Question about using Roth401K dollars for first 5 years of FIRE

[ericrugiero]

I'm looking at options for covering expenses in the first 5 years of FIRE while getting a Roth conversion ladder going. 

Obviously, money in taxable accounts and Roth IRA contributions could be used.  How about using Roth 401K dollars? 

I have access to a version of mega backdoor Roth through my company 401K.  (After tax 401K contributions with an immediate conversion to Roth 401K)  So, I'm trying to determine how much of this money would be available for early retirement.  The first 5 years of FIRE are the main thing I'm wondering about. 

From some reading I've done it sounds like when I leave my job I can roll the Roth 401K balance into an existing Roth IRA (which is more than 5 years old).  At that point, the amount I have put in can be withdrawn without penalty (my basis).  But, any amount that has been earned while in the Roth 401K or after it's converted must stay until 59.5 to be tax free. 

Does this sound right?  I'm not seeing as much about Roth 401K early withdraws so I want to be sure I'm planning correctly. 

My companies future isn't looking as secure as it did so I'm trying to get my ducks in a row.  Thanks 

[EvenSteven]

Alan S. over at Bogleheads is the be all end all authority on this stuff.

brcarls wrote: ↑Fri Feb 15, 2019 2:30 pm
I have researched this and am still uncertain.

I am 45.
I have a Roth IRA which I contributed to more than 5 years ago.
I have a Roth 401k, all contributions were more than 5 years ago. (huge gains in this)

If I were to FIRE now, could I rollover my Roth 401k to my Roth IRA and begin withdrawing my original Roth 401k contributions, or does a clock start when I do the rollover?

What about the Roth 401k gains? Is there anyway to unlock those penalty-free before I reach age 59.5?

Upon retirement, you would do a direct rollover of your Roth 401k balance to your Roth IRA. The plan would issue you a 1099R showing the amount rolled over and in Box 5 it would show the amount of your Roth 401k contributions. With gains, that amount would be less than the amount rolled over.

From there you would be responsible for tracking the composition of your Roth IRA, integrating the Roth 401k money. Your regular Roth IRA contributions balance would be increased by that amount in Box 5. Keep that 1099R indefinitely. The increased Roth IRA regular contribution balance is available for distribution tax and penalty free anytime. If you have done in plan Roth rollovers to your Roth 401k in addition, then you must also track the amount and year of those rollovers like you would a Roth IRA conversion.

If you take a distribution from Roth conversion funds before the conversion has been held 5 years, you will owe a 10% penalty on the taxable amount of those conversions. After 5 years the conversions are penalty free. After all your Roth IRA regular contribution and conversion contribution balance has been distributed, any additional distributions would come from earnings. Earnings are subject to tax and penalty until age 59.5. You just need an organized way to track your Roth IRA amounts, as you will need that info in order to know the tax impact of any distributions and to be able to report those distributions on Form 8606.

So it looks like you have it right, just make sure that the conversions from your mega backdoor Roth have been seasoned for 5 years.

[terran]

I think that's right, but since this is a mega backdoor Roth I think an additional requirement is that any taxable conversions (any gains in after tax before they were converted to Roth) have to wait 5 years from the conversion or you'd pay a penalty on them. There's a table floating around somewhere that shows the various timelines, but I'm not sure where I've seen it, or what a good search term to find it would be, so maybe someone else will have it handy and can post.

[seattlecyclone]

You've got it basically right but there are some wrinkles around the in-plan mega backdoor.

The treatment of Roth 401(k) money rolled into a Roth IRA is spelled out in 26 CFR § 1.408A-10. See Question 3 in that link for how the Roth 401(k) rollover fits in with the Roth IRA ordering rules. While the Roth IRA has three separate categories for withdrawing (contributions, conversions, earnings), this regulation doesn't put any portion of your rollover into the "conversions" bucket. Instead anything considered "investment in the contract" goes into the "contributions" category of your IRA and everything else goes in earnings. "Investment in the contract" for this purpose is defined in answer 6 here as the part of your rollover that wouldn't count as income if it were a withdrawal rather than a rollover. The consequence of this is that your in-plan mega backdoor conversion (but not the post-conversion earnings) will go into your Roth IRA contributions bucket, skipping ahead of any conversions that may be in your Roth IRA already such as from the regular backdoor.

An astute reader might look at the above paragraph and notice a potential loophole: if in-plan conversions go directly into the Roth IRA contributions bucket upon being rolled over, what's to stop you from converting a bunch of pre-tax money to Roth in your 401(k) and then rolling it into your Roth IRA where it could be immediately withdrawn without a 10% early withdrawal penalty? The answer is there's a "special recapture rule" that applies the 10% early withdrawal tax to distributions of taxable in-plan rollovers within five years. This rule does not apply to withdrawals that are rolled over to your IRA, but it does apply to withdrawals of this money from your Roth IRA within five years after the in-plan conversion.

A question I have about the above, but have never found the answer to, is how is this special recapture rule applied when you only withdraw part of your Roth IRA contributions bucket before the five-year clock expires?

Suppose you have a Roth IRA with $25k in the contributions bucket pre-rollover. You roll a $100k Roth 401(k) into your Roth IRA, of which $50k is "investment in the contract" and $10k of that is subject to the five-year special recapture rule. Now you have $75k in the contributions bucket of your IRA, of which $10k is subject to the special recapture rule. If you withdraw the whole $75k it's pretty clear that you would be subject to a $1,000 ($10,000 * 10%) tax due to the special recapture rule. What happens if you only withdraw $25k? Maybe it's prorated and you owe $333, or maybe it's considered front-loaded and you owe the whole $1,000, or maybe it's back-loaded and you don't owe anything. I could see a certain logic behind any of these three possibilities, but have never seen a definitive source for which is the correct treatment.

To avoid this mess I suggest keeping the amount subject to this recapture rule to a minimum. Perform your mega backdoor conversions as soon after your paychecks as you reasonably can do, so that there's little to no growth between the contribution and the conversion. That way instead of having potentially thousands of dollars subject to the special recapture rule, it would be a much less significant number.

[MDM]

I think that's right, but since this is a mega backdoor Roth I think an additional requirement is that any taxable conversions (any gains in after tax before they were converted to Roth) have to wait 5 years from the conversion or you'd pay a penalty on them. There's a table floating around somewhere that shows the various timelines, but I'm not sure where I've seen it, or what a good search term to find it would be, so maybe someone else will have it handy and can post.

A couple of places:
- on the 'Basic Terms' tab of the case study spreadsheet.  Ok, it's not "basic" but it's there....
- Footnote 19 under Treatment of Distributions in the Bogleheads wiki

[terran]

A question I have about the above, but have never found the answer to, is how is this special recapture rule applied when you only withdraw part of your Roth IRA contributions bucket before the five-year clock expires?

Do you have reason to believe the ordering rules for Roth withdrawals wouldn't apply to Roth 401(k) rolled over to Roth IRA the same as if they'd been made to Roth IRA in the first place?

• Regular contributions
• Taxable portion of first conversion
• Nontaxable portion of first conversion
• Each subsequent conversion, in order, with the taxable portion coming out first for each conversion
• Earnings (any increase in value occurring inside the Roth IRA)

Source: https://fairmark.com/retirement/roth-accounts/roth-distributions/distribution-overview/

That would seem to imply that the taxable amount of each conversion would come out first and then the non-taxable amount.

[seattlecyclone]

A question I have about the above, but have never found the answer to, is how is this special recapture rule applied when you only withdraw part of your Roth IRA contributions bucket before the five-year clock expires?

Do you have reason to believe the ordering rules for Roth withdrawals wouldn't apply to Roth 401(k) rolled over to Roth IRA the same as if they'd been made to Roth IRA in the first place?

Yes. See the links I posted above. While there would be some logic to treating it exactly the same as if all the contributions and conversions into the Roth 401(k) happened in the Roth IRA instead, we can't assume the tax code will be logical in every instance! The regulation (26 CFR § 1.408A-10) says that for the purpose of Roth IRA ordering rules, the portion of the Roth 401(k) that counts as "investment in the contract" is treated as Roth IRA contributions and the rest is treated as Roth IRA earnings. It says nothing about any portion of the rollover being treated as a conversion for this purpose.

This is corroborated in other places, such as the instructions for Form 8606. These instruct you to "Increase the amount on line 22 by any amount rolled in from a designated Roth account that is treated as investment in the contract." Line 22 is the line that you report your basis in Roth IRA contributions when you make an early withdrawal. Your basis in the conversions bucket is reported on Line 24 (and the instructions for this line specifically state "Don’t include amounts rolled in from a designated Roth account since these amounts are included on line 22."

The separate "special recapture rule" therefore attaches a 10% early withdrawal tax to a portion of your Roth IRA contributions bucket if part of your Roth 401(k) "investment in the contract" was made up of recent in-plan conversions. Which portion, exactly? I've never seen that bit written down and would love to see a definitive answer.

[terran]

Thanks @seattlecyclone. I think I might have found the answer, let me know what you think. First I came across this post from Alan S. over on the Bogleheads forum, which led me to IRS Notice 2010-84 . You'll see that Q&A 12 says basically the same thing as your special recapture link and Q&A 13 expands "on allocating distributions to the taxable amount of in-plan Roth rollovers" where it says:

If an amount distributed is treated as attributable to an in-plan Roth rollover, then the rules of § 408A(d)(4)(B)(ii)(II) and the last sentence of § 408A(d)(4) apply. Thus, a distribution is attributed to an in-plan Roth rollover on a first-in-first-out basis and any amount attributed to such a rollover is allocated first to the taxable amount of the rollover.

To me that says the rollovers come out in order, and the taxable amount comes out first. So basically, an in plan Roth rollover that's rolled over to a Roth IRA will act the same as if it was in the Roth IRA in the first place with each rollover coming out in the order it was made and the taxable amount coming out before the non taxable amount. Would you agree? Does this provide a definitive source for your special recapture rule question or am I not understanding?

[seattlecyclone]

I'm not fully convinced.

That IRS Notice does describe how to treat withdrawals from your Roth 401(k). The allocation rules are indeed very similar to the Roth IRA withdrawal ordering rules: the basis from direct contributions (if allowed to be distributed according to the rules of the plan) is considered to be withdrawn before the basis from in-plan conversions, and the in-plan conversion basis is considered to be withdrawn in FIFO order, taxable before non-taxable. When you're making a partial rollover from Roth 401(k) to Roth IRA you can indeed look at these rules to see how much of the money you're rolling over to your Roth IRA would be subject to this five-year recapture rule if you withdraw it too soon.

While this IRS Notice does say how to calculate how much of your Roth 401(k) withdrawal is subject to the five-year recapture rule, and it does say that this rule follows any applicable money into a Roth IRA, what it doesn't say is how this rolled-over Roth 401(k) basis interacts with existing basis in your Roth IRA once you commingle those funds. You might reasonably argue that the FIFO ordering that applied to the Roth 401(k) withdrawal would still apply to that subsequent withdrawal from your Roth IRA, but I just don't see that being explicitly stated in the linked document.

[MDM]

Maybe the IRS also doesn't understand it ;), and that's why Alan S. finds
I never hear from a taxpayer who says the IRS has questioned their 8606 basis amount (line 22 or 24) and that is quite remarkable when you consider that the average Roth owner has no idea what their basis is.

[RobertFromTX]

I'm resurrecting this old thread in case there is anybody around that might know more information!

If I read https://www.law.cornell.edu/cfr/text/26/1.408A-10 correctly for Q-3

Q-3. For purposes of the ordering rules on distributions from Roth IRAs, what portion of a distribution from a rollover contribution from a designated Roth account is treated as contributions?

A-3. (a) Under section 408A(d)(4), distributions from Roth IRAs are deemed to consist first of regular contributions, then of conversion contributions, and finally, of earnings. For purposes of section 408A(d)(4), the amount of a rollover contribution that is treated as a regular contribution is the portion of the distribution that is treated as investment in the contract under A-6 of § 1.402A-1, and the remainder of the rollover contribution is treated as earnings. Thus, the entire amount of any qualified distribution from a designated Roth account that is rolled over into a Roth IRA is treated as a regular contribution to the Roth IRA. Accordingly, a subsequent distribution from the Roth IRA in the amount of that rollover contribution is not includible in gross income under the rules of A-8 of § 1.408A-6.

then, if I contribute an amount to my employer Roth 401k, then leave the company and roll to a Roth IRA and wait 5 years... I can withdraw the full amount tax free / no penalty?

[MDM]

I'm resurrecting this old thread in case there is anybody around that might know more information!

If I read https://www.law.cornell.edu/cfr/text/26/1.408A-10 correctly for Q-3

Q-3. For purposes of the ordering rules on distributions from Roth IRAs, what portion of a distribution from a rollover contribution from a designated Roth account is treated as contributions?

A-3. (a) Under section 408A(d)(4), distributions from Roth IRAs are deemed to consist first of regular contributions, then of conversion contributions, and finally, of earnings. For purposes of section 408A(d)(4), the amount of a rollover contribution that is treated as a regular contribution is the portion of the distribution that is treated as investment in the contract under A-6 of § 1.402A-1, and the remainder of the rollover contribution is treated as earnings. Thus, the entire amount of any qualified distribution from a designated Roth account that is rolled over into a Roth IRA is treated as a regular contribution to the Roth IRA. Accordingly, a subsequent distribution from the Roth IRA in the amount of that rollover contribution is not includible in gross income under the rules of A-8 of § 1.408A-6.

then, if I contribute an amount to my employer Roth 401k, then leave the company and roll to a Roth IRA and wait 5 years... I can withdraw the full amount tax free / no penalty?

Yes, if the rollover would have been a qualified distribution.

Earnings included in the rollover, if it would not have been a qualified distribution, would be taxable if the Roth IRA distribution is also not qualified.

[seattlecyclone]

Right, that "if the rollover would have been a qualified distribution" thing is key.

Remember the rules for making a qualified distribution from a Roth 401(k): more than five years after your first Roth 401(k) contribution, and also (at least 59½ years old or disabled or dead).

If you don't meet those qualifications to withdraw from your Roth 401(k) for free, rolling it into your Roth IRA isn't a way to get around the age limits for withdrawing the earnings tax-free. Instead the amount of your contributions carries over, and so does the amount of earnings.

[RobertFromTX]

Ah okay, so it sounds like I should keep records of my 401k contributions when I rollover to an IRA so that I know how much of the rollover was Contribution vs Earnings. I don't think the new IRA custodian would know or keep track of that.

[seattlecyclone]

Exactly. The 1099-R you get from your 401(k) provider the year you rollover should say how much was contributions. You'll need to save that information for use on Part III of Form 8606 to calculate any taxable amount of your next withdrawal from your Roth IRA.

[ender]

You've got it basically right but there are some wrinkles around the in-plan mega backdoor.

The treatment of Roth 401(k) money rolled into a Roth IRA is spelled out in 26 CFR § 1.408A-10. See Question 3 in that link for how the Roth 401(k) rollover fits in with the Roth IRA ordering rules. While the Roth IRA has three separate categories for withdrawing (contributions, conversions, earnings), this regulation doesn't put any portion of your rollover into the "conversions" bucket. Instead anything considered "investment in the contract" goes into the "contributions" category of your IRA and everything else goes in earnings. "Investment in the contract" for this purpose is defined in answer 6 here as the part of your rollover that wouldn't count as income if it were a withdrawal rather than a rollover. The consequence of this is that your in-plan mega backdoor conversion (but not the post-conversion earnings) will go into your Roth IRA contributions bucket, skipping ahead of any conversions that may be in your Roth IRA already such as from the regular backdoor.

An astute reader might look at the above paragraph and notice a potential loophole: if in-plan conversions go directly into the Roth IRA contributions bucket upon being rolled over, what's to stop you from converting a bunch of pre-tax money to Roth in your 401(k) and then rolling it into your Roth IRA where it could be immediately withdrawn without a 10% early withdrawal penalty? The answer is there's a "special recapture rule" that applies the 10% early withdrawal tax to distributions of taxable in-plan rollovers within five years. This rule does not apply to withdrawals that are rolled over to your IRA, but it does apply to withdrawals of this money from your Roth IRA within five years after the in-plan conversion.

A question I have about the above, but have never found the answer to, is how is this special recapture rule applied when you only withdraw part of your Roth IRA contributions bucket before the five-year clock expires?

Suppose you have a Roth IRA with $25k in the contributions bucket pre-rollover. You roll a $100k Roth 401(k) into your Roth IRA, of which $50k is "investment in the contract" and $10k of that is subject to the five-year special recapture rule. Now you have $75k in the contributions bucket of your IRA, of which $10k is subject to the special recapture rule. If you withdraw the whole $75k it's pretty clear that you would be subject to a $1,000 ($10,000 * 10%) tax due to the special recapture rule. What happens if you only withdraw $25k? Maybe it's prorated and you owe $333, or maybe it's considered front-loaded and you owe the whole $1,000, or maybe it's back-loaded and you don't owe anything. I could see a certain logic behind any of these three possibilities, but have never seen a definitive source for which is the correct treatment.

To avoid this mess I suggest keeping the amount subject to this recapture rule to a minimum. Perform your mega backdoor conversions as soon after your paychecks as you reasonably can do, so that there's little to no growth between the contribution and the conversion. That way instead of having potentially thousands of dollars subject to the special recapture rule, it would be a much less significant number.

I've been digging into this again today and I have come to the same conclusion you have - it's not actually concrete what the tax treatment of someone who converts aftertax dollars into Roth in their 401k ends up being.

Your interpretation seems the most logical however it is a bit strange as it references a designated Roth account but the aftertax 401k rollover does not fit this as per the IRS definitions - https://www.law.cornell.edu/cfr/text/26/1.401(k)-6

No where in https://www.law.cornell.edu/cfr/text/26/1.401(k)-1 (section (f), but the link won't work) does it even address after-tax conversions (it only addresses regular contributions, aka normal Roth 401k contributions). If you consider the in plan conversion a rollover you can then treat it as such but it's unclear to me what the exact tax mechanic for conversions there is.

[seattlecyclone]

Your interpretation seems the most logical however it is a bit strange as it references a designated Roth account but the aftertax 401k rollover does not fit this as per the IRS definitions - https://www.law.cornell.edu/cfr/text/26/1.401(k)-6

I hadn't read that particular definition before. I've always understood "designated Roth account" to be a synonym for "the Roth part of your 401(k) or 403(b) or 457(b)." That's how it's used in this IRS FAQ page about designated Roth accounts.

No where in https://www.law.cornell.edu/cfr/text/26/1.401(k)-1 (section (f), but the link won't work) does it even address after-tax conversions (it only addresses regular contributions, aka normal Roth 401k contributions). If you consider the in plan conversion a rollover you can then treat it as such but it's unclear to me what the exact tax mechanic for conversions there is.

I think your confusion may be from looking for the term "conversion" specifically. That FAQ has a section with several questions and answers about in-plan rollovers to Roth. They don't use the term "conversion" because of course they have to use a different term for the employer accounts than IRAs, but the FAQ explicitly defines movements of pre-tax and after-tax amounts into your designated Roth account as an in-plan rollover. So there's your mechanic. Moving your after-tax 401(k) money to Roth 401(k) is an in-plan rollover to a designated Roth account and the CFR I linked previously about the coordination between designated Roth accounts and Roth IRAs would therefore seem to apply.

[ender]

Your interpretation seems the most logical however it is a bit strange as it references a designated Roth account but the aftertax 401k rollover does not fit this as per the IRS definitions - https://www.law.cornell.edu/cfr/text/26/1.401(k)-6

I hadn't read that particular definition before. I've always understood "designated Roth account" to be a synonym for "the Roth part of your 401(k) or 403(b) or 457(b)." That's how it's used in this IRS FAQ page about designated Roth accounts.

No where in https://www.law.cornell.edu/cfr/text/26/1.401(k)-1 (section (f), but the link won't work) does it even address after-tax conversions (it only addresses regular contributions, aka normal Roth 401k contributions). If you consider the in plan conversion a rollover you can then treat it as such but it's unclear to me what the exact tax mechanic for conversions there is.

I think your confusion may be from looking for the term "conversion" specifically. That FAQ has a section with several questions and answers about in-plan rollovers to Roth. They don't use the term "conversion" because of course they have to use a different term for the employer accounts than IRAs, but the FAQ explicitly defines movements of pre-tax and after-tax amounts into your designated Roth account as an in-plan rollover. So there's your mechanic. Moving your after-tax 401(k) money to Roth 401(k) is an in-plan rollover to a designated Roth account and the CFR I linked previously about the coordination between designated Roth accounts and Roth IRAs would therefore seem to apply.

Ah, yes, I missed that section in the FAQ about after-tax. Nice of the IRS to use "after-tax" both in context of normal Roth contributions as well as after-tax contributions. Hah.

Realistically this even more conclusively answers this then - if you are actually doing an in-plan rollovers for your aftertax contributions then roll it out of the 401k into a Roth IRA, you're able to treat the aftertax rollover (in entirety) as Roth principal and withdraw immediately.