Q.: A co-worker told me I should open a Roth IRA before I retire because otherwise my Roth 401(k) will get taxed if I use any of it in five years. Is that true and if so, how do I do that when my income is too high to open a Roth? I’ve been funding that for 10 years so the amount in there is not minor.
–Seth in Taos
A.: Seth, there are a few five-year rules that apply to Roth accounts. I will just touch on two of them today. If your plan is to just let the Roth grow, these rules can be made irrelevant.
The first five-year rule applies to Roth 401(k) accounts. It states that earnings are taxable if distributed before age 59½ or the account has not been open for at least five years. You didn’t mention your age but since you have been contributing for 10 years, distributions of earnings would only be taxable if made prior to your age 59½.
It is important to note that the taxes do not apply to contributions and when taking a distribution, the contributions are distributed first. Since contributions were made with after-tax money, those distributions would be received tax-free.
A similar five-year clock applies separately to Roth IRAs. If the Roth IRA that would receive the rollover is your first Roth IRA account or it has been less than five years since you opened your first Roth IRA (even if that account no longer exists) the earnings are subject to tax upon distribution until the five-year period passed.
What I suspect your co-worker is referring to is that by opening a Roth IRA now, when your Roth 401(k) is rolled over to a Roth IRA, you will have already started that five-year clock. Again, the contributions come out first so you would still have access to some funds tax-free even if the Roth IRA was your first Roth IRA.
You may wonder if you have satisfied the five-year rule in the 401(k), why would you roll the funds to a Roth IRA? The two most common reasons are better investment options and to avoid Required Minimum Distributions (RMD). Unless you are still working and eligible for a delay, you would be subject to RMD at age 72 on the Roth 401(k) accounts. There are no RMD on your individual Roth IRA.
Of course, if you view the RMD as an unnecessary nuisance, it is likely your intent is to let the Roth account grow so rolling it into a Roth IRA subject to the five-year rule on earnings may not matter.
As for how to get funds into a Roth IRA to start that clock when your income is too high to make a contribution (Adjusted Gross Income over $144,000 for a single, $214,000 for joint filers in 2022), the two most common ways are an “in-service distribution” or converting IRA funds to a Roth IRA. An in-service distribution allows persons over age 59½ to access or rollover 401(k) funds before retirement. See your plan documents to see if your plan includes such a provision.
The conversion can be of existing IRA money or a new IRA via a “back door Roth IRA”. Last year a bill eliminating the back door option got some traction but did not pass. The term “back door Roth” can also conjure fears of the notorious “pro rata rule”. However, you can avoid a high tax bill while starting the five-year clock, by converting a small amount. I’ve seen one done for a mere $1.
If you have a question for Dan, please email him with ‘MarketWatch Q&A’ on the subject line.
Dan Moisand is a financial planner at Moisand Fitzgerald Tamayo serving clients nationwide from offices in Orlando, Melbourne, and Tampa Florida. His comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some reader questions are edited to aid the presentation of the subject matter.