Know the Rules for Roth 401(k) Rollovers

During turbulent financial times, when layoffs are rampant, it is important to have a sound financial plan to weather the uncertainties. It is equally important to be aware of what your options are with regard to your employer-sponsored retirement plan in the event you are let go. The rollover options for 401(k) accounts are probably well known by now, but this may not be the case for Roth 401(k) accounts. If your job is at stake or you're considering a career move, read on for a look at options for handling your Roth 401(k) account. (For background reading, see A Closer Look at the Roth 401(k).)

The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) provided for designated Roth contributions that new or existing 401(k) and 403(b) plans can accept. This new feature became effective for years beginning on or after January 1, 2006. Unlike deferrals to traditional 401(k) accounts, the deferrals to a Roth 401(k) are on an after-tax basis. In other words, the amount of the Roth contribution is included in an individual's gross income and therefore taxed on the amount being deferred as if the individual had actually received the money.

The rollover options for a Roth 401(k) follow those of a traditional 401(k). That is, you can roll the funds over to an IRA or into a new employer's 401(k). Just as the distribution of a traditional 401(k) is moved into a traditional IRA, the distribution from a Roth 401(k) is rolled into a Roth IRA. If your new employer has a Roth 401(k) option and allows for transfers, you may also be able to roll the "old" Roth 401(k) into the "new" Roth 401(k).

The best way to accomplish either rollover is from trustee to trustee. This ensures a seamless transaction that will not be challenged later by the IRS as to whether it was made for the full amount or in a timely manner. If, however, you do 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 payer is generally required to withhold 20%.

What happens, though, when you want to take distributions from either the new Roth 401(k) or the Roth IRA that houses the rollover funds? As far as distributions from the new Roth 401(k), that depends on the plan itself; your new employer's human resources department should be able to assist with that.

Roth IRA contributions can be withdrawn at any time tax-free and penalty-free regardless of age.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. As you may already know, a qualified distribution from a Roth IRA is one that is made after the five-year rule is met and after age 59½, after death, as a result of disability or for a first home purchase (limits apply). These qualified distributions are both tax and penalty free. Nonqualified distributions subject to income taxes are distributions of earnings that do not meet the five-year holding rule but are made after the age of 59½, due to disability, death or for a "life event." Nonqualified distributions subject to both income taxes and penalties are distributions of earnings in which these exceptions have not been met. This may sound relatively simple but the five-year rule can be tricky. (For more insight, read Asset Distributions a Key Consideration for Retirees.)

"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," notes 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."

If you decide to roll over the funds from your old Roth 401(k) to your new Roth 401(k) by a trustee-to-trustee transfer (also called a direct rollover), the number of years the funds were in the old plan can count toward the five-year period for qualified distributions. However, the previous employer must contact the new employer about the amount of employee contributions and the first year they were made. (For other considerations, see How After-Tax Rollovers Affect Your IRA.)

If an employee did only a partial rollover to the new Roth 401(k), additional reporting would be necessary by the new Roth 401(k) and the five-year period starts again. That is, you do not get credit for the amount of time the funds were in your old Roth 401(k).

If the rollover is to a Roth IRA instead, the holding period within the Roth 401(k) does not carry over. That is, if the client has an existing Roth IRA, once the Roth 401(k) distribution is in the account, it has the same holding period as the Roth IRA funds. Let's assume, for example, that the Roth IRA was opened in 2000. You worked at your employer from 2006-2009 and were then let go or quit. 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 have been contributing to the Roth 401(k).

Rolling over a Roth 401(k) into a Roth IRA is usually the optimal thing to do, particularly because the options within an IRA are typically significantly greater and better than within a 401(k) plan. "More frequently than not, individual IRA accounts have more options than a 401(k). 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]," says Carlos Dias Jr., wealth manager, Excel Tax & Wealth Group, Lake Mary, Fla.

Although it is usually not advisable to tap retirement funds, in desperate times the unthinkable may become the only option. The need for these retirement funds should be considered prior to rolling the money into an IRA, particularly if there is not one already in place, as this would begin the five-year holding period anew. 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. Should Leaving Employees Roll Over 401(k) Assets or Not? discusses the issue in depth.