Reasons to Consider an In-Service Distribution

Few people know that it is possible to take your money out of a 401(k) or other employer-sponsored retirement plan and continue working for the employer. The move clearly is allowed in the tax law, and many employer plans allow it. Some employees should consider taking this step.

The action is known by pension experts as an “in-service distribution.” The tax law allows rollovers and penalty-free distributions from employer plans after the employee reaches age 59½. Unlike for younger workers, there is no requirement that the worker leave the employer’s service. The worker can empty the account and stay in the same job. The account can be rolled over to an IRA. Or it can be taken as a distribution, income taxes paid, and the remainder invested. Since the worker continues with the employer, future contributions still can be made to the plan.

Many employer plans, and most large employer plans, allow in-service distributions.

This is not an all-or-nothing option. The law, and most plans, allow the employee to take an in-service distribution of less than the full account balance.

There are several reasons to consider an in-service distribution.

A middling or worse 401(k) plan is a prime reason. The plan might have high expenses or poor investment options or both.

A related reason is that the employee wants access to investments not available through the plan. Many employer plans do not offer anything other than basic stock and bond funds. Real estate, commodities, and our “hedge fund” mutual funds usually are not available through employer plans. Employer plans generally do not allow the purchase of individual stocks and bonds, or allow them only through a “brokerage window” account that can be more expensive than a discount broker.

Beginning in 2008, a 401(k) balance can be rolled over directly to a Roth IRA. You have to pay taxes on the converted amount just as with a conversion of a traditional IRA to a Roth IRA, and the $100,000 income limit still applies until 2010. But the multi-step process of 401(k) to traditional IRA to Roth IRA is not necessary. The IRS has not issued regulations on the conversions. At least some tax advisors believe that an employee can roll over only any after-tax contributions in the account and not owe any taxes on the conversion. Future earnings on the Roth eventually are distributed tax free.

An in-service distribution is not for everyone.

A good 401(k) plan is worth staying in. Some plans have access to institutional funds not available to individual investors that charge very low fees or have other benefits. In addition, loans can be taken from 401(k) plans but cannot be taken from IRAs.

Employer stock in a retirement plan should not be rolled into an IRA. Special taxes breaks are available at retirement if the stock is distributed to a taxable account and various conditions are met. We covered this strategy in the November 2007 issue. Do not move employer stock in a plan without consulting a tax advisor.