What You Should Know Before Taking an "In-Service" Distribution from Your 401(k)

If you’re participating in a company retirement plan like a 401(k) or 403(b)—especially if you're 59 ½ or older—you may have access to your funds even before you retire. This option is called an in-service distribution, and while it can provide greater flexibility, it’s not a decision to take lightly. In fact, some financial advisors push in-service distributions as a way to create revenue for themselves. That’s why we believe you should be skeptical and cautious if an advisor recommends one.

Let’s break down what an in-service distribution is, when it might make sense, and—more importantly—when it might not.

What Is an In-Service Distribution?

An in-service distribution allows you to take money out of your employer-sponsored retirement plan while you're still working for the company. If your plan allows it, you could roll those funds into an Individual Retirement Account (IRA), where you might have more investment options. It’s different from a 401(k) loan or a hardship withdrawal, both of which come with their own rules and limitations.

Why Do Some Advisors Recommend It?

Some advisors suggest in-service distributions with the pitch that they can provide “better investment options” outside of your 401(k) or that the investment options within your 401(k) are too limited. In reality, we've seen this strategy used to place funds into products like fixed index annuities (FIAs) inside IRAs. While these may sound appealing, many FIAs come with high surrender fees—sometimes up to 15%—and those fees can last 10 years or more. That’s a huge commitment, and not always in your best interest.

A Key Drawback: It May Eliminate the Backdoor Roth Strategy

Here’s a major financial planning consequence that often goes overlooked: taking an in-service distribution can effectively kill your ability to do a backdoor Roth IRA.

Let’s look at an example:

• You have $1,000,000 in your 401(k), and no IRAs.
• You want to use a backdoor Roth strategy to contribute $8,000 into a Roth IRA.
• Since this is a non-deductible IRA contribution, you can convert it tax-free.

But if you roll $500,000 into an IRA via an in-service distribution, the IRS's pro-rata rule kicks in. That $8,000 conversion would now be 98% taxable—defeating the purpose of the strategy.

Bottom line: A large traditional IRA balance makes Roth conversions far less efficient.

When Might an In-Service Distribution Make Sense?

There are two situations where this option could be worth considering:

1. To Cover Major Medical Expenses - If you're under 59 ½, the 10% early withdrawal penalty on retirement funds is waived when used to pay for medical expenses that exceed 7.5% of your AGI.

2. To Help Pay for College - The IRS waives the early withdrawal penalty on IRA funds used for qualified higher education expenses. So, if your 401(k) allows in-service distributions, you could roll funds into an IRA and tap into them for college costs—just keep in mind:

Penalty-free doesn’t mean tax-free. The distributions will still count as taxable income.️ That extra income could bump you into a higher tax bracket if you're still working.

Important Restrictions and Rules on In-Service Distributions

Before considering this strategy, understand the restrictions that may apply:

• Pre-tax elective deferrals (i.e., the salary contributions you make) usually can’t be touched before age 59 ½.
  • Employer contributions, rollovers, and after-tax contributions may be eligible earlier—but not always.
  • Some plans require:
    • A minimum number of years of participation.
    • Funds to have been in the plan for a certain period.
    • A limit on the number of in-service distributions (e.g., one per year).
      
      

Each retirement plan is unique, so you'll need to check your plan documents or contact your plan administrator.

So, Is It Right for You?

An in-service distribution can offer valuable flexibility—but that doesn’t mean it’s the right choice for everyone.

Here’s when it might make sense:

• You need to access retirement funds for a large expense, and other strategies aren’t available.
• Your 401(k) has poor investment options and high fees.
• You’re nearing retirement and working with a trusted advisor on a carefully considered rollover plan.

But here’s when it might not:

• You’re happy with your 401(k)'s low-cost index funds.
• You want to preserve the ability to do backdoor Roth contributions.
• You don’t fully understand the investment product you’re being pitched.

Final Thoughts

If you’re thinking about taking an in-service distribution, do your homework. Your decision affecta your taxes, investment flexibility, and long-term planning strategies.

And most importantly—talk to a  financial advisor who’s not conflicted and who doesn't gain financial from your decision to do an in-service distribution. Be sure to watch our video on this topic to learn more.