A Roth 401k plan offers advantages of both a 401k retirement savings plan and a Roth IRA account. Also, qualified distributions are not subject to income tax. Consequently, plan participants can save more tax-free dollars for their retirement years. Distributions that include investment earnings are subject to federal income tax when the distribution does not comply with the five-year holding rule.
1. Determine if the distribution from your Roth 401k account is a qualified distribution. If not, it may be subject to federal income tax and a 10-percent early distribution penalty. For the IRS to treat a withdrawal as a qualified distribution, you must make the first contribution to the account at least five years before receiving a distribution. You must also meet at least one of the other conditions the IRS requires. You must not begin receiving distributions until after age 59 1/2, you must be disabled or be the beneficiary of a deceased IRA owner. In addition, you may not have to pay tax if you take a qualified first-time homebuyer distribution.
2. Report taxable income when receiving a non-qualified distribution from the account. For instance, if 25 percent of the money in the account is attributable to earnings from the investment rather than contributions, you must pay taxes on 25 percent of the distribution. The IRS considers interest earnings as ordinary income. Include any non-qualified portion of a Roth 401k distribution in gross income.
3. Choose whether you want the flat rate of 10 percent withheld or if you want an additional amount withheld from each distribution payment. Once you begin receiving distributions from your Roth 401k, the payer will automatically withhold federal income tax unless you indicate otherwise. You have the option of not having federal income tax withheld.
4. Complete Form W-4P -- Withholding Certificate for Pension or Annuity Payments -- if you do not want federal income tax withheld from your distribution payments. You can also use this form to indicate an additional dollar amount of tax you want withheld from each payment. For tax withholding, you must indicate your filing status and total number of exemptions. Itemizing deductions and claiming tax credits and other deductions will reduce the amount of your withholding.
- Even if you do not meet the five-year requirement, there are certain situations in which you may be able to avoid paying the 10-percent penalty. You still must be age 59 1/2, disabled or the beneficiary of a deceased IRA owner. Using the money from a distribution to pay major unreimbursed medical expenses or qualified education expenses are some of the other conditions for which the IRS might not impose the penalty.
- Look at current IRS tax brackets for an estimate of where your income falls in regard to tax rates. The tax rate you pay depends on your filing status and total taxable income. Take note of the income cutoffs for each tax bracket. This can help you determine if you need to have an additional amount withheld for taxes.
- The five-year holding period for qualified Roth 401k distributions will not be the same if you worked for different companies throughout the years. Each employer’s Roth account will have its own holding period for qualified distributions.
- Congressional Research Service: Individual Retirement Accounts and 401(k) Plans – Early Withdrawals and Required Distributions
- IRS.gov: Withholding Certificate for Pension or Annuity Payments
- Domini Social Investments: Roth IRAs
- SmartMoney: Understanding the Roth 401(k)
- The CPA Journal: Final Roth 401(k) Distribution Regulations
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