A 401(k) plan is a great vehicle for employees to save for retirement. The money invested into this employer-sponsored retirement plan is saved pre-tax and grows on a tax-deferred basis. Taxes on this deferred income are not paid until the money is withdrawn from the plan, usually in retirement. Employers often match employee contributions up to a certain percentage.
There are strict rules governing 401(k) plans. For example, there is usually a penalty if the money is withdrawn prior to age 59½, though most plans allow for distributions without penalty at age 55 if the employee has separated from service. There are also annual limits on how much pre-tax income can be put into a 401(k) plan. For 2019, the limit for participants is $19,000 per year. For participants 50 years old and older, the limit is $25,000 per year.
Many employees only think to rollover their 401(k) plans when they switch jobs or retire. These qualified assets are typically rolled over into another employee-sponsored 401(k) plan or into an Individual Retirement Account (IRA). If the individual has recently retired, an IRA is a good option if they want more control over the funds, more investment options or if they want to consolidate the funds into a single account.
An in-service rollover allows a current employee to move all or some of the assets in their employer-sponsored 401(k) plan into an IRA without taking the money as a distribution. An employee who is at least 59½ years old will avoid the 10% penalty on the money moved and will not be immediately required to pay the deferred taxes on the money.
Benefits of an In-Service Rollover
Not all 401(k) plans are created equal, and many plans offer only a handful of investment options including mutual funds, stable value funds and company stock. Some plans may offer employees the ability to invest in stocks, bonds, exchange traded funds and other investments, but most have a limited number of investment options available to participants.
A rollover into an IRA will give the employee more investment options and more control over how his or her retirement funds are invested. With an IRA, individuals may have access to a broader universe of investments than they otherwise would with a 401(k) account. They can also choose who they want to manage the funds.
Individuals who decide on an in-service rollover can generally still contribute to their company’s 401(k) plan, though it is important to note the rules are different for each plan, and the employee may be temporarily barred from contributing to their 401(k) after the rollover.
Eligible plan participants should examine what fees they are currently being charged and if rolling the funds into an IRA could reduce their total expenses. Keep in mind many of the investments available in an IRA will have associated fees, and custodians holding the account will often charge a range of fees including fund management fees, advisory fees, service fees and trading commissions.
Drawbacks to an In-Service Rollover
Not all company 401(k) plans will allow an in-service rollover to an IRA, so the first step is to find out whether an in-service rollover is an option with your plan. From there, you can decide whether an in-service rollover is right for you.
While employees are generally still able to contribute to their 401(k) plans after an in-service rollover to an IRA, some plan sponsors may impose a temporary ban on contributions if the employee pulls money from the plan. Individuals who still plan on contributing to their 401(k) plan after the rollover should find out if they will be temporarily penalized for withdrawing funds.
While individuals generally need to wait until age 59½ to take withdrawals from retirement accounts to avoid the 10% penalty, many 401(k) plans allow penalty-free withdrawals for early retirees at age 55. For an IRA, the individual generally must be 59½ to avoid the 10% penalty.
While normally not recommended, a 401(k) loan can provide needed funding for individuals who find themselves in a financial crunch. For individuals younger than age 59½, 401(k) loans can only be taken by active employees and must be paid back over a determined time frame to avoid being taken as a distribution subject to taxes and the 10% penalty. Individuals are not permitted to take out loans against their IRAs.
While there is the potential to reduce fees with an in-service rollover, there is also the possibility of increased fees for IRA investors. Since individuals have greater control over their account and access to a greater number of investment options with an IRA, investors need to be mindful they could be choosing more complicated investment strategies that could generate higher fees.
It is also important to understand the impact an in-service rollover can have on Net Unrealized Appreciation (NUA). Net Unrealized Appreciation allows the participant to apply long-term capital gains to the difference between the value in the average cost basis and current market value of a security in a tax-deferred account. An in-service rollover could impact the participant’s ability to utilize NUA in the future to the extent of preventing use of the strategy. Everyone’s situation is unique, and investors should consult with their tax advisors when considering NUA.