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Using 'In-Service Withdrawals' To Fund Life Insurance Needs

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In looking for assets to help fund an established life insurance need or other financial goal, you may find prospects among the employees of a small-sized business. If they are still employed and over age 59 1/2 (to avoid tax penalties), they may have a profit-sharing plan that is eligible for an “in-service distribution.”

As a result, taking an “in-service withdrawal” may be just the ticket to help a client find those premium dollars you thought were lacking.

How in-service withdrawals work

In-service withdrawals are permitted because, unlike defined benefit and other pension plans that must provide for retirement benefits, profit-sharing plans (which include 401(k) plans) are not so limited. Profit-sharing plans can permit a distribution of all or part of a participant’s vested interest that has remained in the plan for at least two years prior to the distribution.

The plans may also allow a participant with at least 5 years of plan participation to withdraw all or part of the participant’s vested interest, including amounts contributed within the last 2 years. In-service withdrawals can also be used for the purchase of incidental life, accident, or health insurance.

So, provided the plan permits distributions while the participant is still actively working and participating in the plan by virtue of the 2-year (“aged money”) or the 5 years of plan participation rule, in-service withdrawals are permitted.

In-service withdrawals can be done under various conditions, such as after a fixed number of years (at least two years as noted above); the attainment of a stated age; or upon the prior occurrence of some event such as a layoff, illness, disability, retirement, death, or severance of employment.

Remember, the profit-sharing plan document must specifically allow for such distributions. Many profit sharing plans allow for in-service withdrawals if elected in the agreement adopting the plan.

Such withdrawals can’t be made from amounts attributable to elective pre-tax contributions (including deferrals plus earnings, qualified non-elective, and matching contributions) from Internal Revenue Code (IRC) 401(k) profit-sharing plans prior to age 59 1/2 , except for hardship withdrawals and disability. However, hardships are generally limited to the employee’s pre-tax elective deferrals, less any prior hardship distributions, except for pre-12/31/88 gains if the plan provides for them. Also, hardship withdrawals cannot be rolled over into IRAs. In-service withdrawals can still be taken from other non-401(k) employer profit sharing contributions that are allowed in the plan.

Rolling into an IRA

In-service distributions from a profit-sharing plan can be rolled over into an IRA, even though the participant is not age 59 1/2 , deceased, disabled or separated from service. That’s because IRC Section 402(c)(4) describes distributions eligible for rollover as “any distribution” from a qualified plan, with limited exceptions. So, provided the in-service distribution doesn’t come within any of the exceptions (such as equal periodic distributions over a long period, required minimum distributions, and hardships from 401(k) plans), they can be rolled over.

Like other distributions, in-service withdrawals made prior to age 59 1/2 are ordinary income and subject to the 10% premature distribution penalty tax. This is true unless they fit under a stated exception to the tax, they are directly rolled over (to avoid 20% mandatory tax withholding) or they are rolled over within 60 days to an IRA or other plan.

Remember, the extent to which participants may take in-service withdrawals in profit-sharing plans are governed by the plan’s terms, and should appear in the plan’s summary plan description. All plans are limited in the extent to which they may allow in-service withdrawals. As we have seen, 401(k) plans are subject to more restrictions in this regard than non-401(k) profit-sharing plans.

As we know, the primary reason for qualified profit-sharing plans is to provide the participant with retirement income. However, occasionally a life-changing event, such as the birth of a child, the protection of other dependents, etc. creates a need for life insurance or another financial vehicle.

How to stand out

Perhaps it is difficult to find enough personal after-tax dollars to pay for the necessary insurance, special needs trust, etc. The IRC offers the option to access these dollars from profit-sharing plans even before actual retirement to assist clients in meeting their objectives. Therefore, asking your clients if such a plan exists may help you stand out as an advisor who can help them find the dollars to purchase the product they need.

Also, your prospecting shouldn’t be limited to only employers with in-service withdrawal provisions in their plans. That’s because profit-sharing plans can be amended to include these provisions if they don’t already have them. In searching for money, let’s leave no stone unturned.

Ron Merolli, JD, is director of advanced sales at National Life Group, Montpelier, Vt. You can e-mail him at [email protected]