| Distributions & Loans |
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D-1 Q: How are benefits paid from a 401(k) plan?
A: Distributions from a 401(k) plan may be made in the form of a lump sum distribution; a direct rollover to another qualified plan or IRA; installments over a fixed period including the life expectancy of the recipient; or an annuity that provides periodic payments over the life expectancy of the recipient. D-2 Q: What is the latest date that we must distribute an employee's 401(k) money?
-TOP
A: A 401(k) plan must provide that, unless a plan participant makes a request to the contrary, the money in a plan participant's 401(k) account will be paid no later than the 60th day after the end of the plan year in which the latest of three events occurs: (1) the participant reaches either age 65 or the normal retirement age specified in the plan, whichever is earlier; (2) the 10th anniversary of the year in which the participant joined the plan; or (3) the participant terminates employment. However, if the participant terminates employment or is a 5-percent owner of the employer, whether or not employed, a distribution from the plan must occur (or begin, if it is in the form of a series of payments) no later than April 1 of the year following the year in which such employee reaches age 701/2. D-3 Q: What is the earliest that employees are entitled to their
401(k) money without incurring penalties?-TOP
A: Penalty-free distributions from a 401(k) plan are permitted only when a plan participant dies, becomes disabled, reaches age 591/2 or separates from service after age 55. Also, distributions paid on termination of employment over the life expectancy of the participant are exempt from any additional taxes. Distributions that do not qualify under one of these criteria, including hardship withdrawals, are early withdrawals, and are subject to a 10-percent additional tax as well as regular income tax. D-4 Q: What is the earliest that employees are able to receive any distributions from a 401(k) plan?-TOP
A: Employer discretionary or matching contributions may be withdrawn if two years have passed since they were allocated under the plan, or if the participant has five years of plan participation. Employee after-tax contributions may be withdrawn at any time. Of course, distributions can only be made as provided under the terms of the Dian. D-5 Q: Do I have to get an employee's permission to make a distribution from
his or her account?-TOP
A: Nonforfeitable (vested) benefits worth more than $5,000 ($3,500 before the Taxpayer Relief Act of 1997 (TRA '97); may not be distributed without the employee's consent before the employee reaches normal retirement age. Spousal consent also may be required. Amounts under $5,000, however, may be distributed without the employee's consent. Such distributions are subject to the 10-percent additional penalty and 20-percent withholding tax on early distributions and are includible in taxable income unless they are rolled over within 60 days. D-6 Q: What happens if we terminate our 401(k) plan?-TOP
A: If there is a partial or complete termination of the plan, then all accrued benefits (to the extent that they are funded) immediately become 100-percent vested (or nonforfeitable) and must be available for distribution to participants. For profit-sharing and stock bonus plans, this is also the case if there is a continuing lack of meaningful contributions to the plan. If the plan is terminated within a few years of its inception, it may be deemed "nonpermanent" and disqualified from favorable tax treatment. As an alternative, a plan may be "frozen." In addition, a distributior of elective contributions to a participant is not permitted if the employer establishes or maintains a successor plan. D-7 Q: If Employer A is sold to Employer B, what happens to Employer A Is 401(k) plan?-TOP
A: Distribution of elective contributions to all participants is permitted upon termination of a 401(k) plan resulting from the sale of "substantially all" (at least 85 percent) of the employer's assets. (Employer B may choose to continue the old plan.) This is also the case if an employer sells its interest in a subsidiary that employs the plan participant. D-8 Q: Does an employer have to report an employee's 401(k) distribution to the IRS?-TOP
A: Yes. All distributions from a 401(k) plan must be reported to the IRS on Form 1099-R, "Statement for Recipients of Total Distributions From Profit-Sharing, Retirement Plans, Individual Retirement Accounts, Etc." The employee must be provided with a copy of the 1099-R form as well. D-9 Q: What happens if the ADP test
for a plan year is not satisfied?-TOP
A: If the ADP test for a plan year is not satisfied, the portion of the 401(k) plan attributable to elective contributions-and, most likely, the plan in its entirety-will no longer be qualified. The regulations, however, provide several mechanisms for correcting an ADP test that does not meet the requirements of the law. These mechanisms are as follows: D-10 Q: What is the tax treatment of
corrective distributions to employees?-TOP
A: The tax treatment of corrective distributions to employees depends on when the distribution is made. A corrective distribution made within 2 1/2 months after the end of the plan year is includible, to the extent at attributable to matching contributions, in the employee's gross income for the taxable year of the employee ending with or within the plan year in which the excess aggregate contribution arose. A corrective distribution made more than 2 1/2 months after the end of the plan year will be includible, to the extent attributable to matching contributions, in gross income for the taxable year in which distributed. The same rules apply to any income allocable to excess aggregate contributions. However, if the total amount of excess contributions and excess aggregate contributions for a plan year is less than $100, excess aggregate contributions and any allocated income will be includible in the year distributed regardless of when the corrective distribution is actually made. D-11 Q: What happens if a plan fails
to make a corrective distribution of excess aggregate contributions and
allocable income?-TOP
A: If a plan fails to make a corrective distribution during the 12month period following the plan year in which the excess aggregate contribution arose, the plan will be disqualified for that plan year and for all subsequent plan years in which the excess aggregate contribution remains in the plan. If a corrective distribution is made before the end of the 12-month period but more than 2 1/2 months after the end of the plan year, the employer will be subject to a 10 percent excise tax on the amount of the excess aggregate contributions. The excise tax can be avoided, however, if the employer makes QNECs enabling the plan to satisfy the ACP test. To be taken into account in performing the ACP test, QNECs must be made no later than 12 months after the plan year to which they relate. Thus, in 401(k) plans using the prior-year testing method in performing the ACP test, QNECs must be made no later than 12 months after the end of the prior plan year. D-12 Q: Are safe harbor employer contributions and QNEC contributions (used to pass adp/acp
tests) available for 401(k) loans?-TOP
A: Yes (TAG 5/15/2001) D-13 Q: Is there a special exemption for people who are 55+ and leave their job and want to take money from their 401(k) without penalty?-TOP
A: Yes. Their 401(k) lump sum distribution is exempt from the 10% excise tax if it is made after the employee has separated from service and the separation from service occurs during or after the calendar year in the which employee attained age 55. (TAG 5/17/2001) D-14 Q: Has the 20% back-up withholding been eliminated for hardship withdrawals? -TOP
A: Yes. (TAG 8/4/2001) D-15 Q: Does the 20% back-up withholding still apply to lump-sum
distributions?-TOP
A: Yes. (TAG 8/4/2001) D-16 Q:
Does the 20% back-up withholding still apply to all lump-sum distributions
from a 401(k) plan?-TOP
A: Yes. (TAG 8/01) D-17 Q:
What is a lump sum distribution?
-TOP
A: A lump sum distribution is a payment of the entire balance of a plan participant's 401(k) account within a single tax (calendar) year of the participant. D-18 Q:
What is fivD-year forward averaging?
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A: Because lump sum distributions may push recipients into a higher tax bracket for the year of the distribution, they are accorded special tax treatment in the form of fivD-year forward averaging. This method can be used to reduce the impact of the distribution to the recipient in a single tax year by calculating the tax that would be paid if the payment were broken up and spread over a fivD-year period. FivD-year forward averaging will not be available for distributions made after 1999. This averaging option has been repealed by the Small Business Job Protection Act of 1996, enacted Aug. 20, 1996. In addition, special 10-year forward averaging rules apply to individuals who reached age 50 by Jan. 1, 1986. D-19 Q:
What constitutes a disability?
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A: Although the term "disability" is not defined in ERISA Section 401(k) or the IRS' Section 401(k) regulations, Code Section 72(m) defines the term as the inability "to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long continued and indefinite duration." Because this definition is rather restrictive, some employers apply a more liberal standard pertaining to "inability to perform normal work." D-20 Q:
How is a hardship defined under the hardship withdrawal rules?
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A: In general, a hardship distribution can only be made on account of an "immediate and heavy financial need" of the employee and must be necessary to satisfy that need. (As a plan feature, hardship withdrawals are optional.) IRS rules specify four expenses that would qualify: payment of medical expenses, purchase of a principal residence, payment of tuition D-21 Q:
What is a QDRO?
-TOP
A: A qualified domestic relations order (QDRO) creates or recognizes an alternate payee's right to receive all or a portion of the benefits payable to a participant under a retirement plan. The order must be made according to a state domestic relations law and must meet minimum qualification requirements. D-22 Q:
What is a Stream-of-Payment QDRO?
-TOP
A: A Stream-of-Payment QDRO provides that all or a portion of the participant's benefit otherwise payable to the participant is to be paid to an alternate payee. Stream-of-Payment QDROs are usually used when the QDRO awards an interest in alimony or child support payments. D-23 Q:
What is a SeparatD-Interest QDRO?
-TOP
A: A SeparatD-Interest QDRO provides that the participant's accrued benefit under the plan is to be divided and a portion of the entire benefit is to be awarded to the alternate payee outright. SeparatD-Interest QDROs are common in defined contribution plans. D-24 Q:
What is the difference between participant loans and hardship withdrawals?
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A: Although both allow employees access to their prD-tax contributions, only loans must be repaid. A loan can be made against the employee's entire account balance, and must be repaid within five years (or 10 years if used to purchase a principal residence). Interest that is not tax deductible must be charged. D-25 Q:
Are there limits on the amount that an employee is allowed to borrow?
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A: Employees with $20,000 or less in their accounts may borrow up to $10,000 tax-free; employees with larger account balances may borrow half of their account balance tax-free, up to a maximum of $50,000 reduced by the highest account balance within the previous 12 months. Amounts borrowed in excess of those limits are considered taxable income. An employer may set a minimum loan amount up to $1,000. D-26 Q:
When are participant loans prohibited?
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A: Loans made under a 401(k) plan must meet ERISA's prohibited transaction rules, which require that a 401(k) plan loan must be available to all participants reasonably equitably. The rules also require that loans must be adequately secured and must charge a rate of interest commensurate to what lenders would charge. Loans that do not meet these criteria are prohibited. D-27 Q:
What happens if a loan is in default?
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A: Neither the tax code nor ERISA provides specific guidelines as to whether (or when) a 401(k) employee loan must be declared in default. IRS proposed regulations under Section 72(p) provide guidance on when a loan will be treated as a distribution for tax purposes. DOL regulations say that a 401(k) plan can refrain from treating a loan that becomes taxable under Section 72(p) for failure of timely repayment as a "distribution" until the defaulting participant is otherwise entitled to receive his or her 401(k) benefits. D-28 Q:
What are guidelines for a 401(k) Loan?
-TOP
A: A plan feature that allows participants to borrow money from their plan account and to pay it back through automatic after-tax payroll deduction. Generally, a loan is allowed for 50 % of the vested account balance, or $50,000 - whichever is less. If there is an outstanding loan balance, this amount is subtracted from the highest outstanding loan balance in the last 12 months. General loans can be financed for up to five years. If the money is used to purchase a primary residence, the loan can be extended up to 10 years. As long as participants repay the loan on time, they aren't subject to withholding taxes or penalties, as they would be if they withdrew the money from their account before retirement. Not all plans offer loans. D-29 Q:
Can a 401(k) be used as collateral for a independent loan? (In this question it is assumed the participant is NOT taking out a 401(k) loan, but instead "pledging" his/her 401(k) to a third-party lender).
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A: No; by federal law a qualified retirement plan sanctioned by the IRS cannot be used a collateral for an independent third-party loan. D-30 Q:
If a participant's employment is terminated prior to the last day of the
Plan Year, is the employee automatically entitled to either matching or
profit sharing contributions?
-TOP
A: No. If the plan document dictates, the employee may be required to work at least 1000 hours during the Plan Year, and/or be employed on the last day of the Plan Year to receive the contributions. (TAG) D-31 Q:
If an employee terminates employment, can he/she take a distribution of their
401(k) assets, even if the individual returns to the company as a legitimate independent contractor?
-TOP
A: YES. D-32 Q:
What are the 3 basic exceptions to the 10% penalty for distributions from the 401(k) prior to age 59 1/2?-TOP
A: D-33 Q:
If a disabled employee has a certification of a Social Security Disability can
he/she avoid the mandatory 20% backup withholding associated wit a distribution?
-TOP
A: No. Disabled employees who take distributions before 59 1/2 only avoid the 10% penalty. They are still subject to the 20% backup withholding. D-34 Q:
When an employee terminates employment and takes a lump sum distribution,
what form is used to send with the 20% backup withholding which is sent to
the IRS? How soon after the distribution is made must this payment be
made? -TOP
A: Federal Tax Deposit Form (Form 8109-B). Generally, income tax withheld from plan payments must be deposited with an authorized financial institution or a Federal Reserve bank or branch. A Federal tax deposit form must be included with each deposit. The timing requirement follows payroll withholding deposit rules. D-35 Q:
What is a default IRA rollover? -TOP
A: EGTRA creates a new rule for the distribution of terminated employee's 401(k) assets if they are between $1000 and $5000 and the employee does not elect a form of distribution. The employer can force the distribution, but must now open a "default IRA" for the proceeds to be rolled in to. I do not know how a default IRA can be set-up without the signature of the terminated employee. D-36 Q:
If an employer processes a distribution for a terminated employee, and in
error rolls all of their accounts to another plan, forgetting to keep the
non-vested employer contributions, can the non-vested amount be retrieved
within a certain time period? -TOP
A: The plan fiduciary or trustee is required to seek repayment if a terminated participant is paid more than their vested amount. There is not a prescribed time frame, but, as in the case with most corrections, the sooner the better. D-37 Q:
Is it permissible to change the interest rate on a 401(k) loan? Example:
an employee took out a loan when prime was high. The employer would like to
now lower that rate to reflect the current market rate. -TOP
A: Yes, participant loans may be refinanced to a lower interest rate if the loan policy permits refinancing, but the 401(k) Easy loan pac indicates that the loan interest rate shall be fixed, so it would not be allowed within 401(k) Easy. |