There are about 60 million Americans currently with 401(k) accounts, which can be excellent wealth accumulation vehicles. Not to mention, many workers find 401(k)s to be highly convenient, with automatic contributions, employer matching, and other perks that make for simplified retirement saving.
Unfortunately, the reality is that many retirees witness their 401(k)s plummet just before retirement–and the investment options that come with these plans can oftentimes be limited. Plus, it is common for retirement accounts to top seven figures heading into retirement, so a large market drop during the final working years can be extremely detrimental and have major consequences on someone’s financial health during their final decades.
So to effectively retire, one must transition successfully from a wealth accumulation phase to one of preservation and growth. Even still, this cannot be done lightly or with little strategy. There are many factors at play including tax implications, earnings caps, and Social Security considerations that must all be accounted for before moving money around and making important decisions ahead of retirement.
However, what many are often unaware of is that at the age of 59 ½, the IRS allows retirees to avoid a collapse in their 401(k) by letting them perform what is referred to as an “in-service distribution”. So what exactly is an in-service distribution, when can they be utilized, and what are some things you need to consider before taking these distributions?
What is an In-Service Distribution?
An in-service distribution is made when a worker takes a withdrawal from their employer-sponsored retirement plan while they’re still employed by the company. This can include both pre-tax contributions by the employee as well as employer contributions. Most commonly this occurs with a 401(k) account, but other qualified plans like a 403(b) or 457 plan, or thrift savings plans can also take in-service distributions.
In-service distributions are particularly valuable because as workers near retirement, the risk of losing their savings and wealth from a plummet in the stock market becomes increasingly consequential. Thus, in-service distributions can help them diversify their holdings and better protect their wealth in ways that they view as more suitable as they approach retirement.
So while employer-sponsored plans like 401(k)s often come with a menu of a few mutual funds you can choose from, rolling funds over into an IRA offers you a wider range of possibilities and investment vehicles to utilize that can be tailored to your specific needs. With an IRA account, you can hold a number of other securities aside from equities which can help you diversify and have more control over your assets, like bonds, ETFs, and other alternative investments.
How Do In-Service Distributions Work?
Workers can use in-service distributions while still employed to roll over a portion of their employer-sponsored retirement plan into a traditional IRA. In-service distributions can also be rolled over to annuities if the worker prefers that route. IRAs are typically more suitable for employees to have control over their wealth and the holdings in their portfolios, which is why many workers will opt for this strategy once they reach 59 ½.
In addition, whether the worker rolls the funds into a traditional or Roth IRA may be limited by the specific rules of the employer-sponsored program, and will cause different tax implications.
Even still, 401(k) plan administrators are not required by law to inform you of the in-service distributions you’re entitled to. As you could imagine, companies offering these 401(k)s don’t necessarily want employees to withdraw money early. Not to mention, the government has largely backed this sentiment as well, with the idea that those saving up for retirement should be careful about withdrawing retirement savings early.
Thus, you may have to do some digging to find out exactly what the provisions are for your plan, and what rules you are subject to when it comes to in-service distributions. The good news is that the large majority of employer-sponsored retirement plans in the United States will allow for these to occur, so it’s just a matter of finding the exact rules that you’re subject to and what tax implications you may face.
Considerations for In-Service Distributions
So, if you’ve reached 59 ½ and believe that you have better investment options outside of your 401(k) plan to help preserve your wealth, you will want to consider the following factors in order to make the right choice for you.
- Does your retirement plan allow you to take in-service distributions?
- Are there any conditions or criteria you must meet?
- What type of accounts can you roll the money into?
- Will you face any tax implications?
Once you determine that your plan will allow for in-service withdrawals, you can begin to formulate a strategy that gives you more flexibility and control over your funds. Working with a financial planner or advisor at this time can be extremely helpful, as they can help you navigate this stage of retirement planning given their expertise.
It’s also important to keep in mind that you can continue to contribute to the employer-sponsored retirement account even if you are taking in-service distributions, as long as you remain under the annual limit. This means an employer-matching that occurred before will continue as long as you remain employed, given that the matching is based on contributions rather than the account value.
In addition, if you were borrowing against your employer-sponsored retirement account, taking in-service withdrawals could be affected given the lower balance it will have. Plus, there aren’t similar benefits with an IRA to borrow against its value like with a 401(k), so this may be a drawback for some workers.
Even still, you need to be aware of the tax implications that you may face when taking in-service distributions, so let’s dive deeper into what those may be.
What are the Tax Implications of In-Service Distributions?
Most in-service distributions can be made to a tax-defrred account without penalty once workers have reached the age of 59 ½. There are also other exceptions; for example, an employee may withdraw up to $10,000 for the purchase of their first home, if they declare a hardship, or display severe financial need, in addition to a number of other scenarios that don’t require the employee to be 59 ½ years old.
If an employee decides to take in-service withdrawals before they’re 59 ½, they will likely face a 10% early withdrawal penalty tax on the amount that is distributed. However, there are some exceptions.
One example is if the in-service withdrawal is used to cover medical expenses that are more than 7.5% of their adjusted gross income, the premature penalty tax may be waived. Additionally, employees may be able to avoid this penalty if the funds are used to make court-ordered payments to an ex-spouse or child,
Final Thoughts on In-Service Distributions
Market volatility in this current cycle isn’t going away anytime soon. So for those who are approaching retirement, there may need to be some strategy tightening and consideration for how you will be preserving your wealth ahead of retirement. Just because you have millions saved up in your retirement accounts now doesn’t mean this money is guaranteed. After all, a million-dollar portfolio can drop to a value of $800,000 quickly if a market correction wipes off 20% of the stock market’s value in a short amount of time.
This is especially true now with looming talks of a recession, so pre-retirees should be aware of the risks they face in the coming years, and how they can best protect their portfolios. Since the stock market is now expected to have lower returns in the coming periods than what we’ve experienced over the past decade, it’s likely that many workers today will realize losses in their retirement accounts.
Thus, rolling over your 401(k) savings into an IRA account once you are 59 ½ is a great strategy that you should consider implementing. While company-sponsored retirement plans may not give you the control and flexibility you need to effectively preserve your wealth, you can take matters into your own hands and diversify your holdings separately from your company’s plan.
As with many financial decisions, whether or not a worker chooses to take in-service distributions will be an individual choice, though working with a professional like a financial planner can help you stay on track and prepared for retirement. For more helpful tips on financial planning for retirement, college, and more, consider joining one of our upcoming webinars.
Disclosures
Securities and advisory services offered through Independent Financial Group, LLC (IFG), a Registered Investment Adviser. Member FINRA/SIPC. Vaylark Financial Services and IFG are unaffiliated entities. Licensed to sell securities in the following states: CT Information provided is from sources believed to be reliable however, we cannot guarantee or represent that it is accurate or complete.
Opinions are those of the author and not necessarily those of Vaylark Financial Services or Independent Financial Group (IFG). IFG does not provide tax or legal services. Please discuss these matters with the appropriate professional.
Investing is subject to risk, including possible loss of principal. Determining which investments are appropriate for an individual investor will depend on your investment objectives, risk tolerance, and time horizon and should be discussed with your financial advisor before implementing any investment plan.
