Finance Q&A

Financial Q&A

Q IFinancial Q&A

Protecting your investment portfolio

Q: I am 60 years old and plan to switch to part-time status at my practice in the next year before I fully retire at age 65. My group retirement plan offers a Roth 401(k) and traditional 401(k) option that I have contributed to for many years. I plan to use my 401(k) assets to supplement living expenses at retirement, but after reading an article on Roth distribution and taxation rules, I am unsure if that is a wise choice. Is it better to use traditional 401(k) or Roth 401(k) assets to supplement expenses at retirement?

A. The answer depends on your financial situation. Traditional 401(k) contributions are made with pre-tax dollars, so if you plan to start distributions from the traditional portion of your 401(k) at age 65, the withdrawals will be subject to ordinary income tax. Withdrawals from a Roth 401(k) enjoy a different tax treatment because of the after-tax contributions. Any amount you contribute to a Roth 401(k) is considered basis and is always withdrawn tax-free. Amounts above basis are termed earnings, and they are subject to tax (early penalty & ordinary income) if distributed before a certain period. While disability or death can be a qualifying event for tax-free status, two basic conditions are normally required to qualify your Roth earnings as tax-free for distribution purposes. First, a five-year holding period must be met for the Roth account. This starts with the first Roth contribution made. The second condition requires that any distribution of earnings must begin after the account holder reaches age 59.5. In many cases, qualifying for tax-free status is not a problem because like you, most people started contributing to their Roth accounts early on, and they will not use the funds until after the 59.5 age requirement.

You should also be aware the Roth 401(k) portion of your retirement plan will require an annual minimum distribution or RMD starting at age 72. You can avoid the RMD for the Roth 401(k) portion by rolling that amount into an existing Roth IRA. This will allow you to defer distributions from the Roth IRA until you are ready. Once again, distributions will be subject to the five-year and 59.5 rule for tax-free status on earnings, but the start for the five-year clock now depends on the age of the Roth IRA account. If you are rolling assets into an existing Roth IRA that was previously funded, you assume the five-year holding period of that account. If you open a new Roth IRA for the Roth 401(k) rollover, the five-year period starts with the first contribution of that account. Years of contributions made to the Roth 401(k) in your retirement plan would not be counted toward this five-year Roth IRA requirement.

Here is a simple way to remember the order in which Roth distributions must be made. • Contributions come out first: Always tax-free. • Converted amounts come out second: Subject to the five-year OR 59.5 age rule for tax-free status. • Earnings come out last: Subject to the five-year AND 59.5 age rule for tax-free status. Before you take any action, I suggest you seek the advice of a financial professional for additional distribution questions and timing decisions.

William B. Howard, Jr., ChFC, CFP

International Place II 6410 Poplar Ave., Suite 330 Memphis, TN 38119 Telephone: (901) 761-5068 Fax: (901) 761-2217 whoward@whcfa.com