Many working Americans jump-start their savings for retirement by enrolling in their company’s 401(k) plan, and those numbers continue to increase as companies move to an auto-enrollment model. At Krilogy, we encourage our clients to participate in their company-sponsored retirement plans, including 401(k)’s, because these types of plans implement disciplined savings and can be instrumental in building wealth. But there comes a time as you get closer to retirement when you may want to make some changes. Perhaps you feel behind, or are worried about preserving your wealth and stretching your retirement income out as long as possible. For some, a non-hardship, in-service withdrawal from a 401(k) may be a wise consideration – and it’s an option you may not even know exists.
What is a non-hardship, in-service withdrawal?
A 401(k) in-service (non-hardship) withdrawal is a withdrawal from a 401(k) by a plan participant that does not require a “triggering event” such as leaving the employment of the company. The participant is still employed by the sponsoring company, but this little-known IRS rule allows the participant to make a withdrawal once they reach age 59-1/2 and avoid the 10% early withdrawal penalty IF the funds are rolled into an IRA within 60 days. If the 60 day period passes and the IRA rollover is not completed, you will be subject to all taxes and penalties associated with an early withdrawal.
It’s important to note that such withdrawals are “non-hardship,” which means the funds will not be used to pay for immediate and heavy financial needs for the participant, such as medical expenses or the purchase of a primary residence. Hardship withdrawals are very limited by retirement plans.
Why are these types of withdrawals allowed?
With the legions of Baby Boomers approaching retirement age each day, the IRS and large employers recognized the need to allow individuals who reach age 59-1/2 to access their funds and move them into accounts they control, such as an IRA. While 401(k) plans can be a bit more limiting, an IRA can give the investor additional options and more flexibility in terms of the types of assets and investment vehicles they can hold inside their IRA.
Why would I consider doing an in-service withdrawal?
When an investor begins approaching retirement age, there are two things that we as advisors focus on:
- Developing an appropriate investment strategy for the remaining income-earning years based on the client’s goals and risk tolerance
- Planning for the client’s income strategy once they reach retirement
When we get to this phase, there are many options for a client to consider that are available in an IRA which are not available within a 401(k) plan. For example, in an IRA we can purchase individual bonds creating a bond ladder with a customized maturity structure, allowing for scheduled maturity over time. This allows the client to begin creating their income strategy for retirement. Such a strategy isn’t allowed in a 401(k), where it’s only possible to purchase bond funds. For clients who are risk averse, another option could be to purchase an annuity inside the IRA, which may be utilized to provide income solutions for life. Again, this isn’t something that’s allowed in a 401(k).
We also consider the costs associated with the various funds and investment vehicles. Inside a 401(k), there’s little room to lower investment costs, yet in an IRA you have more control over your choices and can analyze each in order to pursue lower cost options.
Finally, IRA’s are more flexible with their beneficiary options. In the case of death, you may leave the IRA as-is and the title simply changes to the beneficiary. In most 401(k) plans, the assets must be liquidated before they are passed on to the spouse or beneficiaries. All of this means that you have enhanced control, and puts you in a position to actively manage your money.
Does my plan allow for in-service withdrawals?
Each employer-sponsored 401(k) will have plan documents associated with it. If you don’t have these documents, ask your HR or employee benefits department to provide them. Plan documents outline what is allowed and what the terms are, including the maximum amount you’re allowed to withdraw. Chances are your plan does allow for an in-service withdraw. According to www.thinkadvisor.com, “recent studies indicate that upwards of 90% of 401(k) plans permit in-service withdrawals for non-hardship purposes” once the plan participant reaches age 59-1/2. Savvy participants expect this as an option, so an increasing number of employers are offering it as part of their benefits package to help attract and retain talent.
The challenge is this: many employees are not made aware that this option exists, and they don’t know to ask. Employers aren’t proactive about educating employees on the options, so the responsibility falls on the employee to find out what the plan allows for. It can take a little work, but it’s worth it in terms of knowing what your options are, and if making an in-service withdrawal may be right for you.
Why might an in-service withdrawal not be a fit for me?
While there are many good reasons to pursue an in-service withdrawal, they certainly aren’t appropriate for every situation:
- 401(k)’s allow for loans. IRA’s do not. That means if you think you are going to need access to this money in the short-term, you may be better off keeping the money in your 401(k). We typically advise that taking a loan from your 401(k) should be a last result, but recognize that there are cases where a client needs to do so.
- If you retire early, you can make a penalty-free withdrawal from a 401(k) at age 55. An IRA requires you to reach the age of 59-1/2 to avoid the early withdrawal penalty.
- It’s easier (thus more tempting) to spend money from an IRA than a 401(k).
Important things to know about in-service withdrawals
I’ve mentioned these items in the paragraphs above, but I felt it important to re-iterate the following points about in-service withdrawals as they are crucial to the process and can be quite harmful if missed:
- This process is for non-hardship withdrawals only. A hardship withdrawal is defined as a distribution due to a heavy and immediate financial need with the withdrawal being necessary and limited in scope to pay only for that specific need. This could include medical bills or other hardship, and we typically advise taking a hardship withdrawal only as a last resort. A non-hardship withdrawal is that which is specifically applicable to the in-service withdraw at age 59-1/2, and as defined by your plan documents.
- The withdrawal from your 401(k) plan MUST be rolled over into an IRA within 60 days to avoid taxes and penalties associated with an early withdrawal. If you work with a financial advisor, he or she should assist you with this process. In addition, you should always consult with your tax professional to answer any tax questions you may have. In any case, it is your responsibility to make sure this happens.
Because every situation is unique, talking with a financial professional before you make any decisions is very important. He or she can help you consider your goals, what your options are, present various scenarios, and help you make informed decisions. The Krilogy team has witnessed many clients leverage this tool as part of their investment strategy. We can help you determine if it may be an appropriate move for you.
Krilogy Financial® is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.
Krilogy Financial does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.