Question of the week: What is an In-Service Distribution and do I want one?

A common question at my workshops.

What is an in-service distribution and do I want


Before we examine this question, let’s go to Investopedia for a definition.

An In-Service Distribution is a withdrawal made from a qualified plan account before the holder experiences a triggering event. A triggering event, such as reaching a certain age, or leaving an employer, is often needed to be able to withdraw funds from a plan, such as a 401(k).

I know it sounds kind of complicated and it is...(Sorry!)

The topic of In-service distributions becomes relevant when the account-holder still works at the company where the account is held. Some plans allow this distribution while others do not so it’s best to consult your plan documents to see where you fall.

Sadly, just because IRS regulations allow for you to take an in-service distribution, this doesn’t necessarily mean that the plan rules will allow it. There is no requirement for an employer-sponsored retirement plan to permit in-service distributions. I’ve seen it both ways and it’s best to check with your HR people or retirement plan administrator to determine if in-service distributions might be available for you and under what situations they are permitted.

My purpose here is to answer a question I get from people who have either achieved age 59 1/2 or have a plan that allows them to do an in-service distribution.

Should I do one?

As with everything else in the investment universe, there are pros and cons.

Here are some of the advantages:

Diversification: By rolling the distribution into an individual retirement account you may have a wider range of options for investment. For those clients wishing to limit exposure to the stock market and to bonds this could be quite beneficial as many employer plans lack options other than stock and bond funds. On the subject of bond funds and lack of choice, many employer plans only have one bond fund. For better or worse if you desire some fixed income exposure, you’re sort of at the mercy of whomever picks the funds.

Control: As the owner of the IRA, you can determine which investments to include and the timing of making investments, which can be restricted inside of an employer retirement account. This is similar to the point above, but there is a lot to be said about being able to control your own destiny.

One of the biggest mistakes people make is in trusting their employer to take care of their retirement, or more accurately, believing the employer provided the best retirement plan possible. Most often, the retirement plan you have was never meant to be the best, merely, the cheapest. Maybe that’s a bit cynical but I ran a business that had a 401K plan. We wanted to help, but we also wanted to keep costs down.

Beneficiary Options: Generally speaking, the options available for non-spouse beneficiaries of an IRA are typically much more liberal than the options available to a non-spouse beneficiary inside of an employer retirement plan.

Professional management: It is normally much easier to find a professional money manager for individual retirement account. The limited options available inside of an employer plan makes it more difficult for a professional manager to provide adequate diversification. Sadly, investors are typically quite bad at, well, investing. (If you don’t believe me Google the term Dalbar and you’ll quickly learn that the average stock investor doesn’t do nearly as well as the average stock fund.)

Lower costs: Another reason to consider an in-service rollover is to escape a bad plan that has higher-than-normal expenses. Some plans have annual fees with their investment options that are way above average and if you’re stuck in one of those, you can reduce costs by rolling your 401(k) money into an IRA with a lower-cost fund company.

Interestingly, 71% of people (2011 study by AARP) think they pay no fees. Which is kind of RIDICULOUS! (Financial firms don’t do things for free!)

Transparency: IRAs offer more transparency. The problem with lack of transparency in 401K’s has become so big that the department of labor has recently come out with a set of fiduciary rules for 401K plan providers in order to make them more transparent. If steps like this are necessary, then you know there’s a problem.

Now some disadvantages:

Age limitation: As I mentioned above, you must be 59 1/2; years old in order to take an in-service distribution and not be subject to a 10% penalty by the Internal Revenue Service. (This is not as much a disadvantage as it is a black or white issue. Either your old enough or not but, certainly, it would be a huge disadvantage if you were forced to pay the penalty.)

Creditor protection: Employer retirement plans may have more protection than an individual retirement account for claims by your creditors. (Consult a bankruptcy attorney to be sure but, generally speaking, you’re afforded greater protection from creditors with an employer-held retirement plan. IRAs have some protection but that number is capped. There are also differences when it comes to the IRA and other parties to a bankruptcy proceeding.xs)

Investment expenses: Your employer’s plan may have lower investment costs than your individual retirement account and, over a number of years, any difference in the investment expenses can become a material factor for you to consider. (You’ll notice that this concept is covered above in advantages but it can go the other way just the same. It just depends on the specifics of your particular plan. Some plans are rip-offs...)

Loans: Some employer plans allow for loans from your account balance. You cannot take a loan from an individual retirement account although there are some situations where a withdrawal is allowed.. This may be important in a case of hardship. If need be (with an employer plan), you can take out a loan or a hardship withdrawal from your 401(k), but, as I mentioned, it’s treated differently with an IRA. (Note: It’s rarely a good idea to take a loan from your 401K and I’ll cover why in a future post.)

As with anything else you should check with a tax professional if you’re considering an in-service distribution. To be sure, an in-service rollover from your employer’s retirement plan into an individual retirement account can be a useful option in the right circumstances but it might not be the fit for your scenario and if it is not done properly, it can become a taxable transaction.

It should also be pointed out that in qualified plans, the age-55 rule allows participants who stop working at age 55 or older to take distributions without having to endure the 10% IRS premature distribution penalty. This may tip the scales in your favor if you want to roll the money over.

Two paragraphs of caution:

When somebody tells you an IRA is free of expenses – RUN!

The Government Accountability Office (GAO) reported in 2013 that seven of the 30 largest 401 (K) service providers told undercover investigators that their firms’ IRAs were FREE – without divulging that these investments had transaction fees and other expenses. Generally speaking, I advise my clients to convert to an IRA, but if it seems too good to be true, it probably is.

Make sure you do the distribution correctly!

A final word of caution: If you do the in-service distribution, make sure you do it correctly. There is a 60-day window for account holders to move their money into an IRA after withdrawing it from their 401(k). This can be accomplished either by a direct transfer from your 401(k) plan to the IRA or by having the money sent to you for deposit into your IRA. In some cases, you can take the distribution and move the money yourself but this is not advised. The simplest, easiest and quickest way is a trustee-to-trustee transfer and your plan administrator will have the forms.

Always remember that failure to meet this 60-day window will typically trigger regular income taxes on every dollar, plus a 10 percent early distribution penalty if you are under age 59½. And that’s no way to make your money last!

That’s just the way it works!

Required disclosures: Investment advisory services offered through Brookstone Capital Management, LLC (BCM), a registered investment advisor. BCM and (Strataxa Retirement Advisors, LLC) are independent of each other. Insurance products and services are not offered through BCM but are offered and sold through individually licensed and appointed agents.

Information provided is not intended as tax or legal advice, and should not be relied on as such. You are encouraged to seek tax or legal advice from an independent professional