Investment Strategy

07/28/09 - Roth 401k Rollovers

By: Investor Solutions

During these 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 401k accounts are probably well known by now but may be less so for Roth 401k accounts.

The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) added Code section 402A, providing for designated Roth contributions that new or existing 401k and 403b plans can accept. This new feature became effective for years beginning on or after January 1, 2006. Unlike deferrals to traditional 401k accounts, the deferrals to a Roth 401k 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 monies.

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

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 401k or the Roth IRA which houses the rollover funds? As far as distributions from the new Roth 401k, that depends on the plan itself and your new employer’s human resources department should be able to assist with that. As you may already know, a “qualified distribution” from a Roth IRA is one that is made after the 5 year rule is met and is a distribution made after 59 1/2, due to death, disability or for a first home purchase. This may all sound very simple but the 5 year rule can be tricky.

If you decide to roll over the funds from your old Roth 401k to your new Roth 401k by trustee to trustee transfer (also called a direct rollover), the number of years the funds were in the old plan can count toward the 5 year period for qualified distributions. However, the previous employer must contact the new employer to advise them of the amount of employee contributions and the first year they were made.

If an employee did only a partial rollover to the new Roth 401k, additional reporting would be necessary by the new Roth 401k and the 5 year period starts brand new. That is, you do not get credit for the amount of time the funds were in your old Roth 401k.

If the rollover is to a Roth IRA instead, the holding period within the Roth 401k does not carry over. That is, if the client has an existing Roth IRA, once the Roth 401k distribution is in the account, it has the same holding period as the Roth IRA funds. For example, let’s assume 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 5 years, the full distribution rolled into the Roth IRA meets the 5 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 5 year period begins the year the Roth IRA was open regardless of how long you have been contributing to the Roth 401k.

Rolling over a Roth 401k 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 401k plan. Although it is usually not advisable to tap retirement funds, there are those times in life, as many people have seen recently, where the once unthinkable is the only solution. The need for these retirement fund should be considered prior to rolling over the money into an IRA particularly if there is not one already in place as this would begin the 5 year holding period anew. Before making a decision, speak to your tax or financial advisor about what may be best for you.