Dangers of Roth In-Plan Conversions

by Prof. Robert Bloink and Prof. William H. Byrnes

Roth 401(k)s are becoming more popular—and more readily available—with each passing year.  Savers are naturally attracted to the opportunity to create a source of tax-free income during retirement without the hassle of establishing and managing a personal Roth IRA outside of the employment context.  That said, Roth 401(k)s are governed by rules that can quickly become more complicated than employees tend to expect—especially when the individual later transfers their Roth 401(k) funds into an outside Roth IRA.  One of those rules can subject the individual to an unexpected 10% penalty when the funds are transferred outside of the employer-sponsored plan.  Understanding this often-overlooked “recapture” rule can allow the individual to plan ahead and potentially avoid the penalty tax.

Roth 401(k)s and Roth IRAs: Background

Like a Roth IRA, Roth 401(k)s are funded with after-tax dollars.  Typically, the Roth 401(k) funds and earnings can be withdrawn tax-free in the future.

A special rule applies to Roth IRAs.  After initially opening and funding the Roth IRA, the client must wait five years before they can withdraw the amounts that have been converted (regardless of the client’s age), or the client will incur a 10% penalty on the amounts withdrawn.

That five-year clock starts running on January 1 of the year the client executes the Roth conversion (regardless of the date on which the Roth conversion actually takes place).  For example, a client who converts traditional funds to a newly opened Roth IRA on April 15, 2024 must wait until January 1, 2029 to withdraw the funds penalty-free (even if the penalty applies, the Roth funds themselves are not subject to ordinary income tax again).

Many individuals choose to fund their Roth 401(k) by executing a rollover from their existing employer-sponsored 401(k).  Because the 401(k) and Roth 401(k) are technically housed within the same employer plan, these rollovers are referred to as in-plan conversions.

Understanding the Recapture Rule

After funding a Roth 401(k), individuals often eventually roll those funds into an outside Roth IRA—whether because they’re changing jobs or otherwise.  Assuming the client has executed an in-plan conversion to fund their Roth 401(k) in the past, a special recapture rule may apply.

If the client is under age 59 ½, a 10% recapture penalty will apply if the client then takes a distribution from the Roth IRA within five years of opening the account.  The penalty only applies to the funds that were taxable at the time of the in-plan conversion.

Ordering rules also apply.  If the client executed an in-plan conversion and then rolled those funds into a Roth, any distribution is considered to first come from the converted amounts and then from any earnings on that amount.

Clients are not subject to the recapture penalty if any of the otherwise-existing exceptions to the 10% early withdrawal penalty applies.  Those exceptions include buying a first home, paying for certain qualifying medical expenses, qualifying emergency expenses, disability, death, etc.  This is true even though Roth IRAs aren’t technically subject to early withdrawal penalties (once the five-year waiting period has passed).

Likewise, the recapture penalty doesn’t apply if the client rolls the funds into another Roth 401(k) or Roth IRA (it only applies to funds actually withdrawn from the account).

The recapture rule is often surprising to clients who believe that they’ll be able to access their Roth funds without any type of tax liability at any time.  Typically, Roth accounts are relatively simple because if the client waits long enough, the funds are entirely tax-free.  As with anything in the Internal Revenue Code, however, the rules can get complicated when clients unexpectedly need to access their retirement funds.

Conclusion

Whenever a client engages in a retirement-account-related transaction, it’s always a good idea to ensure they’re familiar with the full range of rules governing their accounts to avoid unexpected tax consequences down the line.

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