Founded in 1993 by brothers Tom and David Gardner, The Motley Fool helps millions of people attain financial freedom through our website, podcasts, books, newspaper column, radio show, and premium investing services. Then we will explore withdrawals from a Roth 401(k). Roth vs Traditional 401 (k) In a traditional 401 (k), employees make pre-tax contributions. Note that much of this post discusses withdrawals before age 59 ½. Many like the Rule of 55, which is a rule that allows taxpayers to take amounts from workplace retirement plans such as 401(k)s without the early withdrawal penalty. If you move your money into a newly opened Roth IRA, you will have to wait five years from the first Roth IRA contribution regardless of how long ago you first contributed to the 401(k). Loans allow you to access the money in your Roth 401(k) without serious tax consequences, but are risky because of the penalties if you become unable to pay back what you borrowed. Roth 401 (k) Withdrawal Rules There are three types of withdrawals from a Roth 401 (k): qualified distributions, hardship distributions and non-qualified distributions. And, of course, the rollover from the Roth 401(k) to a Roth IRA eliminates future RMDs. We also live in a world where increasing numbers of people invest through a Roth 401(k). Roth IRAs are a type of Individual Retirement Account that allow investors to grow their money tax-free. The owner of a Roth 401(k) who qualifies for a qualified distribution does not need to roll the Roth 401(k) to a Roth IRA to take a tax free withdrawal. The cream-in-the-coffee rule can be waited out. However, if you take gains out of your account before age 59 1/2, this is generally considered an unqualified or "early" withdrawal. This illustrates that numbers matter in this regard. Learn why a Roth IRA may be a better choice than a traditional IRA for some retirement savers. Normally you may borrow up to $50,000 or 50% of your vested account balance, whichever is less, if your plan administrator allows it. If a 401(k) … Recall the example of Lilly above. Loans do not trigger taxes or an early-withdrawal penalty. Understanding Qualified Distributions. While rollovers of nonqualified distributions do not eliminate Roth 401(k) earnings, they do eliminate the cream-in-the-coffee rule. You should try to do a direct rollover, which means the funds are transferred directly from your current Roth account to your new one, as this reduces the potential for tax complications. He has made $100,000 of contributions to the Roth 401(k) which has grown to $200,000. She also made a $10,000 conversion from a traditional 401(k) to her Roth 401(k) in 2014. The contributions to a Roth 401(k) are already taxed, so the money withdrawn is tax … It applies when a taxpayer separates from service at age 55 or older (up to age 59 ½, when withdrawals become penalty free), and the plan allows partial withdrawals. To get our feet wet, first I will illustrate the ordering rules for withdrawals from a Roth IRA. On the list above, you'll notice the IRS allows tax-free withdrawals only if you made the first contribution to your account at least five years earlier. Unlike the sequenced layering of Roth IRA withdrawals, Roth 401(k) withdrawals generally default to what Ed Slott refers to as the “cream-in-the-coffee” rule. Here is the order of distributions that come out of a Roth IRA: Second Layer: Roth IRA conversions (first-in, first-out). Consider that before thinking about how the tax rules apply to withdrawals. However, if one employs the “withdraw then rollover” strategy, keeping money in the Roth 401(k) can work as effectively as rolling over to a Roth IRA. There is a third way to overcome the cream-in-the-coffee rule. There's another tricky rule to be aware of with Roth 401(k) accounts. As a practical matter, as long as the taxpayer does not plan on withdrawing more than the rolled over amount in the first five years, this nuance is not likely to be a gating issue in determining whether the Roth 401(k) should be rolled over to a Roth IRA. He has contributed $100,000 over more than five years to his Roth 401(k), and it is currently worth $200,000. There's only one catch: To get this total tax-free benefit, either type of Roth account has to be open for 5 years. You also won't owe any penalties on it. The amount contributed to a designated Roth … Market data powered by FactSet and Web Financial Group. This blog post only presents an educational introduction to those rules. If, instead, James follows the “rollover then withdraw” strategy and rolls his Roth 401(k) to a Roth IRA, the first $100,000 he withdraws before age 59 ½ will be a return of contributions, and only if he exceeds $100,000 in withdrawals will he have ordinary income and a penalty. 401 (k) withdrawals Depending on your situation, you might qualify for a traditional withdrawal, such as a hardship withdrawal. And while you pay interest to yourself when paying back your loan, the interest will likely be below the return on investment you could have earned had you left your funds invested for your future. A second option for James would be to do the “withdraw then rollover” strategy whereby James would direct half of each distribution (the earnings half) to a Roth IRA in order to avoid ordinary income taxation on the earnings portion. In 2021, at a time when her Roth 401(k) is worth $60,000 and Lilly is 45 years old, Lilly takes a $15,000 withdrawal from her Roth 401(k). 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