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
- 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;
- 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.
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
- Payment necessary to prevent the eviction or foreclosure of
the employee from his primary residence.
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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