In-Service Distributions from a Qualified Retirement Plan
By Ethan Branum, QKA, CIP
We have a client who is deciding whether to establish a SEP plan or a 401(k) plan. I know that with a SEP plan employees can take their money out at any time, but when can they withdraw money from their 401(k) plans while still working?
When an employer establishes a 401(k) plan, the employer gets to decide when employees can request a distribution while they are still working, referred to as an “in-service distribution.” This must be stated in the plan document. There are, however, some restrictions, depending on the type of contributions in the employees’ accounts.
Employer contributions, such as matching contributions or profit sharing contributions, do not have an age restriction. For example, if an employer elects to do so in its plan document, it could permit an in-service distribution after a predetermined number of years of participation, or after becoming 100 percent vested. Any participant age can be used. But the employer must remember that if it allows an in-service distribution before age 59½, a distribution of pretax amounts will be taxable to the employee and subject to the 10 percent early distribution penalty tax unless another penalty tax exception applies.
What is different in a 401(k) plan as opposed to a simplified employee pension (SEP) plan is that employee contributions (elective deferrals) are contributed either on a pretax basis or on a Roth after-tax basis. Importantly, these employee contributions are not allowed to be distributed as an in-service distribution before age 59½. Therefore, an employer cannot elect in its plan document to allow an in-service distribution of employee elective deferrals before age 59½.
Are there other ways that employees can take out their elective deferrals before age 59½ as a distribution?
Employees are allowed to distribute their elective deferrals from a 401(k) plan as a “hardship distribution” if certain requirements are met. First, employees requesting a hardship distribution must have an “immediate and heavy financial need.” This essentially means that employees have no other means to pay for the financial emergency that they are facing. Second, the circumstances for which employees can take a hardship distribution are limited to seven reasons: paying medical expenses; purchasing a principle residence; paying tuition or related education expenses; preventing eviction or foreclosure; paying funeral expenses; paying for casualty repair; and incurring expenses and losses, including loss of income, because of a FEMA-declared disaster. Employees who can substantiate through documentation that they meet one of the seven conditions are considered to have an immediate and heavy financial need, and, if approved by their employer, they can take a hardship distribution while employed.
I’ve heard that employees can take loans from their 401(k) plans?
An employer could elect in its plan document to allow employees to take plan loans from their 401(k) plan assets. This gives employees access to a portion of the money in their 401(k) plan, but they must pay their account back with interest. Employees who pay back the loan in accordance with their plan’s loan parameters will not be taxed on the loan.
If an employer decides to allow loans, it must establish and enforce its loan policies. The employer can decide for what reasons employees can take a loan, how much can be taken within the limits of regulations, how many loans can be outstanding at one time, what the interest rate will be, and with what frequency employees are required to pay back a loan (such as on a payroll basis). Allowing plan loans can be administratively burdensome but it can also be a tool to entice 401(k) plan participation.
While a SEP plan does not allow plan loans without taxation like the 401(k) plan does, a SEP plan has the ultimate flexibility when it comes to distributions, as SEP plan contributions go into a Traditional IRA and are always accessible to the employee. But the various distribution options that can be offered by a 401(k) plan make it just as versatile as a SEP plan—if the employer chooses to draft the plan document in that manner.
