What Happens to Your Roth 401(k) When You Quit?

A Roth 401(k) is an employer-sponsored retirement plan funded with post-tax dollars. This means contributions do not lower your current taxable income, but qualified withdrawals in retirement are tax-free. When you separate from an employer, whether through resignation or termination, you must decide what to do with the funds accumulated in your Roth 401(k) account. The path you choose will depend on your new employment status, the rules of your old and potentially new retirement plans, and your long-term financial goals.

Core Options for Your Roth 401(k) Funds

Upon leaving your job, you have four choices for the assets in your Roth 401(k):

• Leave the funds in your former employer’s plan. This is often possible, but you will no longer be able to make contributions to the account. The money can remain invested according to the plan’s offerings.
• Move the money to a retirement plan at your new job. If your new employer offers a Roth 401(k) and the plan accepts rollovers, you can consolidate your retirement savings, which can simplify account management.
• Roll the funds into a Roth Individual Retirement Account (IRA). A Roth IRA is a personal retirement account that you open and manage yourself, which often provides a wider array of investment choices than a 401(k) plan.
• Cash out the account by taking a lump-sum distribution. This provides immediate access to your money but can have significant tax implications and potential penalties.

Rules for Small Balances

Your account balance plays a role in the availability of these options. Under rules from the SECURE 2.0 Act, if your vested account balance is less than $7,000, your former employer can force your money out of their plan. For balances between $1,000 and $7,000, the plan administrator may automatically roll your funds into an IRA in your name. If the balance is under $1,000, the employer may issue you a check for the full amount.

Understanding Rollovers and Distributions

A direct rollover is the most straightforward process, where the administrator of your old plan sends the money directly to your new Roth 401(k) or Roth IRA. This trustee-to-trustee transfer avoids tax consequences, as you never take possession of the funds. An indirect rollover is an alternative where your former plan administrator sends you a check, and you have 60 days to deposit the funds into another qualified retirement account to avoid taxes and penalties on the earnings.

The tax treatment of a distribution separates the balance into your contributions and investment earnings. Since your contributions were made with post-tax money, you can withdraw them at any time, tax-free and penalty-free. The earnings portion is treated differently. If a withdrawal of earnings is non-qualified, it is subject to ordinary income tax and a 10% early withdrawal penalty if you are under age 59½, reported on IRS Form 5329.

Qualified Distributions

A qualified distribution must meet two tests set by the IRS. First, you must satisfy the five-year rule, which requires that five years have passed since January 1 of the year you first contributed to your Roth 401(k). For example, if your first contribution was in June 2020, your five-year clock would be satisfied on January 1, 2025.

This five-year clock does not carry over if you roll your Roth 401(k) into a Roth IRA. The Roth IRA has its own five-year rule for determining qualified distributions of earnings. This separate clock begins on January 1 of the tax year you first contributed to any Roth IRA, meaning a new five-year period could start.

Second, you must meet a triggering condition, the most common of which is reaching age 59½. Other qualifying events include becoming totally and permanently disabled or the distribution being made to a beneficiary after your death. Only when both the five-year rule and a triggering condition are met can you withdraw your earnings tax-free and penalty-free.

The Rollover Process

The first step in a rollover is to gather the necessary information. You will need the account number for your old Roth 401(k), contact information for the plan administrator, and the details for the receiving account. This includes the name of the financial institution, the new account number, and any specific mailing or wiring instructions they require for a rollover.

With this information, you can initiate the rollover by contacting your former employer’s plan administrator. You will need to request the appropriate rollover distribution forms. These forms will ask for details about where the money is going.

For a direct rollover, the process is largely out of your hands after you submit the completed paperwork, as the funds will be transferred directly between the financial institutions. If you opt for an indirect rollover, you will receive a check from your old plan administrator. It is your responsibility to deposit the full amount into the new retirement account within the 60-day period.