DEFINITION of In-Service Withdrawal
In-service withdrawals are made from qualified employer-sponsored retirement plans such as 401(k) plans before participants experience a triggering event. These events generally include reaching age 59 1/2, being terminated from employment, becoming disabled, or death. However, certain tax penalties may be levied on the amount withdrawn depending on the specifics of the distribution.
BREAKING DOWN In-Service Withdrawal
In-service withdrawals can be made in the form of hardship withdrawals if the plan allows it. The IRS permits plans to make hardship distributions when a participant displays an "immediate and heavy financial need."
Employees are automatically considered to have an immediate need if they require the money to cover certain medical care expenses, educational costs and payments needed to prevent eviction from a principal residence, as well as other conditions deemed necessary for hardship distributions by the IRS.
A plan can allow a hardship withdrawal only after the employee has exhausted all other distributions or nontaxable loans available under the plan.
Under IRS regulations, hardship distributions from a 401(k) plan are limited to an employee's elective contributions. The income these contributions accumulate generally can't be taken as a hardship withdrawal. If the plan allows, the employer's matching and discretionary contributions can be factored into a hardship distribution.
However, the total amount withdrawn can't exceed what is necessary to cover the immediate financial need as well as any applicable penalties and taxes. Employees would also not be allowed to make deferrals to their plans within six months after receiving the hardship distribution.
Tax Implications of In-Service Withdrawals
Most withdrawals made from a qualified employer-sponsored retirement plan before reaching age 59 1/2 will come with a 10% early penalty tax on the amount being distributed along with applicable federal income and state taxes. For example, say a 45-year-old individual is granted a hardship withdrawal from his 401(K) plan to help cover a $1,000 medical expense. The early withdrawal penalty alone would chip away $300 leaving him with only $700. He would also be liable for any applicable federal income and state taxes.
However, the 10% premature penalty tax can be waved if the in-service withdrawal or hardship distribution is used to cover medical expenses that exceed 7.5% of adjusted gross income (AGI) or if it is used to make a court-ordered payment to a divorced spouse, child or dependent. Other exemptions are defined by the IRS.
In addition to hardship distributions, individuals can take other types of in-service withdrawals from their employer-sponsored retirement plans while still employed with the company sponsoring the plan, and before breaching a triggering event. For example, non-safe harbor employer matching contributions and profit-sharing contributions can be distributed at any age.
An individual can also withdrawal voluntary contributions at any time. Some plans allow employees to make these after-tax contributions in order for workers to boost nest eggs and secure certain tax benefits.
Overall, however, the types and treatment of each eligible in-service distribution would be outlined in the summary plan description or the plan document itself. Specific tax details are set by the IRS.