Distribution is the word the IRS and the financial industry use to talk about withdrawing money from an employer-sponsored retirement plan or any other tax-deferred retirement plan, like an IRA. Generally, tax-deferred employer-sponsored plans like 401(k), 403(b), 457 and Thrift Savings Plan are governed by similar IRS regulations. The specifics mentioned below apply to 401(k) plans but generally will apply to other plans.The major exception to this is the 457 plan – funds are available for distribution without penalty at any age, upon separation from the employer sponsoring the plan. People who remain employed with the employer sponsoring the plan will not be eligible for distributions until attaining age 70½ or retiring. Regular income taxes will still apply.
Generally, employees are eligible to take penalty-free distributions at age 59½, but the IRS does not require that employees take distributions until the calendar year that the employee turns 70½. People can take distributions from employer-sponsored plans prior to age 59½, but the IRS will assess a penalty of 10% in addition to the income taxes due. The IRS offers significant tax benefits for employer-sponsored retirement plans – this is an investment that is never subject to capital gains taxes and allows employees to make contributions on a pre-tax basis, including untaxed company matches, to encourage employees to save for retirement. These retirement plan tax advantages are the reason that there is a significant penalty for disobeying the rules.
There are several scenarios in which an employee will need to decide what kind of distribution to take from a 401(k) or other employer-sponsored plan. Below is information about 401(k) distributions, which will often be similar to other employer-sponsored plans. Please consult your plan documents about the specific kinds of distributions that are allowed in your plan. And always consult your tax adviser before taking any action that could trigger a taxable event.
Below we have described four distribution scenarios:
- Separation From Employer
- Separation From Employer With Outstanding Loan
- Non-Penalized Distributions Taken After Age 59½
- Minimum Required Distributions
Separation From Employer
In the event that an employee separates from an employer, for any reason, there are several options the employee can consider in deciding what to do with a 401(k) account balance. Here is a breakdown of the options:
1. Leave the money in the plan:
Often a separated employee is allowed to keep 401(k) money in the plan as long as the individual has a vested account balance of at least $5,000.
2. Cash out:
Note that, for the proceding reasons, Smart401k strongly recommends against this action. Cashing out prior to age 59½, even due to separation from employment, could have a drastic impact upon the balance of money received and upon income taxes. The IRS assesses a 10% penalty for early withdrawal (prior to age 59½). Further, the 401(k) plan provider will be required to withhold 20% for federal income taxes and 2% to 8% for state income taxes, depending upon state of residence. Additionally, the employee will receive a 1099R the following tax season that will state that the entire distribution was taxable income – possibly bumping the employee into a higher tax bracket.
3. Rollover into new employer’s plan:
A rollover into a new employer’s 401(k) plan will not trigger any taxes or penalties. Consolidating these two accounts allows the owner to easily track and manage retirement savings since all money will be in the same account.
4. Rollover into IRA:
A rollover into an IRA will not trigger any taxes or penalties. Obviously an IRA rollover means an additional account to manage for individuals who have found alternate employment and will invest in the new employer’s retirement plan. The major advantages of an IRA are:
- Access to virtually limitless investment options that these individual accounts offer – a typical 401(k) generally offers 10 to 30 investment options,
- A tax situation that is more advantageous for beneficiaries in the event that the account-holder dies and
- Less-extreme partial withdrawal penalties – which might make an IRA rollover a better option than leaving the money in a former employer’s 401(k) plan for someone recently laid-off who needs to take a partial distribution.
Separation From Employer With Outstanding Loan
Separating from employment with an outstanding 401(k) loan will be more complicated than a simple separation-from-employment scenario. Below are the four main options for someone in this position:
1. Leave the funds in the former employer’s 401(k) plan while paying off the loan:
The primary benefit of this option is that the loan will not go into default, thereby saving an additional tax payment. There will be a loan repayment time frame (this varies between plans), and there are penalties for deviating from the repayment plan. Lump-sum repayment methods will vary from plan to plan (personal check, EFT, wire and cashier’s check are possible options), and plan documents should enumerate the available methods.
2. Let the loan go into default:
Leave money in the former employer’s 401(k) plan, but stop making loan repayments. 401(k) loan default does not have a negative impact upon credit, but it triggers a taxable event. Some employers assess penalties in addition to the IRS penalty. The IRS will treat a defaulted loan the same as an early withdrawal, with the caveat that accrued loan interest will also be considered income for tax purposes. People under 59½ will owe an additional 10% penalty assessed, on top of regular federal and state income taxes. As with an early partial withdrawal or cash-out, a defaulted loan will trigger the receipt of a 1099R, which will increase taxable income.
3. Cash out the 401(k) account:
The net effect of cashing out a 401(k) account with a loan is that taxes and penalties will be paid on the entire account value, including the loan. But since the employee already received the loan money, the distribution will not include that amount. Here is an example based on a total account value of $10,000 – with $5,000 of that being a loan:
- No taxes have been paid on the loan, so taxes will be taken based on the entire account balance – the employer will withhold 20% of $10,000 for federal income tax, which is $2,000.
- An additional 2% to 8% will likely be withheld for state income taxes.
- The 10% early withdrawal penalty will apply to the entire $10,000.
- Assume for this example that the employee lives in a state with a 5% automatic income withholding: 20% withheld for federal taxes, 5% withheld for state taxes and a 10% penalty means that 35% of the account balance will be withheld ($3,500). On top of that, $5,000 already was received in the form of the loan. So the employee would receive $1,500 in this scenario.
4. Rollover to an IRA or new employer’s 401(k) plan:
Unfortunately, IRS rules do not allow the transfer of a loan from one plan to another. In the case of a rollover, if a loan is not paid off prior to the rollover, the loan is considered defaulted. The account owner will need to pay taxes and penalties on the loan, and that portion of the account balance will not rollover to the new employer’s plan or IRA. Employers cannot deduct taxes from rollover checks, so the employee is responsible for the balance of taxes the following tax season. The employee will receive a 1099R indicating that the loan was a cash payment to the account owner.
Non-Penalized Distributions Taken After Age 59½
People over age 59½ will not be subject to the 10% penalty on cash distributions. These people have several options for their money. Most employers will allow the money to remain invested in the 401(k) plan, regardless of employment status, as long as there is at least $5,000 in account value. When the time comes, there are several distribution options:
1. Cash out:
Proceeds are made payable directly to the employee, and the employer will withhold 20% in federal income taxes and 2% to 8% in state income taxes. All money is considered earned income and could bump the recipient into a higher tax bracket. Obviously larger withdrawals will result in more income tax and a higher tax bracket. The former employer would send a 1099R during tax season reflecting the distribution and taxes.
A rollover to an IRA or a new employer’s plan both are acceptable – the account owner can continue to invest on a tax deferred basis in either case. No taxes are assessed with a rollover. Some institutions will allow the in-kind transfer of company stock to the new account, but other institutions require that company stock be sold.
3. Income annuity:
Some plans will allow the account-holder to fund an annuity directly from a private insurance company, and the annuity will pay a monthly benefit for the expected lifetime. No taxes are assessed with the transfer to the income annuity. If there is a joint-and-survivor annuity, the primary account holder and the designated beneficiary would receive the monthly payment for the duration of both expected lifetimes. The annuity distributions would then be subject to ordinary income tax.
There are three primary ways to take installment distributions. In every case, the employee would make arrangements with the employer in accordance with the 401(k) plan documents. Because the account remains open and the money is invested during the distribution period, the account balance will be affected by the market. (Most people choose extremely conservative investments during this time.) Because of the variable nature of investments, all installment options have one unknown element: Either (a) the length of time the account owner receives installment distributions is unknown, or (b) the amount of money received per installment distribution is unknown.
- Fixed Installments: A set dollar amount is paid until the account balance drops to zero. All money remaining in the 401(k) plan (awaiting future distribution) would remain invested, so the account’s ongoing rate of return will impact how long the money will last. If the installment period is more than 10 years, the payments are not rollover eligible. This option is best for people who want to know exactly how much they will receive each time an installment is paid, similar to a paycheck.
- Variable Installments (also called Fixed-Period Installments): A variable dollar amount is paid over a fixed period of time. The initial payment is determined by dividing the current account balance by the requested number of payments. Thereafter, the amount paid is typically based on the preceding December 31 value of the account balance divided by the remaining number of payments. If the installment period is more than 10 years, the payments are not rollover eligible. This option is best for people who have a set time period during which they need income. They might have other investment vehicles that will be paying them over time so they don’t have to know exactly how much is coming in the mail each month.
- Lifetime Expectancy Installment: A variable dollar amount is paid over the participant’s expected lifetime or until the account reaches zero, depending on which happens first. This installment scenario uses an IRS calculation to estimate life expectancy, called the lifetime expectancy factor. Since the IRS calculation changes each year, the parameters of the installment plan also change annually. For example, one year the IRS calculation might state that a person will likely live to age 85. The next year the IRS calculation might estimate the life expectancy is 86. The installment payment is based on the lifetime expectancy factor, so this could yield a drastically different annual installment rate if life expectancy changes. The initial payment is determined by dividing the current account balance by the calculated number of payments, which is determined using the participant’s life expectancy (single life expectancy), or the joint life expectancy of the participant and a beneficiary. Thereafter, the amount paid is based on the preceding December 31 value of the account balance divided by the lifetime expectancy factor spread across that year’s payments. This would be ideal for people who want payments to last all or most of their lifetime – and possibly continue during their beneficiary’s lifetime.
Required Minimum Distribution (RMD)
During the April following the calendar year that the owner reaches age 70½ and is no longer employed, they are legally required to take a Required Minimum Distribution (RMD), also called a Minimum Required Distribution (MRD). Distributions taken late are taxed at the rate of 50%, whereas the account owner can elect the tax withholding rate for RMDs taken on time. RMDs are partial annual payments required by the IRS. The rule is in place to ensure that retirees actually withdraw from retirement accounts rather than using them as a vehicle to pass money to heirs. The RMD amount is based on the preceding December 31 value of the account balance and life expectancy tables. Most employer plans send notifications prior to the end of the calendar year an employee turns 70½ (or leaves employment if older than 70½) that indicate the amount of the RMD. Plan rules will dictate the source of the money.