You might be able to transfer a portion of your 401(k) to an individual retirement account(IRA) while still employed. This is known as an in-service withdrawal. While in-service withdrawals can be a good option, that isn’t always the case. Here is what you need to know and how in-service withdrawals work.
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What Is an In-Service Withdrawal?
An in-service withdrawal is a withdrawal from a qualified employer-sponsored retirement plan while an employee is still working. A 401(k) is a common example of these plans, but it can also include plans like 403(b).
An in-service withdrawal may be possible at any time. But there might be penalties if the right conditions are not met. Generally, you must be at least age 59 ½ or have a qualifying hardship that the IRS deems an immediate and heavy financial need.
Other circ*mstances like job loss may permit an in-service withdrawal without penalties. Later, we will cover the specific scenarios in which in-service withdrawals may be permissible.
How In-Service Withdrawals Work
How in-service withdrawals work depends in part on the reason for the withdrawal. For example, it may be used to cover a qualifying hardship, such as medical expenses. Alternatively, you might decide to make an in-service withdrawal because you aren’t satisfied with your employer’s investment options. And you prefer to manage your own investments.
If you have a qualifying financial need, you can take a distribution from the plan. And you can use the money to cover your expenses. Or, if you prefer to manage your own investments, you can make a rollover from your 401(k) to an IRA. However, your employer might have specific conditions where a rollover is permitted. So check with your benefits office first if you are considering this option.
Financial Hardship Distributions
An in-service withdrawal is normally permitted without penalties if you are at least 59 ½. However, the IRS has laid out several scenarios where an in-service distribution might be possible sooner. According to the IRS website, distributions can be made before age 59 ½ to cover the following:
- Expenses for medical careincurred by the employee, the employee’s spouse or any dependents of the employee or necessary for these persons to obtain medical care
- Costs directly related to the purchase of a principal residence for the employee (excluding mortgage payments)
- Payment of tuition, related educational fees and room and board expenses for the next 12 months of postsecondary education for the employee or the employee’s spouse, children or dependents
- Payments necessary to prevent the eviction of the employee from the employee’s principal residence or foreclosure on the mortgage on that residence
- Funeral expenses; or
- Certain expenses relating to the repair of damage to the employee’s principal residence
If you want to make an in-service withdrawal before age 59 ½ and you aren’t experiencing any of these qualifying hardships, you can also expect a 10% penalty and possibly income tax. According to the IRS, “financial need may be immediate and heavy even if it was reasonably foreseeable or voluntarily incurred by the employee.”
Still, taxes can be complicated, and you could be hit with a penalty even if you aren’t expecting one. Hence, the decision should be carefully considered, preferably with the help of a financial advisor.
Tax Implications
An in-service withdrawal can have significant tax consequences and penalties depending on the circ*mstances. The IRS has laid out several scenarios in which the 10% penalty will not apply, even if you are younger than 59 ½. Those scenarios include:
- Payments made to a beneficiary after the death of the participant
- Payments made to a participant for medical care up to the amount allowable as a medical expense deduction
- Timely payments made to reduce excess contributions
- Payments made because the participant has a qualifying disability
Other situations might allow you to avoid penalties, such as when you withdraw voluntary contributions. Check with your plan’s administrator to find out when you can make an in-service withdrawal without penalties.
Bottom Line
In-service withdrawals usually occur when you make a distribution from a qualified employer-sponsored retirement plan like a 401(k). While your plan might allow you to make an in-service distribution before 59 ½, there may be penalties in addition to income tax.
Certain hardships might allow you to avoid these penalties. Medical expenses or costs related to the purchase of a residence are among them. Check with your benefits office and, if possible, work with a financial advisor to avoid unnecessary costs when making an in-service withdrawal.
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