Advanced Underwriting Consultants

Question of the Day – June 3

Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers.  Here’s the question of the day.

Question: My 50 year old client has a designated Roth account in his 401(k) plan, which is held at an employer from which he has separated from service.  Is it better for his to leave the account at his employer, or roll the account over to a Roth IRA?

Answer: In general, it would probably be more advantageous from a tax perspective to roll over the account to a Roth IRA.

Qualified distributions from a designated Roth account, like distributions from a Roth IRA, are tax free.  For a distribution to be qualified, it must be made more than five years after the initial contribution to the designated Roth account and one of the follow three tests must be met:

  • The participant must be older than 59 ½,
  • The participant must be disabled or
  • The participant must have died.

The definition of qualified distributions is substantially similar for Roth IRAs.

However, nonqualified distributions are taxed more favorably when they come from Roth IRAs than from designated Roth accounts.  A nonqualified distribution from a Roth IRA is tax free up to the taxpayer’s investment in the account.  A nonqualified distribution from a designated Roth account comes out of the basis and taxable buckets on a pro-rata basis, making part of any nonqualified distribution taxable.

Here’s an example.  Say that the taxpayer has an account with $10,000 in it–$6,000 of which is after-tax contributions, and $4,000 of which is gain.  Say also that the taxpayer wants to take a nonqualified distribution of $3,000 from the account.

If the distribution is from a Roth IRA, all $3,000 will be a tax free return of basis

If the distribution is from a designated Roth account, 60% of $3,000 will be a return of basis ($1,800), and the other $1,200 will be a taxable distribution.  If the distribution is prior to age 59 ½, the taxpayer may also be liable for the 10% penalty tax on the early taxable distribution.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.