Distributions From An IRA

[Sam Slade]

An individual wishes to avoid the 10% penalty on the early distribution from his 401K account to pay education expenses for his son which does not live with him and for which he does not claim as a dependent. Can he roll the funds over from the 401k to an IRA and then pay his son's qualified education expenses if his former spouse claims the son as a dependent and avoid the penalty? If he can is there any set period of time the funds have to reside in the IRA account? If his son claims himself as a dependent then the father who would provide the funds can"t claim the exclusion from the penalty (correct???).

[veritas]

I believe the question is

Can he roll over funds from a 401k to an IRA if he is still employed with the company providing the 401k?

[Sam Slade]

Distributions From An IRA

He is still employed with the company and will roll funds from a 401 K to an IRA. The original question is as stated.

[Bees Knees]

He is still employed with the company and will roll funds from a 401 K to an IRA. The original question is as stated.

Everything else is irrelevant. You CANNOT take a distribution from a 401(k) in order to roll the funds into an IRA if you are still employed by the company sponsoring the 401(k). Certain exceptions apply, but not the one you described.

See IRC Section 401(k)(2)(B)(i)(I)

[New York Enrolled Agent]

I'm going to disagree slightly but coming to the same conclusion. Based on the circumstances, the taxpayer possibly could take a hardship withdrawal. See Reg §1.401(k)-1(d)(3)(iii)(B)(3). The child need not be a dependent.

However, hardship withdrawals can not be rolled over into IRA accounts.

[RJM]

401k in-service withdrawals

401k in-service withdrawals are allowed and very common. Withdrawals are permitted up to 100% of the funds in the plan. Several clients have done this this past year. One client does it every year, to invest in more risky investment choices in his aggressive IRA. The code and ERISA both permit this as a qualified plan distribution, eligible for rollover to an IRA, and otherwise subject to the 10% penalty.

Two years ago I petitioned a client company (on behalf of a client employee) to change its adoption agreement to permit the in-service withdrawal. They agreed, as long as the employee had at least 10 years of service. The plan adoption agreement was changed again last year, to shorten this restriction to 5 years of service, because other employees heard about it and wanted to do the same. The adoption agreement had 2 check-boxes, one for 5 years, and the other for 10 years. It was a Sungard prototype plan (one of the larger national qualified plan authors).

http://www.irs.gov/retirement/articl...108942,00.html links to an IRS info-page, the last line stating that in-service non-hardship withdrawals are OK in a 401k. You can google "401k in-service withdrawal" and get oogles of references.

[okie1tax]

401K Rollover

I thought the whole idea was to avoid the 10% penalty. He asked if a rollover would do that and Bees Knees and NYEA both explained that a "rollover" is not allowed. Neither said you could not do a withdrawal.

[Bees Knees]

I disagree

401k in-service withdrawals are allowed and very common. Withdrawals are permitted up to 100% of the funds in the plan. Several clients have done this this past year. One client does it every year, to invest in more risky investment choices in his aggressive IRA. The code and ERISA both permit this as a qualified plan distribution, eligible for rollover to an IRA, and otherwise subject to the 10% penalty.

Two years ago I petitioned a client company (on behalf of a client employee) to change its adoption agreement to permit the in-service withdrawal. They agreed, as long as the employee had at least 10 years of service. The plan adoption agreement was changed again last year, to shorten this restriction to 5 years of service, because other employees heard about it and wanted to do the same. The adoption agreement had 2 check-boxes, one for 5 years, and the other for 10 years. It was a Sungard prototype plan (one of the larger national qualified plan authors).

http://www.irs.gov/retirement/articl...108942,00.html links to an IRS info-page, the last line stating that in-service non-hardship withdrawals are OK in a 401k. You can google "401k in-service withdrawal" and get oogles of references.

Sorry, but you are directly contradicting the code. The code is very clear. In-service distributions are not allowed under a 401(k) plan, unless the participant meets one of the exceptions:

Section 401(k) Cash or deferred arrangements

(1) General rule
A profit-sharing or stock bonus plan, a pre-ERISA money purchase plan, or a rural cooperative plan shall not be considered as not satisfying the requirements of subsection (a) merely because the plan includes a qualified cash or deferred arrangement.

(2) Qualified cash or deferred arrangement
A qualified cash or deferred arrangement is any arrangement which is part of a profit-sharing or stock
bonus plan, a pre-ERISA money purchase plan, or a rural cooperative plan which meets the requirements of subsection (a)--

(A) under which a covered employee may elect to have the employer make payments as contributions to a trust under the plan on behalf of the employee, or to the employee directly in cash;

(B) under which amounts held by the trust which are attributable to employer contributions made pursuant to the employee's election--

(i) may not be distributable to participants or other beneficiaries earlier than--

(I) severance from employment, death, or disability,
(II) an event described in paragraph (10),
(III) in the case of a profit-sharing or stock bonus plan, the attainment of age 59\1/2\, or
(IV) in the case of contributions to a profit sharing or stock bonus plan to which section 402(e)(3) applies, upon hardship of the employee, and

(ii) will not be distributable merely by reason of the completion of a stated period of participation or the lapse of a fixed number of years;

The new Military bill even has a provision in it to allow another exception to the general rule that you cannot take an in-service distribution unless one of the exceptions apply. The Joint Committee’s technical explanation of that bill says on page 11:

Limitation on in-service distributions
Under present law, certain types of contributions to a retirement plan are subject to
restrictions that generally limit distributions to a participant prior to the participant severing employment with the employer that sponsors the plan. This limitation on in-service distributions applies to: (1) elective deferrals under a qualified cash or deferred compensation arrangement (a “section 401(k) plan”); (2) amounts attributable to a salary reduction agreement under a section 403(b) tax-sheltered annuity; (3) amounts contributed to a custodial account described in section 403(b)(7); and (4) amounts deferred under an eligible deferred compensation plan (described in section 457(b)).

The explanation of the new law then goes on to explain the new rule on page 16 which says in part:

Under the provision, an individual is treated as having been severed from employment during any period the individual is performing service in the uniformed services while on active duty for a period of more than 30 days for purposes of the limitation on in-service distributions with respect to: (1) elective deferrals under a section 401(k) plan; (2) amounts attributable to a salary reduction agreement under a section 403(b) tax-sheltered annuity; (3) amounts contributed to a custodial account described in section 403(b)(7); and (4) amounts deferred under an eligible deferred compensation plan (described in section 457(b)). Thus, such individuals are not prohibited from receiving distributions on account of not severing employment.

Why all the fuss if any plan can be amended for any reason to allow in-service distributions?

The fact is, you can’t. Yes there are exceptions, but you have to follow the rules. As to the IRS website statement that you linked, that was said in the context of an in-service distribution that meets one of these special exceptions.

[Nashville]

Poor performance

Why all the fuss if any plan can be amended for any reason to allow in-service distributions?

Good answer may very well be that savvy investors want to bail out of a poor-performing 401k plan after receiving the benefit of the employers' contributions, and roll over their 401k into their own IRA where they can stop the plunder by the custodian.

A 401k is a smart thing because of employer matching. A typical $1000 contribution by an employee could typically be matched with another $500 from the employer. Bingo! Instant 50% return tax deferred!!

But after that, fees as high as 3-4% eat away at the $1500, such that better performing alternatives can be found almost anywhere! I have a client who wants to stay in her 401k so that her client will match her contribution, and as long as she is in that 401k she can't take any distributions including rollovers. However, her employer changes custodians every 2-3 years, and when they change, this gives her the golden opportunity to rollover everything into her own IRA, and then start anew with the 401k at work. I see her 1099-Rs when this happens and they are all "G" coded as rollovers.

Were it not for the prohibition on distributions as pointed out by Bees, I believe many others would resort to this strategy. Wonder if rollovers are interpreted as "in-service distributions" for these purposes??

[RJM]

Thanks Bees

Thank you for the additional backup... We have probably been doing something not permitted. The worst thing is that I worked with one client's TPA attorney a couple years ago to determine whether this was permitted. He has been signing off on these rollover distributions, and made the adoption agreement changes. I am wondering why the custodian has not been issuing 1099Rs that would flag the IRS, even with 100% distributions for one employee. My inclination is to let sleeping dogs lie at this point, but to discourage these distributions in the future.

Some of the google searches on this topic flat out give incorrect information, stating that deferrals are also eligible for the rollover treatment. I was stupid to rely on these for any comfort, but I honestly thought that everything on the internet had to be true!

-Naive tax accountant

[Bees Knees]

Naive could get you in trouble

I would worry about my malpractice liability insurance. If the IRS audits a pension plan and determines the rules are not met, the worst case scenario is the pension plan is immediately terminated and all vested benefits become fully taxable to the participants. Imagine all the lawsuits the innocent plan participants would then file against the one who gave the bad advice.

Even if I think I know the rules, I would never advise a client to amend their pension plan to say anything. I know just enough to be dangerous. Instead, I might voice my opinion, but then tell them they need to talk to the pension plan administrator to see what can be done. If the client self-administers their own plan, I’d tell them to seek the advice of an expert. The same is true for any legal advice. We are not lawyers. Trying to by-pass an attorney to save your client a few bucks could put you at-risk for malpractice.

[ChEAr$]

Is it possible?

that after tax balances within a 401k plan can be distributed without trigerring 1099R's?

One of my clients upon retiring rolled over his entire 401k into an IRA, and this total
included both pre tax and post tax balances.

[RJM]

To Bees: For the employee who was taking 100% distributions, the Plan TPA's attorney was blessing all of these transactions, and set up the changes to the adoption agreement. We were assured that there was no problem with these withdrawals, and the TPA has prepared 5500's with all this knowledge.

I will gather my old notes and e-mails, and talk with the TPA's attorney and see how he wants to proceed. In 2003-4 I did an EPCRS filing for a Plan with much more serious flaws with transactions with the sole shareholder, and the IRS was very nice about the whole thing, allowing the owner to cure the serious defects without any penalty.

[Burke]

that after tax balances within a 401k plan can be distributed without trigerring 1099R's?

One of my clients upon retiring rolled over his entire 401k into an IRA, and this total
included both pre tax and post tax balances.

Not good. He should have taken the post-tax contributions out first, or rolled them into a ROTH separately. Now it may be a problem with the new custodian unless they were notified of his basis. Check with them to see if they have it, and if not, if they can adjust their records to show it. He may be able to withdraw that exact amount, roll it over, and then file 5329 if the 1099R shows inappropriate code. Be prepared to document that basis.

[ChEAr$]

not as difficult as you might think.

Not good. He should have taken the post-tax contributions out first, or rolled them into a ROTH separately. Now it may be a problem with the new custodian unless they were notified of his basis. Check with them to see if they have it, and if not, if they can adjust their records to show it. He may be able to withdraw that exact amount, roll it over, and then file 5329 if the 1099R shows inappropriate code. Be prepared to document that basis.

Custodian doesn't care as to basis, since that is documented with form 8606 from now till
eternity.