Timing is everything – especially when it comes to investments. Participants deferring compensation into a 401(k) plan receive the benefit of dollar-cost-averaging through consistently timed contributions, as well as the benefit of compounding interest over a long time. But as savvy investors know, the world of investing is much larger than the mutual funds and bonds tied to a recordkeeper’s platform. Workers who have accumulated a significant account balance in their employer’s retirement plan might want to invest in alternative investments not allowed in their employer’s plan, like real estate or a promising business start-up. Other clients may want to offset the volatility of the stock market with investments that are not subject to the same market swings. Usually, time is of the essence with these types of opportunities, and participants do not want to wait until they retire to move their money from a workplace retirement plan to a self-directed IRA.
Some participants may be eligible to take an “in-service” distribution from their employer’s retirement plan before they retire. You might want to help your clients explore taking an in-service distribution and rolling it over to a self-directed IRA if they
1. Have retirement savings tied up in an employer-sponsored plan,
2. Are still working for that employer, and
3. Want to diversify their retirement investment portfolio with the investment options available with a self-directed IRA.
Retirement Plan Distribution Rules
Unlike IRAs, qualified retirement plans require participants to have a specific distribution-triggering event before they can withdraw their funds from the plan. Typical triggering events for employer contributions include severing employment and reaching normal retirement age. Elective deferrals and designated Roth contributions generally cannot be distributed unless the participant has severed employment, died, become disabled, attained age 59½, or experienced a specific type of financial hardship. If a participant has rolled money into the current employer’s plan from another retirement plan, they may be able to access those rollover dollars at any time, without a distribution triggering event, depending on the terms set by the plan.
Many plans include triggering events that allow participants to access their savings while they are still employed. One of these is referred to as an in-service distribution. Assets that are typically available for in-service distributions include employer profit sharing and matching contributions and after-tax employee contributions. If the employer elects in the plan document, the plan can require participants to have up to 5 years of participation before being eligible for an in-service distribution, or that amounts must be held in the plan for at least 2 years before being distributed. Additionally, or instead, the employer can require attainment of a certain age.
For example, the employer could choose to allow in-service distributions after a participant reaches age 50, and both the 5- and 2-year rules are satisfied.
Elective deferrals, QNECs, QMACs, and safe harbor contributions may also be available for in-service distributions. These types of assets are not subject to the 5- and 2-year rules but the plan must include reaching age 59½ as a condition for distribution. (If deferrals are distributed as part of a “401(k) hardship distribution” on account of a specific financial hardship, the distribution is not eligible to be rolled over.)
Defer Taxation on In-Service Distributions with a Direct Rollover
If a participant requests a direct rollover of the in-service distribution to a self-directed IRA, they can avoid income tax withholding and any immediate taxation on the distribution. If the distribution is paid to the participant first, on the other hand, the plan must withhold 20% of the taxable portion and remit it to the IRS. If the participant does not make up that 20% when rolling the distribution over to an IRA, the 20% will be taxable to the participant in the year of distribution. The taxable portion of an in-service distribution not rolled over is also subject to the 10% early distribution tax if the participant is under 59½ unless an exception applies.
Before requesting an in-service distribution, plan participants may want to determine if spousal consent to the distribution will be required (if they are married), as well as from which “bucket” of their plan account the distribution will be made.
The primary candidates for in-service distribution rollovers to self-directed IRAs are typically those who are age 59½ and older:
1. Many plans allow in-service distributions of employer contributions beginning at age 59½.
2. Deferrals are available for distribution at age 59½ (if permitted by the plan).
3. Having less time to recover from a major investment loss, workers age 59½ or older may want to protect a portion of their savings from the volatility of the stock market but continue to grow those assets.
4. By age 59½, many workers have amassed a significant account balance in their employer’s plan.
5. The 10% early distribution tax no longer applies if they choose to distribute the rolled over assets from their self-directed IRA before retirement.
Financial advisors can help clients evaluate their in-service distribution options by having the client request a copy of the Summary Plan Description (SPD) from their plan administrator and then reviewing the SPD with them.