What Is In-Service Withdrawal?

Thoughtful person sitting in a coffee shop with laptop contemplating an early retirement withdrawal
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DEFINITION

In-service withdrawal occurs when you take funds from your employer-sponsored retirement plan while you're still working or before being let go from your job.

In-service withdrawal occurs when you take funds from your employer-sponsored retirement plan while you're still working or before being let go from your job. It's allowed under certain circumstances, but you might incur penalties by taking cash out, and it could affect your retirement assets.

Definition and Example of In-Service Withdrawal

You're making an in-service withdrawal from your employer-sponsored retirement plan if none of these conditions exists:

  • Retirement at age 59 1/2
  • Disability
  • Termination from your job
  • Death

It's considered to be a regular withdrawal if one of these factors applies to you.

  • Alternate name: Early distribution

How In-Service Withdrawal Works

Making an in-service withdrawal from your 401(k) is almost never a good idea. You'll be subject to taxes and penalties in just about every case. Taking an early distribution will also reduce the value of your 401(k), often permanently. You'll also lose the bonus of non-taxable compounding, which will leave you with less money when you retire.

There are two types of employer-sponsored retirement accounts: defined benefit (DB) and defined contribution (DC). Each works differently when it comes to in-service withdrawal. Both types are covered under the Employee Retirement Income Security Act of 1974 (ERISA), which sets the standards for an employer to offer a pension plan.

Defined Benefit Retirement Accounts 

Defined benefit retirement accounts are administered by a pension fund manager. These plans usually require that the employee contribute a percentage of their salary to their account. The company often matches that contribution in some way.

One of the biggest differences between defined benefit and defined contribution plans is that you usually have to be vested in a defined benefit plan. You can’t withdraw any money—including the money you put in—until you're vested. You get a set benefit payment per month when you retire. Defined benefit plans include many teacher retirement plans (TRS).

Defined Contribution Retirement Accounts

Defined contribution retirement plans often require that both the employee and the employer contribute to the plan. The employer will often match the employee's contribution up to a certain percentage. You may also have to be vested. The vesting could be on a schedule.

You can always draw out your own funds if you have a defined contribution plan, but you can only draw out your employer’s funds according to the vesting schedule if there is one. Examples of defined contribution plans include 401(k) and 403(b) plans. The rules of these plans are set by the IRS.

Other Retirement Accounts

There are other types of retirement accounts, including:

  • Thrift Savings Plans: These are retirement funds for federal government employees. They have rules that are very much like those of 401(k) plans.
  • Section 457(b): These are non-qualified, eligible deferred compensation plans for state and local governments and tax-exempt organizations. They follow different rules. Employees can make in-service withdrawals at any time.
  • SEP and SIMPLE Individual Retirement Accounts (IRAs): These are used in small businesses. There are no rules for in-service withdrawal for a SEP IRA. SIMPLE IRAs have vesting requirements. The penalty for an in-service withdrawal is increased to 25% if you haven't been vested (generally during the first two years you're in the plan).

When Can In-Service Withdrawals Be Taken?

There are allowable circumstances in accounts that permit in-service withdrawals. The need for the in-service withdrawal must be immediate. You must also be facing a heavy financial burden.

The in-service withdrawal must be limited to the amount of the need. This is called a "hardship in-service withdrawal." It assumes that the employee can’t get the money from other sources, such as wages or loans, because that would add to the hardship.

The funds can only come from employee/employer matching contributions, not from any income earned on them.

Reasons for an In-Service Withdrawal

The IRS set six allowable reasons for an in-service withdrawal in 2017:

  1. Medical expenses for the employee or their spouse, dependents, or a beneficiary
  2. Costs directly related to the purchase of the employee’s principal residence, including mortgage payments
  3. Tuition and all related post-secondary educational costs, including room and board, for the employee, spouse, children, spouse’s children, or a beneficiary for the next 12 months
  4. Payments necessary to prevent the foreclosure of the employee’s principal residence or eviction of the employee from that residence
  5. Funeral expenses for the employee, their spouse, their children, or a beneficiary
  6. Certain expenses to repair damage to the employee’s principal residence

Key Takeaways

  • In-service withdrawal occurs when an employee takes funds from a qualified employer-sponsored retirement plan while still working.
  • Certain triggering events, such as job loss, render withdrawals allowable.
  • Different types of retirement accounts have different rules.
  • There's usually a tax consequence for an early distribution, so it should only be used as a last resort.

Article Sources

  1. Internal Revenue Service. "Retirement Topics - Exceptions to Tax on Early Distributions."

  2. U.S. Department of Labor. "Types of Retirement Plans."

  3. Internal Revenue Service. "SIMPLE IRA Withdrawal and Transfer Rules."

  4. Internal Revenue Service. "Retirement Plans FAQs Regarding Hardship Distributions."