By Sarah Brenner, JD
Director of Retirement Education

More and more Americans have retirement savings in Roth 401(k)s. With their rising popularity come some complicated tax issues. These funds are often rolled over to Roth IRAs at retirement or when a participant changes job. While the rollover process to the Roth IRA is fairly straightforward, the rules for determining the taxation of these funds when eventually distributed from the Roth IRA can be tricky. In a recent Slott Report post, Andy Ives tackled these rules: https://irahelp.com/slottreport/roth-401k-to-a-roth-ira-rollover-how-does-this-work/.

Special Recapture Rule

On top of these already complicated rules, those who roll over funds from an in-plan 401(k) conversion to a Roth IRA may face an additional unexpected hurdle. (An in-plan conversion is a transfer within the 401(k) from a non-Roth account to a Roth account.) There is an extra rule that can apply to those who are under age 59 ½ and take a distribution of these funds from their Roth IRA within five years from the year of the conversion. If such a distribution is taken, a 10% penalty can apply. This may come as a surprise to many because the penalty applies to the converted funds, despite the fact that they are not taxable when distributed from the Roth IRA.

The IRS calls this a “special recapture rule.” It only applies to funds that were taxable at the time of the conversion and will not apply if one of the exceptions to the 10% penalty (such as disability or death) can be used. This recapture rule follows the funds from the Roth 401(k) to the Roth IRA.

Example: In 2022, Josie, age 40, converts $50,000 in taxable funds as an in-plan conversion from her pre-tax 401(k) account to her Roth 401(k) account. In 2024 Josie changes jobs. She rolls over $56,000 ($50,000 in funds from the in-plan conversion, plus $6,000 in earnings) from her Roth 401(k) plan to her first Roth IRA. Josie then takes a $20,000 distribution from her Roth IRA. Due to the ordering rules that apply to Roth IRA distributions, Josie’s distribution will be considered to be a return of funds from the in-plan conversion, and the $20,000 distribution will not be taxable. However, due to the special recapture rule, it will be subject to a 10% penalty unless an exception applies. This is because Josie is under age 59 ½ and it has been less than five years since she did the in-plan conversion.

The date of Josie’s in-plan conversion is considered to be January 1, 2022 no matter when she does it in 2022. So, if she would have waited to take a distribution of the funds from the in-plan conversion until January 1, 2027, she could have avoided the 10% penalty.

Know the Rules and Avoid Surprises

The best strategy when any funds including in-plan conversions are rolled to a Roth IRA is to hold out for long term. If Roth funds are not touched until retirement, the rules are easy, and the payoff is tax-free distributions. However, sometimes life gets in the way, and the funds are needed sooner than expected. If you are considering a Roth distribution, you do not want to be surprised by unexpected negative tax consequences. This is why being on top of all the complicated Roth rules, including this sneaky special recapture rule, is so important.

Rolling Over Your In-Plan Conversion? Watch Out for the Recapture Rule