Cashing Out a Roth 401(k) After Leaving a Job
Accessing your Roth 401(k) funds after leaving a job has financial consequences that depend on separating your contributions from account earnings.
A Roth 401(k) is a retirement savings plan funded with after-tax contributions. After leaving a job, you have several options for your account, including taking a complete cash distribution. This action has financial consequences, and this article focuses on the financial outcomes and procedural steps of cashing out.
Determining the Taxable and Non-Taxable Portions
When you cash out a Roth 401(k), the money is divided into two parts for tax purposes. The first is your contribution basis, representing the after-tax dollars you personally contributed. This portion is always returned to you free of federal income tax and penalties. The second part is the earnings, which includes all investment gains. This growth is potentially subject to income taxes and early withdrawal penalties, depending on whether the withdrawal is “qualified” by the IRS.
To illustrate, imagine you contributed $30,000 to your Roth 401(k) over several years. Due to market growth, your account is now valued at $38,000. In this scenario, your contribution basis is $30,000, and the earnings are $8,000. If you were to cash out the entire account, the $30,000 basis would come back to you without any tax consequences, while the $8,000 in earnings would be subject to specific tax rules.
Your plan administrator will track these figures and report them to you and the IRS upon withdrawal.
Tax and Penalty Consequences of Cashing Out
Tax and penalty implications depend on whether the withdrawal is a “qualified distribution.” A distribution is qualified if two IRS requirements are met: at least five years have passed since your first contribution (the five-year rule), and you have reached age 59½, become disabled, or the distribution is made to a beneficiary after your death. When a distribution is qualified, the earnings are free of federal income tax.
Most people cashing out after leaving a job, particularly those younger than 59½, take a “non-qualified distribution.” In this case, the earnings portion is taxed as ordinary income at your marginal tax bracket, and state income taxes may also apply.
On top of income tax, the earnings are subject to a 10% early withdrawal penalty if you are under age 59½. This penalty is assessed directly on the earnings amount and is separate from the income tax liability.
Using the previous example, if you cash out with $8,000 in earnings and are under 59½, the distribution is non-qualified. The $8,000 is added to your taxable income for the year. You would also owe an $800 penalty (10% of $8,000) to the IRS when you file your tax return.
Exceptions to the 10% Early Withdrawal Penalty
While the 10% early withdrawal penalty on earnings from a non-qualified distribution is common, the IRS provides several exceptions. If you qualify for an exception, the earnings are still subject to ordinary income tax; the exception only waives the 10% penalty.
An exception applies if you leave your job during or after the calendar year you turn 55. Under this rule, you can take distributions from that employer’s 401(k) plan without the 10% penalty. This exception is specific to the 401(k) of the employer you just left and does not apply to IRAs or 401(k)s from previous jobs.
Other exceptions from the 10% penalty include distributions for:
- Total and permanent disability.
- Payments made to your beneficiaries or estate after your death.
- Unreimbursed medical expenses that exceed 7.5% of your adjusted gross income (AGI).
- Payments made as part of a Qualified Domestic Relations Order (QDRO) in a divorce.
- Certain distributions for military reservists called to active duty.
The Process of Requesting a Cash Distribution
To cash out your Roth 401(k), contact your former employer’s plan administrator. You can find their contact information on an account statement or through your former company’s human resources department. They will provide the necessary distribution request forms.
The paperwork will require personal information for verification. You will elect a full cash distribution and specify how you wish to receive the funds, such as by check or direct deposit.
When you request a cash-out, the plan administrator must withhold 20% of the taxable portion (the earnings) for federal income taxes. This is a prepayment of the income tax you will owe. The final tax you owe may be more or less than this amount, depending on your tax bracket.
After the paperwork is processed, you will receive your account balance minus the 20% withheld from the earnings. Early the following year, the plan administrator will send you IRS Form 1099-R. This form details the gross distribution, the taxable amount, and the federal tax withheld, and you must use it to report the transaction on your tax return.