Rolling over a Roth 401(k) to a Roth IRA can make sense in the right circumstances, but you need to be aware of the rules.
When you rollover funds from a Roth 401(k) to a Roth IRA, it’s the age of the Roth IRA that sets the clock for the 5-year rule.
It's also important to understand the income limits on a Roth IRA to make sure you're eligible.
I'm 56 and have both a traditional and a Roth 401(k). Right now I contribute the maximum to my Roth each year. I plan to roll the Roth 401(k) into a Roth IRA before 70½ to avoid having to take an RMD. Two questions: Do I need to open a Roth IRA five years prior to the rollover to meet the 5-year rule? And can I contribute to a Roth IRA even though I max out my Roth 401(k)?
I rarely get questions regarding a Roth 401(k) rollover, but as this type of retirement plan becomes more widely available, I'm sure more and more people will be looking for similar answers. So thanks for asking.
I think you're right on target with your basic idea. With a Roth 401(k)—unlike a Roth IRA—you must take a required minimum distribution (RMD) beginning at age 70½. So the idea of rolling your Roth 401(k) money into a Roth IRA before that magic age makes a lot of sense. Rather than being required to take a certain amount out of your retirement savings each year, with your money in a Roth IRA, you can choose how much, when—or if ever—you want to make withdrawals.
But as you suggest, there are certain things you need to be aware of to make sure you can take full advantage of all the Roth IRA benefits.
Digging into the 5-year rule
One of the key benefits of a Roth IRA or Roth 401(k) is that, while contributions aren't tax-deductible, both contributions and earnings can be withdrawn tax and penalty free once you reach age 59½. That can make a huge difference in your tax liability during retirement. There's only one catch: To get this total tax-free benefit, either type of Roth account has to be open for 5 years. The clock starts ticking January 1st of the year you make your first contribution.
That seems fairly straightforward. However, what most people might not realize is that when you rollover a Roth 401(k) to a Roth IRA, the clock is reset. And in this case, it's the timing of the Roth IRA that counts.
For example, let's say you've had a Roth 401(k) for 10 years and you've also had a Roth IRA for five years. If you roll your Roth 401(k) into your Roth IRA, there's no problem. You've met the 5-year rule. But now let's say you've only had your Roth IRA for 3 years. Even though your Roth 401(k) meets the 5-year rule and then some, if you roll it into your 3-year-old Roth IRA, you'd have to wait another two years before you could withdraw earnings tax-free (although, as with any Roth account, you could withdraw your contributions tax-free at any time).
So to answer your first question, yes, it could make sense to open a Roth IRA at least five years before you plan to rollover your Roth 401(k). However, it's not enough to open it. You have to make a contribution for the 5-year time period to start. The problem is that not everyone is eligible to do so.
The ins and outs of opening and contributing to a Roth IRA
The easy answer to your second question is again, yes, you can potentially contribute to a Roth IRA even if you contribute the yearly maximum to a 401(k). In fact, it's an ideal retirement savings scenario to contribute the maximum to both. And it's something I highly recommend if you can afford it. For 2019, you can contribute up to $19,000 to a 401(k) with a $6,000 catch up if you're 50 or over and $6,000 with a $1,000 catch up to a Roth IRA (if you're 50 or over). Together, that's a sizeable savings.
So on the surface, it would appear you're good to go. However, although there are no income limits for contributing to a Roth 401(k), there are yearly income limits for contributing to a Roth IRA, and that could throw a wrench in your plan. For 2019, if your adjusted gross income (AGI) is $137,000 or over for single filers ($203,000 or over for married filing joint) you won’t be eligible to make a Roth IRA contribution.
A possible backdoor solution
There is a possible solution in what's called a "backdoor Roth." The IRS allows you to convert a traditional IRA to a Roth IRA even if you're above the income limits. Basically, you first open a traditional IRA and make a contribution. You then convert that IRA to a Roth. If your contribution to the traditional IRA was tax-deductible, you'd have to pay income taxes on the money converted to the Roth, but from then on, you'd enjoy the tax-free benefits. In your case, if you were able to do this five years before your rollover, your Roth IRA would meet the 5-year rule, and you'd have tax-free access to both your contributions and earnings (as long as you're age 59½). If this is something you think might work for you, I recommend talking to a financial or tax advisor.
Some additional considerations
You say you're contributing the maximum to your Roth 401(k), but you may want to consider splitting your contribution between your traditional 401(k) and your Roth 401(k). This provides a bit of tax diversification, giving you a tax deduction now as well as tax-free withdrawals later. And the tax deduction might also have a side benefit of lowering your AGI, possibly making you eligible for a Roth IRA. It's all worth some consideration. Your financial or tax advisor can help you figure out what's best for you.
Have a personal finance question? Email us at firstname.lastname@example.org. Carrie cannot respond to questions directly, but your topic may be considered for a future article. For Schwab account questions and general inquiries, contact Schwab.