By Greg Storen
A client recently walked into my office and placed his 401(k) statement on my desk. He looked at me, pointed to the document and asked, "Can I bombproof my 401(k)?" We reviewed his statement, investment options and expenses, then considered his ability to lower risk inside the 401(k).
Unimpressed, his next question was, "Is there anything else I can do?" I hesitated for a moment, then asked him if he'd ever considered an In-Service Distribution. He looked at me with a blank stare that immediately let me know he had no idea what I was talking about.
Many employees diligently focus their energy on accumulating assets into their Employee Retirement Income Security Act 401(k) or 403(b) employer plans. But, they don't take the time to understand all the associated rules; specifically, in-service distributions and other options those plans may afford to them as they approach retirement age.
Most employees are aware they have the option to roll their employer plan over to an Individual Retirement Arrangement (IRA) when they retire. However, very few know that they can take a distribution from the plan while they're still employed with the company. The employee must be over the age of 59.5 to access the majority of their funds, and the fact that the Employee Retirement Income Security Act of 1974 (ERISA) may allow for such a distribution doesn't necessarily mean your employer's plan permits it.
Rollover while you are still employed
The In-Service Distribution allows you to initiate a tax-free, trustee-to-trustee rollover into an IRA while you're still employed, offering advantages heading into retirement. The rollover can be made from a traditional employer plan, a Roth employer plan or a combination plan. (If you're completing an In-Service Distribution for a Roth portion of your plan, you must be sure it rolls over to a Roth IRA.)
John Doe has been employed with ABC Widgets, Inc. for 35 years. At age 62, John is three years away from retirement and wants to decrease risk in his 401(k). John's 401(k) plan does allow for In-Service Distributions, so he decides to diversify and take advantage of this option. John and his adviser determine to allocate 35% of his 401(k) to an outside investment. They agree upon and choose a lower-cost, lower-risk fixed indexed annuity and rebalance the 401(k) in order to accomplish this goal.
Advantages and Disadvantages of In-Service Distributions
- Unlimited Control: Once you roll employer plan dollars over to your IRA, you have total control and ownership of that investment. You can choose the investment strategy and the custodian without any restrictions, including unlimited withdrawal options. Under your employer's plan, you're restricted to the investments they select and also face potential blackout periods, related fees and limited distribution options.
- Investment Diversification: If you opt to roll over your employer plan dollars, you'll be able to choose the investments you want in your IRA without being subject to the limited options of an employer plan. Or, you can use the In-Service Distribution to enjoy the best of both worlds by leaving some dollars in the employer plan and also transferring some to your IRA.
- Beneficiary Options: With employer plans, ERISA requires a spouse to be the primary beneficiary unless he/she signs paperwork to recuse himself/herself. With an IRA, you can name anyone as a beneficiary with no approval or additional signatures required. Your IRA beneficiary can be updated and changed as frequently as you like, just remember to always name a primary and a contingent beneficiary.
- Federal Tax Withholding: When you withdraw dollars from an employer plan, 20% federal withholding is required. If dollars are transferred to a rollover IRA and then withdrawn, there is no federal withholding requirement. The owner determines the federal and state withholding amounts needed, if any.
- Fees: IRA owners are able to shop and compare competitive fee pricing, which can result in savings compared to employer plan fees. My clients often say, "Oh, there are no fees in my 401(k)," but we know this isn't true. Under ERISA, Code sections 408(b) (2) and 404(a) (5) require all plan participants receive a full disclosure of fees related to their company plan, including indirect and direct compensation and services. This information helps employees make the most informed decisions.
- Bankruptcy Protection: IRA owners maintain bankruptcy protection for their IRAs up to $1,283,025. However, like the ERISA plan, the amount of IRA dollars protected in bankruptcy is unlimited if dollars are rolled over to an IRA. Creditor protection in the IRA varies from state to state; some states have unlimited creditor protection while others are limited. Make sure to research the state in which you live.
- Prefund Your Retirement IRA: Once a rollover IRA is opened, it's ready to house any additional plan dollars you contribute prior to retirement, making the transition that much easier.
- Net Unrealized Appreciation (NUA): Transferring plan assets to an IRA can disqualify an opportunity to benefit from Net Unrealized Appreciation (NUA), an option to tax gains from highly appreciated company stock at the more favorable long-term capital gains tax levels as opposed to ordinary income tax. Company stock is transferred from the company plan to a non-qualified account. Ordinary income tax is paid on the basis of the company stock, and the gain of this stock will be taxed at long-term capital gains rates when sold in the future. The ability to pay tax at the long-term rate on a portion of the plan dollars benefits the account owner.
- After-tax Dollars: Some qualified plans allow you to contribute after-tax dollars. Just be sure these monies are distributed to a Roth IRA or non-qualified account, as you don't want to co-mingle after-tax dollars with pre-tax dollars. If this happens, your CPA will be required to complete IRS tax form 8606 every year thereafter on your federal taxes to inform the IRS what amount of after-tax money is in your pre-tax IRA. It's much easier to segregate the two balances and have 100% access to your after-tax dollars.
- No Required Minimum Distributions (RMDs): Individuals are required to start taking their Required Minimum Distributions (RMDs) the year they turn 70½, or by April 1 the year following. The amount of money they must withdraw is based on the Single Life expectancy table or Joint Life expectancy table. If individuals do not take the appropriate distribution, the IRS can penalize them up to 50% of the RMD. Employees who remain working for the employer that houses their company plan do not have to take dollars out of the plan at age 70½ , and are allowed to waive the RMD until April 1 the year after they retire. Exceptions also exist for pre-1987 403B plan dollars; check your company plan for more information.
- Borrowing Availability: You may be able to take a loan from your company plan if the plan allows. You are not allowed to borrow money from a rollover IRA or contributory IRA.
Weighing the Pros and Cons
My client had a tough decision to make. His company plan offered many advantages to him as an employee, but as he learned more about IRAs and assessed his needs approaching retirement, the best choice became clear. He could remain employed and keep contributing to his employer plan, while also diversifying his assets and laying the groundwork for his future retirement plan by taking advantage of an In-Service Distribution. As we all know, the needs of each individual are unique. Understanding your company's ERISA plan, the options available to you and when they can be used can make a real difference in your personal retirement planning.
About the author: Greg Storen is president and founder of Storen Tax & Financial Group and a member of Ed Slott's Elite IRA Advisor GroupSM. For more information about this group, or to find a member near you, visit www.irahelp.com.
Storen is a Registered Representative of INVEST Financial Corporation member FINRA/SIPC, and an Investment Advisor Representative of INVEST and Brass Tax Wealth Management, registered investment advisors. INVEST and its affiliated insurance agencies offer securities, advisory services and certain insurance products. INVEST does not offer tax or legal advice, and is not affiliated with Storen Tax & Financial Group, Brass Tax Wealth Management or Ed Slott. Opinions expressed are those of the author.
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