Know the Rules for Roth 401(k) Rollovers

If you have moved jobs while holding a traditional 401(k), you are probably familiar with the rollover options for these ubiquitous retirement accounts. You may be less sure, though, of your options when you leave an employer with whom you hold a Roth 401(k), the newer and less prevalent cousin of the traditional 401(k).

The main difference between the traditional 401(k) and the Roth 401(k) is that the former is funded with pretax dollars while Roth contributions are in post-tax dollars so there is no tax hit from a qualified withdrawal made in the future.

If your job is at stake, or you are considering a career move, here are your options regarding your Roth 401(k) account when changing employers.

The Rollover Options

For the most part, your choices for a Roth 401(k) follow those of a traditional 401(k), but the transfers should be to Roth versions of the available accounts. If you opt to roll over the funds to an IRA, the funds from the Roth 401(k) should be transferred into a Roth IRA. If your new employer has a Roth 401(k) option and allows for transfers, you should also be able to roll the old Roth 401(k) into the new Roth 401(k).

Rolling over a Roth 401(k) into a Roth IRA is generally optimal, particularly because the investment choices within an IRA are typically wider and better than those of a 401(k) plan. “More frequently than not, individual IRA accounts have more options than a 401(k),” said Carlos Dias Jr., founder and managing partner of Dias Wealth LLC in Lake Mary, Fla. “Depending on the custodian, sometimes your options in a 401(k) are limited to mutual funds or a few different ETFs, versus being able to invest in a plethora of choices [in an IRA].”

Note, however, that funds in 401(k)s are better protected against many legal judgments. This could be a reason for choosing a new employer’s 401(k) option.

The best way to accomplish a rollover to either a Roth IRA or another Roth 401(k) is from trustee to trustee. This ensures a seamless transaction that should not be challenged later by the IRS, who may be concerned whether the transaction was made for the full amount or in a timely manner.

If, however, you decide to have the funds sent to you instead of directly to the new trustee, you can still roll over the entire distribution to a Roth IRA within 60 days of receipt. If you choose this route, however, the paying trustee is generally required to withhold 20% of the account balance for taxes.

Distributions From Your Rolled-Over Roth

Although it is typically not advisable to tap retirement funds before you leave the workforce, in tight times, the undesirable option may become the only option. If you must withdraw money from your Roth at the time of the rollover or soon after that, be aware that the timing rules for such withdrawals differ from those of traditional IRAs and 401(k)s. Some of these requirements may also apply to Roths that are rolled over when you are at or close to retirement age.

Specifically, to make distributions from these accounts without incurring any taxes or penalties, the distribution must be qualified, which requires that it meets what is known as the five-year rule. Also applied to inherited retirement accounts, this rule requires that funds had remained intact in the account for a five-year period to avoid or at least minimize taxes and penalties. (While this may sound relatively simple, the five-year rule can actually be tricky, and careful consideration of how it applies to your situation—and perhaps a good tax advisor—is recommended.)

A Roth 401(k) Rolled Into a Roth IRA

Roth IRA contributions can be withdrawn at any time tax-free and penalty-free regardless of age. However, the rules for distributions of earnings vary. A qualified distribution from a Roth IRA is one that meets the five-year rule and is also made after age 59½, after death, or as the result of a disability or a first-time home purchase. These qualified distributions are free of both taxes and penalties.

If these conditions are not met, withdrawals from the account will be subject to both selective income taxes and a penalty. “If you do make a non-qualified distribution, income taxes will be levied only on earnings on your contributions, but a 10% penalty will be applied to the total amount,” said Mark Hebner, founder and president of Index Fund Advisors Inc., Irvine, Calif., and author of Index Funds: The 12-Step Recovery Program for Active Investors.

Funds from a Roth 401(k) rolled into another such account are subject to favorable treatment with respect to the five-year holding period. However, the same treatment does not apply to the timing of a Roth 401(k) that’s rolled over to a new Roth IRA. On the other hand, if you already have a Roth IRA account, the holding period for that account applies to all of its funds, including those rolled over from a Roth 401(k) account.

To illustrate this impact, let’s assume that your Roth IRA was opened in 2010. You worked at your employer from 2016 to 2019 and were then let go or you resigned. Because the Roth IRA that you are rolling the funds into has been in existence for more than five years, the full distribution rolled into the Roth IRA meets the five-year rule for qualified distributions.

On the other hand, if you did not have an existing Roth IRA and had to establish one for purposes of the rollover, the five-year period begins the year the Roth IRA was opened, regardless of how long you had been contributing to the Roth 401(k).

The need for these retirement funds should, then, be considered prior to rolling money from a Roth 401(k) to a Roth IRA. This is particularly the case if there is not already a Roth IRA in place since the five-year holding period would begin anew under this scenario.

A Roth 401(k) Rolled Into Another Roth 401(k)

If you roll your old Roth 401(k) to a new Roth 401(k), the specific distribution rules from the new account will vary by the plan itself; your new employer’s human resources department should be able to assist with this.

However, some basic conditions apply. If you decide to roll over the funds from your old Roth 401(k) to your new Roth 401(k) through a trustee-to-trustee transfer (also called a direct rollover), the number of years the funds were in the old plan should count toward the five-year period for qualified distributions. However, the previous employer must contact the new employer concerning the amount of employee contributions that are being rolled over and must confirm the first year they were made.

Note, too, that the rollover generally must be complete in order for the new funds to enjoy the carryover of the time period from the old Roth 401(k). If an employee did only a partial rollover to the new Roth 401(k), the five-year period would start again. That is, you do not get credit for the period the funds were in your old Roth 401(k).

Before making a decision, speak to your tax or financial advisor about what may be best for you. One option could even be leaving the Roth 401(k) in your previous employer’s plan, depending on the circumstances and that plan’s rules.

The Bottom Line

Rules for rolling over a Roth 401(k) are complicated. Be sure you fully investigate the tax and other implications before you decide how to handle these funds after you leave the company whose plan held those funds. A mistake here could be costly.