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Tax Tips: Should You Rollover Your Roth 401k into a Roth IRA?

If you have retirement funds held in the Roth 401k plan of a prior employer (or a similar employer sponsored, after-tax retirement account such as a Roth 403b or Roth 457 account), you might want to consider rolling those after-tax retirement accounts directly into a Roth IRA. While there are many similarities to the tax-free investment growth that these accounts offer, it is important to understand the differences that exist before making a rollover.

Advantages

  • Roth IRAs typically provide a broader selection of investment options than those offered in a Roth 401k.
  • Roth IRAs do not require the original owner to take minimum annual distributions once they reach age 70½, but a Roth 401k is subject to Required Minimum Distributions (RMDs) even though the distributions are tax exempt (this eventually forces you to start moving money out of a tax sheltered account and into accounts where future growth and earnings will be subject to tax.)
  • Roth IRA earnings distributions prior to age 59½ could qualify for exemptions from the 10% premature withdrawal penalty in some circumstances that are not available for Roth 401k distributions (ex. first-time home buyers, etc.)

Disadvantage

  • Roth 401k plan management fees might be lower than fees related to the management of a Roth IRA if you pay an advisor to manage the account for you.

Don’t forget to consider the five-year rule!

Another important aspect of converting a Roth 401k into a Roth IRA is the impact it could have on the five-year rule for distributions. What is this five-year rule? In order for any distribution of earnings from either a Roth 401k or a Roth IRA to be a “qualified” distribution that is exempt from income tax (and possibly a 10% premature withdrawal penalty), the distribution must take place after the Roth has been open for at least five tax years (even if the owner is older than 59½, dies, is disabled, or qualifies for some other exemption to the age 59½ requirement.)

Here are a few key points related to this five-year rule:

  • The five-year “clock” begins January 1st of the tax year that you first open the account. This means that if you first established a Roth IRA in April of 20X1 in order to make a 20X0 tax year contribution, the Roth IRA would be considered open on January 1, 20X0.
  • When you roll a Roth 401k balance into a Roth IRA, it is subject to the five-year clock of the Roth IRA account (even if the Roth 401k has been open much longer.)

One way to ensure that you don’t run afoul of the five-year requirement on a rollover is to open the Roth IRA account and make a minimal contribution to it at least five tax years before you know you will take a distribution from the account. Then, when you roll a Roth 401k into it later, the five years will have already passed, and the five-year holding period will be satisfied. In fact, as long as you have any Roth IRA open for at least five years (under your name and Social Security number), you can roll the Roth 401k into another Roth IRA and it will meet the five-year requirement based on having another pre-existing Roth IRA.

Paul Hansen, CPA, CFP®

Legal Information and Disclosures

This memorandum expresses the views of the author as of the date indicated and such views are subject to change without notice. HFG Trust has no duty or obligation to update the information contained herein. Further, HFG Trust makes no representation, and it should not be assumed that past investment performance is an indication of future results. Moreover, wherever there is potential profit there is the possibility of loss. This memorandum is being made available for educational purposes only and should not be used for any other purpose. The information contained herein does not constitute and should not be construed as an offering of advisory services or an offer to sell or solicit and securities or related financial instruments in any jurisdiction. Certain information contained herein concerning economic trends and performance is based on or derived from information provided by independent third-party sources. HFG Trust believes that the sources from which such information has be obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. This memorandum, included the information contained herein, may not be coped, reproduced, republished, or posted in any form without the prior written consent of HFG Trust.