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A recent call with a financial advisor in Massachusetts is representative of a common question that has to do with Roth contributions.
Welcome to the Retirement Learning Center’s (RLC’s) Case of the Week. Our ERISA consultants regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans, and other types of retirement savings and income plans, including nonqualified plans, stock options, Social Security, and Medicare. This is where we highlight the most relevant topics affecting your business.
“My client is required to make catch-up contributions as designated Roth contributions beginning in 2026 due to her high income ($150,000+). She has a Roth IRA, but has never contributed to a designated Roth account before, and does not expect to work another five years. Is she still able to avoid taxation on Roth earnings when distributed?”
Yes, with careful planning, taxation on designated Roth contribution earnings can often be avoided – even for individuals who retire before satisfying the five-year clock in an employer-sponsored retirement plan.
When discussing designated Roth accounts, it is important to understand that multiple five-year periods may apply, each with a different purpose:
The five years required for designated Roth earnings to be tax-free when distributed after a qualifying event (a “qualified distribution” under IRC §402A(d), and
The five years applicable to conversions of amounts to designated Roth contributions for purposes of avoiding the 10% early distribution penalty [the “recapture rule” under IRC §72(t)]
For clients near retirement, the focus is typically on the first rule that determines when designated Roth account earnings may be distributed tax-free.
For designated Roth earnings to be tax-free, two conditions must be met:
The individual must have satisfied a five-taxable-year period, AND
The distribution must occur after a qualifying event, most commonly the attainment of age 59½.
For individuals who are already over age 59½, the only remaining requirement is satisfying the five-year requirement.
For employer-sponsored retirement plans, that five-year clock begins on January 1of the year of the first designated Roth contribution, rollover, or in-plan conversion. Each employer-sponsored retirement plan maintains its own separate five-year clock.
Designated Roth accounts in employer sponsored retirement plans are always distributed on a pro-rata basis between contributions and earnings. As a result:
Every distribution from the account includes some earnings, and
If the plan’s five-year period has not been satisfied, the earnings portion of the distribution is taxable even if the individual is over age 59½.
This pro rata rule is often the source of unexpected taxation at retirement, unless the distribution is qualified.
Taxation on designated Roth account earnings can often be avoided by rolling designated Roth account assets from an employer sponsored retirement plan to a Roth IRA before taking distributions. Roth IRAs operate under a separate five-year holding period for purposes of qualified distributions:
All of an individual’s Roth IRAs are aggregated, and
The five-year period begins January 1 of the year of the first contribution or rollover to any Roth IRA.
Roth IRAs follow different distribution ordering rules than those for designated Roth accounts. When a distribution is taken from a Roth IRA, amounts are deemed to come out in the following order:
Roth contributions
Roth conversion (taxable at conversion)
Roth conversion (nontaxable at conversion), and then
Earnings
Because earnings are distributed last, retirees can often take Roth IRA distributions entirely from contributions (tax- and penalty-free), leaving earnings untouched and untaxed while the five-year clock continues to run.
So, if your client’s Roth IRA has existed for five years, she may be able to do a rollover to her Roth IRA (with an earlier five-year clock for qualified distributions). Plus, earnings from the Roth IRA are distributed last.
Your client does not need to work another five years, but the five-year clock for a qualified designated Roth account distribution still must be satisfied. A rollover may help your client avoid taxation of designated Roth account earnings and potentially make them available sooner.
Understanding the interaction between the different five-year rules for designated Roth accounts and Roth IRAs, the order for distributions and rollover rules can help minimize taxable distributions.