Financial Definition of In-Service Withdrawal
In-service withdrawal, also known as early distribution, occurs when an employee takes a withdrawal of funds from a qualified employer-sponsored retirement plan while still working or before experiencing a triggering event. A triggering event is retirement at age 59 ½, disability, termination from the company, or death. If you withdraw funds from your employer-sponsored retirement account without any of these four events happening, you have made an in-service withdrawal or taken an early distribution from your retirement plan.
Making an in-service withdrawal from your employer-sponsored retirement plan is almost never advisable. In just about every case, you will be subject to taxes and penalties. Making an in-service withdrawal will also reduce the value of your retirement account, usually permanently, leaving you with less money when you retire.
Expanded Definition of In-Service Withdrawal
There are two types of employer-sponsored retirement accounts. Defined benefit accounts and defined contribution accounts are the two main types of retirement plans. Both types are covered under the Employee Retirement Income Security Act of 1974 (ERISA) which sets the minimum standards for an employer to offer a pension plan.
- Defined Benefit Retirement Accounts – These retirement plans are the pension plans that most employees used to have. They are administered by a pension fund manager. Defined benefit plans usually require the employee to contribute a percentage of their salary to their retirement account and, often, the company matches that contribution in some way. One of the biggest differences between the defined benefit and defined contribution plans is that you usually have to be vested in the defined benefit plan before you receive any benefits. You can’t draw out any money, including your own contributions until you are vested. When you retire, you get a set benefit payment per month. Defined benefit plans include many teacher's retirement plans (TRS) but they are becoming less common.
- Defined Contribution Retirement Accounts – These retirement plans are typically what is available to employees now. Defined contribution retirement plans usually require that both the employee and the employer contribute to the plan in some matching arrangement. You may also have to be vested when you have a defined contribution plan, but the vesting is different than in the defined benefit plan and may be on a schedule. You can always draw out your own funds if you have a defined contribution plan, but you can only draw out the employer’s funds according to the vesting schedule if there is one. Examples of defined contribution plans are 401(k) and 403(b) plans.·
Requirements for In-Service Withdrawals
Defined benefit plans usually prohibit taking any in-service withdrawals from them. The 401(k) and 403(b) defined contribution plans allow for in-service withdrawals under certain circumstances as determined by the Internal Revenue Service.
The first circumstance is that the need for the in-service withdrawal must be immediate and it must be a heavy financial burden. Second, the in-service withdrawal must be limited to the amount of the need. This is called a hardship in-service withdrawal. It is assumed that the employee can’t get the money from other sources like wages or other loans because that would add to the amount of the employee’s financial hardship. The available funds can only come from employee/employer matching contributions and not from any income, like dividend and interest income, earned on them.
Six Reasons for an In-Service Withdrawal
In 2017, an IRS regulation was passed that established six reasons that an employee might have for an in-service withdrawal:
- Medical expenses for the employee, spouse, dependents, or beneficiary
- Costs directly related to the purchase of the employee’s principal residence including mortgage payments
- Tuition and all related post-secondary educational costs, including room and board, for the employee, spouse, children, spouse’s children, and beneficiary for the next 12 months
- Payments necessary to prevent the foreclosure of the employee’s principal residence or eviction of the employee from that residence
- Funeral expenses for the employee, spouse, children, or beneficiary
- Certain expenses to repair damage to the employee’s principal residence
Other common qualified employer-sponsored retirement savings plans are:
- The Thrift Savings Plans, the retirement fund for federal government employees has very similar rules and conditions to the 401(k).
- The 457(b) retirement plan is a non-qualified employee retirement plan for state and local government workers. It follows different rules and employees can make an in-service withdrawal at any time.
- SEP and SIMPLE Individual Retirement Accounts (IRA’s) are used in small businesses. There are no rules for in-service withdrawal for the SEP IRA. SIMPLE IRA's have vesting requirements and the penalty for in-service withdrawal is increased to 25% if you have not been vested which is generally during the first two years you are in the plan.
The Pros and Cons of In-Service Withdrawals
There are virtually no pros to taking an in-service withdrawal from your employer-sponsored retirement account. The only possible pro is that you are using your own money instead of owing money to a financial institution, but at a heavy price. If you take an in-service withdrawal, you not only reduce the principal of the amount of money you will have at retirement, but you lose the interest and dividends you would have earned from that principle. On top of that, for all of the retirement accounts delineated above, you will owe a 10% penalty for in-service withdrawal and for the SIMPLE IRA, you might owe a 25% penalty.
Next, you have to consider the taxes you will owe on your in-service withdrawal. You will pay taxes at your marginal tax rate.
If your marginal tax rate is 28%, here is an example of what you would owe if you withdraw $1000:
$1000 x .10 = $100 penalty + $1000 X .28 = $280 taxes = $380. Out of a $1000 in-service withdrawal, $380 of it will be taken by the federal government.
Unless you are facing a dire emergency, there is little reason to take an in-service withdrawal.