A Guide to 401(k) In-Service Withdrawals for Employees

Can you withdraw money from your 401(k) while you are still employed? Not everyone should; not everyone can. However, if you can, it may mean that you can effectively implement part of your retirement income strategy before you retire. 

If your 401(k) permits it, you may have the opportunity to take an in-service withdrawal and redirect some of your 401(k) funds into another investment vehicle.

A 401(k) in-service (or non-hardship) withdrawal can provide you with early access to a portion of your retirement assets, freeing you to manage them as you wish. If you’re uncomfortable with the investment choices in your 401(k), you might be wondering how some of those assets would do in other kinds of investments, especially those with less risk exposure. 

Understanding In-Service Withdrawal 

This very question has led some people to withdraw assets from qualified retirement plans such as 401(k)s and direct them elsewhere.  

In some cases, you will want to consider rolling over the balance into an IRA. Doing this without changing jobs is called an in-service rollover. This may give you a broader variety of investment options than your workplace plan. Not all plans offer the option, though. Some may, for instance, have special requirements, such as age or length of contributions. You should also consider potential problems, as well. The rollover doesn’t shut down your 401(k), but you may be limited in how you might be able to make further contributions. It’s also important to remember that your IRA may have different withdrawal rules than your 401(k) plan, so once the rollover is made, it may be a long while before it can be withdrawn.¹ 

A non-qualified annuity contract may be structured to provide tax-deferred growth for retirement or immediate income. You aren’t even required to take distributions at age 70½ (though your contributions aren’t tax-deductible.) Another nice feature: non-qualified annuities do not have annual contribution limits. There are, however, annual contribution limits on qualified annuities held within IRAs and employer-sponsored retirement plans.^2,3

Today, you can find non-qualified annuities that are structured to pay lifelong income payments. Some of these annuities may let you allocate assets across a mix of stocks, bonds, and funds through subaccounts.⁴ 

With features like these, you may be interested in these kinds of investments if you are approaching retirement age. 

Penalties

The guarantees of an annuity contract depend on the issuing company’s claims-paying ability. Annuities have contract limitations, fees, and charges, including account and administrative fees, underlying investment management fees, mortality and expense fees, and charges for optional benefits. Most annuities have surrender fees that are usually highest if you take out the money in the initial years of the annuity contract. Withdrawals and income payments are taxed as ordinary income. If a withdrawal is made prior to age 59 ½, a 10 percent federal income tax penalty may apply (unless an exception applies). 

If you are still working and pull money out of your 401(k) before age 59½, you will almost certainly pay a 10 percent early withdrawal penalty plus income taxes on the money you take out. But you might be able to make early withdrawals with the help of IRS Rule 72(t).⁵

Rule 72(t), based on life expectancy, lets you schedule fixed income withdrawals for five years or until you reach 59-1/2, whichever is longer. It lets you receive fixed, equal payments according to IRS calculations.⁵

First things first: make sure you can do this. Talk with your employee benefits officer at work, and see that the Summary Plan Description (SPD) permits non-hardship withdrawals. Talk with your financial or tax advisor to make sure it is an appropriate move for you given your overall financial strategy. If you know you’ll need more retirement income, there can be real merit to reinvesting early withdrawals from a 401(k) in vehicles that generate it.

In-Service Withdrawal vs. 401(k) Loan

In some cases, though, you may not be looking to create a withdrawal for a specific purpose or investment, such as an emergency or perhaps purchasing a primary residence. In these cases, you may be considering taking a loan from your 401(k).

The conventional wisdom about taking a loan from your 401(k) plan is often boiled down to: not unless absolutely necessary. That said, it isn’t always avoidable for everyone or in every situation. In a true emergency, if you had no alternative, the rules do allow for a loan, but they also require a fast repayment if your employment were to end. Recent legislative changes may impact the repayment terms, which would offer some flexibility to those taking the loan. Before taking out a loan, review the terms carefully.

The requirement for repaying a loan taken from your 401(k) retirement account after leaving a job was 60 days or else pay the piper when you file your income taxes. The 2017 Tax Cuts and Jobs Act changed that rule – now, the penalty only applies when you file taxes in the year that you leave your job. This also factors in extensions. So, as an example: if you were to end your employment today, the due date to repay the loan would be the tax filing deadline, which is April 15 most years or October 15 if you file an extension. Most of what transpires after a 401(k) loan still applies. Your repayment plan involves a deduction from your paycheck over a period of five years. The exception would be if you are using the loan to make a down payment on your primary residence, in which case you may have much longer to repay, provided that you are still with the same employer. You aren’t just repaying the amount you borrow, but also the interest on the loan. Depending on the plan, you’re likely to see a prime interest rate, plus one percent.⁶

How does this differ from an in-service withdrawal? Basically, you have to pay back the loan, while the in-service rollover moves the money from your tax-advantaged workplace account to your IRA, where it can be invested differently. In either event, you will want to consult with a trusted financial professional as you make the move.^1,6 

If you do take the loan or rollover, a good practice may be to continue making contributions to your 401(k) account, even as you repay the loan. Why? First, to continue building your savings. Second, to continue to take advantage of any employer matching that your workplace might offer. While taking the loan may hamper your ability to build potential gains toward your retirement, you can still take advantage of the account, and that employee match is a great opportunity.