In-Service Withdrawal: The Law and The Plan Rules

It’s a sad fact many 401k plans are bad: the investment choices are poor; the fees are high. People naturally ask if there’s a way to take the money out of the plan to their own account. We all know when you leave your job, you can. It’s called a 401k rollover. In most cases you should do a rollover as soon as you leave.

Can you take money out without leaving your job? Some plans do allow it. It’s called an "in-service withdrawal" or an "in-service distribution." In-service means you are still working for the employer sponsoring the plan. Because some plans allow it, a common suggestion is "ask your plan administrator."

It’s a little more complicated than that.

401k plans must follow the law. The law allows certain things and prohibits certain things. A plan can be more restrictive than the law but a plan can’t be more liberal than the law. If the law allows something, the plan can allow it but the plan doesn’t have to allow it. If the law prohibits something, there is no way a plan can allow it.

So you first have to understand what the law allows and what the law prohibits. If the law doesn’t allow it, don’t waste time asking your plan administrator. If the law allows it, do ask. Maybe your plan allows it; maybe it doesn’t.

When it comes to rolling over money from a 401k plan while still working for the employer, the law allows rolling over:

  • Employer contributions: match, profit sharing
  • Employee after-tax (not Roth) contributions
  • Employee pre-tax and Roth contributions only if the employee reaches age 59-1/2

If the plan cooperates, it’s possible to roll over money in the three buckets above. If you are already over 59-1/2, or if you want to take out the employer match, or if you made after-tax contributions, it’s worth inquiring if your plan allows in-service distributions.

Note after-tax contributions are not the same as Roth 401k contributions. Unlike Roth 401k contributions, earnings on after-tax contributions are still taxed. Not all plans allow after-tax contributions to begin with, let alone withdrawing those contributions in-service. If you are lucky enough to have a plan that allows after-tax contributions AND in-service withdrawal of such after-tax contributions, the money can be rolled into a Roth IRA. It’s a great way to transform after-tax savings into a Roth IRA.

The law prohibits rolling over these contributions from a plan while the employee is still working for the employer:

  • Employer safe harbor match or safe harbor nonelective contributions
  • Employee pre-tax or Roth contributions before the employee reaches age 59-1/2

Unfortunately most people are going after the last category: employee pre-tax or Roth contributions before reaching age 59-1/2. The law doesn’t allow it. No dice. Don’t bother asking your employer or 401k plan administrator.

Why does the law lock you into an employer plan? The official justification is that the government wants to make sure your retirement savings are saved until retirement and not squandered away before then. But why do you gain the right to squander it away when you change jobs? Because they want to give you an opportunity to consolidate your savings. If you are smart enough to protect your retirement savings when you change jobs, you’d think you are smart enough to protect it at other times too.

Allowing one rollover per year would breathe competition into the 401k world. Instead, we have regulators dancing on the margins about beefing up fee disclosures. Sure it helps adding some pressure to employers and service providers when the fees are out in the open, but disclosed high fees are still high fees. If people don’t have a way out, it adds insult to the injury.

See All Your Accounts In One Place

Track your net worth, asset allocation, and portfolio performance with free financial tools from Personal Capital.

FREE E-mail Newsletter

Join over 3,000 readers and get new articles by e-mail:

No spam. Unsubscribe any time.

Comments

  1. edward says

    TFB, just as an opinion, would you be happy with your employer plan if it was a Fido one that included brokerage link? It’s not the full spectrum of investment choices, but still a vast improvement over what I had during most of my prior 401k experience, and probably adequate for most people. At least I can now buy those TIPS :) ! Still, I declined to rollover my existing balance into the new 401k.

  2. Andy says

    My employer plan is awful. All the equity options have expense ratio around 1.3-1.5%, and the bond options also have expense ratio close to 1%. All petition for change has fallen on deaf ears.

    I figure that I won’t work for this company forever though, so I think I would still be better off getting the money into a tax-sheltered location, and then move them out to a rollover IRA when I change job.

  3. Wm Tanksley says

    I have a hard time reading discussions of Roth rules, but I seem to recall a rule that says it’s permitted to withdraw contributions at any time: because it’s already taxed, it’s not controlled.

    So if it’s Roth, you CAN get it out — but the result will be plain old cash, not any kind of protected account, and the only way to get it back under a tax advantaged shield is to contribute it, and thus use up some of this year’s permitted contribution. (Of course, you can always buy something that you don’t expect to have to be taxed on for a long time, such as a very stable stock or commodity; that’s an effective tax shield, if you can find it.)

    Am I reading this wrong? It seems like this is a decent point to bring up in this discussion.

    -Wm

  4. bob says

    You want to know why the law is this way. It is because it was drafted by lobbyists. Naturally the investment banks and financial entities who keep your money want it this way. Everyone gets upset when the “government” controls your money, but I don’t hear a peep when private companies do the same thing. Private companies are even worse than the government because they have a profit motive so they do their very best to screw you.

  5. Harry Sit says

    @Wm Tanksley – Roth IRA and Roth 401k have different rules. You can withdraw your original contributions from a Roth IRA before age 59-1/2 without penalty. You can’t withdraw your contributions to a Roth 401k before 59-1/2 while still working for the same employer.

  6. Harry Sit says

    @edward – I would be very happy with a Fidelity plan with a brokerage link, if the brokerage link doesn’t have a huge annual fee (< $100). It'll be way above an average 401k plan and better than the one from my own employer.

  7. Wm Tanksley says

    Thank you, TFB; you’re right to correct me (the rules ARE different), but as far as I can find the IRS isn’t as strict as you describe. You can withdraw, but you have to pay the same 10% penalty for a “nonqualified withdrawal”. Probably not worth it for people merely seeking a bit simpler management. The only upside is that unlike a standard 401k, Roth 401ks charge the 10% tax only on growth, not on contributions. The major difference from an individual Roth IRA is that the IRS computes the 10% tax based on how much your entire account has grown; you are taxed EVERY time you make a withdrawal, rather than saving all the taxes until the last (and possibly evading them if you withdraw less than your deposits prior to retirement age).

  8. Harry Sit says

    @Wm Tanksley – Even nonqualified distributions from Roth 401k have to meet certain requirements (for example hardship). You can’t just withdraw at will, like you do from a Roth IRA. Hardship withdrawals can’t be rolled over. See this IRS FAQ:

    “Since an employee makes designated Roth contributions from after-tax income, can the employee make tax-free withdrawals from his or her designated Roth account at any time?

    “No, the same restrictions on withdrawals that apply to pre-tax elective contributions also apply to designated Roth contributions. If a plan permits distributions from 401(k) or 403(b) accounts because of hardship, an employee may choose to receive a hardship distribution from his or her designated Roth account. The hardship distribution will consist of a pro-rata share of earnings and basis and the earnings portion will be included in gross income unless the employee has had the designated Roth account for 5 years and is either disabled or over age 59 ½.”

  9. Wm Tanksley says

    TFB – the article you linked to is extremely hard to read, and it’s omitting important information — but it agrees with what I said: the paragraph just above the one you quoted says that even nonqualified distributions may be made, and are subject to income tax ONLY on the gains. (The reason I suspect this is omitting something is that it mentioned nothing about the 10% penalty on early distributions.)

    The same page (just below) also discusses how to handle rollovers, but at this point I’m starting to wonder whether I’m paranoid, because there’s SO much they’re not saying about when one can rollover it would be financial suicide to use that page as a guide.

    BTW, my Vanguard 401k allows cash distributions at any time from both Roth and standard, as does Schwab’s. They won’t pay your taxes for you, but they’ll hand over the cash.

    -Wm

  10. Harry Sit says

    @Wm Tanksley – Sorry about the IRS page being hard to read. I didn’t write it. :) When it comes to withdrawing from Roth 401k, there are three related but distinct issues:

    1) When are you allowed to withdraw from a Roth 401k account, regardless of tax consequences?

    By law, one of these: termination of employment; age 59-1/2; death; disability; financial hardship, plan termination. Plan rules: further restrictions possible.

    2) *If* you are allowed to withdraw from a Roth 401k, how are you taxed on the withdrawal?

    No tax if the withdrawal is qualified: five-year rule AND (59-1/2 or death or disability). Tax on earnings if the withdrawal isn’t qualified. Partial withdrawals are prorated (not treated as contributions first as in a Roth IRA).

    3) If a withdrawal from a Roth 401k is not qualified, do you also owe a 10% early withdrawal penalty?

    Yes if the withdrawal is before age 59-1/2 and it doesn’t meet one of the exceptions: death, disability, termination of employment after age 55, QDRO, medical expenses exceeding X% of AGI, substantially equal payments. 10% penalty is only on the taxable amount, i.e. earnings.

    Because you said your plans let you withdraw at any time, I’m guessing you are over 59-1/2. It’s consistent with what I wrote in the post.

  11. Wm Tanksley says

    I’m a mere 36 years old… A better hypothesis would be that Vanguard doesn’t care if I get hauled in front of tax court :-). But I don’t think either is correct.

    My complaint about the IRS page isn’t because I don’t understand it (and I wasn’t trying to complain about it, by the way; I’m glad you pointed to it); it’s because it’s _actually_ incomplete, for example almost completely missing information about the 10% penalties (it only mentions them in one very special context, even though we both know that they apply many other times — almost any time income taxes apply).

    From what I can see, there’s no legal bar to withdrawing before age 59 1/2; it’s never actually prohibited (do you see a prohibition?). You’ll simply have to pay taxes and penalty on the part that’s attributable to earnings. And that’s pretty much what happens in a Roth IRA as well (albeit the IRA lets you control taxes better).

    Note that your own message agrees with me in the next-to-last paragraph: you say it IS possible to withdraw before 59 1/2 AND without meeting the definition of a qualified withdrawal. The IRS defines exactly what happens when you withdraw before 5 years of holding and before 59 1/2, and it’s not particularly punitive. Clearly if the IRS defines the consequences of doing something it permits doing that thing.

    On the other hand, it’s also clear that the IRS permits a provider to deny a worker access to 401k funds, unless the worker convinces the provider of hardship. The provider doesn’t have to prove the hardship to the IRS; Congress and/or the IRS wanted to allow providers to lock funds in the accounts, but didn’t want to COMPLETELY lock the funds away. That’s the only function of the hardship clauses.

    -Wm

  12. Harry Sit says

    @Wm Tanksley – The legal bar is in the “one of these” link in my previous comment.

    General Distribution Rules

    The rules for whether you are allowed to withdraw, regardless of tax consequences, are the same for pre-tax 401k and Roth 401k. This is confirmed by the bold sentence I quoted from the IRS page before.

    It’s possible to withdraw before 59-1/2 but it has to be one of the permitted reasons. Termination of employment is the most common. Death, disability, and financial hardship are other less common permitted reasons.

    Since you are under 59-1/2, have you left the employers behind the Vanguard and Schwab 401k plans? If so, that’s why they let you withdraw at any time without documenting death, disability, or financial hardship. This post discusses in-service withdrawals. In-service means you are still working for the same employer sponsoring the plan.

    Or maybe you have been talking about hardship withdrawals all along. Yes, hardship withdrawals are allowed at any time. However, hardship must be documented and approved. The plan also has to suspend your contributions for 12 months. Not a good way to take money out of the plan.

  13. Wm Tanksley says

    Thank you again, for spending all this time on me.

    I’ve spent a good deal of time digging for info, and I can’t find anything clear on this; I’m FINALLY going to accept what you’ve been saying all along (sorry). I’m going to suspect that the pages that said otherwise were simply confusing IRA and 401k.

    So — anyone reading this — TFB is right.

    -Wm

  14. Brian says

    TFB,

    My employer allows for in-service withdrawals of after-tax 401k contributions and the associated earnings once a year. I am now starting to max out my after-tax contributions as well as my pre-tax contributions with the plan of rolling over the after-tax money and its earnings every year to my Roth.

    Since the earnings on the after-tax contributions are considered pre-tax, I just have to pay ordinary incomes tax on those earnings when I roll it over to a Roth, right?

    Are there any other watch-outs when making an in-service rollover of after-tax contributions to a Roth?

  15. Harry Sit says

    @Brian – If you are OK with paying tax on the earnings for one year, rolling over from the plan to a Roth IRA is straight forward. You get a 1099-R from your plan administrator. It will tell you how much of the distribution is taxable. You pay ordinary income tax on that (no 10% penalty), and it’s a done deal.

    If the earnings are substantial, you can be more fancy and roll over to a traditional IRA instead of a Roth IRA. Roll the earnings (together with all your other pre-tax IRA money) back into the plan and convert only the after-tax portion to Roth. But if it’s only one year worth of earnings, I don’t think it’s worth the fancy legwork.

  16. FFH says

    My 401(k) stinks.
    Would like to roll-over to T-IRA (private, self-directed) for better returns without quitting job.

    It seems unreasonable, if not insane, that the law would prohibit me from doing so while staying with the current employer.

    Note:
    I’m talking about the law (DoL, IRS), not the plan.

    I see 2 options:
    - Change the law to allow for in-service rollover, ie. once a year, maybe during open-enrollment season (direct rollover, trustee-to-trustee, ….)
    - Make available an option for direct deposit from company payroll to private pre-tax accounts (“T-IRA”, “private 401k” or whatever) based on employee’s choosing, bypassing the company’s 401k.

    (I’m talking all pre-tax here. No Roth involved)

    Anybody up for filing a petition?

  17. Wm Tanksley says

    FFH, I have no problem with that — sign me up. I doubt we’ll get anything in the current regulatory climate; Dems hate individual accounts (look what they did to HSAs for no particular reason) and Repubs have way more problems.

    With that said, are you maximizing your IRA contribution? It’s better to start than not to!

    -Wm

  18. FFH says

    Wm Tanksley:
    I’m maxing out Roth each year.
    That cancels out T-IRA contribution ($5K combined max.),
    leaving 401k as the only other remaining (tax-deferred / exempt) vehicle.

    Obama was pretty big on 401k savings lately – keyword “auto-enrollment”.
    Seems strange to be forced into a crappy 401k plan, legally, without having an option to rollover the money to a better / private investment facility WHILE you work there….

    What’s the reasoning behind all this nonsense, anyway ?

  19. Wm Tanksley says

    FFH, there are lawmakers who have started to ponder consolidating all the different retirement accounts, but I’m not extremely hopeful anytime soon. The rationale for keeping it the same appears to be that 401k’s are good for “wealthy” people, and many lawmakers want to avoid giving more benefits to the wealthy than they give to the poor. (This holds true even if the change would leave the poor better off than they were.)

    -Wm

  20. David says

    >>>Allowing one rollover per year would breathe competition into the 401k world<<<

    Getting rid of employer plans and not taxing *any* savings plan would breathe competition into retirement planning, give them more control over their savings, make them more responsible, and give people back the rights to what they've earned.

  21. Jim Stiekes says

    more info please on straight in service withdrawals, not rollovers or transfers. Which laws apply? What are the limitations? If I took one last year, why can’t I take anotehr this year?

  22. Harry Sit says

    @Jim Stiekes – The same laws and the same limitations. It doesn’t matter whether you rollover the withdrawal. If the law allows, the plan doesn’t have to allow. If the law doesn’t allow, the plan can’t allow it. The law doesn’t limit the *number* of in-service withdrawals. Your plan can place a limit.

  23. Brian F says

    I am thinking about an in-service after-tax withdrawal to help purchase a new home. If I withdraw the eligible amount now and it turns out I do not need the entire amount, can I put back the remainder after closing?

  24. S says

    My company had give me rollover check from my 401K, which I had rolled over into IRA. I am still employed by this company. The company was acquired by another company last year and the new company want 401K in their plan, which was expensive. So we ask to rollover, so they provide us the check to roll over. Now they are asking for reverse that transaction. Can they force me ? What happen if I don’t

  25. Harry Sit says

    S – Yes they can force you if you weren’t eligible for a rollover to begin with. I wouldn’t mess with the employer on this.

  26. BBeck says

    TFB – thank you for the article and comments.

    In regards to in-service withdrawals/rollovers from 401k for pre-59.5 . . . .where can I find the specific govt reference. Is it posted on either irs.gov or erisa website? Thank you

  27. Michelle Morris says

    Dear TFB,

    I really enjoy your posts- keep up the good work!

    Do you know if these same rules apply to 403(b) plans?

    Thank-you,
    Michelle

    • Harry Sit says

      Yes the same rules apply with regard to an employee’s own contributions and earnings on those contributions. With regard to the employer’s contributions and the earnings, there is a further limit if the 403b is set up as a custodial account as opposed to an annuity contract.

  28. Jackson T says

    I have a plan for my small business and found myself having to find a new administrator a few years ago. My previous administrator did not follow the inservice distribution rules and distributions were occurring that should not have been. I had to find a new administrator willing to fix the errors at an affordable price. My new administrator took over and walked me through the Voluntary Compliance Program and the plan is now operating according to the rules. I highly recommend using a TPA with knowledge, experience and a proven track record.

  29. Paul Gipple says

    I was told this in a business seminar last weekend. If you have a 401k (pre tax) plan at your work and are currently employed with said employer and are 100% vested you can request an inservice transfer of funds to a qualified program of your choice. If my employer program does not have an inservice transfer clause they can ask the program provider to create one. Once the employer asks, the provider must comply. Is this true? Thanks…..

  30. Gary wowman says

    I have had a Roth 401k with Vanguard through my employer for several years with the usual standard before tax 401k company match. I am old enough to retire and Vanguard notified me that if I remove my money they will keep several thousand dollars to cover the taxes that were not paid by my companies matching contributions. Is this standard practice? Why can’t I get it all and pay the taxes myself?
    Thanks.
    Gary

  31. Harry says

    Gary – If you take the pretax money out as a check paid to you, the law requires a 20% withholding. It’s best to do a rollover from the 401k to an IRA. Then you can take money from your IRA on your own schedule.

  32. Ravi says

    Hmmm, I am not sure about the statement “law prohibits rolling over these contributions from a plan while the employee is still working for the employer: … Employee pre-tax or Roth contributions before the employee reaches age 59-1/2″

    This Merill Lynch article seems to contradict it:

    “Some companies allow active employees participating in a qualified employer retirement plan to withdraw a portion of their plan’s account balance upon request, without demonstrating a specific financial need”

    It says that any of these funds are eligible for in-service withdrawal:
    - After-tax contributions, plus earnings
    - Rollover amounts, plus earnings
    - Company match contributions, plus earnings
    - Before-tax contributions, plus earnings (if you
    are disabled or have reached age 591/2)

    • Harry says

      If you are pointing out that I left out the “disabled” exception to before-tax contributions, thank you. Becoming disabled and still working for the same employer would be a corner case. Otherwise I don’t see where it contradicts. The article already pointed out that after-tax contributions are not the same as Roth contributions. Rollover amounts refer to money you rolled into the plan. If you have a bad plan, and you are looking for ways to take money out, you wouldn’t roll money into the plan.

  33. Ravi says

    Harry,
    I was not referring to the disabled exception.
    I was taking about rolling over a portion of the vested funds (for e.x., employee contributions) from an 401k plan to a Rollover IRA while still being employed at the employer.

    PS: How do I hit “Reply” to a “Reply” to stay in the same thread?

    • Harry says

      Ravi, I limited the nested level to 2 to keep it readable. Otherwise the paragraphs will get very narrow. Just reply to the first comment that started the thread (your #33).

      Where do see the contradiction from the Merrill Lynch article then? It also said you can’t roll over before-tax contributions and their earnings while still working for the employer until you are 59-1/2 or you become disabled.

Leave a Reply

Your email address will not be published. Required fields are marked *