One of the main advantages of contributing to a Roth 401(k) or a Roth IRA is the opportunity to withdraw your funds completely tax free.
However, for the tax-free withdrawal rule to apply to your full balance (your personal contributions and any earnings you made), you must ensure you are making a qualified distribution. Otherwise, the portion of the withdrawal that applies to your earnings will be subject to taxation and potentially an early withdrawal penalty.
For a Roth distribution to be considered qualified, it must meet both of the following criteria:
5-year waiting period: You began making Roth contributions at least 5 years ago
Qualified distribution event: Your withdrawal is due to an allowable reason or circumstance
The IRS has a tool on their website designed to help you determine if a distribution from a Roth 401(k) or Roth IRA will be taxable, but here’s a breakdown of the rules that apply.
What is the 5-year waiting period?
In order for a distribution of Roth assets to be qualified, you cannot withdraw earnings until it's been at least 5 years since you first contributed to a Roth account. This period begins on the first day of the tax year in which you made your first Roth contribution, regardless of the actual day the contribution was made. For instance, if you began contributing to your Roth account on May 20, 2023, then your 5-year start date will be January 1, 2023.
Here’s how the 5-year waiting period applies to 401(k) and IRAs:
Roth 401(k): There is a 5-year start date for each plan you participate in that will apply to all 401(k) Roth contributions in that plan. That 5-year start date does not transfer to another plan even if you rollover your Roth 401(k) assets to another plan.
Roth IRA: There is a single 5-year start date that will apply to any Roth IRA you establish that is set by the very first time you make a contribution to any Roth IRA.
How is the 5-year waiting period affected by rollovers and transfers?
The effect of moving Roth assets between 401(k) plans and IRAs will depend on the type of account the assets are moving from and where they are moving to:
Roth IRA to Roth IRA: Since you have a single 5-year start date that applies to all Roth IRAs you have, the movement between different Roth IRA accounts has no effect on the 5-year waiting period.
Roth 401(k) to Roth 401(k): Because each 401(k) plan has its own 5-year start date, when you rollover Roth assets from one 401(k) plan to another, the rolled over assets will be subject to the 5-year start date of the receiving plan. The 5-year start date does not rollover with the assets.
Roth 401(k) to Roth IRA: When you rollover Roth 401(k) assets to a Roth IRA account, the assets become subject to the 5-year start date for the IRA. If the rollover to a Roth IRA is the first contribution you have ever made to a Roth IRA, then that rollover starts the 5-year waiting period. The 5-year start date does not transfer from the Roth 401(k) to the Roth IRA.
Roth IRA to Roth 401(k): You cannot rollover Roth IRA assets to a Roth 401(k) plan.
How is the 5-year start date affected by death or divorce?
According to the IRS, the 5-year start date does not get reset by death or divorce. Distributions to beneficiaries or alternate payees will use the 5-year start date of the original account holder or decedent.
However, if a beneficiary or alternate payee choses to treat the amount as their own (by rolling over the assets to an account in their own name), the 5-year start date for that account will be used for any subsequent distributions.
What are the qualified distribution events?
In addition to meeting the 5-year waiting period, the distribution must also meet one of the following requirements to be tax-free:
You are at least age 59 ½
You are disabled (uses same definition as the 10% penalty exemption)
Made to a beneficiary or your estate due to your death
You are a first-time homebuyer (for Roth IRAs only and has a lifetime limit of $10,000)
Determining contributions vs. earnings
If you decide to take a distribution that is less than your full Roth account balance, any distributions from the portion that is considered earnings would be subject to taxation. The portion that is from your personal contributions is always tax free. The IRS has specific rules in place for determining which portion of your distribution amount is considered earnings.
Roth 401(k): Distributions from a Roth 401(k) account will always be part contributions and part earnings determined pro-rata. For example, if your Roth 401(k) account is 80% contributions and 20% earnings, your distribution will be considered 80% contributions (always tax free) and 20% earnings (subject to tax unless a qualified distribution as outlined above).
Roth IRA: For distributions from a Roth IRA, the IRS has specific ordering rules. When applying these ordering rules, you must add together all Roth accounts you own. The first amount to be distributed from the Roth IRA will be from actual contributions (including rollovers from Roth 401(k) accounts). Once all actual contributions have been distributed, any conversions or rollovers from pre-tax retirement plans will be distributed (taxable assets first). Finally, when all other assets have been distributed, earnings will be distributed. It is the responsibility of the Roth IRA account owner to track contributions, rollover, and conversions to properly determine the taxable amount being distributed.
Examples of how qualified distributions apply
Example 1: Full tax-free distribution
Ace first contributed to a Roth IRA on April 14, 2009. In 2023, she has $9,800 in contributions with $1,000 of that being earnings and decides to take a distribution of her full account balance to purchase her first home.
Because Ace meets both the 5-year waiting period and the first-time homebuyer qualified distribution event, the distribution is qualified and the entire amount will be tax free. Also note that the full distribution of her Roth IRA balance will not restart the 5 year waiting period for any subsequent Roth IRA contributions. Her 5-year start date will remain January 1, 2009.
Example 2: Partially taxable distribution
Polly first contributed Roth deferrals to her 401(k) plan on July 1, 2021. In 2023, she retires at the age of 64 and takes a full distribution of her Roth 401(k) account balance. At the time of distribution, she has $25,000 in her Roth 401(k) account, $6,000 of which are earnings.
While Polly does have a qualified distribution event (because she is older than 59 ½), she has not met the 5-year waiting period. As such the $6,000 in earnings will be included as taxable income for 2023.
Is the distribution from your Roth a qualified distribution?
