The primary goal of a
retirement plan is to accumulate savings to provide income after
retirement. Most plans also allow distributions before retirement
age for a number of circumstances, including termination of
employment and financial hardship. Non-taxable participant loans may
also be an option.
Not surprisingly, plan administrators have witnessed an increase
in the number of withdrawal requests over the past year as a result
of the difficult economic times in which we live. Hardship
distributions and plan loans are on the rise, as employees struggle
to keep up with mortgage payments or put children through college.
This article will review the different types of withdrawals
available in a qualified plan and the rules that apply.
Salary deferral plans often allow participants to withdraw the
money they contributed in the event of financial hardship. The
available amount is limited to actual deferrals, reduced by prior
distributions. Earnings on deferrals may not be distributed unless
they were credited to the account before 1989.
To be eligible, the participant must have exhausted all other
available resources. Absent information to the contrary, a hardship
withdrawal shall be deemed necessary if:
- The participant has taken all other distributions and loans
available under all plans of the employer (loans must be taken
first unless they would increase the financial hardship);
- The distribution amount does not exceed the amount of the
financial need (taxes and penalties may be considered); and
- The participant suspends deferral contributions to the plan
for six months.
There also must be an immediate and heavy financial need. Under
the safe harbor hardship rules, the IRS failsafe list of financial
necessities includes the following:
- Deductible medical expenses for the participant, spouse or
- Purchase of a principal residence of the participant;
- Cost of tuition and related educational expenses for the
next 12 months of post-secondary education for the participant,
spouse or dependents;
- Funds needed to prevent eviction from or mortgage
foreclosure on the participant's principal residence;
- Funeral expenses for the participant's parent, spouse,
children or dependents; and
- Deductible repairs for the participant's principal
A plan may also permit a hardship distribution if the financial
need for medical, tuition or funeral expenses is incurred by the
participant's primary beneficiary.
Some profit sharing plans allow hardship distributions from
employer contribution accounts. Such hardship distributions would be
subject to rules that are similar, if not identical, to the deferral
hardship rules. Hardship distributions are not permitted from
Qualified Nonelective, Qualified Matching Contribution or safe
Plans may allow in-service distributions upon attaining normal or
early retirement age. Pension plans may allow distributions to
employees who reach age 62 and continue to work. Profit sharing
plans may have more liberal distribution rules for allowing
in-service distributions prior to retirement age.
Plans that allow after-tax or rollover contributions may permit
these accounts to be distributed at any time at the participant's
Termination of Employment
Most plans allow benefits to be distributed when a participant
terminates employment, whether the termination is due to retirement,
disability, death or other separation of service. However, a plan
may delay distribution until the terminated employee reaches the
plan's normal or early retirement age. Participants still employed
as of the plan's normal retirement age must become fully vested in
their accrued benefits. Many plans also provide full vesting upon
death, disability or early retirement.
If total benefits are $5,000 or more, the participant must
consent to the distribution. Benefits of less than $5,000 can be
cashed out without consent, if provided under the plan, but if the
cash-out exceeds $1,000, it must be an automatic rollover to an IRA
for the participant's benefit.
Required Minimum Distributions
The beginning date for required minimum distributions (RMDs) is
April 1st following the year a participant turns age 70½. However, a
plan may provide (and most plans do) that employees who do not own
more than 5% of the company will delay their RMDs until the year
they actually retire. A bill was recently introduced in Congress to
delay the starting age for RMDs from 70½ to 75.
Due to the severe downturn in the stock market in 2008, Congress
passed a law waiving the RMD for 2009 only. This will give investors
a chance to leave more of their money in their retirement accounts
with the hope that losses can be recouped if the market rebounds.
The waiver applies to defined contribution plans but not to defined
benefit plans. It relates to death benefit distributions as well as
age 70½ RMDs. A minimum distribution can still be provided upon
request and, since it's not required, it would qualify for rollover
Form of Benefit
Pension plans must provide that an annuity is the normal form of
benefit distribution. If the participant is married, the normal form
becomes a joint and survivor annuity providing at least a 50%
survivor's annuity to the spouse. Alternative forms of distributions
may also be provided, but they require spousal consent if the
participant is married (see below).
Non-pension plans (e.g., 401(k) and profit sharing plans) do not
have to provide an annuity distribution option but, if one is
provided, the same spousal consent rules apply to a married
participant electing a non-annuity option.
Death benefits must be distributed to the beneficiary within five
years of the year of death, unless they are being paid out over the
beneficiary's life expectancy, in which case they must begin by
December 31st of the year following the year of death. Other rules
apply where the participant dies after distributions have begun.
Pension law provides that if an annuity is available as a benefit
option, the spouse must consent to any form of benefit other than a
joint and survivor annuity providing at least 50% to the surviving
spouse. If the participant elects any other form of distribution,
such as a lump sum, direct rollover, etc., the spouse must consent
in writing and the signature must be witnessed by a notary or a plan
Such consent must be obtained after the spouse has received
timely explanations and benefit projections. A spouse must also
consent to a beneficiary designation other than the spouse. Many
plans require spousal consent for in-service withdrawals, including
participant loans, even if an annuity option is not available.
Taxation of Benefits
Participants and beneficiaries must be given a "Special Tax
Notice" which explains the tax consequences of the various
distribution options. Generally, benefits that are distributed from
a qualified plan are taxable to the participant as ordinary income
at the participant's applicable tax rate. Distributions from a Roth
account are not taxable if the account is at least five years old
and the participant has attained age 59½, died or become disabled.
If these requirements are not met, the earnings distributed are
If a distribution is eligible for rollover, mandatory 20% tax
withholding is required (certain exceptions apply). Also, a 10%
penalty tax applies for taxable distributions prior to age 59½.
There are several exceptions including distribution due to
disability, death and separation from service after attaining age
55. A bill was recently introduced in Congress to waive the 10%
penalty on plan distributions in the event of unemployment or to
make mortgage payments.
A participant can avoid current taxation of a plan distribution
by rolling it over to another qualified plan or an IRA. This is
usually accomplished by a direct rollover from trustee to trustee
thereby avoiding the 20% mandatory tax withholding.
Currently, a taxable distribution can be rolled over to a Roth
IRA if the individual's modified adjusted gross income does not
exceed $100,000. This results in the distribution being currently
taxable and treated like a Roth IRA conversion. The $100,000
adjusted gross income restriction is repealed as of 2010 at which
time anyone can do a taxable Roth rollover.
A spouse beneficiary can roll over a death benefit distribution
to an IRA or another qualified employer plan and delay distribution
until age 70½. As of 2007, plans were allowed to provide that
nonspouse beneficiaries can directly rollover death benefit
distributions to an IRA which will be treated like an inherited IRA
(in 2010 this will become a mandatory provision). Inherited IRAs are
subject to the same distribution rules applicable to death benefits
under a qualified plan; therefore, distributions cannot be delayed
until age 70½. The advantage of this option is where the decedent's
plan does not allow for lifetime payments to the beneficiary, since
this would now be available from the rollover IRA.
Many defined contribution plans allow active participants to
borrow money against their retirement accounts. The advantages of
taking a loan instead of an in-service distribution are: the loan is
non-taxable and not subject to the 10% premature distribution
penalty; it does not deplete retirement savings; and, in the case of
participant directed accounts, it is a guaranteed investment,
secured by the participant's vested interest.
Loans are limited to the lesser of $50,000 (reduced by the
highest loan balance of the prior 12 months) or 50% of the vested
benefits. They must bear a reasonable rate of interest and be repaid
within five years (longer terms are allowed for the purchase of a
principal residence). A plan may impose other restrictions such as a
minimum loan amount or a limit on the number of outstanding loans.
Loans that are in default become taxable to the participant,
including the 10% penalty (unless participant has attained age 59½).
Tough economic times have led to an increase in hardship
distributions and participant loans over the past year. While it's a
blessing to have such money available in time of need,
pre-retirement withdrawals can result in reduced benefits at
retirement. A plan loan may be preferable to a taxable distribution,
especially since it avoids a 10% premature distribution penalty.
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