The primary goal of a
retirement plan is to accumulate savings to provide income after
retirement. Most plans also allow distributions before retirement age
for a number of circumstances, including termination of employment and
financial hardship. Non-taxable participant loans may also be an
option.
Not surprisingly, plan administrators have witnessed an increase in
the number of withdrawal requests over the past year as a result of
the difficult economic times in which we live. Hardship distributions
and plan loans are on the rise, as employees struggle to keep up with
mortgage payments or put children through college.
This article will review the different types of withdrawals
available in a qualified plan and the rules that apply.
Financial Hardship
Salary deferral plans often allow participants to withdraw the
money they contributed in the event of financial hardship. The
available amount is limited to actual deferrals, reduced by prior
distributions. Earnings on deferrals may not be distributed unless
they were credited to the account before 1989.
To be eligible, the participant must have exhausted all other
available resources. Absent information to the contrary, a hardship
withdrawal shall be deemed necessary if:
- The participant has taken all other distributions and loans
available under all plans of the employer (loans must be taken first
unless they would increase the financial hardship);
- The distribution amount does not exceed the amount of the
financial need (taxes and penalties may be considered); and
- The participant suspends deferral contributions to the plan for
six months.
There also must be an immediate and heavy financial need. Under the
safe harbor hardship rules, the IRS failsafe list of financial
necessities includes the following:
- Deductible medical expenses for the participant, spouse or
dependents;
- Purchase of a principal residence of the participant;
- Cost of tuition and related educational expenses for the next 12
months of post-secondary education for the participant, spouse or
dependents;
- Funds needed to prevent eviction from or mortgage foreclosure on
the participant's principal residence;
- Funeral expenses for the participant's parent, spouse, children
or dependents; and
- Deductible repairs for the participant's principal residence.
A plan may also permit a hardship distribution if the financial
need for medical, tuition or funeral expenses is incurred by the
participant's primary beneficiary.
Some profit sharing plans allow hardship distributions from
employer contribution accounts. Such hardship distributions would be
subject to rules that are similar, if not identical, to the deferral
hardship rules. Hardship distributions are not permitted from
Qualified Nonelective, Qualified Matching Contribution or safe harbor
accounts.
In-Service Distributions
Plans may allow in-service distributions upon attaining normal or
early retirement age. Pension plans may allow distributions to
employees who reach age 62 and continue to work. Profit sharing plans
may have more liberal distribution rules for allowing in-service
distributions prior to retirement age.
Plans that allow after-tax or rollover contributions may permit
these accounts to be distributed at any time at the participant's
request.
Termination of Employment
Most plans allow benefits to be distributed when a participant
terminates employment, whether the termination is due to retirement,
disability, death or other separation of service. However, a plan may
delay distribution until the terminated employee reaches the plan's
normal or early retirement age. Participants still employed as of the
plan's normal retirement age must become fully vested in their accrued
benefits. Many plans also provide full vesting upon death, disability
or early retirement.
If total benefits are $5,000 or more, the participant must consent
to the distribution. Benefits of less than $5,000 can be cashed out
without consent, if provided under the plan, but if the cash-out
exceeds $1,000, it must be an automatic rollover to an IRA for the
participant's benefit.
Required Minimum Distributions
The beginning date for required minimum distributions (RMDs) is
April 1st following the year a participant turns age 70½. However, a
plan may provide (and most plans do) that employees who do not own
more than 5% of the company will delay their RMDs until the year they
actually retire. A bill was recently introduced in Congress to delay
the starting age for RMDs from 70½ to 75.
Due to the severe downturn in the stock market in 2008, Congress
passed a law waiving the RMD for 2009 only. This will give investors a
chance to leave more of their money in their retirement accounts with
the hope that losses can be recouped if the market rebounds. The
waiver applies to defined contribution plans but not to defined
benefit plans. It relates to death benefit distributions as well as
age 70½ RMDs. A minimum distribution can still be provided upon
request and, since it's not required, it would qualify for rollover
treatment.
Form of Benefit
Pension plans must provide that an annuity is the normal form of
benefit distribution. If the participant is married, the normal form
becomes a joint and survivor annuity providing at least a 50%
survivor's annuity to the spouse. Alternative forms of distributions
may also be provided, but they require spousal consent if the
participant is married (see below).
Non-pension plans (e.g., 401(k) and profit sharing plans) do not
have to provide an annuity distribution option but, if one is
provided, the same spousal consent rules apply to a married
participant electing a non-annuity option.
Death benefits must be distributed to the beneficiary within five
years of the year of death, unless they are being paid out over the
beneficiary's life expectancy, in which case they must begin by
December 31st of the year following the year of death. Other rules
apply where the participant dies after distributions have begun.
Spousal Consent
Pension law provides that if an annuity is available as a benefit
option, the spouse must consent to any form of benefit other than a
joint and survivor annuity providing at least 50% to the surviving
spouse. If the participant elects any other form of distribution, such
as a lump sum, direct rollover, etc., the spouse must consent in
writing and the signature must be witnessed by a notary or a plan
representative.
Such consent must be obtained after the spouse has received timely
explanations and benefit projections. A spouse must also consent to a
beneficiary designation other than the spouse. Many plans require
spousal consent for in-service withdrawals, including participant
loans, even if an annuity option is not available.
Taxation of Benefits
Participants and beneficiaries must be given a "Special Tax Notice"
which explains the tax consequences of the various distribution
options. Generally, benefits that are distributed from a qualified
plan are taxable to the participant as ordinary income at the
participant's applicable tax rate. Distributions from a Roth account
are not taxable if the account is at least five years old and the
participant has attained age 59½, died or become disabled. If these
requirements are not met, the earnings distributed are taxable.
If a distribution is eligible for rollover, mandatory 20% tax
withholding is required (certain exceptions apply). Also, a 10%
penalty tax applies for taxable distributions prior to age 59½. There
are several exceptions including distribution due to disability, death
and separation from service after attaining age 55. A bill was
recently introduced in Congress to waive the 10% penalty on plan
distributions in the event of unemployment or to make mortgage
payments.
Rollovers
A participant can avoid current taxation of a plan distribution by
rolling it over to another qualified plan or an IRA. This is usually
accomplished by a direct rollover from trustee to trustee thereby
avoiding the 20% mandatory tax withholding.
Currently, a taxable distribution can be rolled over to a Roth IRA
if the individual's modified adjusted gross income does not exceed
$100,000. This results in the distribution being currently taxable and
treated like a Roth IRA conversion. The $100,000 adjusted gross income
restriction is repealed as of 2010 at which time anyone can do a
taxable Roth rollover.
A spouse beneficiary can roll over a death benefit distribution to
an IRA or another qualified employer plan and delay distribution until
age 70½. As of 2007, plans were allowed to provide that nonspouse
beneficiaries can directly rollover death benefit distributions to an
IRA which will be treated like an inherited IRA (in 2010 this will
become a mandatory provision). Inherited IRAs are subject to the same
distribution rules applicable to death benefits under a qualified
plan; therefore, distributions cannot be delayed until age 70½. The
advantage of this option is where the decedent's plan does not allow
for lifetime payments to the beneficiary, since this would now be
available from the rollover IRA.
Participant Loans
Many defined contribution plans allow active participants to borrow
money against their retirement accounts. The advantages of taking a
loan instead of an in-service distribution are: the loan is
non-taxable and not subject to the 10% premature distribution penalty;
it does not deplete retirement savings; and, in the case of
participant directed accounts, it is a guaranteed investment, secured
by the participant's vested interest.
Loans are limited to the lesser of $50,000 (reduced by the highest
loan balance of the prior 12 months) or 50% of the vested benefits.
They must bear a reasonable rate of interest and be repaid within five
years (longer terms are allowed for the purchase of a principal
residence). A plan may impose other restrictions such as a minimum
loan amount or a limit on the number of outstanding loans.
Loans that are in default become taxable to the participant,
including the 10% penalty (unless participant has attained age 59½).
Conclusion
Tough economic times have led to an increase in hardship
distributions and participant loans over the past year. While it's a
blessing to have such money available in time of need, pre-retirement
withdrawals can result in reduced benefits at retirement. A plan loan
may be preferable to a taxable distribution, especially since it
avoids a 10% premature distribution penalty.
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