The hidden 'escape hatch' in your 401(k)

By D. Scott Emge, CPA

Frustrated with the limited investment choices available in your employer’s retirement plan?

Don’t fret. You may not have to wait until retirement to unlock the investment potential of those retirement plan assets.

That’s right: Your employer’s retirement plan may contain a little-known provision that may allow you to roll over these assets into an IRA rollover while you’re still employed and without incurring any immediate tax liability.

Here’s how it works: Normally, you’re eligible to take a distribution from your employer’s retirement plan after a triggering event, such as separation from service or extended disability. Some employer retirement plans, however, offer employees the ability to take a distribution upon reaching a minimum age or meeting a length-of-service requirement while they’re still employed. This is called an in-service, non-hardship withdrawal distribution election.

If you qualify for this distribution, you may elect to roll over all or a portion of these retirement assets while continuing to participate in your employer’s plan without penalty. But first, you need to determine if your employer’s plan allows these distributions and under what circumstances.

Most often, only profit-sharing and 401(k) plans allow for in-service, non-hardship withdrawal distributions. They are not permitted in defined benefit or cash balance plans. The only way to find out for sure is to ask your employer for a copy of the plan’s summary plan description (SPD). If they cannot supply an SPD, then you can call the toll-free number on your monthly 401(k) statement and ask if you can take an in-service, non-hardship withdrawal distribution election.

The SPD will tell you if your employer’s plan allows this option and under what circumstances. In some cases, the plan requires you to be age 59½ or older. You should also confirm that by electing an in-service, non-hardship withdrawal distribution election, you would not forfeit your ability to continue to participate in your employer’s plan.

Why should you go to all this trouble? The answer in a nutshell is flexibility. Used properly, an in-service, non-hardship withdrawal distribution election can provide additional investment and tax-planning alternatives not commonly available in an employer retirement plan.

Case in point: Investment options inside an IRA rollover opened with a full-service financial firm can be unlimited. You can select from mutual funds, individual stocks and bonds, CDs or perhaps a combination of various other types of investment vehicles. In addition, if your gross income is less than $100,000, you may wish to convert your retirement plan balance to a Roth IRA. However, only by rolling your retirement plan balance to a traditional IRA can you later convert to a Roth IRA.

Also, if a portion of your retirement plan balance consists of company stock, rolling over these assets into an IRA will allow you to use limit orders when you sell shares. A limit order will authorize the automatic sale of a specified number of shares should the stock trade at a predetermined price. You determine and set the sale price limit.

Moreover, while a surviving spouse can always roll over an employer’s retirement plan into an IRA, the same is not true for other beneficiaries, such as children or grandchildren. By transferring employer plan assets to an IRA rollover, you gain the ability for these beneficiaries to receive payments from an inherited IRA over their lifetimes. This “stretch IRA” option is usually not permitted in employer retirement plans.

If you elect an in-service, non-hardship withdrawal distribution election, be sure you roll the assets into an IRA. Otherwise, distributions not rolled to an IRA are subject to a mandatory 20 percent federal withholding tax, federal and state income taxes and a 10 percent premature distribution penalty if you are younger than 59½.

In-service, non-hardship withdrawal distribution elections may not be suitable for everyone. If you currently have an outstanding loan, a distribution may cause the loan to be deemed a taxable distribution. Also, qualified retirement plans always provide creditor protection that, unlike an IRA, is dependent upon your state law.

Finally, your employer plan may offer a specific investment option that is not available elsewhere.

D. Scott Emge is a financial advisor with Smith Barney Lutherville. He can be reached at (410) 494-1868 or scott.emge@smithbarney.com.

Citigroup Inc., its affiliates, and its employees are not in the business of providing tax or legal advice. These materials and any tax-related statements are not intended or written to be used, and cannot be used or relied upon, by any such taxpayer for the purpose of avoiding tax penalties. Tax-related statements, if any, may have been written in connection with the “promotion or marketing” of the transaction(s) or matter(s) addressed by these materials, to the extent allowed by applicable law. Any such taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor.

Smith Barney is a division of Citigroup Global Markets Inc. Member SIPC.

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