View This Newsletter: Rules and Taxation of 401(k) Plan Distributions

Overview:

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 contributions to the participant’s account.

• 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 (not a Roth IRA) or another qualified plan.
• 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).
• 10% Premature Distribution Penalty
  • If the participant is under age 59½, the distribution will generally be subject to a 10% premature distribution penalty unless an exception applies.
• Retirement and Termination
  • Participants who attain the plan’s normal retirement age become 100% vested in the employer’s account balance and are often eligible to receive a distribution, even if still employed.
• Disability Benefits
  • Plans may permit distributions due to total and permanent disability.
  • Most plans provide for 100% vesting if the participant becomes disabled.
• Death Benefits
  • Plans typically provide for 100% vesting upon the death of the participant. The participant’s beneficiary is permitted to roll over the death benefit to an IRA.
• Required Minimum Distributions (RMDs)
  • 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.
  • Here is some more information on Required Minimum Distributions (RMDs)
• Hardship Distributions
  • Many plans permit hardship withdrawals of salary deferrals.
  • 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.
• 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
  • 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.
• 2017 IRS Annual Limits
  • Included in the newsletter are the 2017 limits as well as the 2016 limits.
  • Here is more information on the 2017 IRS Annual Limits.

Pinnacle Plan Design is a third-party administrator (TPA) for employer-sponsored qualified retirement plans. We specialize in retirement plan design, administration and actuarial consulting for 401(k)/profit-sharing plans, defined benefit plans, cash balance plans, and 403(b) plans. Pinnacle Plan Design proudly serves businesses nationwide.