Rule Changes For In-Service 401(k) Rollovers

RULES CHANGES FOR IN-SERVICE 401(k) ROLLOVERS

401(k)-to-Roth rollovers are now possible before age 59½.

 

There is a  new possibility in the world of the 401k. Sometimes employees want to pull money out of a 401(k) before they retire. It isn’t always because of an emergency. Some workers want to make an in-service non-hardship withdrawal just to roll their 401(k) assets into an IRA. Why? Often times they see substantial lower account fees and in almost every case, IRAs provide greater investment choices ahead.

As a result of the Tax Increase Prevention Reconciliation Act (or TIPRA), tax laws now permit in-service non-hardship withdrawals from 401(k), 403(b) and 457 plans to traditional IRAs and Roth IRAs before age 59½. Of course, the 401k plan has to allow for the employee to take a distribution from the plan, and the funds have to be eligible for a direct IRA rollover.¹

This option may be very interesting to highly compensated employees who want the tax benefits of a Roth IRA. The income limits that prevented them from having a Roth IRA have been repealed, and they may have sizable 401(k) account balances. With this option, they can take part or all of their sizeable 401k funds and move it into a Roth IRA.

So does your plan allow for the withdrawal? Good question. If a company’s 401(k) plan has been customized, it may allow an in-service withdrawal for an IRA rollover. If the plan is pretty boilerplate, it may not.

The five-year/two-year rule also has to be satisfied. IRS Revenue Ruling 68-24 says that for an in-service withdrawal from a qualified retirement plan to take place, an employee has to have been a plan participant for five years or the funds have to have been in the plan for two years.²

Does the Summary Plan Description (or SPD) on your company’s 401(k) plan allow non-hardship withdrawals? If it doesn’t, it may need to be customized to do so. This year, plan administrators nationwide are fielding employee questions about rollovers to Roth IRAs.

401(k) plan participants need to make sure the plan permits this. An Request a copy of the SPD. If you ask and no one seems to know where it is, then call the toll-free number on your monthly 401(k) statement and ask a live person if in-service, non-hardship withdrawal distributions are an option. In some 401(k)s, an in-service non-hardship withdrawal will prevent you from further participation; be sure to check on that as well.

If this is permissible and you want to make the move, you better make an IRA rollover with the assets withdrawn. If you don’t, that distribution out of your qualified retirement plan will be slapped with a 20% federal withholding tax and you still have to pay federal and state income taxes. Oh yes, you will also incur the 10% early withdrawal penalty if you are younger than age 59½. Additionally, if you have taken a loan from your 401(k), any in-service withdrawal might cause it to be characterized as a taxable distribution in the eyes of the IRS.³

Obviously, this IRA rollover possibility is not a big hit with the national and regional retirement plan providers, who would like to see you keep participating in their 401(k) programs rather than partly or fully bail out. But many employees would like a broader and more diverse range of investment options -- and some would like the chance to direct their money into vehicles designed to produce future income streams.

Plan administrators and participants should talk to a financial consultant that understands the unique changes that have recently transpired in the 401k arena. If you don’t know who to turn to, I respectfully suggest me. Give me a call or shoot me over an email.

Citations.

¹ articles.sun-sentinel.com/2009-08-16/business/0908140293_1_roth-ira-roth-conversions-simple-ira [8/16/09]

² smbhr.benefitnews.com/news/rolling-the-dice-with-a-roth-ira-rollover-2682826-1.html [1/22/10]

³ macpa.org/Content/22372.aspx [2/1/10]