For many people, the balance in a retirement account such as a 401(k) could be their largest asset. So, it only stands to reason that, whenever you need money for an emergency or other situation – and there is nowhere else to turn – these funds can look pretty appealing.
But should you take an in-service withdrawal while you’re still in your working years?
Before you contact your HR department and run off with a big check in your hand, there are several items to consider here – because in many ways, taking an in-service withdrawal could make a bad financial situation even worse, rather than better.
Understanding How In-Service Withdrawals Actually Work
First, it is important to have a good understanding of just exactly what an in-service withdrawal is.
What is an in-service withdrawal?
In-service withdrawals are defined as taking funds out of a qualified employer-sponsored retirement plan – such as a 401(k) plan – before experiencing a triggering event. In other words, you are still “in service” to your employer when you request these funds.
What exactly qualifies as a “triggering” event for taking an in-service withdrawal?
- Reaching age 59 ½<
- Separation from service (i.e., quitting or being terminated from employment)
- Becoming disabled
Depending on your particular situation, though, you still need to be careful when taking an in-service withdrawal from your plan. One reason for this is because you could find yourself with various fees and/or penalties on the amount you withdraw. Another is that, once you have removed money from the account, you will lose out on any future growth that you could have otherwise attained from those dollars.
Hardship-Related In-Service Withdrawals
In some cases, a retirement plan will allow an individual to take an in-service withdrawal if he or she has experienced (or is currently experiencing) various types of hardships. For instance, based on IRS rules, hardship distributions may be permitted with a person has “an immediate and heavy financial need.”
These may include situations like:
- The need for medical care
- Housing expenses (i.e., without the funds, you may be evicted or foreclosed upon and will lose your home)
- Certain education-related costs
But, even if you are in the midst of an approved hardship, you would still have to exhaust all other financial options – including securing a loan from your retirement plan – before you can take an acceptable in-service withdrawal.
So you have to ask yourself if taking an in-service withdrawal is really worth it.
Taxes and In-Service Withdrawals
In addition to various penalties that could be incurred in relation to in-service withdrawals, Uncle Sam will also benefit from these types of transactions. That’s because, in addition to the Federal income tax that is due on the amount withdrawn, if you are under the age of 59 ½ when you take an in-service withdrawal, you will also be subject to an additional 10% “early withdrawal” penalty. So, the amount that you actually net out from in-service withdrawals can be much less than the amount that you initially take out of your account.
In some instances, this 10% early withdrawal charge may be waived. For instance, if your in-service withdrawal or hardship distribution is used for covering medical expenses – and those expenses exceed 7.5% of your adjusted gross income for that year, then you may not need to pay this fee.
Likewise, if you are using your in-service withdrawal for the purpose of making a court-ordered payment to your divorced ex-spouse, and/or a child or dependent, you may also have the 10% early withdrawal penalty waived.
Looking at In-Service Withdrawals from a Different Angle
Acceptable in-service withdrawals don’t necessarily always have to be for emergencies or hardships, though. For instance, while you are still employed with your company, there are other circumstances where taking money out of your retirement plan may make sense.
Profit sharing contributions, as well as non-safe harbor employer matching contributions into the plan, can be distributed at any time, as can voluntary contributions that you have deposited into the plan.
But you still need to be careful here. In these instances, while the IRS determines how these types of distributions may or may not be taxed, there could still be other fees and/or rules that are set by the summary plan description, or in the plan document itself, that outlines these for the specific plan.
Will Taking an In-Service Withdrawal Really Be To Your Advantage?
Today, given that defined benefit pension plans have all but disappeared, there are many people who are depending on the money from their employer-sponsored 401(k) or other similar plans for some – or even all – of their future retirement income.
For that reason, along with the tax advantages that qualified retirement plans can provide, it is typically best to leave that money in place and to only take an in-service withdrawal if these funds are your last resort. That way, they can continue to grow and compound exponentially over time, until they are needed in retirement.
Not sure whether or not you should take an in-service withdrawal from your retirement plan? We can help. At Annuity Gator, we specialize in working with people who are planning ahead for income in retirement. We can take a look at where you are now financially, and where you’d like to be – and then design a path to get you there.
Feel free to reach out to us anytime here.