Qualified retirement plans allow employees to accumulate assets, providing financial security once these workers retire. When economic times get tough or people fall into personal financial crises, they often consider taking money out of these retirement plans as a stop-gap measure. However, the government has an incentive to ensure that individuals are financially independent during their retirement years, as this reduces the financial burden of having to provide supplemental income for retirees. To this end, Congress has implemented rules that prevent employees from distributing retirement plan assets before the age of 59.5 or, if later, the retirement age as defined by the plan.
Regulations as well as the plan rules provide guidelines that determine when an employee becomes eligible to distribute assets from qualified plans, such as profit sharing, money purchase pension and 401(k) plans. An employee who wishes to distribute assets from his or her plan needs to be aware of these eligibility requirements as well as the consequences of the distribution.
Eligibility Requirements for Qualified Plan Distributions
The requirements for distributing assets from your retirement plan are commonly referred to as "triggering events". At a minimum, these include:
1. Attaining Retirement Age: A qualified plan may allow an employee to begin receiving distributions from the plan upon his or her attainment of retirement age. While most plans use the default of 59.5 as the plan's retirement age, others use ages ranging from 55 to 65. Sixty-five is the maximum allowed by the IRS.
2. Termination From Employment: A qualified plan may allow an employee to begin receiving distributions once he or she is no longer employed by the plan sponsor. Note that some plans do not consider this a triggering event and may require the employee to attain the plan's retirement age to be eligible to receive distributions.
3. Death:Should the employee die, his or her beneficiaries are eligible to receive distributions from the plan.
4. Disability: An employee who becomes disabled may be eligible to receive distributions from the plan. Generally, disability is defined as the inability to perform gainful services for an indefinite period. A plan may provide its own definition of disability as a triggering event.
5. Termination of the Plan: A plan may allow employees to begin receiving distributions in the event the plan be terminated.
6. In-Service Withdrawal: Unless the plan is a money-purchase plan, it may allow employees to receive distributions before experiencing a triggering event. This kind of distribution is referred to as an in-service withdrawal. Some plans limit the availability of in-service withdrawals to cases of employees experiencing financial hardship, which includes instances when the employee needs assets to pay medical bills, mortgage or rent to prevent eviction, and education expenses. For a particular plan's definition of financial hardship, the employee should refer to his or her summary plan description (SPD) or the plan document. The SPD, which must be provided to every participant, is a document that explains the plan provisions in layman's terms.
Tax and Penalty Consequences of Distributing Retirement Plan Assets
If an employee experiences a triggering event and elects to receive a distribution from the plan, he or she should be aware of the tax and penalties that may apply to the amount:
Generally, an employee must treat qualified-plan amounts distributed as ordinary income. This means that he or she may be required to pay federal and state tax on the amount. Note: Distributions of after-tax contributions are not subject to federal tax. State law determines whether the amount is subjected to state tax.
If the distribution occurs while the employee is under age 59.5, the amount will be subject to a 10% early-distribution penalty unless the employee meets an exception. The exceptions (to the 10% early-distribution penalty) include distributions that are:
- Made to the employee's beneficiary on or after the death of the employee
- Made because the employee has a qualifying disability as defined by the plan
- Made as part of a series of substantially equal periodic payments beginning after separation from service and made at least annually for the life or life expectancy of the employee or the joint lives or life expectancies of the employee and his or her designated beneficiary. (The payments under this exception, except in the case of death or disability, must continue for at least five years or until the employee reaches age 59.5, whichever is the longer period.)
- Made to an employee after separation from service if the separation occurred during or after the calendar year in which the employee reached age 55
- Made to an alternate payee under a qualified domestic relations order (QDRO). A QDRO is a judgment, decree, or order assigning the employee to pay child support, alimony or marital property rights to a spouse, former spouse, child or other dependent. The QDRO must contain certain specific information such as the name and last known mailing address of the participant, the name of each alternate payee and the amount or percentage of the participant's benefits to be paid to each alternate payee. A distribution that is paid to a child or other dependent under a QDRO is taxed to the employee. A distribution that is paid to a spouse or former spouse under a QDRO is taxed to the recipient of the assets.
- Made to an employee for medical care up to the amount allowable as a medical expense deduction
- Made in a timely manner to reduce excess contributions
- Made because of an IRS levy on the plan
Claiming the Penalty Exception
For the distributions that he or she receives from the qualified plan account during the year, the employee will receive a copy of IRS Form 1099-R from the payor, which is the financial institution or plan administrator responsible for processing plan distributions, tax withholding and tax reporting. Generally, if the employee qualifies for an exception to the 10% early-distribution penalty and provides the necessary documentation to the payor, this exception will be noted on the 1099-R. Should the payor fail to indicate this exception, the employee may file IRS Form 5329 with his or her federal tax return to claim the exception.
If distributions are eligible to be rolled over to another eligible retirement plan, the payor is required to withhold federal taxes of 20% of the amount rolled over, which is paid to the IRS, unless the total for the year does not exceed $200. Some financial institutions will withhold additional amounts for state tax if applicable. These eligible retirement plans are:
- Traditional IRA (including SEP and spousal IRAs)
- Qualified plans, including profit sharing, money purchase pension, 401(k), target benefit and defined benefit
- 403(b) plans
- 403(a) plans
- 457(b) plans
Eligible rollover distributions include amounts distributed from the retirement plan except the following:
- Required minimum distributions
- Distributions that are part of a series of substantially equal payments made at least once a year over any of the following periods:
- The employee's life or life expectancy
- The joint lives or life expectancies of the employee and beneficiary
- A period of 10 years or longer
- A hardship distribution (as defined by the plan)
- A corrective distribution of excess contributions
- Loans treated as distributions
- Dividends on employer securities
- The cost of life insurance coverage
Avoiding the 20% Withholding
An employee may avoid the 20% withholding if the distribution is processed as a direct rollover to a Traditional IRA. Given that Traditional IRAs are not subject to the triggering event rules, the employee could withdraw the amount from the Traditional IRA and then be subjected only to the early-distribution penalty (if applicable).
Caution: Some individuals, should they chose not to have taxes withheld from their retirement plan distributions, may be required to make estimated tax payments. To be sure, individuals should consult with their tax professionals.
60-Day Rollover Rule
If the employee needs the assets for a short period, he or she may return the amount to an eligible retirement plan as a rollover contribution by the 60th day after the distributed assets were received. Distributions that are rolled over to an eligible retirement plan within 60 days after the employee receives the distribution are not subjected to income tax or the early-distribution penalty. If the payor withheld any tax from the distribution, this amount cannot be returned to the employee, even if he or she decides later to rollover the distribution. The employee may roll over the full amount by replacing the withheld amount with out-of-pocket assets. Alternatively, he or she may roll over only the amount received; however, the amount withheld for taxes must be treated as income and will be subject to the early-distribution penalty rules.
Consider Alternative Sources of Funds
If you are not of retirement age, be careful about disturbing your retirement nest egg. Before choosing to distribute assets from your retirement plan, compare the cost of using other sources - such as regular savings, or loans from friends, family members or financial institutions. Remember also the benefits of the tax-deferred growth you will enjoy should you choose to allow the assets to remain in your retirement plan. Your financial planner can help you make comparative projections and determine the most financially sound choices.