Distributions and Rollovers: What You Need
to Know About Roth 401(k)s

The Roth 401(k) resembles the Roth IRA in that contributions are made with after-tax dollars and qualified withdrawals can be made tax free. But, as the name implies, it also shares many of the rules affecting traditional 401(k) plans.

If your employer offers the Roth 401(k), there are many issues surrounding this retirement saving vehicle that you need to consider. In particular, if you anticipate making a job change or retiring in the near future, you’ll want to pay close attention to the rules governing distributions from Roth 401(k)s. How do they differ from regular 401(k)s? How are they the same?

Does Your Distribution Qualify?

Like the Roth IRA, distributions from a Roth 401(k) are generally tax free and penalty free if the owner meets certain requirements. Specifically, in order to qualify for tax-free treatment, distributions from a Roth 401(k) must be made after the participant reaches age 591⁄2 or on account of the participant’s death or disability, and after the participant has held the account for at least five years. This is referred to as the five-year aging rule and applies even in cases where the participant has retired.

Although distributions may be permitted if one or more of these qualifications are not met ("nonqualified distributions"), tax-free and/or penalty-free treatment is reserved for "qualified distributions" as described above.

The Rollover Option and 70 1⁄2 Rule

For employees who leave a job where they had been contributing to a Roth 401(k), the IRS provides two choices for managing those assets. Job changers may roll the account balance into another Roth 401(k) plan that accepts rollovers, or they may roll the account into a Roth IRA.

Retirees may want to note that Roth 401(k)s have the same minimum distribution requirements as traditional 401(k)s and traditional IRAs: Participants must begin taking minimum distributions after they reach age 70 1⁄2. However, because the same option to roll assets from a Roth 401(k) account into a Roth IRA applies to retirees, and because Roth IRAs do not require account holders to take distributions during their lifetime, the 70 1⁄2 rule need not come into play.

This presents an intriguing estate planning strategy for individuals who would like to pass assets held in a Roth 401(k) to heirs. In addition, individuals can continue to make contributions to a Roth IRA beyond age 70 1⁄2 as long as they have earned income.

Who Might Benefit the Most?

In deciding if a Roth 401(k) account is an attractive option, individuals should consider — among other things — the potential impact on their personal tax situation.

For instance, because contributions to a Roth 401(k) are taxed at the time of the contribution, such an account might be attractive to individuals who believe that tax rates may go up in the future or who expect their own income to increase significantly over time (e.g., younger workers). By locking in today’s tax rates, these workers can create a hedge against potential future tax increases.

In addition, depending on their tax bracket and number of years until retirement, highly compensated workers may benefit from going the Roth 401(k) route, particularly if they have been shut out of contributing to a Roth IRA due to its income limitations.  (Income eligibility for Roth IRAs in 2009 phases out between $105,000 and $120,000 for single filers and $166,000 to $176,000 for those who are married and file jointly.)

Points to Remember

• The Roth 401(k) combines features of both Roth IRAs and regular 401(k) plans.
• The rules governing distributions from Roth 401(k)s differ somewhat from the rules affecting distributions from regular 401(k) plans.
• Like the Roth IRA, distributions from a Roth 401(k) are generally tax free and penalty free if certain requirements are met.
• Although Roth 401(k)s require minimum distributions to commence at age 70 1/2, assets from a Roth 401(k) may be rolled into a Roth IRA, which does not require account holders to take a distribution during their lifetimes.
• The Roth 401(k) might be attractive to individuals who believe that tax rates may go up in the future or who expect their own income to increase significantly over time.

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