401(k) plans are subject to strict participant distribution rules. These rules are intended to dissuade plan participants from cashing out their savings prior to retirement. Following these rules is a plan qualification requirement. That means IRS sanctions - including fines or plan disqualification – can result when an employer fails to follow their plan’s rules properly. With some basic 401(k) distribution education, these consequences can be easy to avoid.
We get a lot of questions about 401(k) distributions from employers. Below is a FAQ with answers to the most common questions we receive. We hope you’ll find our 401(k) distribution guide helpful.
When are 401(k) Distributions Permitted?
In general, 401(k) plans cannot permit participant distributions until a distributable event occurs. These events can vary based on the terms of the governing plan document.
The distributable events required by law include:
- Death, disability, or severance from employment
- Plan termination
401(k) plans are also allowed – but not required – to offer “in-service” distributions under the following conditions:
- Elective deferrals (including Roth), safe harbor contributions, QNECs and QMACs cannot be distributed before the participant attains age 59.5.
- Profit sharing and non-safe harbor matching contributions can be distributed at any age.
- Rollover and voluntary after-tax contributions can be distributed at any time.
How are 401(k) Distributions Taxed?
All rollover-eligible distributions are subject to mandatory 20% federal income tax withholding when paid in cash. Distributions that cannot be rolled over (e.g., hardships, RMDs) are subject to 10% federal withholding unless the participant elects a lower amount. State tax withholding may also apply.
The ultimate tax liability on a 401(k) distribution, however, will depend upon the participant’s actual federal and state income tax rates. That means participants will receive a tax refund if their actual federal tax rate is less than the 20% withholding rate or owe more taxes if their rate is higher.
401(k) distributions paid to participants younger than age 59½ in cash are generally subject to a 10% premature withdrawal penalty. However, exceptions to this rule apply. Common exceptions include:
- The participant terminates employment during the calendar year in which they attain age 55
- The participant is the beneficiary of the death distribution
- The participant has a qualifying disability
- The participant is the beneficiary of a Qualified Domestic Relations Order (QDRO)
- The distribution is due to an ADP/ACP test refund.
How are Roth Deferrals Taxed Differently?
Traditional employee deferrals are contributed on a pre-tax basis and then taxed upon distribution. Roth deferrals are the opposite. They are contributed on after-tax basis and then distributed tax-free.
The earnings on Roth deferrals can also be distributed tax-free if part of a “qualified withdrawal.” A qualified withdrawal is one that occurs:
- at least five years after the calendar year in which Roth deferrals were first made and
- after the participant:
- Attains age 59½
- Becomes disabled
If Roth deferrals are part of a non-qualified withdrawal, their earnings are taxable at applicable Federal and state rates and may be subject to the 10% premature withdrawal penalty.
Additional answers to Roth questions can be found in our Roth FAQ.
Do 401(k) Distributions Always Require Participant Consent?
No. The law allows 401(k) plans to force-out small account balances – defined as less than $5,000 – related to terminated participants without consent. Under these force-out rules, account balances between $1,000 and $5,000 must be rolled into a personal IRA for the benefit of the terminated participant. Amounts below $1,000 can be distributed to the terminated participant in cash.
Terminated participants with a larger balance can leave their account in their former employer’s plan until Required Minimum Distributions (RMDs) must commence.
What is a Hardship Distribution?
A hardship distribution is a form of in-service distribution. To qualify for a hardship distribution, a 401(k) participant must meet two criteria. First, they must have an “immediate and heavy financial need.” Second, the distribution cannot exceed the amount “necessary to satisfy” the financial need.
What’s an Immediate and Heavy Financial Need?
401(k) plans have two options for defining an “immediate and heavy financial need:” 1) use the IRS safe harbor definition, or 2) use a custom definition. Most 401(k) plans choose the safe harbor option. It specifies six events that are automatically considered as an immediate and heavy financial need:
- Medical care expenses for the employee, the employee’s spouse, dependents or beneficiary.
- Costs directly related to the purchase of an employee’s principal residence (excluding mortgage payments).
- 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.
- Payments necessary to prevent the eviction of the employee from the employee’s principal residence or foreclosure on the mortgage on that residence.
- Funeral expenses for the employee, the employee’s spouse, children, dependents, or beneficiary.
- Certain expenses to repair damage to the employee’s principal residence.
- Expenses resulting from a federally declared disaster.
What’s 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 needed to cover the “immediate and heavy financial 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 Necessary to Substantiate a Hardship?
When the safe harbor definition of immediate and heavy financial need is used by a 401(k) plan, employers have two options for “substantiating” a hardship distribution – basically, confirming the participant’s hardship request meets the plan’s need and amount requirements.
- Traditional substantiation method – obtain the actual source documents that substantiate the need for the distribution. This is the only option for non-safe harbor hardships.
- Summary substantiation method – rely on a participant-provided summary of the financial hardship, provided that the summary contains certain information.
Regardless of method used, hardship documentation must be retained in accordance with ERISA’s documentation retention rules.
What are the Consequences for Taking a Hardship Distribution?
Taking a hardship distribution can be costly. Not only are they taxable at personal income rates, but most participants under age 59 ½ will pay an additional 10% early distribution penalty. Further, hardship distributions can’t be repaid or rolled to another retirement plan. That means the amount distributed will miss out on future earnings. Due to the power of compound interest, these lost earnings can become substantial over time.
In short, taking a hardship distribution should be a last resort.
What are Required Minimum Distributions?
A Required Minimum Distribution (RMD) is the minimum amount a 401(k) participant must withdraw from their account annually.
RMDs must commence no later than the April 1 following the calendar year in which the participant:
- Attains age 72, or if later,
- Retires (assuming the participant is not a 5% owner of the plan sponsor).
For subsequent calendar years, the RMD deadline is December 31.
How are RMDs Calculated?
The required RMD amount for a year is calculated by dividing the market value of the participant’s 401(k) account (as of December 31 of the prior year) by a life expectancy factor.
Are Roth Deferrals Subject to the Same RMD Rules as Roth IRAs?
No. Roth IRAs are not subject to RMDs until the death of the IRA owner, while Roth deferrals are subject to the same RMD timing rules as pre-tax contributions.
However, RMDs from a Roth account can be sidestepped by rolling the balance to a Roth IRA prior to the RMD deadline.
Can RMDs be Rolled Over?
No. RMDs can’t be rolled to another retirement plan to defer taxation. They must be distributed in cash.
How are RMDs Taxed?
The taxable portion of a RMD is subject to Federal taxation at ordinary income rates. RMDs may also be subject to state and local taxes.
RMDs are not subject to mandatory 20% tax withholding because they are not rollover-eligible. Instead, they are subject to 10% withholding unless a different % is elected by the participant.
What are the Consequences of Missing an RMD?
Missing an RMD could lead to serious consequences for the plan and the affected participant. A plan can technically be disqualified for failing to correct a missed RMD – however most plans will self-correct the issue to avoid trouble. The affected participant could be subject to a 50% IRS excise tax on the missed RMD amount. The IRS may waive 50% excise tax if the missed RMD was due to reasonable error and that reasonable steps were taken to remedy the shortfall.
Staying Out of Trouble Can be Easy!
Employers must understand the 401(k) plan’s distribution rules to follow them properly. The good news – these rules are straightforward in general.
Have further 401(k) distribution questions? Talk to your 401(k) provider. A qualified provider will have a quick answer.