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A 401(k) plan permits
employees to defer a portion of their salaries on a pre-tax basis with
the objective of accumulating assets for retirement. Additional assets
are accumulated if the employer makes matching and/or profit sharing
contributions to the participant’s account.
With today’s mobile workforce, many distributions are made before
retirement because employees usually become eligible to receive
distributions when they terminate employment. Distributions also become
payable due to death, disability or a Qualified Domestic Relations Order
(QDRO). In addition, many 401(k) plans permit hardship withdrawals.
Sometimes active participants are forced to take minimum distributions
after reaching age 70½.
In the following pages we will explore the rules and tax consequences
associated with the various types of distributions from a 401(k) plan.
Rollover vs. Cash Distribution
Distributions from 401(k) plans are generally made in
a lump sum, although some plans permit participants to elect installment
payments or an annuity. If the distribution is eligible for rollover,
the participant can avoid immediate taxation by rolling it over to a
traditional IRA (e.g., not a Roth IRA) or another qualified plan.
Distributions eligible for rollover include:
 | Lump sum payments to terminated
participants (including disabled or retired); |
| Death benefits paid to a spouse
beneficiary; |
| QDRO distributions to a spouse or
former spouse; |
| In-service distributions unless made
on account of hardship; and |
| Installment payments over a period
of less than ten years. |
Distributions ineligible for rollover include:
| Death benefits to a non-spouse
beneficiary; |
| Age 70½ required minimum
distributions; |
| Hardship distributions from all
accounts; |
| Corrective distributions due to
failed nondiscrimination tests or exceeding legal limits; |
| Loans treated as distributions; and
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| Installment payments of ten years or
more or over the life expectancy of the participant or the joint lives
of the participant and beneficiary. |
The portion not directly rolled over and distributed
in cash is taxed in the year received and is generally subject to
mandatory federal income tax withholding and possibly subject to a
penalty as described below. The participant gets a second chance to roll
over the cash distribution within 60 days of its receipt. However, he
must find money to replace the tax withheld if he wants to roll over
100% of the distributed amount.
Mandatory Federal Tax Withholding
If the participant elects to receive a cash
distribution and it is eligible to be rolled over, the taxable portion
is subject to 20% mandatory income tax withholding (state tax
withholding may also apply). For example, if the participant’s taxable
cash distribution is $100,000, he will only receive $80,000 and the
other $20,000 will be forwarded to the IRS (which may not necessarily be
sufficient to cover the tax on the distribution). Participants may waive
tax withholding for distributions ineligible for rollover.
10% Premature Distribution Penalty
If the participant is under age 59½, the distribution
will generally be subject to a 10% premature distribution penalty unless
one of the following exceptions apply:
| Participant is totally and
permanently disabled; |
| Participant separated from service
during or after the calendar year in which he attained age 55;
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| Death benefits paid to a
beneficiary; |
| QDRO distributions to an alternate
payee; |
| Payments made directly to the
government to satisfy an IRS tax levy; |
| Corrective distributions due to
failed nondiscrimination tests or exceeding legal limits; |
| Medical expense distributions that
do not exceed deductible medical payments; and |
| Substantially equal payments made
after separation from service over the life expectancy of the
participant or the joint lives of the participant and beneficiary.
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The 10% penalty is reported and paid to the IRS along
with the participant’s income tax return.
Retirement and Termination
Participants who attain the plan’s early or normal
retirement age become 100% vested in the employer’s account balance and
are often eligible to receive a distribution, even if still employed.
If the participant terminates employment before the plan’s retirement
age, his employer account balance is subject to the plan’s vesting
schedule (salary deferrals are always 100% vested). Many 401(k) plans
provide for distribution of the participant’s account balance shortly
after termination of employment.
If the terminated participant’s account balance is over $5,000, it
cannot be distributed without the participant’s consent. The plan may
permit an involuntary cash-out if the vested account balance is $5,000
or less. Effective March 28, 2005, involuntary cash-outs between $1,000
and $5,000 are required to be rolled over to an IRA established by the
plan sponsor on behalf of the participant.
Death Benefits
Participants should complete beneficiary designation
forms naming both primary and alternate beneficiaries. Generally, the
death benefit is required to be paid to the participant’s spouse unless
the spouse has consented in writing, witnessed by a notary public or a
plan representative, to another beneficiary designated by the
participant.
Plans typically provide for 100% vesting upon the death of the
participant. The participant’s spouse is permitted to roll over the
death benefit to avoid immediate taxation. Rollovers are not permitted
by non-spouse beneficiaries.
Disability Benefits
Plans may permit distributions due to total and
permanent disability. The plan document will specify the criteria for
determining eligibility for disability benefits. Most plans provide for
100% vesting if the participant becomes disabled.
Required Minimum Distributions
The minimum distribution rules require that
participants and beneficiaries begin receiving distributions by certain
deadlines and limit the period over which benefits can be paid. The
following participants are required to begin receiving minimum
distributions:
| More than 5% owners who have reached
age 70½ even if they are still actively employed; and |
| Non-owner employees who have
terminated employment and have reached age 70½. |
For more than 5% owners, annual distributions must
begin by the April 1st of the year following the year in which the
participant attains age 70½ (unless a special written election was made
before 1984). For actively employed non-5% owners who have attained age
70½, the required beginning date is the April 1st following the year in
which the participant terminates. (Prior to 1996, all actively employed
participants who turned age 70½ were required to begin receiving minimum
annual distributions and some plans may still include this provision.)
The amount of the distribution is generally calculated by dividing
the participant’s account balance by life expectancy factors provided by
the IRS.
Qualified Domestic Relations Order
A QDRO provides child support or alimony payments or
divides marital property as part of a divorce or separation. Many plans
permit the immediate cash-out of benefits to the alternate payee,
usually the spouse or child, which avoids the need for segregated
accounts. Payments to a participant’s spouse (or former spouse) are
taxable to the spouse in the year distributed unless rolled over.
Distributions to a child of the participant are taxed as income to the
participant and are not eligible for rollover.
Hardship Distributions
Many plans permit hardship withdrawals of salary
deferrals. Only the amount the participant deferred may be distributed.
Earnings on the deferrals may not be distributed unless they were
credited to the participant’s account generally before 1989.
The IRS rules regarding hardship withdrawals are very specific and
regulations require the satisfaction of two conditions:
| There is an immediate and heavy
financial need; and |
| Other resources are not available to
satisfy the need. |
A safe harbor method of satisfying these requirements
is utilized by many 401(k) plans which permits a hardship distribution
if it is due to:
| Medical expenses incurred by the
employee, the employee’s spouse or other dependents not reimbursed by
insurance; |
| Costs directly related to the
purchase of a principal residence of the employee; |
| Payment of tuition and related
college/graduate school expenses for the next twelve months for the
employee, the employee’s spouse, children or other dependents; or
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| Payment necessary to prevent the
eviction or foreclosure of the employee from his primary residence.
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Final 401(k) regulations, which generally become
effective for plan years beginning on or after January 1, 2006, expand
the list of safe harbor hardship events to include:
| Burial or funeral expenses for the
employee’s parent, spouse, child or dependent; and |
| Repair of damage to the employee’s
principal residence that would qualify as deductible casualty
expenses. |
Participants must first have taken all other permitted
withdrawals and loans available from all plans maintained by the
employer and are not permitted to make any contributions to any plan
sponsored by the employer for at least six months after receipt of the
hardship withdrawal.
The above mandated requirements are only applicable to salary
deferrals. Some plans also permit hardship withdrawals from profit
sharing and matching contribution accounts, which are permitted to have
less restrictive hardship withdrawal requirements. To simplify plan
administration, some plans apply the salary deferral rules to all
accounts.
IRS Special Tax Notice and Reporting
Before making a distribution election, each
participant must be given a "Special Tax Notice Regarding Plan Payments"
which explains the tax consequences of distributions. Plan distributions
are reported to the IRS on Form 1099-R which includes information
concerning the type of distribution, taxable amount, taxes withheld and
whether or not the 10% penalty is applicable.
Summary
Distribution decisions hold myriad consequences.
Employees who do not consider the tax consequences may be in for a rude
awakening when they complete their tax returns and discover that not
only do they owe additional income taxes on the distributed amount but
also a 10% penalty. Plan administrators need to be aware of these
complex rules in order to communicate effectively with participants
seeking to take distributions from the plan.
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