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2 Ways to Upgrade Your 401(k) Without Leaving Your Job

In-service distributions and in-plan conversions can be useful tools for workers to improve their retirement investing options.

Most investors who participate in company-sponsored retirement plans know that leaving their workplace retirement plans--either because they've gone on to a new job or retired--opens up a world of opportunities. They can roll their company retirement plan assets into an IRA, taking advantage of more or better investment options. (Of course, venturing beyond the 401(k) menu's options can also invite trouble.) They can even convert some of their traditional 401(k) assets to Roth IRA assets at the time of rollover. Such conversions trigger income taxes, of course, but the benefit is the ability to take tax-free withdrawals on the Roth assets in retirement.

But employees may not have to wait until they retire or leave the firm to be able to make improvements to their 401(k)s. If their plans offer what's called an "in-service distribution," they can move a portion of their money from the company retirement plan to an IRA even as they remain with the same employer. Additionally, some company retirement plans offer an "in-plan conversion," which gives employees the chance to convert traditional 401(k) assets to Roth 401(k) assets within the confines of the same plan.

Both options give workers the opportunity to upgrade or otherwise align their company retirement fund assets with their goals and tax situations.

In-Service Distribution
How It Works: For 401(k) investors, an in-service distribution (or in-service withdrawal) allows them to move a portion of their 401(k) balances (or a portion of their balances in 403(b), 457, or other defined-contribution plans) to an IRA while they're still working for their employer. Not all plans offer the in-service distribution option, and plan participants are limited in what portion of their balances they can withdraw. Prior to age 59 1/2, only employer contributions and employee aftertax (not Roth) contributions are eligible for in-service distribution, though many plans allow for an in-service distribution of the whole balance once the participant reaches age 59 1/2. The details on whether an in-service distribution is available, and which portion of assets are eligible for an in-service distribution, will be outlined in the Summary Plan Description, a document that details the rules and other features of the 401(k) plan. 

Who Can Benefit: There are a few key profiles of individuals who might be able to benefit from an in-service distribution.

The first and most obvious contingent is employees whose employer-provided plans are subpar--they might be costly (either in terms of administrative expenses or what the underlying funds charge) or they don't offer funds that align with the investor's preferences. For example, an investor might strongly prefer index funds, but the 401(k) plan features an all-active menu. Participants who are older than 59 1/2 will have the most leeway to take advantage of the in-service distribution with the bulk of their balances, whereas in-service distributions for employees who are younger than 59 1/2 will be limited to employer matching contributions and aftertax 401(k) contributions.

Those aftertax 401(k) contributions aren't the same as Roth IRA contributions: While both are made with after-tax dollars, the Roth 401(k) contributions can begin accumulating tax-free investment returns from the start, whereas the aftertax contributions accumulate tax-deferred interest as long as the money stays inside the plan. That's where the in-service distribution comes in: Those aftertax 401(k) contributions can be rolled over into a Roth IRA where they can begin racking up tax-free earnings. The way that the plan accounts for the aftertax 401(k) contributions will determine what taxes are due upon the rollover, as discussed here. Thus, it's a good idea to examine the tax implications before taking an in-service distribution from a 401(k). 

Know Before You Go: Having an escape hatch on a 401(k) plan, which is what an in-service distribution is, sounds encouraging. But in-service distributions prior to age 59 1/2, to the extent that they're available, only apply to a portion of investors' balances. Moreover, they're likely to be available for employees who need them the least. That's because the plans with attractive features (like in-service distributions, or automatic rebalancing) are also the mostly likely to field a topflight, low-cost menus in the first place. They'll tend to be the most available and attractive to investors who are making aftertax 401(k) contributions.

Another caveat is that 401(k) plans feature guardrails that help keep investors away from narrowly focused, risky investments; once the investor exits the 401(k), those safeguards go away. In addition, depending on the state, 401(k) assets may have better creditor protections than IRA assets. It's also worth noting that assets within an IRA are only eligible for penalty-free withdrawals only after age 59 1/2 unless the investor meets certain criteria, whereas penalty-free withdrawals are available to 401(k) participants at age 55 as long as the employee has retired or otherwise separated from service. Thus, investors who move assets to an IRA prior to retirement are giving up some flexibility to take withdrawals between age 55 and age 59 1/2. Finally, 401(k) participants with employer stock can take advantage of favorable tax treatment--net unrealized appreciation--as long as the money remains inside the 401(k). But once the money is removed from the 401(k), that option goes away.

In-Plan Conversion
How It Works: In contrast with an in-service distribution, which entails steering assets from the company-sponsored retirement plan into an IRA, an in-plan conversion leaves all of the assets inside the 401(k) (or 403(b) or 457 plan). With an in-plan conversion, provided the 401(k) plan allows for it, the investor converts either traditional or aftertax 401(k) assets to a Roth 401(k). 

Who Can Benefit from It: As with any conversion of traditional accounts to Roth, the individuals who can benefit most from an in-plan conversion are the ones who expect to be in a higher tax bracket at the time of withdrawal than at the time of conversion. In-plan conversions can also make sense for individuals who don't expect to need all of their 401(k) assets during their lifetimes; while Roth 401(k)s are subject to required minimum distributions, Roth IRAs, which Roth 401(k)s can be rolled into upon retirement or separation from service, aren't subject to RMDs. Finally, in-plan conversions may be a good option for retirement savers who have made aftertax (not Roth) 401(k) contributions. 

Know Before You Go: As with conversions of traditional IRA assets to Roth, the pro rata rule applies to any conversions; in other words, the taxes due in the year the conversion occurs depend on the ratio of never-been-taxed money in the account to money that has already been taxed. (This posting from Michael Kitces does a deeper dive into the tax treatment of conversions done inside a plan.) And for investors who aren't eligible to take penalty-free distributions from their accounts, any taxes due upon conversion should be available outside the confines of the company retirement plan; otherwise, pulling additional funds from the account to pay the taxes will trigger a penalty. Check with a tax advisor before embarking on in-plan conversions; partial conversions may be advisable.

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