For clients who have recently started to see rebounding 401(k) values, the prospect of allowing those funds to remain exposed to market fluctuations may seem too great a risk as they near retirement age and begin to crave retirement income guarantees. Fortunately, options exist to allow these clients to take control of their risk exposure using their 401(k) funds without actually waiting until retirement. By taking advantage of little-known IRS rules that provide for in-service 401(k) withdrawals, the client can use funds that are already earmarked for retirement to implement an annuity strategy that guarantees income during retirement — without incurring a single penalty — while they are still working and contributing to the 401(k).

In-Service withdrawals: the rules

While IRS guidelines generally permit 401(k) plans to offer penalty-free in-service withdrawals, the first step for any client is to determine whether the plan itself actually contains provisions permitting these pre-retirement withdrawals. Recent studies, however, indicate that upward of 90 percent of 401(k) plans permit in-service withdrawals for nonhardship purposes once the client reaches age 59½.

Generally, the rules allow the client to avoid penalties by directly rolling certain types of 401(k) funds into an IRA within the traditional sixty-day window that applies to tax-free rollovers. In general, the 401(k) funds will be eligible if they are employer-matching and profit-sharing contributions, employee after-tax contributions to a traditional 401(k), or pre-tax employee and Roth contributions once the client reaches age 59½.

These rules must be followed carefully in order to avoid the 10 percent penalty tax that typically applies to premature 401(k) distributions.

The fixed annuity strategy

Transferring 401(k) funds to an IRA can offer a variety of benefits, such as increasing investment options and allowing heirs to take advantage of the rules governing inherited IRAs to stretch the tax-deferral benefits over their lifetime. Despite this, for many clients, the most attractive option may be to invest the IRA assets in a fixed indexed annuity that can provide them with a level of guaranteed retirement income that is established even before reaching retirement.

As most clients know, a fixed indexed annuity is one that bases the performance of the annuity upon the performance of one or more major market indices, capping the gains that can be realized within the product in order to provide a cushion against any investment losses that would be realized if the funds were directly invested in the market.

Not all fixed indexed annuities are created equally, however, and it is important that the client understand the contractual fine print before committing to any particular product. Since the client who makes the in-service withdrawal has yet to retire, the annuity should be one that offers flexibility as to the date that annuity payouts will begin.

Further, the rules governing how gains are credited to the client’s account can be important to maximizing the value of the annuity. Also known as a “rollup,” the annuity product (or attached rider) will provide a method for determining how frequently gains are credited to the account value. In some cases, the client will have to wait for a set period of time to begin annuity payouts in order to take advantage of the rollup, but other contracts offer riders that provide for a daily rollup so the client has greater flexibility in determining a retirement date.

Conclusion

Although the counterargument to the annuity-within-an-IRA strategy is that both vehicles offer tax deferral benefits that can make housing the annuity within the IRA redundant (at least from a tax perspective), for the risk adverse client who is approaching retirement age, the strategy can make sense. For these clients, the certainty that hard-earned retirement funds are protected against market volatility in the years leading up to retirement can prove invaluable.

Your questions and comments are always welcome. Please contact the Panel of Experts.