A solid financial plan requires the examination of all available opportunities to use financial resources to meet important life goals. Many 401(k) plans have a unique feature that can either create a world of opportunity for your retirement plans or create a tax and retirement planning nightmare. This 401(k) plan feature is known as an in-service withdrawal.
It is widely understood that distributions from a 401(k) plan that are made before you reach age 59 ½ are taxed as ordinary income. But the real kicker is the fact that minus a few exceptions, they are also subject to an additional 10% early withdrawal penalty.
The in-service withdrawal exception
In-service withdrawals or “in-service distributions” allow you to take distributions or roll your contributions over to an IRA after reaching age 59 1/2 while you are still an employee of the company. (It is important to note that not all 401(k) plans have the option to allow participants to take an in-service distribution while still actively employed. According to the Plan Sponsor Council of America, it has been estimated that up to 77% of 401(k) plans allow in-service withdrawals, so check with your 401(k) provider first.)
Typically, the only way to access elective deferrals to a 401(k) plan while you are still working is through a hardship withdrawal or 401(k) loan. Certain triggering events such as financial hardship must occur related to reasons such as unreimbursed medical expenses, buying a primary residence, paying for college tuition, funeral expenses, and to avoid eviction or foreclosure. Hardship withdrawals are subject to ordinary income taxes PLUS a 10% penalty if you are under age 59 ½. You also must prove that you have no other funds available.
In contrast, in-service withdrawals at age 59 ½ (if offered) that are not due to financial hardship are not subject to the 10% penalty and have no restrictions on how you use these assets.
Here’s how it works:
For example, let’s assume you’re still working for an employer and just reached age 59 ½. If your plan allows for an in-service withdrawal, you may choose to either rollover your 401(k) money to an individual retirement account (IRA) or you can even take a cash distribution. There are no penalties if you’ve reached age 59 ½, but withdrawals from a pre-tax 401(k) are still taxed as ordinary income.
This is where it gets tricky from a tax planning perspective. If your distribution is taxed as ordinary income, it will be added to your earned income for the tax year in which you take money out of the 401(k) plan. The distribution could potentially put you in a higher marginal tax bracket and may completely negate the benefits of making contributions to your retirement plan in the first place.
You can avoid having an in-service withdrawal become a taxable distribution by completing an IRA rollover. In fact, if you take a cash distribution and change your mind, there is a 60-day window to complete a rollover to an IRA. This will continue to allow for tax-deferred growth and could potentially give you more investment options to choose from and more flexibility with how your retirement portfolio is structured. This is why it’s the most common in-service distribution.
Reasons to consider an in-service distribution
The primary reason to consider an in-service withdrawal from your 401(k) is the added control and flexibility that comes with rolling assets into an IRA. If you are unhappy with the investment lineup within your 401(k) plan or have high administrative fees and expenses, it may be a welcome relief to know that you have an exit strategy while still remaining with your employer.
Individual retirement accounts may provide you with more (or different) investment choices than the ones offered in an employer sponsored retirement plan. They may allow for greater overall diversification through investments such as individual stocks, ETFs, individual bonds, no-load mutual funds, CDs, separately managed accounts and a number of other choices.
How to find out if your retirement plan allows in-service distributions
In-service distributions may potentially be available through a variety of qualified retirement plans in addition to 401(k)s. Profit-sharing plans, pension plans, employee stock ownership plans (ESOPs) and 403(b) plans are examples of other qualified retirement plans that allow for withdrawals while still working. Since each qualified retirement plan is unique, there are different withdrawal rules governing each specific type of contributions (salary deferral, employer matching contributions, profit sharing, rollover, etc.).
Check with your plan administrator or review a copy of your employer’s summary plan description (SPD) to find out if your plan offers an in-service withdrawal option. In addition to the age 59 ½ requirement, some plans may have a length of service requirement. You should also make sure that taking an in-service distribution will not hurt your ability to continue contributing to your employer’s qualified retirement plan and will not create any problems with your plan’s vesting schedule.
The potential downsides of an in-service distribution
Having more control and flexibility over how and when to access your retirement savings doesn’t necessarily mean this is the smartest financial decision. There are some compelling arguments against taking in-service withdrawals once you reach age 59 ½. Here are just a few of those downsides to consider:
- Cash distributions may end up creating a greater tax burden than waiting until full-retirement to take money out of your 401(k) plan. As retirement nears, the urge to eliminate credit card debt or pay off a mortgage can be significant. You may even have a major purchase (e.g., boat, car, second home) that you want to make and your retirement plan would seem like a logical option. Unfortunately, you will likely pay significantly higher taxes if you take an in-service distribution while you are still working. Waiting until retirement to take out 401(k) assets is often a better alternative since your income level and taxes will likely be much lower.
IRA rollovers will allow you to continue to defer taxes until you choose to withdraw the funds in retirement. However, IRA rollovers also have potential drawbacks you must be aware of.
- You will lose the ability to delay required minimum distributions (RMD) beyond age 70 ½. In reality, this one may not seem as big as a concern because who really wants to work into their 70’s? But with retirement confidence levels low, you may either work beyond the so-called “normal” retirement age out of necessity or because you want to work as long as possible (mind and body willing of course). There are no RMDs from 401(k) plans as long as you are still working (and you don’t own a 5% or bigger stake in the company).
- You will not be able to use a net unrealized appreciation (NUA) strategy if employer stock is rolled into an IRA. This is important if you have highly appreciated company stock in an employer-sponsored retirement plan. Favorable NUA tax treatment allows you to pay income taxes only on the stock’s cost basis. When you eventually sell shares of stock, you are taxed at long-term capital gains rates, which could be significantly lower. Of course, you must weigh the potential tax savings of using the NUA strategy with the risk of having too much invested in any individual stock holding if you decide to hold on to company shares.
- You will no longer have access to borrowing options once 401(k) assets are rolled into an IRA. While borrowing money as retirement approaches isn’t on the top of everyone’s list of potential goals, it remains an option within 401(k) plans if provided by your employer. IRAs do not have loan provisions and you would have to take a taxable distribution to gain access to your assets.
- 401(k)s tend to have broader federal protection from creditors. IRAs have federal protection from bankruptcy protection, but that protection has limitations. General creditor protection is decided at the state level. As a result, 401(k) assets tend to have broader protection from potential lawsuits. If you have a pending lawsuit (or think there may be the possibility of one in your future) you should think twice about rolling assets from a 401(k) plan to an IRA.
It is possible that an IRA rollover may end up costing you more in the long run. Always compare the fees, costs, and services to make sure that a rollover fits your short and long-term financial plans. Also, keep in mind that conflicts of interest may exist if financial advisors stand to benefit from your IRA rollover decision. Financial services companies benefit from money in motion and view the IRA rollover market as a significant business opportunity.
There are plenty of valid reasons to consider an in-service withdrawal from your 401(k) plan. Just be sure that your financial advisor is operating in your best interests and not simply trying to generate assets under management (AUM) fees or earn commissions from the sale of investment or insurance products. Consult a fee-only financial planner or utilize the services of unbiased financial wellness providers to learn more about in-service distribution options.
A version of this article was originally published on Forbes.