Certified Plan Sponsor Professional (CPSP) Practice Exam

Are in-service withdrawals exempt from taxation and early distribution penalties?

1. Yes, they are exempt

2. No, they are not exempt

3. Only for hardships

4. Depends on the retirement plan type

The correct answer is: No, they are not exempt

In-service withdrawals, which occur when participants take distributions from their retirement plans while still employed, are generally subject to taxation and early distribution penalties unless specific conditions or exemptions apply. Typically, distributions that occur before the age of 59½ from tax-deferred retirement accounts like 401(k) plans incur both regular income tax and a 10% early withdrawal penalty. This means that unless a withdrawal meets certain IRS criteria for exceptions—such as being due to a disability or qualifying for medical expenses—these withdrawals typically do not avoid penalties or taxes. An important distinction to note is that while some plans may allow for in-service withdrawals, it is often dependent on the circumstances of the withdrawal, such as hardship, which may have its own set of rules and exemptions. In-service withdrawals for hardship purposes may, in some cases, avoid penalties, but generally speaking, they are not broadly exempt from taxes or penalties. Therefore, the understanding that in-service withdrawals are not exempt from taxation and early distribution penalties aligns with the general rules governing retirement plan distributions.