Early Withdrawals for Roth IRAs, Backdoor Roth IRAs, & Mega Backdoor Roth 401ks
Introduction
Roth IRAs are fantastic not only for tax-free growth of investments but also as a source of potential liquidity before retirement. Money directly contributed to a Roth IRA can be pulled out at any time regardless of when you opened it tax-free & penalty-free. In addition, an investor may withdraw the value of past Roth conversions tax-free (and penalty-free if it’s been 5 years since the conversion). Earnings pulled out before 59.5 but will be subject to ordinary income taxes (and penalties unless you have a qualified exception).
Ordering Rules for Roth IRA
You will not need to follow the ordering rules if you have a qualified distribution from your Roth IRA. A qualified distribution is a withdrawal made after 59 ½ (or disability/death) and at least 5 years since the funding of your first Roth IRA. Otherwise, you have a non-qualified distribution and will follow the ordering rules below.
- Contributions
- These include rollovers from designated Roth accounts (e.g., Roth 401k) comprised of “investment in the contract.”
- Conversions & Rollover Contributions on a first-in-first-out basis aggregated by tax year
- Within a particular tax year, the taxable portion of the conversion must be taken out before the non-taxable portion.
- Rollover contributions are conversions from your designated accounts (e.g., 401k) to your Roth IRA.
- Earnings
Roth Conversions Withdrawal Explanation
When you do a Roth conversion, there is a non-taxable portion (your basis from after-tax contributions) and a taxable portion (pre-tax contributions and/or earnings before you converted). You paid taxes on the taxable portion during the conversion but none for the non-taxable portion.
When you withdraw from a Roth conversion, if it hasn’t been at least 5 years since the conversion year, you will owe a 10% penalty on the taxable portion of the conversion.
For example, in 2019, you converted $10,000 of your pre-tax IRA to a Roth IRA. Since this is all pre-tax, you paid ordinary income taxes on the entire $10,000 during the 2019 tax year. The taxable portion of this conversion is $10,000, while the non-taxable portion is $0.
Say your Roth IRA only had the 2019 conversion money and stayed at $10,000. If you withdraw $10,000 in 2020, you won’t have to pay taxes since you already did during the conversion, but you’ll pay a 10% penalty on the taxable portion (10% * $10,000) or $1,000 in the 2020 tax year.
Backdoor Roth IRA
Backdoor Roth IRAs work by contributing to your after-tax IRA, giving it a cost basis for your contribution amount. This amount is converted to a Roth IRA, ideally with $0 in earnings if done quickly after the contribution. Since this contribution is entirely made up of basis (and if it has $0 in earnings), the conversion will be tax-free since it will comprise 100% of the non-taxable portion.
However, there is a pro-rata rule to be aware of. Backdoor Roth IRAs are generally only done if you hold no pre-tax IRA dollars in your accounts. The reason is that when you convert a traditional IRA to a Roth IRA, you must take a proportionate amount of all your IRAs for the conversion. You cannot pick only the after-tax dollars. If you rolled over a pre-tax 401k into your IRA, this strategy will typically be unavailable for you (unless you’re willing to take the tax hit by converting the entire 401k).
For example, say you had $50,000 in your pre-tax IRA due to a prior 401k rollover, and you tried contributing $7,000 to an after-tax IRA and converted $7,000 to your Roth IRA. Only 7,000/57,000 or $860 of the basis would be utilized in the conversion, leaving $6,140 as the taxable portion.
Mega Backdoor Roth 401k & Investment in the Contract
A Mega Backdoor Roth functions by contributing after-tax money to your 401k and converting it to a Roth 401k via an in-plan Roth rollover or directly to your Roth IRA as a conversion. If you initiate a rollover straight to your 401k, the transfer will count as a conversion, and you must follow the conversion ordering rules described above.
However, if you first convert after-tax 401K to your Roth 401k and later initiate a rollover to your Roth IRA, the after-tax contributions will be considered “investment in the contract.” In the final regulations for Designated Roth Accounts Under Section 402A, a non-qualified distribution (rollover) from a Roth 401k to a Roth IRA will be “included in the distributee’s gross income to the extent allocable to income on the contract and excluded from gross income to the extent allocable to investment in the contract (basis).” Furthermore, under Section 1.408A-10, Coordination between designated Roth accounts and Roth IRAs, it explains that for purposes of Roth IRA ordering rules, “the amount of a rollover contribution that is treated as a regular contribution is the portion of the distribution that is treated as investment in the contract under A-6 of § 1.402A-1, and the remainder of the rollover contribution is treated as earnings.”
Thus, the amount you contributed to your Mega Backdoor Roth (from after-tax 401k to Roth 401k) will be accessible in the contributions bucket once it is rolled over into a Roth IRA. Any earnings that occur after the after-tax 401k to Roth 401k conversion will go into the earnings bucket of the Roth IRA. This process will allow you to access the money tax-free once it’s in the Roth IRA. But like with conversions, in-plan Roth rollovers have a special recapture rule equivalent to the 5-year penalty rule. If you take money from an in-plan Roth rollover (even after rolling the Roth 401k into your Roth IRA), you will pay a 10% penalty on the taxable portion of the conversion. However, as we pointed out earlier in the Backdoor Roth IRA section, the taxable portion is typically $0 since you ideally convert the after-tax contributions immediately to your Roth 401k.
If you need to access the amounts contributed to your Mega Backdoor Roth while it’s in your Roth 401k, some plans will allow in-service withdrawals while employed there.
Example of Ordering Rules
The below showcases the order and treatment of non-qualified Roth IRA distributions for tax purposes (typically, most withdrawals before age 59 ½ are non-qualified, but there are exceptions). Assume you opened and funded your first Roth IRA in 2017 and had the following Roth account history from 2017 to 2022:
2017: Roth Conversion: You converted $15,000 from your pre-tax IRA into your Roth IRA. You paid ordinary income taxes on $15,000.
2018: Backdoor Roth: You contributed $5,000 to your after-tax IRA. Before converting to a Roth IRA, it grew to $6,000. During the conversion, you owed ordinary income taxes of $1,000.
2019: Roth Contribution: You contributed $6,000 to your Roth IRA directly.
2020: Mega Backdoor Roth 401k: You contributed $20,000 to your after-tax 401k, which grew to $21,000 before you converted to a Roth 401k. You paid ordinary income taxes on the $1,000.
2021: Your Roth 401k grew to $25,000. You left your company and rolled your Roth 401k to a Roth IRA.
2022: You withdrew $48,000 from your Roth IRA.
Following ordering rules, the $48,000 would be withdrawn in the following sequence for tax purposes:
- $27,000 from Contributions (in no particular order)
- $6,000 from 2019 Roth Contribution
- $21,000 from 2020 Mega Backdoor Roth 401k. Since it has been less than 5 years, you will be subject to a 10% penalty on the taxable portion (10% * $1,000 = $100)
- $15,000 from 2017 Roth Conversion. Although this conversion was entirely taxable, it has been exactly five tax years since the distribution, thus, you will owe no penalties.
- $1,000 from 2018 Backdoor Roth Taxable Portion. It has only been 4 tax years. Thus you will owe a 10% penalty on $1,000, $100.
- $5,000 from 2018 Backdoor Roth Non-Taxable Portion.
After adding up all the penalties, you will owe $200 in the 2022 tax year, which will be filed on Form 5329. If you withdrew any further money from your Roth IRA, since all of the contribution & conversion buckets have been used up, it’ll come all out of earnings. You will owe ordinary income taxes on it and a 10% penalty for the full amount. Certain exceptions exist to the 10% penalty for earnings that you can view on the IRS Pub 590-B here. However, even with an exception, you will pay ordinary income taxes on any withdrawals from earnings prior to 59.5*.
* In addition, there is another 5-year rule for withdrawing earnings from your Roth IRA. Even if you are at least 59.5 years old, your Roth IRA must have been opened for at least 5 years since your first contribution before you can withdraw the earnings from it tax-free.
Sources
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