In-Service Distributions from 401(k) Plans

401(k) Withdrawals During Employment

Recently, a client sent me an e-mail expressing concern regarding an article that discussed the dramatic increase in 401(k) hardship distributions resulting from the recent economic downturn (

For retirement plan sponsors, articles like this one can be alarming, since these plans typically are established to reward long term employees by providing a benefit meant to assist them in retirement.  Some employers are more compassionate than others, and since many of our 401(k) clients are small business owners, they tend to be concerned over the long-term success and financial health of their employees.

The upheaval in the economy has been challenging for retirement plans.  Some plan sponsors have had to reduce or suspend their ‘match’ contributions, employees have reduced their contribution/savings rates, and more and more employees are looking to their retirement accounts as a means to access quick cash.

Three Types of “In-Service” Distributions

There are typically three ways participants can withdraw from their retirement plan accounts prior to reaching a benefit event, such as termination of employment, retirement, etc.  The options, however, are only available if the retirement plan includes these specific provisions.

In-Service Distributions:  Participants can withdraw all or part of their account while still employed after reaching a specific age, typically 59½ or older.

Plan Loans:  Participants can borrow from their accounts.  The IRS limits these loans to 50 percent of the value of the account (to ensure collateral).  Loans are typically repaid through payroll deductions at a set interest rate (for example prime plus 1 percent).  If plan sponsors offer a loan provision, we recommend limiting the number of outstanding loans to one at a time.

Hardship Distributions:  Participants can withdraw from their accounts if they find themselves in an immediate and heavy financial need. Participants must document their financial need to the plan trustee.  This can be an awkward discussion for both the employer and the employee. Participants taking a hardship distribution cannot participate in salary deferral for six months.  Additionally, these distributions are subject to the 10 percent premature withdrawal penalty (if under age 59½) and state and federal income tax.

The ‘safe harbor’ reasons for a hardship distribution include:

  • Expenses for medical care previously incurred by the employee, the employee’s spouse, or any dependents of the employee or necessary for these persons to obtain medical care
  • Costs directly related to the purchase of a principal residence for the employee (excluding mortgage payments)
  • Payment of tuition, related educational fees, and room and board expenses, for the next 12 months of postsecondary education for the employee, or the employee’s spouse, children, or dependents
  • Payments necessary to prevent the eviction of the employee from the employee’s principal residence or foreclosure on the mortgage on that residence
  • Funeral expenses
  • Certain expenses relating to the repair of damage to the employee’s principal residence

Remember, these are all optional provisions which can be included in a 401(k) plan, but they do not need to be included.

Options for Plan Sponsors

So what is a plan sponsor to do?  Whether or not an employer opts to offer any of these plan provisions relies in large part on their philosophy regarding the retirement benefit.  It should be noted that plan provisions that provide for these kinds of withdrawals can also create additional administrative burden for employers who must process and track the withdrawals and amortization schedules in the case of loans.  Another consideration is that loans and other withdrawal options are often perceived as a way to boost participation in the Plan.  The theory is that employees are more likely to contribute to a 401(k) plan if they know they will have access to their account if they need it.

Based on the plan sponsor’s philosophy and employee demographics, careful consideration should be made to determine which type (or types) of In-Service Distribution provisions are appropriate.  Additionally, ongoing 401(k) participant education can help to alert employees about the down side of taking distributions from retirement savings (loss investment opportunity, possible early withdrawal penalties, potential tax consequences, etc.).  Even if a plan sponsor opts to include one of these provisions, they may also discourage participants from using them unless absolutely necessary.

Your Moneta Group Family CFO can help plan sponsors with questions about plan provisions.

Megan Riley, J.D.

Megan is the professional consultant for Nancy Georgen.

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