In-Service Withdrawal: Definition, Rules, Taxes & Penalties

What Is an In-Service Withdrawal?

An in-service withdrawal occurs when an employee takes a distribution from a qualified, employer-sponsored retirement plan, such as a 401(k) account, without leaving the employ of their company.

This may occur without a tax penalty any time after the employee reaches age 59½, or if the employee withdraws up to $10,000 to purchase their first home, declares a hardship, or establishes extreme financial need. In some cases, in-service withdrawals can be made without these events occurring.

Not every retirement plan allows in-service withdrawals, but in 2019, about 70% of those available in the U.S. did offer this option under certain conditions.

Understanding In-Service Withdrawals

By law, normal withdrawals from retirement plans can be made as a result of employment change, hardship and documented financial need, or once the employee has reached 59½ years of age.

In-service withdrawals are a little different. If the plan allows in-service withdrawals, then an employee can take a distribution merely for the purpose of pursuing different investment options that they deem to be more suitable for them. This is usually done in the form of an allowable rollover from the plan to a previously existing 401(k) account or a new traditional Individual Retirement Account (IRA).

This provision can be tricky. For example, rolling over savings from a 401(k) plan to a traditional IRA is allowed by law if the money being moved is from employer contributions (either matched money or profit-sharing accumulations). The money being rolled over cannot come from pre-tax contributions unless the employee is 59½ years old or older.

The solution is to know precisely what your plan allows and what it does not. Finding out such details might be a little harder than it sounds for some employees, because a company administering a company-sponsored retirement plan has an incentive to keep participants from taking money out of their accounts early. The government agrees that employees who are saving for retirement should be very careful about withdrawing money early.

These two factors combine to inhibit your ability to find out the details of your plan's in-service withdrawals because your employer might not advertise such provisions, and the government doesn't require them to do so. To find the information you need, you'll likely have to search a bit online or make a phone call to your 401(k) helpline.

What to Ask Your Plan Administrator About In-Service Withdrawals

If you don't like your current investment options and want to move some or all of your 401(k) money to an IRA that has better choices, you'll need to search for the FAQ pages or call and ask direct questions of the company which manages your retirement plan. Look for the answer to these four questions:

1. Does the plan I am enrolled in allow for in-service withdrawals?
2. If so, what conditions apply?
3. What type of account can I move this money into?
4. What are the tax consequences of this withdrawal?

Since only about 30% of employer-sponsored plans in America don't offer this option, it is worth looking into if you want more investment options. Once you've determined that your plan does allow non-hardship, in-service withdrawals, you'll want to pay attention to the tax consequences of such a decision.

Typically, the distribution must be made to a traditional IRA to avoid generating new taxes, but oftentimes, a distribution to a Roth IRA is allowed if you are willing to pay the taxes that will come from such an action.

Some people might consider paying taxes or penalties worthwhile if their investment options were good enough, but most investors and financial advisers would agree it is generally not considered a sound choice to do so. Still, individual circumstances vary and no one can say that one single choice is best for all investors.

That being said, you should be very careful about your choices in this area. Investors have lost significant money chasing after investments that suggest higher-than-normal rates of return, and in hindsight, paying taxes for the privilege of losing money can feel like adding salt to an open wound.

Tax Implications of In-Service Withdrawals

Most withdrawals made from a qualified employer-sponsored retirement plan before reaching age 59½ will come with a 10% early-withdrawal penalty tax on the amount being distributed. This is in addition to applicable federal income and state taxes. Some exemptions are defined by the Internal Revenue Service (IRS). 

But since non-safe harbor employer matching contributions and profit-sharing contributions can be distributed at any age, and voluntary contributions can be withdrawn at any time, in-service withdrawals can be used if you have alternative investment vehicles you clearly understand and are willing to manage.

The Bottom Line

Several types of employer-sponsored plans allow in-service withdrawals. Depending on the plan's rules and how the plan is structured, there may be various limitations or qualifications on when or how such withdrawals can be made.

If you can find the documentation, your plan administrator's firm should spell out the types and treatment of each eligible in-service distribution in what is called the summary plan description or the plan document itself. Tax information may not be specified there, since specific tax details are set by the IRS.