Early retirement at 55 with Roth 401k?

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Topic Author
nv67
Posts: 25
Joined: Mon Sep 16, 2013 4:05 pm

Early retirement at 55 with Roth 401k?

Post by nv67 »

Hello friends, I have a question about the way the IRS treats Roth 401k distributions under the Rule of 55. I will turn 55 in the 2024 calendar year. I am maxing out my pre-tax 401k, and contributing into the "spillover" bucket to the max (around 65K total of all contributions and matches). The spillover is then subjected to the Mega Backdoor Roth conversion into my Roth 401K (which already exists as well since I used to make contributions to this). The question is, can I take distributions from the Roth 401k when I turn 55 with no penalty and no tax? I will be exercising the Rule of 55, which my company permits. The information is pretty clear on traditional 401k's but I am not able to find much on Roth 401k's and the Rule of 55.

When I called Fidelity last month, the guy I talked to said that the withdrawal of Roth 401k money before age 59.5 would trigger taxes on the gains. When I told him that I plan to take only my contributions, and not the growth, he said that the IRS will give the distribution a "proportional treatment". So If I contributed $100, and it grew to $200, I cannot withdraw my contribution of $100, leaving the growth of $100 in place. The IRS will treat this proportionally as $50 taken from the contribution, and $50 taken from the gains. It then taxes the $50 growth.

When I called Fidelity today, the guy I talked to said that I can take distributions under the Rule of 55 from my Roth 401K without any such tax treatment. He said there will be no penalty, and no tax. He did mention that there is some conflicting information out there.

Naturally, I am confused. Any advice or information from the denizens of this esteemed community will be met with immense gratitude. Thank you,

nv67
FactualFran
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Joined: Sat Feb 21, 2015 1:29 pm

Re: Early retirement at 55 with Roth 401k?

Post by FactualFran »

nv67 wrote: Mon Oct 25, 2021 5:46 pm When I called Fidelity today, the guy I talked to said that I can take distributions under the Rule of 55 from my Roth 401K without any such tax treatment. He said there will be no penalty, and no tax. He did mention that there is some conflicting information out there.
The rule of 55 is about the 10 percent addition tax on early distributions. It is not about the taxation of earnings in non-qualified distribution from a Roth. There would likely be no penalty but there would be tax on the portion of the distribution considered to be earnings. If one of the sources of the conflicting information is the law, regulation, or the IRS, then believe that source.
Olemiss540
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Joined: Fri Aug 18, 2017 8:46 pm

Re: Early retirement at 55 with Roth 401k?

Post by Olemiss540 »

When you separate from your employer, you should be able to roll your Roth 401k over to a Roth IRA and the custodian should report earnings versus contributions. Then you should be able to remove your contributions at any age tax and penalty free.
I hold index funds because I do not overestimate my ability to pick stocks OR stock pickers.
Topic Author
nv67
Posts: 25
Joined: Mon Sep 16, 2013 4:05 pm

Re: Early retirement at 55 with Roth 401k?

Post by nv67 »

Thank you FactualFran. The conflicting info is from two different people that processed my Mega Backdoor, both at Fidelity. The October guy said no taxes on the growth but the September guy said that the growth will be taxed(proportional treatment), even if there is no penalty. The September guys's advice is more in line with your comment.
Alan S.
Posts: 12669
Joined: Mon May 16, 2011 6:07 pm
Location: Prescott, AZ

Re: Early retirement at 55 with Roth 401k?

Post by Alan S. »

nv67 wrote: Mon Oct 25, 2021 5:46 pm Hello friends, I have a question about the way the IRS treats Roth 401k distributions under the Rule of 55. I will turn 55 in the 2024 calendar year. I am maxing out my pre-tax 401k, and contributing into the "spillover" bucket to the max (around 65K total of all contributions and matches). The spillover is then subjected to the Mega Backdoor Roth conversion into my Roth 401K (which already exists as well since I used to make contributions to this). The question is, can I take distributions from the Roth 401k when I turn 55 with no penalty and no tax? I will be exercising the Rule of 55, which my company permits. The information is pretty clear on traditional 401k's but I am not able to find much on Roth 401k's and the Rule of 55.

When I called Fidelity last month, the guy I talked to said that the withdrawal of Roth 401k money before age 59.5 would trigger taxes on the gains. When I told him that I plan to take only my contributions, and not the growth, he said that the IRS will give the distribution a "proportional treatment". So If I contributed $100, and it grew to $200, I cannot withdraw my contribution of $100, leaving the growth of $100 in place. The IRS will treat this proportionally as $50 taken from the contribution, and $50 taken from the gains. It then taxes the $50 growth.

When I called Fidelity today, the guy I talked to said that I can take distributions under the Rule of 55 from my Roth 401K without any such tax treatment. He said there will be no penalty, and no tax. He did mention that there is some conflicting information out there.

Naturally, I am confused. Any advice or information from the denizens of this esteemed community will be met with immense gratitude. Thank you,

nv67
The age 55 separation exception automatically applies, but not all plans will allow you to take partial distributions after you retire. They may require you to take out all or nothing.

The penalty exception will waive any early distribution 10% penalty that would have otherwise applied to distributions you take. For example, your Roth 401k balance will not be qualified until 59.5, so any distribution that will include pro rated Roth 401k earnings will be subject to tax, but not the 10% penalty. And any distribution that includes some earnings on your after tax contributions moved to the Roth 401k will also avoid the 10% penalty on the small amount of earnings.

The first Fidelity rep's explanation of taxes due on pro rated earnings in the Roth 401k was spot on. You could not avoid the income tax, but you would avoid the penalty. The second call resulted in incorrect info, so ignore that one.

Since your Roth 401k will not be qualified (earnings tax free) until 59.5, and Roth 401k do NOT have the distribution ordering rules of a Roth IRA (as indicated by the first rep), you will face some earnings taxes if you withdraw before 59.5.

I don't know if this makes sense in your overall financial picture, but if you were to request a total distribution from your Roth 401k, you could roll over the earnings only to your Roth IRA since earnings are treated as the first dollars rolled over, leaving you with the rest of the balance. Since the rest of the balance will be non taxable, you would effectively have separated your contributions from the earnings. Of course, you could also roll over some of your contributions to the ROth IRA and keep only the amount you need for spending. The earnings could sit in your Roth IRA until 59.5, when they would become qualified and tax free (assuming you have had a Roth IRA for at least 5 years by then). If your mega back door Roth included some small amount of gains you were taxed on due to the IRR, the age 55 penalty exception would waive the penalty for not holding those taxable in plan Roth rollover amounts for the required 5 years.

That may sound OK, but there are 2 downsides:
1) Distribution to you from the Roth 401k will result in mandatory 20% withholding on the taxable earnings amount. That withholding will not be credited back until you file your tax return for the year. You may have to replace the withheld amount to complete the rollover of the amounts you choose to roll over.
2) Using Roth money for living expenses in a low taxable income year, such as when you are retired early before SS benefits and RMDs is not wise. You could use pre tax dollars and apply your standard deduction and lowest marginal rates to some of this and preserve your Roth money while still paying very low taxes.
Topic Author
nv67
Posts: 25
Joined: Mon Sep 16, 2013 4:05 pm

Re: Early retirement at 55 with Roth 401k?

Post by nv67 »

Hi Alan S, thank you so much for taking the time to write a detailed response!

The age 55 separation exception automatically applies, but not all plans will allow you to take partial distributions after you retire. They may require you to take out all or nothing. I believe my company allows me to take a partial distribution, per Fidelity.

The penalty exception will waive any early distribution 10% penalty that would have otherwise applied to distributions you take. For example, your Roth 401k balance will not be qualified until 59.5, so any distribution that will include pro rated Roth 401k earnings will be subject to tax, but not the 10% penalty. And any distribution that includes some earnings on your after tax contributions moved to the Roth 401k will also avoid the 10% penalty on the small amount of earnings.

"The second call resulted in incorrect info, so ignore that one." Done!

Since your Roth 401k will not be qualified (earnings tax free) until 59.5, and Roth 401k do NOT have the distribution ordering rules of a Roth IRA (as indicated by the first rep), you will face some earnings taxes if you withdraw before 59.5.

I don't know if this makes sense in your overall financial picture, but if you were to request a total distribution from your Roth 401k, you could roll over the earnings only to your Roth IRA since earnings are treated as the first dollars rolled over, leaving you with the rest of the balance. Since the rest of the balance will be non taxable, you would effectively have separated your contributions from the earnings. This is a great idea! I knew posting here would let me get the best advice. This is what I will end up doing most probably, since my wife will still be working, this would leave our tax brackets unchanged. Of course, you could also roll over some of your contributions to the ROth IRA and keep only the amount you need for spending. The earnings could sit in your Roth IRA until 59.5, when they would become qualified and tax free (assuming you have had a Roth IRA for at least 5 years by then). If your mega back door Roth included some small amount of gains you were taxed on due to the IRR, the age 55 penalty exception would waive the penalty for not holding those taxable in plan Roth rollover amounts for the required 5 years.

That may sound OK, but there are 2 downsides:
1) Distribution to you from the Roth 401k will result in mandatory 20% withholding on the taxable earnings amount. That withholding will not be credited back until you file your tax return for the year. You may have to replace the withheld amount to complete the rollover of the amounts you choose to roll over. This is OK with me since my wife will still be working and we won't need all the money right away for retirement purposes. I just needed to be able to access my money in case we need it, without incurring a penalty or taxes on earnings.
2) Using Roth money for living expenses in a low taxable income year, such as when you are retired early before SS benefits and RMDs is not wise. You could use pre tax dollars and apply your standard deduction and lowest marginal rates to some of this and preserve your Roth money while still paying very low taxes. I agree. I was focused on the Roth 401k because my wife would still be working (she will work for 3 more years after I retire), and if I take money out of my pre-tax, then our tax bracket may go up.

Thank you once again, I was not aware that we could do the things you suggested (moving earnings only to Roth IRA etc.) I believe I have a path to a solution to my problem now...
Topic Author
nv67
Posts: 25
Joined: Mon Sep 16, 2013 4:05 pm

Re: Early retirement at 55 with Roth 401k?

Post by nv67 »

Olemiss540 wrote: Mon Oct 25, 2021 6:16 pm When you separate from your employer, you should be able to roll your Roth 401k over to a Roth IRA and the custodian should report earnings versus contributions. Then you should be able to remove your contributions at any age tax and penalty free.
Thank you Olemiss540. I saw your and Alan's responses at the same time, and I believe they are more or less saying the same thing.
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