Participants in designated Roth accounts (DRACs) (i.e., Roth 401(k)s, Roth 403(b)s, and Roth 457(b)s) may wish to consider opening a Roth IRA to take advantage of the Roth IRA's more generous five-year rule for qualified distributions.
Qualified distributions are the holy grail of Roth plans: it's when earnings come out income-tax-free. As a reminder, the five-year requirement is only one of the tests for a qualified distribution from employer plans. A participant must also be age 59½ or older, disabled, or deceased in order for the distribution to be deemed qualified. Note also that there's a completely different five-year clock to receive penalty-free distributions following a conversion to a Roth IRA account.
The five-year clock starts on the first day of the first year for which a contribution is made to the DRAC. That’s true even if the participant didn’t make any contributions until December. For example, if the participant started to make Roth 401(k) contributions at any time in 2015, the clock started on January 1, 2015, and the five years will be completed on the last day of 2019. Beginning January 1, 2020, the participant can take qualified distributions if he or she is age 59½ or older or disabled.
DRACs with different employers have different five-year clocks. For example, a DRAC started with one employer in 2014 will have a different five-year clock than a DRAC started with a new employer in 2015. There is some good news: If the 2014 DRAC is rolled over to the 2015 DRAC, the account is treated as if it started in the earliest year of either of the two accounts. In the world of Roth IRAs, however, the Roth IRA owner has just one five-year qualified distribution clock for all of his or her Roth IRAs.
Money withdrawn from a DRAC can generally be rolled to a Roth IRA. However, the age of the DRAC does not transfer to a Roth IRA with the rollover. This could be a significant hitch. If a participant has held a DRAC for several years without holding a Roth IRA, when the Roth IRA is opened to receive the rollover from the DRAC, it'll start a new five-year waiting period before a qualified distribution may be taken from the Roth IRA. On the other hand, if a participant has had a DRAC for one or two years but has owned a Roth IRA for more than five years outside of the plan, he or she can satisfy the five-year test for all the money by rolling the DRAC to the Roth IRA.
Late to the retirement savings game, Jim, at age 60, started contributing to a Roth 401(k). He has put in the maximum contribution (including catch-up contributions) for the past two years. At age 62, the account has a value of $54,000 ($48,000 of after-tax contributions and $6,000 of earnings). Jim separates from service and rolls over his Roth 401(k) to a newly established Roth IRA. He must wait five years before he is eligible to receive a qualified distribution from his Roth IRA. If Jim had contributed to a Roth IRA more than five years before his rollover, the rollover amount (including earnings) could be taken from the seasoned Roth IRA as a qualified distribution.
Contributing to a Roth IRA before or at the start of contributing to a DRAC will start the Roth IRA clock ticking for qualified distribution treatment for the Roth IRA and also for funds from DRAC to be moved into the Roth IRA in the future. This may well prove to be advantageous. While many individuals will be able to contribute directly to a Roth IRA, some may be disqualified due to adjusted gross income limitations. Stay tuned for a future blog post on this issue.
Saving for retirement is hard enough. It requires sacrificing current consumption for future income. Unfortunately, it can be complicated as well. Knowing that the Roth IRA five-year clock is the grandfather of all clocks in the Roth universe may go a long way in helping reward the sacrifice.
If you have any additional questions, please feel free to contact Retirement Strategies Group at (800)722-2333, ext. 3939, or e-mail us at RSG@PacificLife.com.
2015 Publication 590-B – Internal Revenue Service for more information regarding Roth IRAs.
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