By Ian Berger, JD
IRA Analyst

With more 401(k) plans offering Roth contributions and more folks taking distributions from their plans, now’s a good time to review the tax rules governing Roth 401(k) distributions.

Qualified distributions. If your Roth 401(k) distribution meets the requirements for a “qualified distribution,” you’re in luck: It comes out completely tax and penalty-free. A distribution is qualified if it meets two conditions. First, you must be age 59½ or older at the time of distribution (or the distribution must be on account of disability or death). Second, you must have held the Roth 401(k) account for more than five years. This five-year holding period starts on January 1 of the first year you made a Roth contribution to the plan from which you are now taking the distribution.

Example 1: Nia began participating in her employer’s 401(k) plan 10 years ago and made her first Roth 401(k) contribution to that plan six years ago. At age 60, Nia takes a distribution from her Roth 401(k) account. Since Nia is age 59½ or older and she made her first Roth 401(k) contribution more than five years ago, her distribution is tax and penalty-free.

Non-qualified distributions. If your distribution is not qualified, a portion will be subject to tax under the pro-rata rule. To determine how much is taxable, first divide the amount of your Roth 401(k) contributions by your total Roth 401(k) account balance (contributions + earnings). Then, multiply that fraction by the amount of your distribution. Finally, subtract this amount from your distribution amount.

Example 2: Tamal, age 30, takes a $12,000 hardship withdrawal from his Roth 401(k) account. He has made $80,000 of Roth 401(k) deferrals, and his total Roth 401(k) account balance (contributions + earnings) is $100,000. The fraction of Tamal’s Roth 401(k) contributions to his total account balance is 4/5 ($80,000/$100,000). This means that $9,600 ($12,000) x 4/5) of his $12,000 withdrawal is non-taxable. The remaining $2,400 is taxable and, unless an exception applies, is also subject to the 10% early distribution penalty.

Other 401(k) accounts. When you calculate whether your Roth 401(k) distribution is subject to taxes, you can ignore other taxable amounts within your 401(k) plan, such as accounts holding pre-tax deferrals or employer matching contributions.

Special Rules for 2020. If you are an affected person under the CARES Act, you can take up to $100,000 of 2020 distributions from your IRA or your employer plan and receive several tax breaks. First, you won’t be subject to the 10% early distribution penalty. Second, you can spread taxable income ratably over three years. Third, you can recoup taxes on the distribution by repaying all or part of it to an IRA or company plan within three years.

Example 3: If Tamal (from Example 2) lost his job because of COVID-19 and took his Roth 401(k) withdrawal in 2020, he would be exempt from the 10% early distribution penalty. Also, he could spread taxes on the $2,400 taxable portion over three years or recover taxes paid on it by repaying all or part of the $2,400 within three years.