During the last few weeks, I’ve received a variety of questions from advisors and investors after my podcast about rules for “in-service” distributions—essentially, how participants in an employer sponsored retirement plan (401(k), 403(b), etc.) can take a cash distribution and/or roll over their assets tax-free to an Individual Retirement Account (IRA) while still employed. The inquiries focused on “when” and “how.” When am I eligible to take an in-service distribution? How do different plan types (i.e. 401(k) vs. 403(b)) affect in-service distribution eligibility? I’ll explain the myriad of in-service distribution strategies applying to different type of retirement plans and/or sources of funds.
Typically, distributions from qualified retirement plans require a “triggering” event—such as separation from service, disability, death, or retirement—permitting participants to withdraw their funds. Cash distributions made prior to age 59½ are generally subject to federal and state (if applicable) income tax, plus an additional 10% early distribution penalty tax unless an exception applies. Whereas a rollover to an IRA or new employer’s plan is a tax-free transfer of assets.
In-service distributions provide flexibility by offering retirement plan participants the option to “cash out” and/or roll over their account while employed. That said, retirement assets are intended for retirement. Consequently, the maze of rules governing distributions as such generally discourage participants from taking a distribution from their account prior to retirement; but there are exceptions, including separation from service, plan loan, financial hardship, and a new option: birth of a baby or qualified adoption.
As I explained in the podcast, the first step is to determine if and/or when your employer’s retirement plan allows in-service distributions (the plan sponsor has the option to not offer in-service distributions). Contact your human resources department to inquire if an in-service distribution is allowed. According to a recent survey by the Profit Sharing Council of America, more than 70% of 401(k) plans do allow in-service withdrawals.1 Rules on the availability of such withdrawals vary by plan (401(k), 403(b), 457(b), etc.) and contribution type (employee salary deferrals, rollovers, employer match, profit sharing, etc.). The summary plan description (SPD) explains your company’s retirement plan rules and provisions written in an easy-to-read Q&A format.
Notably, in-service distributions rules that apply to qualified retirement plans do not apply to employer-sponsored IRA plans, such as SEP, SAR-SEP, or SIMPLE IRAs. Instead, IRA plan rules are liberal, thus allowing a participant to take a distribution at any time and/or age, although taxes and or penalties may apply.
Tip: An employer sponsoring a qualified retirement plan (i.e. 401(k)) may choose to limit in-service distributions to situations where participants can demonstrate a financial hardship. Although deemed an in-service distribution, hardship distributions are not eligible to be rolled into an IRA. Thus, distributions due to financial hardship are subject to ordinary income taxes plus a 10% penalty tax for those participants under age 59½.
Which Employer Sponsored Retirement Plans Permit In-service Distributions?
As mentioned, many defined contribution (DC) plans today—e.g., 401(k), 403(b), 457(b), Thrift Saving Plan, etc.—allow participants to distribute all or a portion of their retirement benefits out of the plan while employed. Whereas other employer plans only allow distributions upon separation from service or retirement.
Here are general guidelines, by plan and contribution type.
In-service Distributions from 401(k) Plans
A 401(k) plan cannot permit in-service distributions of employee elective deferral accounts prior to age 59½. Instead, typically, the only way to access employee salary deferrals (pretax or Roth), and employers’ 401(k) safe harbor contributions (match and/or non-elective) and employer-qualified non-elective and matching contribution accounts, while employed, is through a financial hardship or plan loan. In other words, these specific pools of money are inaccessible to participants younger than age 59½, unless they die, become disabled, or end their employment.
Conversely, the in-service rules applicable to employer contributions (profit sharing, matching) are much more liberal. Here, contributions are available for an in-service distribution upon the following events: funds that have been contributed to the plan for at least two years; (employee) has participated in the retirement plan for five years; or the employee has attained a certain age (as defined in the plan document/SPD).
Virtually all defined contribution plans permit participants to “roll in” funds from former employers’ retirement plans, including IRAs. However, employers that permit “roll-ins” also can (although are not required to) allow participants to distribute their rollover account balance at any time. Notably, an age restriction does not apply to an account balance that was previously rolled over from a prior employer’s plan or from an IRA. In fact, rollover account funds often are unrestricted. This design assures a participant that he or she can access funds at any time, which makes the new employers retirement plan much more appealing. The SPD will provide guidance.
Aftertax Employee Contributions
Aftertax (not Roth) contributions are generally eligible for an in-service withdrawal. Therefore, an in-service distribution, if permitted by the plan, it may be possible to request, at any time or age, a distribution of aftertax contributions. Furthermore, IRS guidance previously described in Notice 2014-54 offers details on the taxation on a variety scenarios in which a participant takes a distribution from his or her company retirement plan that contains both pretax and aftertax funds (not Roth) while simultaneously providing the option of rolling over their pretax dollars to a traditional IRA and aftertax contributions Roth IRA tax free.
The IRS (via Notice 2014-54) confirmed that participants with both pretax and aftertax money in their 401(k) or another qualified retirement plan can allocate the pretax funds of their distribution to a traditional IRA and aftertax portions to a Roth IRA tax-free!
Tip: There are slightly different, more liberal and generally more favorable distribution rules for “pre-1987” aftertax contributions. Pre-1987 aftertax contributions can potentially be distributed without associated earnings if those dollars have been separately accounted for.
In-service Distributions from Profit-Sharing Plans
The rules permit withdrawals from an employer-funded profit-sharing plan while an employee remains employed after as little as two years of service. Many plans typically require participants to have at least five years of service or participation in a plan.
In-service Withdrawals from Governmental 457(b) Plans
457(b) plans (also known as deferred compensation plans) are retirement plan for employees of state and local governments (i.e. states, municipalities, government agencies, public schools etc.) In addition, certain nonprofit employers may offer “top hat” 457(b) plan. However, “top hat” plans are only available for certain management level employees.
Section 457(b) plans had considerable restrictions when a participant was eligible to distribute funds from their account. However, the rules have been loosened recently as a result of a law change. Under the SECURE Act, governmental 457(b) plan sponsor now can offer in-service distributions to participants starting at age 59½ (rather than age 70 ½ that was previously permitted) for plan years beginning after Dec. 31, 2019.
A 457(b) plan may not make amounts deferred available to a participant earlier than: 1) age 59 ½ (if the plan allows), 2) severance of employment, 3) retirement, 4) an “unforeseeable emergency” (457(b) version of a financial hardship), 5) Required minimum distributions (RMDs), 6) Qualified Domestic Relations Order (QDRO) pursuant to a divorce or (7) plan termination. Some 457(b) plans permit a one-time only, in-service, small-account-balance distribution that applies to accounts valued at $5,000 or less and to which no contributions were made for the preceding two years.
Tip: 457(b) plans sponsored governmental entities may allow rollovers to other eligible retirement plans (401(k), 403(b), another governmental 457(b), and IRAs), while tax-exempt 457(b) plans may not allow rollovers.
In-service Distributions from Pension Plans (Defined Benefit and Money Purchase Plans)
Pension plans generally are not allowed to permit distributions before the earlier of retirement or Normal Retirement Age. However, since 2007, current law has also permitted an employee to receive retirement benefits while still employed and before retirement as long as the participant had reached age 62. The SECURE Act reduces the earliest age an employee can receive in-service retirement benefits from a pension plan from age 62 to age 59½, effective for plan years after Dec. 31, 2019. This provision is voluntary for plan sponsors.
In-service Withdrawals from 403(b) Plans
403(b) plans are unique, because the in-service distribution rules depend on the funding vehicle – annuities or mutual funds. 403(b) investment options generally come in two flavors: Section 403(b)(1) account, which invests solely in annuities, and a Section 403(b)(7) custodial account, which allows for investment in mutual funds.
For both investment vehicles, amounts attributable to 403(b) salary deferrals (pretax or Roth) are not available for in-service distributions before age 59½, unless the employee severs employment, dies, encounters a financial hardship, or becomes disabled. For employer contributions invested in a 403(b)(7) custodial account, the same rules apply. However, for employer contribution amounts held in an 403(b)(1) annuity contract, the plan may provide for in-service distribution upon the occurrence of any specified event (for example, attainment of a specific age, fixed number of years, attainment of specified age; minimum of at least a two-year waiting period. In summary, 403(b) distribution restrictions are dependent upon several variables, including investment funding vehicle (annuity or custodial account), contribution type (salary deferral, employer contribution, etc.), and satisfying a “triggering” event.
Tip: Assets held in a 403(b)(9) retirement income account generally adhere to the rules applied to a 403(b) annuity-funded plan.
403(b) Contract Exchange
A contract exchange is an option to move assets to another 403(b) vendor, and can be done without severance from employment, at age 59½ or any other distributable event—if the plan permits it.
A 403(b) “exchange” is the movement of all or some of portion of a 403(b) account held with one provider to another 403(b) provider that is a part of the employer’s plan. The recipient provider is required to be part of the plan, either because the provider is currently receiving plan contributions under or entered into an Information Sharing Agreement with the employer. Thus contract exchanges are only utilized in plans with multiple approved providers. Such providers must be specifically listed in the plan as being approved in order to receive a contract exchange of assets.
In addition to the requirement that the plan must permit contract exchanges, there are two other requirements: (1) The withdrawal restrictions applicable under the receiving vendor’s 403(b) account must be at least as restrictive after the transfer or exchange as they were before the transaction and (2) distribution restrictions in the new account (plan) must be as stringent as those in the prior contract and the new contract issuer must agree to provide the employer with information necessary for compliance.
403(b) Plan-to-Plan Transfers
A 403(b) plan-to-plan transfer is used to transfer assets between plans, as opposed to within a plan. Unlike a rollover, a plan-to-plan transfer is permitted only between plans of the same type. 403(b)s permit transfers by an active employee from his/her current 403(b) plan to that of a prior employer or to another 403(b) plan at his or her current employer. Importantly, the current plan must permit transfers out and the receiving plan must permit transfers in.
SEP IRA and SIMPLE IRAs
A SEP IRA generally follows the same distribution and rollover rules for a traditional IRA; thus, there are no withdrawal restrictions. Therefore, SEP IRA assets can be withdrawn at any time or age and for any reason; although taxes and penalties may apply unless the funds are rolled over to another eligible retirement plan.
A SIMPLE IRA can be rolled over into the same accounts as a traditional IRA. However, unlike other IRAs, a SIMPLE IRA must have been established for at least two years before it can be rolled over. Otherwise, the SIMPLE account will assess a 25% (not 10%) early distribution penalty on assets that are distributed (including a rollover or Roth conversion) within the first two years of plan participation. A participant can, however, transfer her account to another SIMPLE IRA provider in the first two years without being subject to taxes or penalty.
Tip: A law change expanded SIMPLE IRA portability. You can now rollover IRA funds and employer plan (401(k), 403(b), etc.) funds tax free into a SIMPLE IRA plan once the two-year period of participation is satisfied.
Thrift Savings Plan (TSP)
The Thrift Savings Plan (TSP), introduced in 1986, was created to give federal workers the opportunity to invest in a tax-advantaged account for retirement, similar to a 401(k) retirement savings plan.
TSP retirement savings plan allows for age-based in-service withdrawals upon a federal employee attaining age 59½ or older. The following rules apply to an age-based in-service withdrawal from a TSP:
A participant can only withdraw vested funds (that the participant is entitled to keep) based on years of service.
Amount of the age-based withdrawal must be at least $1,000 or the entire vested account balance (even if it’s less than $1,000).
Up to four age-based withdrawals are allowed per calendar year. If the participant has two separate TSP accounts—a civilian TSP account and a uniformed services account—the participant can only make age-based withdrawals from the account associated with active employment at the time of withdrawal. However, if both accounts are associated with active employment, the participant can make age-based withdrawals from each account.
If you have additional questions, please contact your Lord Abbett representative at 888-522-2388.