Many Americans have a 401(k) retirement savings plan as a benefit of employment with their employers. They contribute a percentage of their compensation to their 401(k) each pay period with the intention of taking distributions at retirement. As with most retirement plans, there are often questions about the timing for taking a distribution and the resulting tax implications. This article summarizes Internal Revenue Service (IRS) guidance, “401(k) Resource Guide – Plan Participants – General Distributions Rules,” for a better understanding of these directives.
Types of Distributions from a 401(k)
The most common type of distribution is one taken upon the retirement of a participant who has reached the age of at least 59 ½. These distributions can be periodic payments, (generally monthly), or can be nonperiodic lump sum payments; there is no additional substantiation requirement beyond proof of age. A participant who has not yet reached the age of 59 ½ may take other types of distributions; however, additional requirements must be met.
Distributions from most 401(k) plans are considered taxable income to the recipient. An exception is the designated Roth 401(k). Before making contributions to a 401(k), a participant should check with his or her employer to inquire whether the plan is a designated Roth 401(k) plan. Also, if certain criteria are not met, the distribution will be subject to an additional 10% income tax over and above the regular income tax liability. The subsections below outline instances when the additional 10% tax may be due.
Distributions Upon Termination of Service from the Participant’s Employer
Once a participant leaves employment, he or she is no longer eligible to make contributions to that company’s 401(k) plan. The former employee may leave the funds in the plan until he or she reaches the age of 59 ½, or may do one of the following:
- Roll over the balance to an individual retirement account (IRA) or 401(k) plan maintained by his or her new employer. This is considered an eligible rollover – the distribution is not taxed at that time.
- Take a lump-sum distribution to pull all of the funds out of the 401(k) account. If the former employee has not reached the age of 55, there will be a 20% mandatory federal income tax withholding and a 10% additional tax for early withdrawal.
A participant may request a hardship distribution out of his or her 401(k) if he or she can demonstrate immediate and substantial financial need. The requirements are stringent– the participant must not be able to meet the financial need using any other resources, including those of his or her spouse and minor children. Generally, a hardship distribution will be granted only for expenses related to:
- Medical care for the participant, spouse, or dependents.
- The purchase of a principal residence for the participant.
- Tuition and educational fees for postsecondary education for the employee, spouse, or dependents.
- Certain federally declared disasters for which IRS relief has been granted.
Though hardship distributions are subject to ordinary income, they are not subject to the additional 10% tax for early withdrawals. Further, a participant may not make additional contributions to his or her 401(k) for six months following the hardship distribution.
Required Minimum Distributions
Another type of distribution is not at the discretion of the participant. Once one reaches the age of 70 ½, he or she is required to take at least a minimum distribution each year thereafter. The plan administrator is obligated to calculate the dollar amount of the participant’s required minimum distribution and disburse the money each year; the participant may not opt out of the distribution.
Know Your 401(k) Plan Rules
Though there are general guidelines that all retirement plans must adhere to, it is always a good idea for a participant to check with his or her employer and/or plan sponsor for specific rules for that 401(k) plan. It is especially important for a participant to familiarize him or herself with the rules regarding distributions prior to taking one so that he or she does not accidentally wind up owing much more income tax than expected.
If you have questions about a retirement plan distribution, particularly one out of a 401(k) plan, or if you would like to request a speaker on this topic for your organization or event, contact one of our PYA executives below at (800) 270-9629.