When Can Distributions Be Made?
Under IRC Sec. 401(a)(14), benefits must be distributed at a certain time, unless the participant has elected to postpone the distribution. The benefit commencement date must be the latest of the following:
(1) 60 days after the end of the plan year in which the participant reaches the normal retirement age;
(2) 60 days after the end of the plan year which includes the 10th anniversary of when the participant commenced participation in the plan; and
(3) 60 days after the end of the plan year in which the participant terminates service with the employer.
Note: Plans are permitted to require a participant to file a claim for benefits before benefits will commence, Treas. Reg. Sec. 1.401(a)-14(a).
A participant generally is treated as having postponed a distribution of his benefits if he fails to elect a distribution form. The terms of the plan determine when a participant will receive a distribution. A plan may not give the employer any discretion to determine when a participant will receive a distribution or how the distribution will be made. Distributions from pension plans (i.e., DB plans, money purchase plans and target benefit plans) are subject to more restrictions than non-pension plans (i.e., 401(k) plans, profit-sharing plans and stock bonus plans). Non-pension plans may provide for a distribution after:
(1) a fixed number of years – must be at least 2 years;
(2) attainment of a specified age; or
(3) upon any other stated event, regardless of whether the participant has terminated employment. Treas. Reg. §1.401-1(b)(1)(ii).
Non-pension plans may provide for distributions upon:
(1) termination of employment;
(2) after a specified period of service or participation (e.g., after 10 years of service with the employer);
(3) financial hardship (as defined by the plan for non-401(k) plans; 401(k) plans must comply with financial hardship rules );
(4) disability ;
(5) layoff;
(6) illness;
(7) termination of the plan;
(8) discontinuance of employer contributions; or
(9) change in the participant's employment or plan participation status.
A. Distribution After Fixed Number of Years by Non-pension plans (profit sharing plans, 401(k) plans, and stock bonus plans) – 2 year rule only applies if the right to take the distribution is based solely on the length of time the withdrawn funds have accumulated. For example, if a distribution is being made because of the participant's hardship, the distribution could come from funds that have accumulated over less than 2 years.
B. Normal Retirement Age - Most plans provide for the payment of plan benefits upon a participant's retirement and attainment of the plan's normal retirement age. Plans are free to define this age, subject to the required minimum distribution rules of IRC § 411. Typically, plans define the normal retirement age as age 65.
C. Early Retirement - Some plans provide for the payment of plan benefits to terminated employees prior to the employee's attainment of the plan's normal retirement age. The benefit is usually reduced to account for the fact that the participant is expected to live longer. A plan may, however, be designed not to provide for the actuarial reduction if certain conditions are met. For example, a plan may require a terminated employee to meet a minimum age and years of service requirement to receive early retirement benefits without any reduction, e.g., attainment of age 55 and at least 10 years of service with the employer. The minimum service requirement may be based on the employee's years of service with the employer or years of participation in the plan.
D. In-Service Distributions
1. Pension Plans
a) For plan years beginning after December 31, 2007, pension plans (DB plan, money purchase plan or target benefit plan) may provide for in-service distributions to a participant who has reached age 62, even if the normal retirement age is later than age 62. See IRC §401(a)(36), as amended by the PPA of 2006 and Treas. Reg. §1.401(a)-1(b)(1)(i).
b) Effective May 22, 2007, in-service distributions after the attainment of the pension plan's normal retirement age are permissible, even if that age is earlier than age 62. Treas. Reg. § 1.401(a)-1(b)(1)(i).
2. Non-Pension Plans (profit sharing plans and stock bonus plans): in-service distributions are permissible even if the participant has not attained the plan's normal retirement age.
E. Involuntary Cash-out – a plan may provide for an involuntary cash-out to participants with a vested benefit of $5,000 or less. A plan can provide for a lower dollar threshold (e.g., $3,500 or less).
F. Distributions on Account of Plan Termination - If a pension plan is terminated, participants may receive a distribution even though they have not been terminated or reached the plan's normal retirement age. IRC §401(a)(20). The rule is different for 401(k) plans. If the employer establishes a successor 401(k) plan, distributions from the terminated plan generally may not be made. IRC §401(k)(10). A successor plan is any alternative DC plan, other than an ESOP, that is maintained at any time during the period beginning on the date of the 401(k) plan's termination and ending 12 months after distribution of all of the 401(k) plan's assets by the same employer that terminated the 401(k) plan, Treas. Reg. §1.401(k)-1(d)(4). Note: A SEP, SIMPLE-IRA plan, 403(b) plan and 457(plan) are not successor plans for this purpose, Treas. Reg. §1.401(k)-1(d)(4)(i).
G. Minimum Required Distribution Rules – IRC §401(a)(9) sets the required beginning date ("RBD") by which distributions must commence to a participant. The intent of the rules is to ensure that a participant cannot indefinitely defer the taxation on plan benefits.
1. A minimum payment must be made to the participant by the RBD and for each year thereafter. Minimum distribution rules also apply to the payment of the participant's death benefits. If a plan does not comply with the requirements of IRC §401(a)(9), the violation is a qualification problem that can be corrected through the IRS's Employee Plans Compliance Resolution System ("EPCRS").
a) The RBD for participants who are not 5% owners is April 1 following the end of the calendar year in which the later of the following occurs: (a) the participant reaches age 70 ½; or (2) the participant dies.
b) The RBD for 5% owners is April 1 following the close of the calendar year in which the owner attains age 70 ½, regardless of whether the owner has retired.
c) If participant dies before the RBD, payment will usually be paid in a lump sum to the participant's surviving spouse or other beneficiary (subject to spousal consent). The distribution must be made distributed within 5 years of the date of the participant's death or over the lifetime of the beneficiary with payments starting within one year of the participant's death, Treas. Reg. §1.401(a)(9)-3, A-1. A plan may specify whether it will apply the 5-year rule or the "life expectancy" rule or allow the participant to choose. A surviving spouse may defer receipt of distributions until December 31 of the year in which the participant would have attained age 70 ½ had the participant lived, Treas. Reg. §1.401(a)(9)-3, A-3(b).
d) If participant dies after RBD, distributions must be made to the participant's surviving spouse or other beneficiary (subject to spousal consent) for a period equal to the longer of the recipient's life expectancy or the participant's remaining life expectancy, Treas. Reg. §1.401(a)(9)-5, A-5.
2. Minimum distribution amount
a) DC plans typically use the "Account Balance Method" to calculate minimum distributions. The minimum distribution amount is calculated by dividing the participant's vested account balance as of the RBD by the participant's life expectancy. DB plans may not use the "Account Balance Method" with one exception, Treas. Reg. §1.401(a)(9)-6.
b) DB plans must use the "Annuity Distribution Method" to calculate minimum distributions, except with respect to lump sum distributions in limited circumstances (see Treas. Reg. §1.401(a)(9)-6, Q&A-1(d). (This method may be used by DC plans to the extent an annuity contract is purchased with respect to all or part of the participant's account balance.) Under this method, the amount of the annual payments depends on the annuity period and the annuity payment intervals (e.g., monthly).
H. 401(k) Plans – Distribution Restrictions (IRC §401(k)(2) and (10))
1. Permissible Distribution Events
a) Employee's severance of employment, IRC §401(k)(2)(B)(i)(I)
b) Employee's death, IRC §401(k)(2)(B)(i)(I)
c) Employee's disability, IRC §401(k)(2)(B)(i)(I)
d) Employee's attainment of age 59 ½ (or a later specified date), even if the employee has not had a severance of employment or separation of services, IRC §401(k)(2)(B)(i)(III)
e) Employee's financial hardship, even if the employee has not had a severance from employment or separation of service, IRC §401(k)(2)(B)(i)(IV)
f) Plan termination, but only if the employer does not maintain a successor plan, IRC §§401(k)(2)(B)(i)(II) and 401(k)(10)
g) For plan years beginning after December 31, 2007, if a plan includes an automatic enrollment feature that is an "eligible automatic contribution arrangement" (EACA defined in IRC §414(w)(3)), the plan may permit an automatically enrolled participant to cash out his/her elective deferrals within a specified period following the date of automatic enrollment, IRC §414(w)
h) Distributions to a qualified reservists in the military, IRC §§401(k)(2)(B)(k)(V)
2. Hardship Withdrawals – The plan must define hardship in objective terms, subject to the hardship withdrawal rules under 401(k). The distribution must be made on account of an immediate and heavy financial hardship and must not exceed the amount needed to satisfy the financial need. Treas. Reg. §1.401(k)-1(d)(3). All relevant facts and circumstances are considered to determining a participant's financial need and whether the employee has other resources reasonably necessary to satisfy the need. Treas. Reg. §1.401(k)-1(d)(3)(iv)(B).
a) Safe harbor – A distribution is deemed to be for an immediate and heavy financial hardship if it is made for any of the reasons below (Treas. Reg. §1.401(k)-1(d)(3)(iii)(B)
(1) Deductible expenses for medical care as defined by IRC §213(d) for the employee, the employee's spouse or dependents;
(2) Cost directly related to the purchase of a principal residence for the employee (not including mortgage payments);
(3) Payments for tuition, related educational fees, and room and board expenses for the next 12 months of post-secondary education for the employee, the employee's spouse, children or dependents;
(4) Payments necessary to prevent eviction from the employee's principal place of residence or to prevent foreclosure on the mortgage of that residence;
(5) Payments for burial or funeral expenses for the employee's deceased parent, spouse, children or dependents;
(6) Expenses for the repair of damage to the employee's principal residence that would qualify for the casualty deduction under IRC §165
b) Substantiation – while the regulations do not provide any guidance on what specific evidence a plan needs to substantiate a hardship, it's a good idea for a plan to require the employee to provide documentation of the hardship (e.g., bill, invoice, foreclosure notice, etc.). A plan may rely upon the employee's written representations that his/her financial need cannot be reasonably relieved through any of the following sources: (a) insurance; (b) liquidation of the employee's assets; (c) cessation of elective deferrals or employee contributions to the plan; (d) other available distributions; or (e) borrowing from commercial sources on reasonable terms. Treas. Reg. §1.401(k)-1(d)(3)(iv)(C).
(1) Safe harbor for establishing financial need: A distribution is deemed to be necessary to satisfy the participant's financial need if:
(a) Amount of distribution does not exceed the amount of the financial need; and
(b) Employee has received all currently available distributions and all available nontaxable loans from the plan and all other plans maintained by the employer, Treas. Reg. §1.401(k)-1(d)(3)(iv)(E)(1); and
(c) Employee has been prohibited form deferring or making contributions for at least 6 months after the hardship distribution, Treas. Reg. §1.401(k)-1(d)(3)(iv)(E)(2).
Maximum Amount of Hardship Distribution – Limited to the aggregate amount of elective deferrals (without adjustment for investment earnings) made by the employee as of the date of the distribution, reduced by previous distributions of elective deferrals. For example, if an employee's account is valued at $50,000 and the participant has contributed a total of $40,000 in elective deferrals, the maximum hardship distribution is $30,000.
c) Amounts attributable to any Qualified Nonelective Contributions (QNECs), Qualified Matching Contributions (QMACs) or safe harbor 401(k) contributions are not eligible for hardship withdrawal.
3. Loans – Typically, loans are only available under profit sharing plans, including 401(k) plans, and are not available from DB plans or money purchase plans. Generally, loan amounts are limited to the lesser of $50,000 or 50% of the participant's vested account balance, reduced by the amount of the highest outstanding loan balance during the one-year period beginning on the date a loan is made, IRC §72(p)(2). A plan may limit the minimum loan amount to a minimum of $1,000, Labor Regs. §2550.408(b)-1.
a) Loans may be made for any reason as determined by the plan. Typically, plans limit loans to hardship situations.
b) Interest rate charged must be reasonable, Labor Regs. §2550.408(b)-1.
c) No more than 50% of the participant's vested account balance may be used as security for the loan, Labor Regs. §2550.408(b)-1.
d) Repayment is usually facilitated through mandatory payroll deduction.
I. Distribution Upon Death of the Participant
1. Beneficiary – A plan may allow participants to designate a beneficiary and provide for a procedure for such designations. A participant may not name a person other than his surviving spouse as a primary beneficiary unless the spouse has consented to such designation.
2. Death benefits must be "incidental" to the primary purpose of the plan to provide retirement benefits, Treas. Reg. §1.401-1(b)(1)(i). DC plans generally will satisfy this requirement because the total death benefit (i.e., QPSA and any additional death benefit) will never exceed the account balance under the plan. A DB plan may not satisfy this "incidental" death requirement. There is no issue if the QPSA is the sole death benefit available. A DB plan may not satisfy this rule if there is any additional death non-QPSA death benefit available.
3. Post-retirement death benefits: (i) QJSA (survivor annuity payable to the spouse); (ii) life annuity (no death benefit unless the life annuity was payable from less than the participant's entire vested accrued benefit); (iii) joint and survivor annuity (survivor annuity); (iv) life annuity with term certain (death benefit is available if the participant dies before the guaranteed term ends – the death benefit is payment for the remaining term certain).
J. QDRO Distributions – A qualified domestic relations order may provide for payments to a spouse, former spouse or dependent of the participant.
K. Corrective Distributions – excess contributions (IRC §401(k)(8)), excess aggregate contributions (IRC §401(k)(m)(6)), excess deferrals (IRC §402(g), excess deferrals and after-tax contributions (Treas. Reg. §1.415-6(b)(6)(iv)). Corrective distributions are not subject to the additional tax on early distributions, are not considered wages for FICA or FUTA purposes, are not eligible for rollover distribution, and are not treated as a required distribution for purposes of IRC §401(a)(9).