One of the features imbedded in our self-directed solo 401(k) plans is that contributions can be made to a designated Roth account per applicable limits. The IRS has compiled a list of frequently asked questions regarding Roth contributions to retirement plans. When reading their Q&A, below, keep in mind that they are referring to solo 401(k)s and group 401(k)s. For those with, or considering adopting, the solo 401(k), remember that you are the “employee” and “employer”. Also, they are only discussing the salary deferral contribution limit and not the profit-sharing contribution (additional amount allowed for solo 401(k)s) portion because it must be contributed pre-tax and is not allowed in group plans.
What is a qualified distribution from a designated Roth account?
A qualified distribution is generally a distribution that is made after a 5-taxable-year period of participation and is either:
made on or after the date you attain age 59½
made after your death, or
attributable to your being disabled.
If a distribution is made to your alternate payee or beneficiary, then your age, death or disability is used to determine whether the distribution is qualified. The only exception is when the alternate payee or surviving spouse rolls over the distribution to his or her own employer’s designated Roth account, in which case their own age, death or disability is used to determine whether the distribution is qualified.
A qualified distribution from a designated Roth account is not included in your gross income.
What is a 5-taxable-year period of participation? How is it calculated?
The 5-taxable-year period of participation begins on the first day of your taxable year for which you first made designated Roth contributions to the plan. It ends when five consecutive taxable years have passed. If you make a direct rollover from a designated Roth account under another plan, the 5-taxable-year period for the recipient plan begins on the first day of the taxable year that you made designated Roth contributions to the other plan, if earlier.
If you are a re-employed veteran making designated Roth contributions, they are treated as made in the taxable year of qualified military service that you designate as the year to which the contributions relate.
Certain contributions do not start the 5-taxable-year period of participation. For example, a year in which the only contributions consist of excess deferrals will not start the 5-taxable-year period of participation. Further, excess contributions that are distributed to prevent an ADP failure also do not begin the 5-taxable-year period of participation.
What types of distributions cannot be qualified distributions and must be included in gross income?
You cannot treat the following types of distributions from a designated Roth account as qualified distributions (or eligible rollover distributions) and must include any earnings paid out in gross income:
Corrective distributions of elective deferrals in excess of the IRC Section 415 limits (lesser of $58,000 for 2021 ($57,000 for 2020) or 100% of earnings).
Corrective distributions of excess deferrals under Section 402(g) ($19,500 for 2020 and for 2021; $26,000 if age 50 or older in 2020 and 2021).
Corrective distributions of excess contributions or excess aggregate contributions.
Deemed distributions under IRC Section 72(p) (where you default on repayment of a loan from the plan).
What happens if I take a distribution from my designated Roth account before the end of the 5-taxable-year period?
If you take a distribution from your designated Roth account before the end of the 5-taxable-year period, it is a nonqualified distribution. You must include the earnings portion of the nonqualified distribution in gross income. However, the basis (or contributions) portion of the nonqualified distribution is not included in gross income. The basis portion of the distribution is determined by multiplying the amount of the nonqualified distribution by the ratio of designated Roth contributions to the total designated Roth account balance. For example, if a nonqualified distribution of $5,000 is made from your designated Roth account when the account consists of $9,400 of designated Roth contributions and $600 of earnings, the distribution consists of $4,700 of designated Roth contributions (that are not includible in your gross income) and $300 of earnings (that are includible in your gross income).
Since I make designated Roth contributions from after-tax income, can I make tax-free withdrawals from my designated Roth account at any time?
No, the same restrictions on withdrawals that apply to pre-tax elective contributions also apply to designated Roth contributions. If your plan permits distributions from accounts because of hardship, you may choose to receive a hardship distribution from your designated Roth account. The hardship distribution will consist of a pro-rata share of earnings and basis and the earnings portion will be included in gross income unless you have had the designated Roth account for 5 years and are either disabled or over age 59 ½.
Is a distribution from my designated Roth account for reasons beyond my control (for example, plan termination or severance from employment) a qualified distribution even though it doesn't meet the criteria for a qualified distribution?
No, if you have not held the account for more than 5 years or if the distribution is not made after death, disability, or age 59 ½, then the distribution is not a qualified distribution. However, you could roll the distribution over into a designated Roth account in another plan or into your Roth IRA. A transfer to another designated Roth account must be made through a direct rollover.
Can I take a loan from my designated Roth account?
Yes, if the plan permits, you can identify from which account(s) in your 401(k), 403(b) or governmental 457(b) plan you wish to draw your loan, including from your designated Roth account. However, you must combine any loans you take from your designated Roth account with any other outstanding loans from that plan and any other plan maintained by the employer to determine the maximum amount you are permitted to borrow. The repayment schedule for your loan from your designated Roth account must separately satisfy the amortization and quarterly payment requirements.