In April 2007 final regulations were issued regarding taxation of distributions from what the IRS calls designated Roth accounts, commonly known as Roth Solo 401ks or Roth Self-Directed 401ks. Since the main advantage of Roth Solo 401k is tax free and penalty free withdrawals, it is important to understand the Solo 401k Roth distribution rules. It's important to note that if distributions are made from the Roth Solo 401k prior to end of the 5 year waiting period and one of the qualifying conditions explained below, the distribution will be considered non-qualified, resulting in taxes and possible penalties of the non basis (contribution) amounts.
Qualified vs. Non-qualified Distribution from a Designated Roth Solo 401k
Qualified Distribution is:
· A distribution from a designated Roth Solo 401k but only after 5 year waiting window has been satisfied and the participant/trustee has reached age 59 1/2, has died, or has become disabled.
· A distribution from a Roth Solo 401k that falls under the qualified distribution definition is not taxable to the participant/trustee.
· A qualified Roth Solo 401k distribution maintains its basis even when funds are transferred to another Roth 401k or to a Roth IRA; therefore, they can be distributed tax and penalty free.
Illustration
After participating in her current Roth Solo 401k for 15 years, Linda decides to retire at age 63 and start making distributions from her Roth Solo 401k. Because Linda established her Roth Solo 401k over 5 years ago and she's over the age of 59 1/2, none of the distributions that she makes from her Roth Solo 401k will be subject to income tax.
Start/End of 5 year waiting period
The 5 year waiting period commences on the first day of the Solo 401k participant/trustee's taxable year, usually January 1, for which the participant/trustee first made Roth Solo 401k contribution.
The 5 year waiting period ends after 5 consecutive years have passed.
The ordering rules for non-qualified distributions from Roth IRAs do not apply to non-qualified distributions from designated Roth accounts in Solo 401k plans.
A Solo 401k Roth distribution that is not a qualified distribution (non-qualified) is subject to the pro-rata rule. This is different than the distribution rules applicable to Roth IRAs where the ordering rules apply.
A non qualified distribution from a Roth Solo 401k results in the participant/trustee including a portion of the distribution in taxable income. To determine the non-taxable amount of the distribution, the after-tax employee contributions (salary deferrals) are divided by the entire balance in the Roth Solo 401k account. The distribution amount is then multiplied by the result.
EXAMPLE
Julie has contributed salary deferrals (after-tax employee contributions) of $20,000 to her Roth Solo 401k. The total balance of her Roth Solo 401k is now $30,000, and Julie has decided to make a distribution of $9,000. Of the distribution, amount of $6,030.00 will be tax free.
Calculated as ($20,000 / $30,000 = .67) ($9,000 X .67 = $6,030.00)
Rolling Roth Solo 401k accounts to other qualified plans or to a Roth IRA
· Provided the receiving qualified plan permits Roth Solo 401k rollovers, existing Roth Solo 401k funds can be moved to another qualified plan such as a 401k. Roth Solo 401k can also be rolled over to a Roth IRA.
The amount considered rolled over is determined differently depending if the funds were moved over as a direct rollover (trustee-to-trustee transfer) or as a rollover (60- day rollover).
If processed as a Direct-Rollover, all amounts can be deposited to another Roth 401k plan or to a Roth IRA.
If processed as a Rollover (payable to the participant and rolled over within 60 days), only earnings (taxable amounts), not the basis, may be rolled over to another Roth 401k. However, the entire amount can be rolled over to a Roth IRA.
