401(k) Distribution Rules: Frequently Asked Questions for Employers and Employees

401(k) plans are subject to strict IRS distribution rules to ensure that retirement savings are used as intended. Whether you're an employer managing a retirement plan or an employee planning for your financial future, understanding when and how distributions are permitted is essential. This FAQ addresses the most important questions about 401(k) distributions, incorporating recent updates from the SECURE Acts and hardship distribution regulations.

What is a 401(k) Distribution?

A 401(k) distribution is a withdrawal of funds from a participant’s retirement account. Distributions can include pre-tax and after-tax contributions, employer contributions, Roth contributions, and investment earnings. IRS rules determine when these funds can be accessed, and most distributions are subject to income tax—plus a 10% penalty if taken early, unless an exception applies.

Most 401(k) distributions can be “rolled over” by depositing the proceeds into another retirement plan or IRA. When a 401(k) distribution is rolled over, you generally don’t pay tax on it until you withdraw it from the new plan.

When Can 401(k) Participants Take a Distribution?

Generally, 401(k) participants can only take a distribution upon the occurrence of a qualifying event, known as a "distributable event." These include:

• • Severance from employment (e.g., resignation, termination, retirement)
  • Disability or death of the participant
  • In-service withdrawals (if the plan allows)
  • Hardship withdrawals (if the plan allows)
  • Withdrawal of after-tax or rollover contributions (if the plan allows)
  • Required minimum distributions (RMDs) starting at a certain age
  • Plan termination

A plan must define which of these events apply. Employers must ensure distributions do not occur unless a permissible event has taken place. Unauthorized distributions can result in plan disqualification.

When is a 401(k) Distribution Eligible for Rollover?

A 401(k) distribution must be an "eligible rollover distribution" to be rolled over to another retirement plan or IRA. You can roll over most distributions except:

• • Hardship withdrawals
  • Required minimum distributions (RMDs)
  • Corrective distributions (e.g., excess contributions)
  • Permissive withdrawals to opt out of auto enrollment
  • Loans treated as deemed distributions
  • A series of payments based on life expectancy or paid over a period of ten years or more

Types of 401(k) rollovers:

There are two main types of 401(k) rollovers – direct and indirect. Direct rollovers are most popular.

• • Direct Rollover: Funds are transferred directly from the 401(k) plan to another retirement account, such as an IRA or another employer's 401(k) plan.

• • • Advantages: No taxes are withheld and the transaction is not reported as income.
    • How it's done: The plan issues a check payable to the receiving institution or wires the funds directly.
  • Indirect Rollover: Funds are paid to the participant, who then has 60 days to deposit them into another eligible retirement account.
    • Drawbacks: federal withholding applies upfront. To roll over the full amount, the participant must replace the withheld amount from other funds.
    • Tax implications: If the rollover is not completed within 60 days, the amount becomes a taxable distribution and may also be subject to an early withdrawal penalty.

When are In-Service Withdrawals Allowed?

In-service withdrawals are distributions a participant takes while still actively employed. Plans have no obligation to offer in-service withdrawals. Common types include:

• • Age 59½ withdrawals: Participants may withdraw elective deferrals (including Roth) and safe harbor contributions after reaching age 59½.
  • Withdrawals of after-tax and rollover contributions: Participants may generally access these funds at any time—even before age 59½—without needing to satisfy a qualifying event.
  • Hardship distributions: These in-service withdrawals are subject to special rules.

What are the Rules for Hardship Distributions?

401(k) plans can offer hardship distributions to help participants pay for certain events. When allowed, a participant must meet two criteria to qualify for a hardship distribution. First, they must have an “immediate and heavy financial need.” Second, the distribution must be limited to the amount “necessary to satisfy” the financial need.

What is an immediate and heavy financial need?

401(k) plans can use either the IRS safe harbor to define an “immediate and heavy financial need” or their own. Most 401(k) plans choose the safe harbor definition. Under this definition, seven events are automatically considered as an immediate and heavy financial need:

1. 1. Medical care expenses for the employee, the employee’s spouse, dependents or beneficiary.
   2. Costs directly related to the purchase of an employee’s principal residence (excluding mortgage payments).
   3. Tuition, related educational fees and room and board expenses for the next 12 months of postsecondary education for the employee or the employee’s spouse, children, dependents or beneficiary.
   4. Payments necessary to prevent the eviction of the employee from the employee’s principal residence or foreclosure on the mortgage on that residence.
   5. Funeral expenses for the employee, the employee’s spouse, children, dependents, or beneficiary.
   6. Certain expenses to repair damage to the employee’s principal residence.
   7. Expenses resulting from a federally declared disaster (SECURE 1.0).

What is the “amount necessary to satisfy” the financial need?

Hardship distributions must be limited to the amount necessary to satisfy the need. This rule is satisfied if:

• • The distribution is limited to the amount necessary to cover the need, including any taxes or penalties that may result from the distribution.
  • The employee could not reasonably obtain the funds from another source.

Unless the employer has actual knowledge to the contrary, they may rely on the employee’s written statement that their need can’t be relieved from other available resources, including:

• • Insurance or other reimbursement.
  • Liquidation of the employee’s assets.
  • The employee’s pay, by discontinuing elective deferrals and after-tax employee contributions.
  • Plan loans or reasonable commercial loans.

What documentation is needed to substantiate a hardship request?

When the safe harbor definition of immediate and heavy financial need is used, employers have two options to substantiate the need:

• • Traditional method – obtain documents that substantiate the need for the distribution (e.g., medical bills, eviction notice).
    • This is the only option for non-safe harbor hardships.
  • Self-certification method – Allows employers to rely on a written certification by the employee that their withdrawal satisfies the need and amount requirements.

Regardless of method used, hardship documentation must be retained in accordance with ERISA’s documentation retention rules.

When Can Voluntary After-Tax or Rollover Contributions Be Withdrawn?

When applicable, 401(k) plans can allow participants to withdraw voluntary (not Roth) after-tax contributions and rollover contributions at any time. Unlike other in-service distributions, these amounts are not tied to age or financial hardship. The taxable portion would be subject to a 10% early withdrawal penalty if distributed before age 59½, unless an exception applies.

What are Corrective Distributions and When Do They Occur?

When a 401(k) plan fails annual nondiscrimination testing or a participant exceeds an annual contribution limit, corrective distributions may be necessary to fix the issue.

Common corrective distributions include:

• • ADP/ACP test refunds: Highly compensated employees (HCEs) may receive a distribution of excess deferrals matching contributions to correct a failed test.
  • Excess annual contributions: If a participant exceeds the IRS 402(g) limit for elective deferrals in a calendar year, the excess amount must be distributed by April 15 of the following year to avoid double taxation.

Employers should act promptly when errors are discovered and ensure corrections are made within IRS-prescribed timelines to avoid additional penalties or plan disqualification.

What Special Rules Apply to Roth 401(k) Contributions?

Roth 401(k) contributions are taxed when made so their amount can be distributed tax-free. When part of a “qualified distribution,” earnings can also be distributed tax-free

A Roth 401(k) distribution is considered qualified—and therefore fully tax-free—if:

• • The participant has held the Roth account for at least five years, and
  • The distribution occurs after age 59½, due to death, or due to permanent disability.

SECURE Act 2.0 (2024) eliminated RMDs from Roth 401(k) accounts, aligning them with Roth IRAs.

Does a Terminated Participant Have to Take a 401(k) Distribution?

It depends upon the size of the terminated participant’s vested account balance. If the balance is below a certain threshold, they may have to take a distribution. Otherwise, their plan may automatically distribute the funds pursuant to the IRS’ automatic rollover rules. Under these rules:

• • If the balance is $1,000 or less, the plan can issue a cash distribution without participant consent.
  • If the balance is between $1,001 and $7,000, the plan must automatically roll the funds over into an IRA established in the participant’s name.

What are Required Minimum Distributions (RMDs) and When Must They Start?

Required Minimum Distributions (RMDs) are the minimum amounts you must withdraw from your retirement accounts each year. The RMD rules are designed to ensure your retirement savings are eventually taxed.

Participants must begin RMDs from a 401(k) account by April 1 of the year following the year they reach their RMD age (unless they are still employed and not a 5% owner of the employer). After the first RMD, future RMDs must be taken annually by December 31.

For example, if you reach age 73 in 2024:

• • Your first RMD is due by April 1, 2025, based on your account balance on December 31, 2023, and
  • Your second RMD is due by December 31, 2025, based on your account balance on December 31, 2024.

SECURE 2.0 made two important changes to the RMD rules:

• • Raised RMD age to 73 beginning in 2023 and to 75 beginning in 2033
  • Eliminated RMDs for Roth 401(k) accounts until after the death of the account owner (aligning them with Roth IRAs).

Missed RMDs are subject to a 25% excise tax, reduced to 10% if corrected within two years.

How are 401(k) Distributions Taxed?

401(k) distributions are typically subject to federal income tax and may be subject to state taxes as well. The tax treatment depends on the type of contribution being distributed and whether the distribution is rolled over:

• • Pre-tax elective deferrals, employer contributions, and earnings: Taxable as ordinary income.

• • Roth 401(k) contributions: Not taxable upon distribution (already taxed).
  • Roth earnings: Tax-free if the distribution is qualified.
  • Voluntary after-tax contributions: Not taxable upon distribution; earnings are taxable.
  • Direct rollovers to another plan or IRA: Not taxable at the time of transfer.

What Tax Withholding Applies to 401(k) Distributions?

Withholding on 401(k) distributions refers to the portion of a withdrawal that a plan must withhold and remit to the IRS (and possibly your state) as a prepayment of your income tax liability.

Here’s how it works:

• • 20% mandatory federal withholding applies to most lump-sum distributions that are eligible for rollover but are paid directly in cash rather than rolled over.
  • 10% federal withholding typically applies to distributions that are not eligible for rollover (such as RMDs and hardship withdrawals), though participants can often elect out.
  • No withholding applies to direct rollovers or qualified Roth distributions.
  • State withholding may also apply depending on the state of residence and the type of distribution.

All taxable distributions must be reported on IRS Form 1099-R. The form includes the gross distribution, taxable amount, withholding amounts, and a distribution code.

Participants should be encouraged to consult a tax advisor to understand the full tax impact of any distribution.

What is the Age 59½ Early Withdrawal Penalty?

Distributions before age 59½ are generally subject to a 10% IRS early withdrawal penalty, in addition to regular income taxes. However, there are several exceptions that allow penalty-free early withdrawals. Exceptions include:

• • Death or disability of the participant
  • Permissive withdrawals to opt out of auto enrollment
  • Separation from service during or after the year the participant turns 55
  • Corrective distributions
  • Payments under a Qualified Domestic Relations Order (QDRO)

Although these distributions avoid the penalty, most are still taxable. Plan sponsors should educate participants about these rules but avoid giving personal tax advice.

Summary of 401(k) Distribution Considerations

(1) Roth rollovers must be made to another Roth account

(2) State withholding may also apply depending on the participant’s residence

Participants should consult a tax advisor before deciding on a distribution option, especially when considering potential penalties, taxes, or long-term investment implications.

Conclusion

401(k) distribution rules are complex and evolving. Understanding them is critical for both employers and employees. For employers, compliance helps protect the plan’s tax-qualified status and ensures participants receive accurate guidance. For employees, understanding these rules helps avoid taxes and penalties and make informed choices about accessing retirement savings.

By staying informed and reviewing plan documents regularly, both employers and employees can make confident, compliant decisions that support long-term goals.