From time to time, I get clients asking if they should use an in-service distribution. As with most things in personal finance, the answer depends on their unique situation. But there are some general guidelines to keep in mind when considering this financial tool.
What is an in-service distribution?
Simply put, an in-service distribution is a withdrawal from a 401(k) that happens before you retire. Ordinarily, people contribute money to their 401(k) during their working years, then they retire and start withdrawing money from the account to fund their retirement. These withdrawals are called distributions.
Sometimes, people want to take distributions before they retire, and there are a number of reasons for making such decisions. Some people may find themselves facing expensive emergencies, such as a health crisis, a storm-damaged home or an imminent foreclosure or eviction. Others might want to buy a home but don’t have the necessary down payment.
In-service distributions taken before age 59½ are subject to a 10% penalty in addition to income tax, unless they qualify as a hardship withdrawal.
Emergencies like those mentioned above often qualify as hardship withdrawals and aren’t subject to that 10% penalty. However, if you just want extra money, you’ll pay the penalty if you take the distribution before you’re old enough. This penalty frequently impacts people who take a distribution from their 401(k) to make a down payment on a house; while it’s perfectly legal to do so, the 10% penalty often makes it an unwise decision.
A common reason for making an in-service withdrawal after age 59½ is to seek out different investment options not currently available in your employer-sponsored 401(k). Rolling over the in-service distribution into an IRA will give you more control over how your money is invested. You can then work with a financial advisor to manage your portfolio more comprehensively than you could in your original 401(k) because you won’t face any plan limitations on where your money can be invested.
Are in-service distributions a good idea?
Whether an in-service distribution is right for you depends entirely on your unique circumstances. Before age 59½, it’s often best to avoid taking those distributions. That 10% penalty is enormous; even if your plan’s investment options are terrible, it would be very hard to make up the difference by changing your portfolio.
It’s also important to recognize that the penalty is only one aspect of the losses you may incur. If you withdraw money from your 401(k) to buy a house, that’s money that won’t be available to grow in the future. If you buy that house in your 20s or 30s, withdrawing $10,000 from a 401(k) could cost you more than $40,000 by the time you retire!
Of course, there are some situations in which an in-service distribution becomes necessary. If the choice is between the inability to get treatment for a life-threatening condition or taking a distribution from your 401(k), taking that distribution might make a lot more sense.
What are the advantages of in-service distributions?
A huge advantage of an in-service distribution after age 59½ is the ability to control your own destiny, so to speak. As financial advisors at Asset Protection Wealth & Tax, we aren’t able to direct an employer-sponsored 401(k) in the same way we can an IRA under our management. If the manager of your 401(k) doesn’t give you the best options for your needs, there’s not much you can do about it.
However, if you roll that 401(k) into an IRA, we can take full control over where your money is invested. That kind of flexibility gives us options you simply won’t get in most employer-sponsored retirement accounts.
Not only can we more effectively direct your investments, but of equal or perhaps greater importance is that we can perform much more effective tax planning. That 401(k) you have through your employer is a tax-deferred account. This means contributions are tax free now, but you will owe taxes on it when you start taking distributions.
Currently, we’re in a favorable tax environment, but the Tax Cuts and Jobs Act, which provides that attractive tax picture, expires at the end of 2025. Unless Congress chooses to extend the tax cuts, which is unlikely, taxes will increase. That means we have a window of opportunity right now to start paying taxes on retirement accounts to reduce the amount of taxes will owe years in the future.
What are the disadvantages of in-service distributions?
Beyond the penalties you pay if you take non-hardship distributions before age 59 1⁄2, one large disadvantage of in-service distributions has to do with retirement income protection. Your employer-sponsored retirement plan is likely covered by the Employee Retirement Income Security Act, or ERISA, which extends a number of protections including making those funds largely immune to many creditors.
A prime example is OJ Simpson. After he was found civilly responsible for the murder of his ex-wife and her friend in a wrongful death lawsuit brought by their family, the resulting judgment was far in excess of his net worth. While the families can garnish his wages, income he makes from selling possessions and many other sources, one income stream they can’t touch is his monthly pension. The same law that protects his pension from garnishment also applies to most 401(k) and other employer-sponsored retirement plans.
However, non-protected assets are one at-fault catastrophic car accident away from potentially being seized by creditors. Rolling your 401(k) into an IRA can expose your assets to such garnishments because ERISA does not cover IRAs.
There are ways to protect non-covered assets, such as umbrella insurance policies, but those protections must be actively sought out; they aren’t automatically assigned as ERISA protections are for your employer-sponsored retirement accounts.
How should I approach deciding whether to take an in-service distribution?
A decision such as this is not one to be made lightly, or alone. The most important step to take is to consult with a professional. Get advice from a financial advisor who is a fiduciary. At Asset Preservation Wealth & Tax, we are always ready to advise our clients on the wisdom — or lack thereof! — of taking an in-service distribution, and because we are fiduciaries, our clients know we have their best interest as our top priority.
Stewart Willis is the founder and president of Asset Preservation Wealth & Tax, a financial planning firm in Phoenix, Arizona. Investment advisory services offered through Foundations Investment Advisors, LLC, an SEC registered investment adviser.
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