Roth 401(k) to a Roth IRA before you reach age 70 ½.

What Is the Five Year Rule for Roth IRAs and Roth 401(k)s?

The Roth 401(k), like the Roth IRA, allows you to withdraw contributions and earnings, tax and penalty free, if you are age 59 ½ or older and you have met the 5 year rule. Nonqualified distributions are subject to both income taxes and penalties. You may qualify to take early distributions penalty free if you become disabled, deceased or experience another qualifying “life event”, but if you have held the account for less than five years, there will be taxes on the earnings you withdraw. 

The 5-year rule means that five tax years must pass from the date of the first contribution to any Roth IRA, or Roth 401(k), before a qualified distribution can be made from the retirement account. The 5-year rule is fairly straightforward in a Roth IRA.  However, what many taxpayers may not realize, is how that 5 year rule is calculated when you rollover a Roth 401(k). If the rollover is to a Roth IRA, the holding period within the Roth 401(k) does not carry over.  Which means, if you have an existing Roth IRA, once the Roth 401(k) distribution is in the account, it has the same holding period as the Roth IRA funds.  If you have had a Roth IRA open for over 5 years, the funds rolled over into that Roth IRA will pass the 5 year test.  However, if you did not already have a Roth IRA open, and you now open one to roll the funds from your Roth 401(k) into currently, the five-year period starts the year the Roth IRA was opened, despite  the number of years you have been making  contributions to the Roth 401(k). 

The take away from this is, if you have a Roth 401(k) that you are contributing to, consider opening a Roth IRA now to start the 5 year rule.  If you experience a job loss, you can roll the funds right into the already established Roth IRA, and if you qualify for early withdrawals, you won’t be held up by a new 5 year rule.

Understanding the benefits of a Roth 401(k) and how to plan for a roll over to a Roth IRA is important. If you would like to benefit from our expertise in these areas, or if you have further questions on this Advisory, do not hesitate to contact our Tax and Accounting specialists, or call us at 1-800-239-1474.