What Is an In-Service Distribution from a Retirement Plan?

An in-service distribution refers to taking money from a retirement plan, such as a 401(k) or pension, while still employed by the company sponsoring the plan. This type of withdrawal allows access to retirement savings under specific circumstances, distinct from distributions taken after leaving employment or retirement.

Understanding In-Service Distributions

An in-service distribution occurs when an employee takes funds from an employer-sponsored retirement plan, like a 401(k), while still actively working for that employer. This differs from typical retirement withdrawals, which usually happen after separation from service. This provision offers some flexibility for plan participants who might need to access their savings before retirement.

Not all retirement plans or employers permit in-service distributions, as eligibility is determined by the specific plan document. Some plans may only allow these distributions once an employee reaches a certain age or has been part of the plan for a specific number of years. The defining characteristic of an in-service distribution is the participant’s continued employment with the plan sponsor.

Common Reasons for In-Service Distributions

Retirement plans may permit in-service distributions under specific conditions outlined in the plan document.

Age-Based Withdrawals

Many plans allow distributions once a participant reaches age 59½, regardless of their employment status. This age often signifies that the 10% early withdrawal penalty may no longer apply, though income tax is still due.

Hardship Withdrawals

These are allowed for an “immediate and heavy financial need” that cannot be met from other reasonably available resources. The Internal Revenue Service (IRS) defines specific qualifying hardships, including:
Unreimbursed medical expenses for the participant, spouse, or dependents.
Costs related to buying a primary residence (excluding mortgage payments).
Tuition and related educational fees for the next 12 months of post-secondary education.
Payments to prevent eviction from or foreclosure on a primary residence.
Burial or funeral expenses.
Certain expenses for the repair of damage to a principal residence.
The amount withdrawn for hardship is typically limited to what is necessary to satisfy that immediate need.

Qualified Plan Loan Offset

A qualified plan loan offset can also result in an in-service distribution. If an employee takes a loan from their 401(k) and then leaves employment or fails to repay the loan, the outstanding balance can be treated as a distribution. This “deemed distribution” occurs because the plan offsets the loan amount against the participant’s account balance, making it a taxable event. Some plans may also allow in-service distributions for other specific purposes, such as purchasing employer stock or after a certain number of years of service.

Taxation of In-Service Distributions

In-service distributions are generally subject to federal income tax as ordinary income in the year received. State income tax may also apply. The tax liability arises because these funds typically originated from pre-tax contributions or tax-deferred growth within the retirement plan.

A 10% early withdrawal penalty generally applies if the distribution is taken before age 59½. However, several exceptions can waive this penalty, even if the distribution occurs before age 59½. Common exceptions include distributions made due to death or total and permanent disability of the participant. Other exceptions include payments for unreimbursed medical expenses exceeding 7.5% of your adjusted gross income (AGI), qualified reservist distributions, or distributions made as part of a series of substantially equal periodic payments. Even if an exception applies, the distribution remains subject to ordinary income tax.

When an eligible rollover distribution is paid directly to a participant, the plan administrator is generally required to withhold 20% for federal income tax. This mandatory withholding applies even if the participant intends to roll over the funds. For non-rollover eligible distributions, such as certain hardship withdrawals, the default federal withholding rate is often 10%, unless the recipient elects a different rate. All distributions will be reported to the IRS on Form 1099-R, which details the amount distributed and any taxes withheld.

Managing In-Service Distributions

Individuals receiving an in-service distribution have several options for managing the funds, each with different tax implications.

Direct Rollover

This method avoids immediate taxation and penalties. Funds are transferred directly from the employer’s retirement plan to another eligible retirement account, such as an Individual Retirement Account (IRA) or a new employer’s plan. This bypasses the mandatory 20% federal income tax withholding that applies to eligible rollover distributions paid directly to the participant.

Indirect Rollover

This allows the participant to receive the distribution directly. The individual has 60 days from receipt to deposit the funds into an eligible retirement account to avoid immediate taxation and any applicable 10% early withdrawal penalty. The mandatory 20% federal income tax withholding still applies. To roll over the full amount and defer all taxes, the participant must contribute additional funds from other sources equal to the 20% that was withheld.

Taking Cash

The funds are fully taxable as ordinary income in the year received. If the participant is under age 59½, the 10% early withdrawal penalty will also apply unless an exception is met.

Before making any decisions, consult with the plan administrator to understand the specific options and rules of your retirement plan. Also, seek guidance from a qualified tax professional to assess the financial consequences for your individual situation.