Roth Rollover Traps

Three sisters--Rosemary, Ginger, and Sage--work at Acme Widget. All three are retiring this year. None of them is disabled. All three have Roth 401(k) accounts at Acme, which they have held for 10 years, and want to roll these accounts over into Roth IRAs. Coincidentally, each sister’s Roth 401(k) account contains exactly $30,000 of contributions (made via salary reduction) and $15,000 of “earnings,” for a total of $45,000. How do the “five-year waiting period” and “qualified distribution rules” apply to these rollovers? Here are their individual situations:

The oldest, Rosemary, is 65. She has had a Roth IRA since 2010.

The second sister, Ginger, is 62. She has never had a Roth IRA. The rollover Roth IRA will be her first.

The youngest is Sage, age 58. She also has never had a Roth IRA before.

Surprisingly, each sister will get different tax results. Here’s why:

Earnings on a Roth account are income-tax-free if distributed in a “qualified distribution.” To have a qualified distribution from a Roth plan, the individual Roth owner must have completed a five-year waiting period and be over age 59 1/2 (or disabled). But years accumulated in a Roth 401(k) account do not count toward the five-year period for a Roth IRA.

So, despite the rollover, there is no carryover of years from the Roth 401(k) to the Roth IRA. Only Roth IRA-holding years count for purposes of the Roth IRA five-year holding period.

Here’s how these rules play out for the sisters: Great for Rosemary, not too bad for Ginger, and horrible for Sage.

Rosemary Rosemary is in a great position, because she already owns a Roth IRA, which she has owned for over five years. She has already met the five-year holding period for all Roth IRAs she will ever own--including a new Roth IRA she establishes today. Whether she rolls her Roth 401(k) account into her already-existing Roth IRA, or establishes a brand new Roth IRA to receive the rollover, she instantly qualifies for "qualified distribution" treatment for any distributions she receives from any of her Roth IRAs, whether old or new. From the moment her $45,000 Roth 401(k) distribution lands in one of her Roth IRAs, all its future earnings are guaranteed to be tax-free because she is over 59 1/2 and has met the five-year holding period test.

Ginger Ginger's situation is different, because she has never had a Roth IRA before. The one she is setting up to receive this Roth 401(k) rollover in 2019 will be her first. This means the earliest time she will be able to have a qualified distribution from the Roth IRA is Jan. 1, 2024; her five-year holding period for the Roth IRA will end Dec. 31, 2023.

While her situation is not quite as good as Rosemary’s, she is still not too badly off. The distribution she is taking from the 401(k) plan is a qualified distribution because she has had this Roth 401(k) account for more than five years and she is over 59 1/2. Thus, the distribution would be totally tax-free to her even if she chose not to roll it over.

Because she is rolling it over, she gets a special treatment: Her rollover of a $45,000 qualified distribution goes into the Roth IRA as a $45,000 “after-tax contribution.” This means she can always withdraw up to $45,000 from the Roth IRA tax-free: After-tax contributions to a Roth IRA come out first when there is a distribution from the account. However, future growth in the Roth IRA will be considered “earnings” in the account, and those cannot be withdrawn tax-free until she has met the five-year holding period test for the Roth IRA.

Because she’s already over 59 1/2, Ginger will not have to worry about that aspect of qualified distributions... but her future earnings in the Roth will be taxable if withdrawn before 2024.

Ginger is thinking: She should have established a Roth IRA way back when, so that she (like Rosemary) wouldn’t face this fresh-start five-year waiting period. It’s too late for that now for Ginger, but if you are reading this article, should you and your clients be establishing Roth IRAs right now (no matter how small!), if you don’t already have one, just in case someday you have this rollover situation?

Sage Sage has a major problem if she rolls over her Roth 401(k) plan now into a Roth IRA. Like her sisters, she won't get to carry over her 10 years in the Roth 401(k) plan to her newly established Roth IRA. But her situation is much different from her sisters'. Her Roth 401(k) plan distribution will not be a qualified distribution--even though she's been in the plan 10 years (so she's met the five-year holding period), Sage (unlike her sisters) is under age 59 1/2. If she took the 401(k) distribution in cash right now, she would get back her $30,000 of contributions tax-free but the $15,000 of earnings would be taxable (and subject to the 10% penalty).

By rolling her distribution over to a Roth IRA, Sage will avoid current tax, but she will be starting all over again to meet the five-year holding period test not only for the Roth IRA’s future earnings (like Ginger) but also for $15,000 of earnings she rolled over from the 401(k) plan. She will get absolutely no credit for the 10 years her money sat in the Roth 401(k) plan.

If Sage had a pre-existing Roth IRA she had established prior to 2014, she (like Rosemary) would have already met the Roth IRA five-year holding period test. Then she would just have to wait another year or two until she is over 59 1/2 to qualify for qualified distributions from the Roth IRA (just as she would have to wait a year or two to qualify for qualified distributions from the Roth 401(k) plan). But she doesn’t have such an account.

Sage should seriously consider leaving her money in the Acme 401(k) plan until after she reaches age 59 1/2. Then she will be in Ginger’s position, receiving a qualified distribution from the Roth 401(k) that can be treated entirely as an after-tax contribution when rolled into a Roth IRA. And while she’s waiting for that big birthday, she could establish a small Roth IRA now, to start the clock ticking on that five-year holding period.

Moral Everyone should start a small Roth IRA as soon as they can, so they will get the five-year waiting period started for every Roth IRA they will ever own. And someone who has lots of years accumulated in a Roth 401(k) plan should think very carefully before rolling money into a Roth IRA if they have not yet achieved age 59 1/2 (and are not disabled).

Where to read more: These rules are more fully explained (with applicable citations) in Chapter 5 of Natalie Choate's book Life and Death Planning for Retirement Benefits (8th ed. 2019), www.ataxplan.com, or www.retirementbenefitsplanning.us.