In-service rollovers are poorly understood by both plan sponsors and participants. A 401(k) plan must specifically allow for this feature. Greater desire for asset allocation and diversification has highlighted the risks associated with having a majority of a participant’s retirement assets with just one plan and one company stock. An in-service rollover may help you diversify the assets you have in an employer-sponsored retirement plan.
We will start with a detailed overview of in-service rollovers. Then we’ll discuss some of the advantages and disadvantages of a nonhardship in-service rollover. Finally, we will review a case study illustrating many of the issues associated with in-service rollovers.
How In-Service Rollovers Work
An in-service rollover is a nonhardship withdrawal and there is no need to prove anything in order to take it. However, an employer-sponsored retirement plan will generally restrict the withdrawal amount.
Keep in mind that not all employer-sponsored plans allow for in-service withdrawals. Profit-sharing plans and 401(k)s may allow them, but money purchase pension and defined benefit plans do not.
An in-service rollover meands that the proceeds are directly rolled to another eligible retirement plan (Rollover IRA). Therefore, the money is not subject to ordinary income tax nor a 10% federal tax penalty if taken before age 59½.
Individuals that decide to convert their in-service rollover amount to a Roth IRA can move the dollars directly into a Roth IRA. Since this would be considered a Roth IRA conversion, it will be subject to income tax, but not the 10% early distribution penalty.
Possible Plan Restrictions on In-Service Rollovers
Now that you know how in-service rollovers work, let’s take a look at some of the plan rules that may apply to these types of withdrawals.
First, there may be restrictions on which assets within the retirement plan are available for withdrawal. Other common restrictions address the frequency and amount of the withdrawals, and the possible suspension of the employees’ ability to participate and receive an employer match on contributions.
Finally, the retirement plan may require that its own specific forms be utilized to request these withdrawals. Participants are encouraged to contact their employers’ benefits department for further details.
Before we discuss which assets can be withdrawn, let’s examine which assets cannot be withdrawn. In general, in-service rollovers:
- Do not allow access to participant contributions (elective salary deferral) until a triggering event has been met, such as leaving the job, reaching retirement age, death, or disability.
- Do not allow access to the non-vested employer contributions.
- For employees with less than five years of participation, the employer contributions must have been held for two or more years prior to withdrawal. This is also known as the “two-year bake” rule.
- The “two-year bake” rule does not apply if the employee has been a participant for five years or more.
Advantages of In-Service Rollovers
There are several advantages to participants requesting an in-service rollover distribution.
- Wider array of investments
- Greater distribution options
- Not subject to 20% mandatory tax withholding on distributions
The first advantage is a wider array of investment options. CDs, stocks, bonds, and other investment options can be used inside of an IRA. IRAs and qualified plans—such as 401(k)s and 403(b)s—are already tax-deferred. Therefore, if an annuity is used to fund an IRA there needs to be a compelling benefit from the annuity’s features other than tax deferral. These features can include lifetime income, death benefit options, and the ability to transfer among investment options without sales or withdrawal charges.
Also, many employer-sponsored plans offer a fixed annuity as a retirement distribution option. Employees who do not want an annuity income stream may prefer other methods of distribution. By rolling retirement assets into an IRA, clients will have more control and flexibility regarding their distribution options. In addition, distributions from an IRA will not be subject to the 20% mandatory tax withholding that typically applies to distributions from employer-sponsored 401(k) plans.
Disadvantages of In-Service Rollovers
Disadvantages of in-service rollovers include a potential loss of:
- Exception to 10% penalty if separated from service after attainment of age 55 and older
- Loans from an IRA are not allowed
- Ability to delay required minimum distributions (RMDs) beyond age 70 ½
- Tax advantages using net unrealized appreciation (NUA) strategy
- Inherited Roth IRA to beneficiaries
If a participant has attained age 55 and older, and then separates from service, they can take distributions from employer-sponsored plans that will not be subject to the 10% early distribution penalty. With IRAs, this option is not available.
Most employer-sponsored plans offer a loan feature. Withdrawals will reduce the available loan amount that may be taken in the future. IRAs do not allow for participant loans.
Employer-sponsored retirement plans may permit participants who are still working beyond age 70½ to delay taking required minimum distributions (RMDs) until they retire. This option is not available to participants who own 5% or more of the business. Again, this option is not available with IRAs.
Net unrealized appreciation (NUA) is not available for nonhardship in-service withdrawals. For a participant to qualify for NUA, he or she must take a lump-sump distribution from the plan. In addition, this type of withdrawal may potentially reduce the future amount that may be eligible for NUA treatment.
Beneficiaries of employer sponsored retirement plans can also choose to set up inherited Roth IRAs as long as they are willing to pay the income tax. This option is not permitted for beneficiaries of IRAs, since they are limited to setting up inherited IRAs only.
In-Service Rollovers–A Case Study
John has been an employee of XYZ Company for more than 20 years and has been participating in the company’s 401(k) plan. Over the years, XYZ has made matching employer contributions in the form of employer stock. The total value of his 401(k) account is $500,000, and $350,000 of the total consists of XYZ stock.
As John’s employer has experienced some difficult times over the past few years, John is concerned that the majority of his retirement plan is allocated in shares of XYZ stock.
John learns that he may be able to diversify the stock portion of his 401(k) account without affecting the benefits of tax deferral or paying any penalties and/or taxes. John may be able to accomplish this by requesting a nonhardship in-service withdrawal and rolling the proceeds directly to an IRA. Once he has completed the in-service rollover, John has the flexibility to diversify his investment holdings and depending upon his IRA provider, may be able to better protect his investment principal.
In-Service Rollovers–A Good Idea?
Before a plan sponsor allows in-service rollovers to be added to a retirement plan or a participant decides to take one, careful consideration is needed. This article helps to illustrate several of the potential advantages as well as disadvantes of an in-service withdrawal to a Rollover IRA. For more information, please feel free to contact us, your 401(k) Advisor.
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