Author Topic: Roth 401k --> Roth IRA. Early withdrawal rules.  (Read 528 times)

lostmonkey007

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Roth 401k --> Roth IRA. Early withdrawal rules.
« on: January 06, 2018, 09:50:32 AM »
I currently hold both pre-tax and Roth dollars within my company 401k account.  Let's say I leave the company today.  Roll over the pre-tax 401k dollars to a tIRA.  And the roll over the Roth 401k dollars to a Roth IRA. 

Now remember, some of the Roth 401k dollars are post-tax contributions from my paycheck.  Some represent earnings/growth.  When I'm considering my early Roth IRA withdrawal rules, will the Roth 401k dollars that were initially post-tax contributions from my paycheck be treated as contributions?   As in, can I withdraw them without the 10% penalty and without waiting the 5-year seasoning period that is typically required of rollovers/conversions into a Roth IRA? 

I understand there are ordering rules for being able to withdraw out of a Roth IRA.  So for sake of simplicity, assume that till this point in time, I had just been contributing the standard, direct (not back-door) contributions (because I was within the ~$130k limit) into my Roth IRA for 5 years (i.e. 5 tax years have transpired since my first Roth IRA action.).  And so from an order perspective, I would first just withdraw 5 x $5,500 contributions then try to tap into these rollover Roth 401k dollars.

Any guidance is appreciated!

seattlecyclone

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Re: Roth 401k --> Roth IRA. Early withdrawal rules.
« Reply #1 on: January 06, 2018, 09:56:47 AM »
The Roth 401(k) contributions will count as Roth IRA contributions when you do the transfer (so they will then be freely withdrawable at any time), and the Roth 401(k) earnings will count as Roth IRA earnings (which would count as taxable income plus get a 10% early withdrawal tax if withdrawn early).
I made a blog! https://seattlecyclone.com/

The Roth IRA was named after William Roth, who represented Delaware in the US senate from 1971-2001. "Roth" is a name, not an acronym. There's no need to capitalize the final three letters.

lostmonkey007

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Re: Roth 401k --> Roth IRA. Early withdrawal rules.
« Reply #2 on: January 06, 2018, 10:50:36 AM »
The Roth 401(k) contributions will count as Roth IRA contributions when you do the transfer (so they will then be freely withdrawable at any time), and the Roth 401(k) earnings will count as Roth IRA earnings (which would count as taxable income plus get a 10% early withdrawal tax if withdrawn early).

Firstly, I'm already maxing $18.5k pre-tax 401k (coupled with $7.5k in pre-tax match from company) and $2,600 in HSA (with $750 coming from company to hit $3,450 annual limit).  After all that and my annual expenses, I have about $70k in after-tax dollars to either deploy into a backdoor Roth IRA, mega backdoor Roth IRA or taxable brokerage account.

General stats:
Age: 27
Annual Income: $180k-$200k
Pre-Tax Retirement:  $36k
Roth Retirement:  $150k
Taxable Brokerage:  $100k
HSA:  $10k
Rainy Day Fund: $20k in cash

I'm suddenly getting a bit more excited about the mega-back door IRA.  I'm able to put up to $29k annually.  My Fidelity administrator allows an in-service non-hardship withdrawal into a Roth IRA as soon as amount leaves paycheck / hits after-tax 401k sub-account.  I also have the option to split any minimal earnings off into a tIRA and send only the contribution dollars to a Roth IRA.  Two scenarios I'm considering:

A)  Send contributions to Roth IRA AND growth to tIRA

Pro:  As soon as my existing Roth IRA conversions satisfy their 5-year holding period by 2023, all of my $29k annual contributions between now and 2023 will be immediately accessible and usable for early retirement
Con: Lose ability to do a clean traditional back-door IRA given my tIRA will start accumulating earnings/growth from my after-tax 401k dollar rollovers.  But do I really care given the annual $29k mega backdoor I'm sending into my Roth IRA already?


B)  Send contributions AND growth to Roth IRA

Pro:  tIRA balance stays at $0.  I can continue to do $5,500 traditional backdoor IRA conversions
Con:  My $29k after-tax contributions will now be co-mingled with taxable conversion of the earnings/growth.  Additionally, if the whole point of this scenario is to do more $5,500 traditional backdoor IRAs, those $5,500 lots will start to slot themselves into the early withdrawal order for my Roth IRA, effectively mooting my ability to touch the annual $29k after-tax paycheck contribution lots without enduring the 5-year holding period.

I'm leaning towards Scenario A) if I do the mega back door.   

And on a more general point, I'm also considering just forgetting this whole Roth IRA business and sticking to a taxable brokerage account.  I'm 27 and have about $150k in Roth assets across my IRA and 401k.  At a 5% real growth, that's ~$700k in real dollars to serve as tax diversification.  In the meantime, I can just take advantage of 0% LTCGs via my taxable brokerage account through income allowable within the low federal tax brackets as well as the standard deduction.

Seattlecyclone (and other respected MMM elders), excited to hear your qualitative critique of this^ last controversial anti-Roth IRA point.  I'm just dubious about the government not in some direct/indirect way affecting the value of my Roth IRA in the future.  Via either increasing qualified age or reducing social security/medicare benefits for people with large Roth IRA balances.  Concept of tying up so much money in Roth IRAs scares me especially given the generally OK alternative of holding tax-efficient (i.e. low or qualified dividend generating holdings like VTSAX) in a taxable brokerage account coupled with low LTCG tax rates AND the liquidity AND not having to track these increasing amount of Roth IRA contributions, taxable conversions and non-taxable conversions.  If the government or your broker automatically did the Roth IRA withdrawal math and managed the ledger, it would be a lot more appealing.  Fact burden of paperwork and proof during audit falls on individuals is just lame (apologies in advance...  I'm already starting to hear the entitled Millennial in me there...).
« Last Edit: January 06, 2018, 02:10:02 PM by lostmonkey007 »

seattlecyclone

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Re: Roth 401k --> Roth IRA. Early withdrawal rules.
« Reply #3 on: January 06, 2018, 02:32:06 PM »
I do the mega backdoor and do your Scenario B with no hesitation. If you make sure to do the conversions shortly after each paycheck, the taxable growth is truly minimal. Maybe $100 per year in a typical year. If the pre-tax growth was truly significant then splitting up can make sense, but it just doesn't seem worth the hassle to me to go through the extra steps just to defer tax on so few dollars, and also lose out on the regular backdoor Roth unless you go through the additional step of rolling that pre-tax IRA back into your pre-tax 401(k).

Regarding your idea to skip out on Roth entirely in favor of taxable accounts, I think that's the wrong way to go.

You only get 0% long-term capital gains to the extent that your income is low enough to take advantage (likely so in retirement, but not so until then). You'll be paying taxes on dividends each year until then if you go with a taxable account, not so in Roth.

Congress could also easily raise the tax rate, as the 0% rate has only existed for about a decade. I don't think this has as much of an entrenched long-term promise built into it as does the idea that Roth IRAs will remain tax-free at traditional retirement age.

If you live in a state with income tax your capital gains probably won't truly be tax-free anyway.

Under current ACA rules, capital gains count as income that reduces your tax credit for health insurance, while Roth withdrawals don't.

The current laws make Roth accounts attractive to an early retiree for these and other reasons. Congress could of course change various laws at any time, however I find major changes to the treatment of existing Roth balances to be much less likely than many other potential rule changes that would hurt you more if you went with taxable instead.

You have enough income to max out your mega backdoor Roth and still save a sizable amount in taxable. This diversification of account types should position you well to weather any changes in laws that may come.
I made a blog! https://seattlecyclone.com/

The Roth IRA was named after William Roth, who represented Delaware in the US senate from 1971-2001. "Roth" is a name, not an acronym. There's no need to capitalize the final three letters.

lostmonkey007

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Re: Roth 401k --> Roth IRA. Early withdrawal rules.
« Reply #4 on: January 06, 2018, 02:46:57 PM »
I do the mega backdoor and do your Scenario B with no hesitation. If you make sure to do the conversions shortly after each paycheck, the taxable growth is truly minimal. Maybe $100 per year in a typical year. If the pre-tax growth was truly significant then splitting up can make sense, but it just doesn't seem worth the hassle to me to go through the extra steps just to defer tax on so few dollars, and also lose out on the regular backdoor Roth unless you go through the additional step of rolling that pre-tax IRA back into your pre-tax 401(k).

Regarding your idea to skip out on Roth entirely in favor of taxable accounts, I think that's the wrong way to go.

You only get 0% long-term capital gains to the extent that your income is low enough to take advantage (likely so in retirement, but not so until then). You'll be paying taxes on dividends each year until then if you go with a taxable account, not so in Roth.

Congress could also easily raise the tax rate, as the 0% rate has only existed for about a decade. I don't think this has as much of an entrenched long-term promise built into it as does the idea that Roth IRAs will remain tax-free at traditional retirement age.

If you live in a state with income tax your capital gains probably won't truly be tax-free anyway.

Under current ACA rules, capital gains count as income that reduces your tax credit for health insurance, while Roth withdrawals don't.

The current laws make Roth accounts attractive to an early retiree for these and other reasons. Congress could of course change various laws at any time, however I find major changes to the treatment of existing Roth balances to be much less likely than many other potential rule changes that would hurt you more if you went with taxable instead.

You have enough income to max out your mega backdoor Roth and still save a sizable amount in taxable. This diversification of account types should position you well to weather any changes in laws that may come.

Like it.  Will have to go back to the drawing board on my thinking regarding the Roth IRA. 

I do live in a state without income taxes (TX) so LTCG would truly be 0% if I stayed in those low income limits.  But you're right that I will indeed be paying some dividend income taxes along the way.  However, it's not a whole lot.  I mostly hold VTSAX in my taxable brokerage accounts and it usually has 95%-100% qualified dividends.  So really my tax hit annually is my VTSAX position * 2.5% avg. dividend yield * 15%.  So we're talking <0.5% of my holdings.  However, I guess that does add up over time. 

Also all of this is predicated on the favorable rules surrounding LTCG tax rates and qualified dividend tax rates.  Both, I suppose, more likely to be tweaked as potential sources of additional tax revenue for the government before it were to tweak Roth IRA rules.  And, getting even more granular, you would hope the government wouldn't go so far as potentially double-taxing my already post-tax contributions (i.e. via backdoor Roth IRAs, both the standard and mega kind). 

Did not know about the ACA rules.  Good to know. 

lostmonkey007

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Re: Roth 401k --> Roth IRA. Early withdrawal rules.
« Reply #5 on: January 06, 2018, 05:40:58 PM »
The Roth 401(k) contributions will count as Roth IRA contributions when you do the transfer (so they will then be freely withdrawable at any time), and the Roth 401(k) earnings will count as Roth IRA earnings (which would count as taxable income plus get a 10% early withdrawal tax if withdrawn early).

Is this true by the way?  How is this tracked via tax forms? 

Let's say I have $100k Roth 401k balance.  It is a combination of contributions and earnings.  When I roll it over to my Roth IRA, wouldn't the 1099R just show it altogether as non-taxable rollover of Roth 401k dollars?  Or there are separate boxes that shows deferrals and earnings separately?

seattlecyclone

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Re: Roth 401k --> Roth IRA. Early withdrawal rules.
« Reply #6 on: January 06, 2018, 06:21:01 PM »
The Roth 401(k) contributions will count as Roth IRA contributions when you do the transfer (so they will then be freely withdrawable at any time), and the Roth 401(k) earnings will count as Roth IRA earnings (which would count as taxable income plus get a 10% early withdrawal tax if withdrawn early).

Is this true by the way?

Yes. This treatment is spelled out in A-3 of 26 CFR 1.408A-10. It states that the portion of your Roth 401(k) rollover that is treated as "investment in the contract" as defined in A-6 of 26 CFR 1.402A-1 counts as Roth IRA contributions for the purpose of the ordering rules, and the rest counts as Roth IRA earnings. My reading of that definition of "investment in the contract" is that it encompasses the portion of your rollover that would not count as income if you just withdrew it to your checking account instead of rolling it into another retirement account. For Roth 401(k)s, that would include your original contributions but not any earnings within the 401(k). However this is just my own interpretation of the text. I'm not a lawyer and I'm especially not your lawyer. Please read it yourself and come to your own conclusions.

How is this tracked via tax forms?

When you make an early withdrawal from your Roth IRA you'll need to file Form 8606 with your tax return. Part III of that form is about distributions from Roth IRAs. Here is where you report the total amount distributed, and figure how much counts as income by subtracting your basis in contributions and conversions. Particularly, on Line 22 you report your contributions. The instructions for Line 22 include the following text:

Quote from: Form 8606 Instructions
Increase the amount on line 22 by any amount rolled in from a designated Roth account that is treated as investment in the contract.

This brings us back to what exactly the "investment in the contract" means, as discussed above.

Let's say I have $100k Roth 401k balance.  It is a combination of contributions and earnings.  When I roll it over to my Roth IRA, wouldn't the 1099R just show it altogether as non-taxable rollover of Roth 401k dollars?  Or there are separate boxes that shows deferrals and earnings separately?

I haven't done this particular transaction before. You'll pay no tax in the year of the rollover so I'm not sure how it would be reported at that time. However your W-2s for the years when you made Roth 401(k) contributions will report your original contribution amounts, which you will eventually report as your "investment in the contract" the first time you withdraw from the Roth IRA.
I made a blog! https://seattlecyclone.com/

The Roth IRA was named after William Roth, who represented Delaware in the US senate from 1971-2001. "Roth" is a name, not an acronym. There's no need to capitalize the final three letters.

lostmonkey007

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Re: Roth 401k --> Roth IRA. Early withdrawal rules.
« Reply #7 on: January 07, 2018, 10:50:07 AM »
The Roth 401(k) contributions will count as Roth IRA contributions when you do the transfer (so they will then be freely withdrawable at any time), and the Roth 401(k) earnings will count as Roth IRA earnings (which would count as taxable income plus get a 10% early withdrawal tax if withdrawn early).

Is this true by the way?

Yes. This treatment is spelled out in A-3 of 26 CFR 1.408A-10. It states that the portion of your Roth 401(k) rollover that is treated as "investment in the contract" as defined in A-6 of 26 CFR 1.402A-1 counts as Roth IRA contributions for the purpose of the ordering rules, and the rest counts as Roth IRA earnings. My reading of that definition of "investment in the contract" is that it encompasses the portion of your rollover that would not count as income if you just withdrew it to your checking account instead of rolling it into another retirement account. For Roth 401(k)s, that would include your original contributions but not any earnings within the 401(k). However this is just my own interpretation of the text. I'm not a lawyer and I'm especially not your lawyer. Please read it yourself and come to your own conclusions.

How is this tracked via tax forms?

When you make an early withdrawal from your Roth IRA you'll need to file Form 8606 with your tax return. Part III of that form is about distributions from Roth IRAs. Here is where you report the total amount distributed, and figure how much counts as income by subtracting your basis in contributions and conversions. Particularly, on Line 22 you report your contributions. The instructions for Line 22 include the following text:

Quote from: Form 8606 Instructions
Increase the amount on line 22 by any amount rolled in from a designated Roth account that is treated as investment in the contract.

This brings us back to what exactly the "investment in the contract" means, as discussed above.

Let's say I have $100k Roth 401k balance.  It is a combination of contributions and earnings.  When I roll it over to my Roth IRA, wouldn't the 1099R just show it altogether as non-taxable rollover of Roth 401k dollars?  Or there are separate boxes that shows deferrals and earnings separately?

I haven't done this particular transaction before. You'll pay no tax in the year of the rollover so I'm not sure how it would be reported at that time. However your W-2s for the years when you made Roth 401(k) contributions will report your original contribution amounts, which you will eventually report as your "investment in the contract" the first time you withdraw from the Roth IRA.

Awesome, thanks again.  I guess the first early withdrawal from my Roth IRA will be quite the enlightening experience.  Tracing back all the contributions, conversions and such.  Don't expect to do it anytime soon, but just doing my pre-work, if you will, now.

seattlecyclone

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Re: Roth 401k --> Roth IRA. Early withdrawal rules.
« Reply #8 on: January 07, 2018, 01:06:12 PM »
Yep, save your records! You might need them decades in the future.
I made a blog! https://seattlecyclone.com/

The Roth IRA was named after William Roth, who represented Delaware in the US senate from 1971-2001. "Roth" is a name, not an acronym. There's no need to capitalize the final three letters.

rollwiddit

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Re: Roth 401k --> Roth IRA. Early withdrawal rules.
« Reply #9 on: January 10, 2018, 01:44:09 AM »
The Roth 401(k) contributions will count as Roth IRA contributions when you do the transfer (so they will then be freely withdrawable at any time), and the Roth 401(k) earnings will count as Roth IRA earnings (which would count as taxable income plus get a 10% early withdrawal tax if withdrawn early).

Is this true by the way?  How is this tracked via tax forms? 

Let's say I have $100k Roth 401k balance.  It is a combination of contributions and earnings.  When I roll it over to my Roth IRA, wouldn't the 1099R just show it altogether as non-taxable rollover of Roth 401k dollars?  Or there are separate boxes that shows deferrals and earnings separately?
I've been doing the Mega Backdoor since 2015 with Fidelity.  I opened a Roth and Traditional IRA also with Fidelity to make the split rollover more streamlined compared to rolling over to my Vanguard IRAs.  Fidelity also charges $25 so I only do it once or twice per year.

On the 1099-R Box 1 shows the "Gross distribution" which are your contributions plus earnings.  Box 5 on the 1099-R shows your after-tax contributions which go to the Roth IRA; this is your contribution bias.  The remainder pre-tax earnings I have going to the Traditional IRA.