#RetireWell: The 401(k) Distribution Opportunity You Need To Think Twice About

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. In-service withdrawals or “in-service distributions” allow participants to take distributions or roll their contributions over to an IRA after reaching age 59 1/2 while the participant is 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 Profit Sharing Council of America, it has been estimated that up to 77% of 401(k) plans allow in-service withdrawals.)

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) plan assets to an individual retirement account or you can even take a cash distribution. There are no penalties if you've reached age 59 ½, but the withdrawals are still taxed as ordinary income.

This is where it gets tricky from a tax planning perspective. Since your distribution is taxed as ordinary income, it is 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.

Forbes