What is the Roth 401(k) Five-Year Rule?

Roth IRAs are becoming an increasingly popular alternative to traditional IRAs because they offer additional flexibility in how and when plan participants can access their money. For that same reason, Roth 401(k) plans are growing in popularity among employers offering qualified retirement plans. Both vehicles allow for tax-free distributions when certain conditions are met, such as abiding by the “five-year rule” for holding the account before taking withdrawals. But there are key differences between the two, not only in the conditions that must be met but also in how the five-year rule is applied.[i]

Before tacking the five-year rule differences, let’s look at some of the other ways the two plans differ.

Contributions may be withdrawn at any time.

Both plans allow you to withdraw your contributions at any time without penalty because you’ve already paid taxes on that money as you earned it. However, while the Roth IRA allows you to withdraw just your contributions without touching your gains, the Roth 401(k) assumes a portion of your withdrawal are gains relative to the proportionate percentage of gains to contributions in your account. For instance, if you contributed $10,000 to a Roth 401(k) and have $1,000 in gains, 10 percent of your contribution withdrawal is considered a gain and is taxed accordingly.[ii]

Required minimum distribution (RMD) rule.

Roth IRAs are not subject to the RMD rule, requiring you to take minimum withdrawals starting at age 72. However, Roth 401(k) plans are subject to the RMD rule, though you may roll your plan into a Roth IRA to avoid the rule.[iii]

Roth IRA funds can be accessed for specific purposes.

With a Roth IRA, you can access funds for specific purposes, such as buying your first home, after the birth or adoption of a child, qualified education expenses, unreimbursed medical expenses, among others. Withdrawals from a Roth 401(k) cannot be made for such purposes without penalty.[iv] Both plans allow for early distributions for a qualifying disability or if the withdrawal is made by a beneficiary or your estate after your death.[v]

How the Five-Year Rule Works[vi]

The five-year rule applies for early withdrawals from both a Roth IRA and Roth 401(k). To a great extent, the rule is applied to both plans in the same way. Under the rule, withdrawals can be made beginning five years from the first day of the year you make your first contribution. For example, if your first contribution is made in December 2021, the five-year holding period begins on January 1, 2021, and runs through December 31, 2025.

In addition, you must be at least 59 ½ when you make your first withdrawal. But, if you turn 59 ½ and you haven’t owned your account for five years, you will have to wait until then to make your first tax-free and penalty-free withdrawal.

How the Five-Year Rule Applies with a Roth 401(k) Rollover

As long as you maintain your original Roth 401(k), whether or not you leave your employer, the same five-year holding period applies. However, if you change employers and start a new Roth 401(k) plan, you will start a new five-year holding period for that plan. But there’s an important exception. If you make a direct transfer from your prior employer’s Roth 401(k) plan to your new employer’s plan, your five-year holding period for the new plan will be deemed to start with the year you made your first contribution to the original plan.[vii]

For example, Larry started making contributions to his company’s Roth 401(k) plan in 2017. He changed employers in 2021, where he continued making contributions. His five-year holding period for his former employer’s plan started on January 1, 2017, and ends on December 31, 2021. His holding period for his new employer’s plan started on January 1, 2021, and ends on December 31, 2025. Larry decides to make a direct transfer of his plan from his former employer to his new employer’s plan in 2021. As a result, his January 1, 2017 starting date from his former employer’s plan will carry over to his new plan, so any withdrawals he makes from his new plan after 2021 will be tax-free (assuming he’s at least 59 ½ or disabled at the time of the withdrawal).

Consider Transferring to a Roth IRA Instead

A similar application of the five-year rule applies when transferring funds from a Roth 401(k) to a Roth IRA. Essentially, the age of the Roth IRA dictates the holding period for all funds in the account. So, if you own a Roth 401(K) for three years and roll it over to a Roth IRA you’ve owned for ten years, all the funds in the account are available for tax-free withdrawals after age 59 ½.

It can be more beneficial to roll your Roth 401(k) funds into a Roth IRA instead of another Roth 401(k) because there are no required minimum distributions with a Roth IRA. More importantly, the income from a Roth IRA is not included in the Social Security tax calculation.[viii] In addition, you may have more investment options with a Roth IRA you set up with a brokerage firm than with an employer-sponsored 401(k) plan.

Regardless of which type of plans are involved, any decision you make around a retirement plan rollover has tax implications, which you should review with your financial advisor. Such decisions should be discussed in the context of your circumstances and your overall financial plan. 

[i] https://www.investopedia.com/articles/personal-finance/063015/roth-401k-vs-roth-ira-one-better.asp 8 October 2021

[ii] Ibid.

[iii] https://www.investopedia.com/roth-ira-required-minimum-distribution-rmd-4770561 9 October 2021

[iv] https://www.fidelity.com/viewpoints/retirement/taxes-on-social-security 9 October 2021

[v] https://www.investopedia.com/roth-ira-withdrawal-rules-4769951 9 October 2021

[vi] https://money.usnews.com/money/retirement/iras/articles/what-is-the-roth-ira-5-year-rule 9 October 2021

[vii] https://money.usnews.com/money/retirement/iras/articles/what-is-the-roth-ira-5-year-rule Ibid.

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