Minimize Taxes on In-Service 401(k) Withdrawals: Strategies and Rollover Rules
Retirement in 2024 looks completely different than it did 20 years ago. More individuals are easing into retirement with a reduced work schedule or more flexible work hours, and some are continuing to work part-time to gradually enter a new chapter of their life. At the same time, some employees want to continue contributing to a retirement plan to take advantage of tax-deferred savings and employer matching. But what happens when the employee needs to start taking distributions from the account? Let’s take a deeper dive into what those options may look like.
An employer-sponsored 401(k) plan has three ways to invest: a traditional pre-tax 401(k), Roth 401(k), and after-tax 401(k). The IRS treats each one differently for tax purposes, and each needs to be accounted for separately within your 401(k). Fortunately, as a participant, you are not responsible for tracking; this duty falls on the plan’s recordkeeper. Here’s what you need to know about these investment types:
Pre-Tax 401(k): Contributions are pre-tax. You receive a deduction from your income today. Earnings grow tax-deferred and are not taxable until you begin withdrawals.
Roth 401(k): Contributions use after-tax dollars. Earnings grow tax-free, and withdrawals are also tax-free if you meet certain requirements.
After-Tax 401(k): Contributions use after-tax dollars (similar to Roth). However, earnings grow tax-deferred and are subject to ordinary income tax rates when withdrawn from the plan at a future date.
An in-service withdrawal occurs when an employee takes a distribution from a qualified employer-sponsored retirement plan, such as a 401(k) account, while still employed with the 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 most do. Let’s address some common questions about in-service distributions:
Can I take an in-service distribution only from the Roth 401(k) and after-tax accounts?
The IRS requires that in-service withdrawal and after-tax amounts in the account, so you cannot take an in-service distribution only from Roth 401(k) and after-tax accounts.
What 401(k) plan in-service distribution strategy could I consider to minimize the tax liability of this withdrawal?
You can minimize tax liability on 401(k) withdrawals. However, if you plan to make a withdrawal, you will likely be forced to execute a rollover of the entire balance. For example, if you took a cash distribution from your Roth account tax-free, any remaining funds would need to come from the after-tax account. In this scenario, withdrawals from the after-tax account are a proportional allocation of both contributions and earnings. This means that the earnings portion of that withdrawal will show as taxable income to you.
From there, you need to execute a direct rollover of the remaining funds within your 401(k) to an IRA. This would include any funds leftover as contributions in the after-tax account not taken as a cash distribution, the portion of earnings in the after-tax account not taken as a cash distribution, and the entire pre-tax 401(k) and employer retirement matching accounts.
How are the proportional amounts calculated?
Many savers have made after-tax contributions to a 401(k) or another defined contribution retirement plan. If your account balance contains both pre-tax and after-tax amounts, any distribution will generally include a proportional share of both.
Example: Your account balance is $100,000, consisting of $80,000 in pre-tax amounts and $20,000 in after-tax amounts. You request a distribution of $50,000, consisting of $40,000 pre-tax and $10,000 after-tax.
Does my withdrawal have to go to the same place?
Distributions sent to multiple destinations at the same time are treated as a single distribution for allocating pre-tax and after-tax amounts (Notice 2014-54). This means you can roll over all your pre-tax amounts to a traditional IRA or retirement plan and all your after-tax amounts to a different destination, such as a Roth IRA.
Example: You withdraw $100,000 from your plan, $80,000 in pre-tax amounts and $20,000 in after-tax amounts. You may request:
- A direct rollover of $80,000 in pre-tax amounts to a traditional (non-Roth) IRA or a pre-tax account in another plan,
- A direct rollover of $10,000 in after-tax amounts to a Roth IRA, and
- A distribution of $10,000 in after-tax amounts to yourself.
Can I roll over just the after-tax amounts in my retirement plan to a Roth IRA and leave the remainder in the plan?
No. You can’t take a distribution of only the after-tax amounts and leave the rest in the plan. Any partial distribution from the plan must include some of the pre-tax amounts. Notice 2014-54 doesn’t change the requirement that each plan distribution must include a proportional share of the pre-tax and after-tax amounts in the account. To roll over all your after-tax contributions to a Roth IRA, you could take a full distribution (all pre-tax and after-tax amounts), and directly rollover pretax amounts to a traditional IRA or another eligible retirement plan, and after-tax amounts to a Roth IRA.
Can I roll over my after-tax contributions to a Roth IRA and the earnings on my after-tax contributions to a traditional IRA?
Yes. Earnings associated with after-tax contributions are pre-tax amounts in your account. Thus, after-tax contributions can be rolled over to a Roth IRA without also including earnings. Under Notice 2014-54, you may roll over pre-tax amounts in a distribution to a traditional IRA and, in that case, the amounts will not be included in income until distributed from the IRA.
Learn More About Your Options
Several types of employer-sponsored plans allow in-service withdrawals. Depending on the plan’s rules and structure, 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 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. Before relying upon your retirement savings for a withdrawal while you’re working, check with your company’s HR department to help you understand what options may be available. From there, you may need additional assistance to determine your tax impact. This would be the time to consider reaching out to an independent advisor who could better help you explore which options are best suited to your individual situation.
Jeffrey R. Lewis
Financial Advisor
CFP®, ChFC®, CRPS®