Partial withdrawal from a Roth 401k
This year Alice contributed $20k after-tax to a 401k, with an automatic in-plan Roth rollover to a Roth 401k. The value of that subaccount then grew to $30k.
Now Alice wants to make a penalty-free early withdrawal of $2k. She could do a $3k rollover to her Roth IRA and then withdraw $2k, with the extra $1k covering the earnings portion of the pro-rata rollover. (For simplicity, assume she has no other Roth IRA funds.)
Fidelity offered instead to roll over $1k to her Roth IRA to cover the earnings, and send $2k directly to her bank account. Is that allowed? (I guess it must be, if Fidelity offered to do it.)
Now suppose instead that Alice already had money in her Roth IRA, all from a taxable conversion last year. That would throw a monkey wrench into the “$3k rollover to Roth IRA” plan, since older conversions come out first when computing the 10% penalty. But since Fidelity is sending the $2k directly to Alice, not passing it through her Roth IRA, would this be a penalty-free withdrawal of the $2k?
Permalink Submitted by Alan - IRA critic on Fri, 2024-08-16 00:17
If 3000 is withdrawn from the Roth 401k of which 1000 is gain, any amount rolled over to a Roth IRA is treated as first coming from the gain. The 2000 would be treated as a regular Roth IRA contribution, available tax and penalty free anytime.
But withholding complicates this somewhat because the plan would have to withhold 20% of the gain ($200), and to complete a full rollover she would have to come up with that 200 from her other funds.
A Roth conversion would not affect this because the 2000 is treated as a regular Roth IRA contribution and would come out before any conversion funds.
Permalink Submitted by ssel on Fri, 2024-08-16 16:36
Alan wrote:
I understand that the $2k is treated as a regular contribution for purposes of the taxable amount computed on Form 8606. However, the $2k was part of an IRR and has a 5-year clock running for purposes of the 10% penalty (“additional tax”) computed on Form 5329. As I learned from none other than Alan, if you roll over funds from an IRR the 5-year clock continues to run. In the above example, there was a 5-year clock on an older Roth conversion, and a separate 5-year clock on a newer IRR (subsequently rolled over). So a withdrawal of $2k from the Roth IRA would — for purposes of Form 5329 — come first from the earlier taxable conversion. Right?
Permalink Submitted by Alan - IRA critic on Fri, 2024-08-16 19:56
Good catch. I overlooked the earlier conversion that comes out prior to the IRR for penalty purposes only. The 10% penalty would be due on Form 5329 for the Roth IRA distribution up to the amount of that conversion.
I wonder if tax software programs even support Appendix C if all prior activity was captured by the program.
Permalink Submitted by ssel on Fri, 2024-08-16 16:46
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Permalink Submitted by ssel on Fri, 2024-08-16 23:44
So now back to the original question about what Fidelity suggested. Here’s how I believe it plays out:
Alice wants to withdraw 2000 from her IRR subaccount, avoiding tax and penalties. A straightforward withdrawal won’t work, because of the pro-rata rule. She instead withdraws 3000, and rolls over 1000 of it to her Roth IRA. Alan has confirmed that the rollover comes first from earnings. So Alice is left with 2000 (minus withholding) that is not from earnings and hence not taxable. And since the IRR itself was not a taxable event (there were no earnings at that time), Alice does not owe any 10% penalty either.
So Fidelity’s suggestion seems to work. Alice gets to withdraw 2000 tax and penalty free (although some of that 2000 goes to withholding).
Alan, is that all correct?
Permalink Submitted by Alan - IRA critic on Sat, 2024-08-17 11:04
Yes, that is correct and very clear under the IRS Regs.
However, in your original post you indicated that “Fidelity offered to roll the 1000 to her Roth IRA”. That’s different than distributing 3000 to her because if Fidelity transferred the 1000 as a direct rollover to her Roth IRA, that would be a second transaction and reported on a different (H coded) 1099R than the distribution to Alice. Fidelity would then separately pro rate the H coded 1099R to show the amount of basis included in the direct rollover (Pro rated with gain). 667 of basis would go into her Roth IRA, not the desired result. And the 2000 actually distributed to Alice would consist of 1333 of basis and 667 of taxable gain and while she could roll over the 667 to eliminate the tax, it would not leave her with enough basis for spending.
Therefore, the 1000 should not be distributed as a direct rollover and generating a second 1099R, The entire 3000 less withholding should be distributed to Alice, then she does a 60 day rollover. No direct rollovers.
Permalink Submitted by ssel on Sat, 2024-08-17 22:09
Yeah, after reading your responses and thinking things through some more, I refined the question a bit when I restated it.
When Alice (not her real name) actually described this to me, she wasn’t quite certain of all the details. I’ll give Fidelity the benefit of the doubt, and assume that there was no direct rollover. More importantly, thanks to you I now know how to advise others going forward.