Despite the obvious handicaps that all-too-often accompanies closed architecture plan design, most participants over the age of 59 1/2 are completely unaware of special in-service distribution rules that allow tax-free rollovers to an IRA...even while you remain on the job and continue to make tax-deferred contributions. It's like the IRS baked a carbon-tipped hacksaw blade in the cake, walked it past the guards in plain sight, and then neglected to inform you the keys to freedom and choice were within your grasp. Though not widely advertised by 401(k) plan providers (who are keenly motivated to retain as many dollars in the plan for as long as possible), it's estimated more than 70% of 401(k) plans now allow in-service distributions. More importantly, that number seems to be growing.
So let's get one thing straight right from the top: defined contribution plans are vehicles specifically intended to set aside money for retirement and really shouldn't be used as a source of funds to finance things like college tuition for kids, vacation homes, or even an auxiliary emergency fund. Orchestrating a 401(k) jailbreak is only appropriate if you intend to preserve the tax deferred status of these funds. This means you should plan to roll your 401(k) funds directly into a Rollover IRA in what's known as a trustee to trustee transfer. A quick word of warning: As much as you might be tempted to forge ahead and quickly ditch your 401(k), it's imperative that you exercise tremendous caution and know the rules before attempting to process an in-service distribution. A botched attempt can trigger a costly (and avoidable) tax event. The conversion rules are technical and the IRS has zero tolerance for mistakes, no matter how innocent.
To understand what jail-break options might be available in your plan, you'll first need to refer to the Summary Plan Description (SPD) on file with your company's benefit administrator or with the human resource department. While employers are never required to offer non-hardship in-service distribution options for eligible employees, it's a feature more and more employers are voluntarily electing to include.
If you are age 59 1/2 or older, your SPD may already give you the right to withdraw funds from your 401(k) plan and roll them directly into an IRA without triggering an immediate tax obligation. It's worth checking out. In-service distributions make a lot of sense if you want to consolidate the number of retirement accounts you need to keep track of, tailor specific estate planning objectives beyond the scope of what your plan permits, or simply expand the range of investment choices to accommodate all your objectives
In the past, some advisors have steered clients away from in-service distributions because of concerns that some bankruptcy and creditor protections apply to 401(k) plans but not IRAs. While you should always consult legal counsel to make sure you are not leaving yourself unnecessarily exposed, that concern now appears to be something of a historical relic. Of particular interest to individuals with substantial account balances, most funds rolled directly into an IRA from 401(k) plan assets are fully protected from bankruptcy under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA). Here in the Midwest, both Michigan and Ohio law also exempts qualified retirement plans and IRAs from the claims of creditors (excluding the IRS) outside of bankruptcy.
Investors should be aware there is one set of circumstances when it almost never makes sense to attempt a jailbreak from a 401(k) plan. This exception occurs when an investor's 401(k) fund balance has significant amounts of net unrealized appreciation (NUA) from employer stock held in his or her 401(k) plan. A NUA strategy can only be launched from a 401(k) plan and represents a special one-time opportunity for the investor to pay taxes on highly appreciated company stock at long-term capital gains rates instead of the ordinary income tax rates that normally would apply to assets held in tax deferred accounts. If this set of circumstances applies to you, chances are you'll already know...but it never hurts to ask your tax advisor to run some projections.
Finally, if you intend to retain an independent advisor to manage assets (like us), make sure you account for the advisor's fee when considering your options. There's no sense in sawing feverishly through the bars of 401(k) jail only to find a brand new ball and chain has quietly been fastened to your ankle.
Michael Reid, CFA is Managing Director and a Partner at Exchange Capital Management. The opinions expressed in this article are his own.