401(k) and Qualified Plans: Distributions

Distribution is the official way of describing withdrawing funds from your retirement plans. Generally, the law requires qualified plans to pay retirement benefits no later than the time an employee reaches normal retirement age, and many plans provide earlier payments under certain circumstances. For example, a plan may allow employees to receive distributions after terminating employment regardless of the employee's age. The plan's summary plan description (SPD) should provide the rules for obtaining the distribution as well as the timing of distribution after termination of employment.

Learning the following terms and concepts will help you understand when you can receive money from your retirement funds – and what the tax implications (or any penalties) are.

Triggering Event (When You Get Your Money)

Generally, distributions from a qualified plan cannot be made until one of the following occurs:

• The employee reaches retirement age, as defined under the plan.
• The employee becomes disabled.
• The employee dies, at which time the beneficiary is eligible for distributions.
• The employee separates from service (leaves the job, voluntarily or otherwise).
• The plan is terminated and is not replaced by another defined contribution plan.

All of the above are referred to as triggering events.

If the plan is a profit-sharing or a 401(k) plan, employees are allowed to take "in-service withdrawals" if the plan permits. An in-service withdrawal is a distribution that may occur without the employee experiencing a triggering event. Some plans will allow an in-service withdrawal only if the employee experiences financial hardships as defined by the plan. Some plans also let participants borrow funds. 

Tax on Early Distributions 

If a distribution is made to an employee under the plan before he or she reaches age 59½, the employee may have to pay a 10% penalty tax on the distribution. This tax applies to the taxable amount received by the employee.

Avoiding the Penalty

The 10% tax will not apply before age 59½ if distributions are taken for reasons that include the following:

• The distribution is made to a beneficiary on or after the death of the employee.
• The distribution is made because the employee acquires a qualifying disability.
• The distribution is made as part of a series of substantially equal periodic payments (SEPP) beginning after separation from service and made at least annually for the life or life expectancy of the employee – or the joint lives or life expectancies of the employee and his or her designated beneficiary. (The payments under this exception, except in the case of death or disability, must continue for at least five years or until the employee reaches age 59½, whichever is the longer period.)
• The distribution is made to an employee after separation from service, if the separation occurred during or after the calendar year in which the employee reached age 55.
• The distribution is made to an alternate payee under a qualified domestic relations order (QDRO).
• The distribution is made to an employee for medical care up to the amount allowable as a medical expense deduction (determined without regard to whether the employee itemizes deductions).
• The distribution is made in a timely way to reduce excess contributions under a 401(k) plan.
• The distribution is made in a timely way to reduce excess employee or employer matching contributions (excess aggregate contributions).
• The distribution is made in a timely way to reduce excess elective deferrals.
• The distribution is made because of an IRS levy on the plan.

Withholding on Eligible Rollover Distributions (You Can Avoid This)

Distributions paid to an employee are subject to a mandatory federal withholding of 20% if the distribution exceeds $200 for the year and is an eligible rollover distribution. Distributions that are not eligible rollover distributions are not subject to the mandatory 20% withholding. There is a way to avoid this withholding, as we will see in a minute. But first, an explanation.

Eligible rollover distributions are distributions of all or any part of an employee's balance in a qualified retirement plan, except if the distribution is any of the following:

• a required minimum distribution
• any of a series of substantially equal periodic payments made at least once a year over any of the following periods:
  • the employee's life or life expectancy
  • the joint lives or life expectancies of the employee and beneficiary
  • a period of 10 years or longer

• a hardship distribution
• a corrective distribution of excess contributions or deferrals under a 401(k) plan and any income allocable to the excess, or a corrective distribution of annual additions and any allocable gains
• loans treated as distributions
• dividends on employer securities
• the cost of life insurance coverage

An employee may avoid the 20% withholding by having the distribution processed as a direct (trustee-to-trustee) rollover to an eligible retirement plan. In a direct rollover the assets are made payable to the trustee or custodian of the receiving retirement plan for the benefit of the employee.

Taking Required Minimum Distributions (You Can't Avoid This)

Under the required minimum distributions (RMD) rules, a qualified plan must provide that either of the following occurs:

• Each participant will receive his or her entire interest (benefits) in the plan by the required beginning date (RBD).
• Each participant will begin to receive regular periodic distributions by the required beginning date. The distributions are annual amounts calculated so that the participant's entire interest is distributed over his or her life expectancy – or over the joint life expectancy of the participant and the designated beneficiary.

The plan administrator must figure the RMD for each participant and distribute the amount to each participant who is required to remove an RMD from his or her qualified plan account.

If an employee participates in more than one qualified plan, the RMD for each plan must be calculated separately. Unlike IRAs, the RMD for multiple plans cannot be combined and taken from one plan.

Required Beginning Date

Generally, each participant must begin receiving RMDs by April 1 of the year following the calendar year they reach age 70½. If the plan allows – and the employee is still employed after they reach age 70½ – the RMD can be delayed until April 1 following the year the employee retires. The option to delay the RMD after April 1 following the calendar year in which the employee reaches the 70½ birthday is not available to employees who own at least 5% of the business.

Subsequent RMD amounts must be distributed by December 31 of each year.

Excess-Accumulation Penalty

Employees who do not take their RMD by the prescribed deadline will owe the IRS a 50% excess-accumulation penalty. The 50% is assessed on the amount that was not distributed.

Example: Excess Accumulation Penalty

Jane's RBD is April 1, 2017. Her RMD for 2017 is $40,000 – and for 2018, her RMD is $38,000. Jane distributed her 2017 RMD of $40,000 on March 1, 2018. By Dec. 31, 2018, she had taken out only an additional $20,000. For 2018, Jane was $18,000 short from meeting her RMD, so she owes the IRS $9,000 [($38,000 - $20,000) x 0.5 = $9,000].

Jane must pay the excess-accumulation penalty when she files her federal tax return, unless she feels that the failure was due to reasonable circumstance – in which case, she may write to the IRS and request that the penalty be waived. If a waiver is requested, the penalty should not be paid unless the IRS denies the request.

Qualified Joint and Survivor Annuity (QJSA)

In a money-purchase pension plan, the retirement benefit payment generally must occur in a series of equal, periodic payments over the lifetime of the employee – or the joint life of the employee and beneficiary – and the payments must continue to the employee's spouse for the rest of his or her life if he or she survives the employee. The periodic payment to the surviving spouse must be at least 50% but not more than 100% of the periodic payment received by the participant while he or she was alive. This form of payment is called a qualified joint and survivor annuity (QJSA), and the plan must provide an explanation of the QJSA in a timely manner.

If the plan provides other forms of benefit payment, the employee and his or her spouse can elect to waive their rights to receive the QJSA and select one of the other payment options available. The waiver must be made in writing within certain time limits and be witnessed by a notary public or plan representative.