Is it possible for a client to keep a defined benefit plan open while simultaneously transferring funds to an IRA or 401(k), or must the plan be terminated first?
Generally, defined benefit plans can be rolled over into other retirement structures upon plan termination. However, business owners often want to roll out the funds early so that they can avoid investment return restrictions. They would still like to keep the plan open so they can continue to make large, tax-deferred retirement contributions.
In this article, we will examine the legality of this matter. We will cover a few tips and tricks along the way. Let’s get started.
Some Background
Business owners use defined benefit plans to make large tax-deductible contributions, but must manage challenges related to investment returns, interest rates, and actuarial estimates.
Therefore, clients often want more investment flexibility while keeping plans open for ongoing tax-deferred contributions.
The good news is that the IRS does allow plan participants to take in-service distributions from a defined benefit plan upon reaching age 59 1/2. This occurred in 2019 with the signing into law of the Bipartisan American Miners Act (BAMA).
Although this is legal, there are specific restrictions and conditions that must be met. The first is that the plan must allow in-service distributions.
What is an “In-Service” Distribution?
An in-service distribution from a defined benefit plan is a payment made to a participant while they are still employed with the company. Traditionally, defined benefit plans only allowed distributions after retirement, separation of service, or plan termination.
However, under certain rules, a plan may be amended to permit in-service distributions once a participant has reached a specific age, typically 59½. This age threshold is significant because it aligns with IRS rules that allow retirement plan withdrawals without the 10% early withdrawal penalty.
The option for an in-service distribution depends on the language of the plan document. Employers are not required to offer it, but the law permits them to do so if the plan is properly amended. If available, the participant may take benefits in a lump sum or in other forms, such as annuity payments.
When a lump sum is offered, the participant can often roll those funds into an IRA or another qualified plan to preserve tax-deferred growth. Importantly, the plan must also remain in compliance with IRS funding and nondiscrimination requirements when such distributions are made.
For business owners, in-service distributions provide greater flexibility in retirement planning. However, restrictions apply, such as funding thresholds or limitations on the amount that can be distributed. Because the rules are complex and vary by plan, participants should review the plan document closely and consult with tax or retirement professionals before pursuing an in-service distribution.
What are the Limitations and Restrictions?
For defined contribution plans, such as a 401(k), in-service distributions at age 59 ½ are relatively straightforward. But for defined benefit plans, an in-service distribution at age 59 ½ is a bit more complex. One of the three following thresholds must be met before a Highly Compensated Employee may complete an in-service distribution:
- After the lump sum payment, plan assets must equal or exceed 110% of current plan liabilities;
- The value of the benefits paid to the participants is less than 1% of the plan’s current liabilities; or
- The participant’s payable benefits do not exceed $5,000.
The above safeguards help ensure the plan has adequate assets available to pay other participants after a lump sum in-service distribution is made. Many business owners are unaware of this when establishing a plan.
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A defined benefit plan may fluctuate between being overfunded and underfunded. For most business owners, receiving a lump sum in-service distribution depends on meeting the 110% funding threshold. If the plan doesn’t pass this test, the owner must contribute enough to reach 110%. Otherwise, only the participant’s accrued benefit can be distributed.
Other Considerations
Making a lump sum distribution available to active employees aged 59 1/2 or older requires careful evaluation of core strategic objectives.
- Beyond de-risking strategies, employers must weigh how in-service distribution options affect employee retention and engagement. These features can help retain experienced workers who might otherwise retire by allowing them to receive pension benefits while remaining employed.
- In-Service Distribution Options Must Include Annuity Payment Forms. Although an employer might be motivated by “de-risking” considerations that are best satisfied if the participant elects a lump sum form of payment, the plan cannot force a lump sum distribution and cannot provide a lump sum distribution as the only in-service Sponsors considering an age 59½ in-service distribution option should consult advisors about benefit calculations for participants who elect early distribution.ion of employment.
- In-service distributions for active employees 59½ or older can be temporary or permanent. IRS rules generally prohibit removing a permanent in-service distribution feature for accrued benefits once it has been implemented. The IRS accepts short-term in-service distributions, but warns that repeated, short-term offerings may be viewed as creating a permanent feature, making it subject to the same restrictions on removal.
- Lump sum distributions are most effective in well-funded plans. If funding falls below certain thresholds, lump sums may be restricted or prohibited. Employers should understand these rules and how accelerated distributions might impact future required contributions.
Adding an in-service distribution provision for employees aged 59½ or older is a strategic decision that affects both the employer’s and the employee’s interests. Careful consideration ensures the potential benefits are maximized for both parties.
Final Thoughts
In summary, while defined benefit pension plans were once locked down to allow distributions only upon retirement, separation, or plan termination, recent legal changes—most notably via the Bipartisan American Miners Act—have opened up the possibility of in-service distributions once a participant reaches age 59½, provided the plan is amended to allow that.
This gives business owners and employees alike more flexibility: under the right conditions, you may be able to take a lump sum while still working, roll that sum into an IRA or other qualified plan, and thus gain greater control over investment choices and tax management. But the ability to do so doesn’t come automatically; the plan’s governing documents must explicitly permit such distributions.
However, that flexibility is subject to meaningful guardrails. Key thresholds—such as having plan assets at least 110% of liabilities, limiting the distributed benefits relative to total liabilities, or ensuring the individual benefit doesn’t exceed a modest de minimis amount—help protect the financial health of the plan and the interests of all participants.
If you’re considering using an in-service distribution option or want to implement one in your defined benefit plan, start with the plan document. Review whether it has been amended to allow distributions at 59½, whether it includes lump sum options and rollover permissions, and whether it meets any of the funding/liability thresholds. With the right structure and careful attention to detail, in-service distributions can offer valuable flexibility, but only if done correctly.
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