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403(b) Plan: Distributions
Generally, amounts received by an employee as a distribution from a 403(b) account is taxable as ordinary income to the employee. If the distribution occurs when the employee is under age 59.5, the amount is subjected to a 10% early-distribution penalty, unless the employee qualifies for an exception.
While most plans allow 403(b) account owners to begin taking distributions when he or she reaches normal retirement age, many 403(b) plans allow earlier payments under certain circumstances. For example, a 403(b) plan's rules may allow employees to receive payment of benefits after terminating employment, even if this is before the employee reaches retirement age.
Qualified Joint and Survivor Annuity (QJSA)
In a Title 1 403(b) plan (discussed in chapter 2), the retirement benefit payment generally must occur in series of equal, periodic payments over the lifetime of the participating employee, and if the employee's spouse survives the employee, the payments must continue to the spouse for the rest of his or her life. The periodic payment to the surviving spouse must be at least 50% but not more than 100% of the periodic payment received by the participant while he or she was alive. This form of payment is called a 'qualified joint and survivor annuity' (QJSA), and the plan must provide an explanation of the QJSA in a timely manner.
If the plan provides other forms of benefit payment, the employee and his/her spouse can elect to waive their rights to receive the QJSA and select one of the other payment options available. The waiver must be made in writing within certain time limits and be witnessed by a notary or plan representative.
Triggering Event
Generally, distributions cannot be made until one of the following occurs:
- The employee reaches retirement age as defined under the plan.
- The employee becomes disabled.
- The employee dies, at which time the beneficiary is eligible for distributions.
- The employee separates from service (experiences severance from employment).
- The employee reaches age 59.5.
- The plan is terminated and is not replaced by another defined-contribution plan.
- The employee who gives salary-reduction contributions encounters financial hardship.
These are referred to as triggering events.
Tax on Early Distributions
If a distribution is made to an employee under the plan before he or she reaches age 59.5, the employee may have to pay a 10% additional tax on the distribution. This tax applies to the amount received, which the employee must include as income.
The 10% tax will not apply before age 59.5, however, if the following occurs:
- The distribution is made to a beneficiary on or after the death of the employee.
- The distribution is made because the employee acquires a qualifying disability.
- The distribution is made as part of a series of substantially equal periodic payments beginning after separation from service, and is 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.)
- The distribution is 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.
- The distribution is made to an alternate payee under a qualified domestic relations order (QDRO).
- The distribution is made to an employee for medical care up to the amount allowable as a medical expense deduction (determined without regard to whether the employee itemizes deductions).
- The distribution is made in a timely way to reduce excess contributions.
- The distribution is made because of an IRS levy on the plan.
Withholding on Eligible Rollover Distributions
Distributions from a 403(b) account are subject to a mandatory federal withholding of 20% if the distribution exceeds $200 for the year and is an eligible rollover distribution. Distributions that are not eligible rollover distributions are not subjected to the mandatory 20% withholding.
Eligible rollover distributions are distributions of all or any part of an employee's balance in a 403(b) plan, except if the distribution is any of the following:
- a required minimum distribution (RMD)
- a 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
- a corrective distribution of excess contributions or deferrals and any income allocable to the excess, or a corrective distribution of excess annual additions and any allocable gains
- loans treated as distributions
- the cost of life insurance coverage
An employee may avoid the 20% withholding by having the distribution processed as a direct rollover to an eligible retirement plan. In a direct rollover, the assets are made payable to the trustee or custodian of the receiving retirement plan.
Required Distributions
For implementing the RMDs, a 403(b) plan must ensure that either of the following occurs:
- Each participant will receive his or her entire interest (benefits) in the plan by the required beginning date (RBD), which is Apr 1 of the year following the calendar year he or she reaches age 70.5.
- Each participant will begin to receive regular periodic distributions by the RBD. The distributions are annual amounts calculated so that the participant's entire interest is distributed over his or her life expectancy or over the joint life expectancy of the participant and the designated beneficiary.
If an employee maintains more than one 403(b) account, the RMD for each account may be calculated separately for each account, or a combined amount may be distributed from one 403(b) account. This is similar to the Traditional IRA rules but unlike qualified plan rules, whereby an employee who participates in more than one qualified plan must calculate and distribute the RMD for each plan separately.
Required Beginning Date
Each participant must generally begin receiving RMDs by his or her RBD, which, as we mentioned above, is Apr 1 of the year following the calendar year he or she reaches age 70.5. If the plan allows it and the employee is still employed after reaching age 70.5, the RBD may be delayed until Apr 1 following the year the employee retires. The option to delay the RBD after Apr 1 following the calendar year in which the employee reached the 70.5 birthday is not available to employees who own at least 5% of the business.
Subsequent RMD amounts must be distributed by Dec 31 of each year.
Excess-Accumulation Penalty
Employees who do not take their RMD by the prescribed deadline will owe the IRS a 50% excess-accumulation penalty. The 50% is assessed on the amount not distributed.
Example
Jane's RBD is Apr 1, 2005. Her RMD for 2004 is $40,000 and for 2005, her RMD is $38,000.
Jane distributed her 2004 RMD of $40,000 on Mar 1, 2005. By Dec 31, 2005, she distributed an additional $20,000.
For 2005, Jane was $18,000 short from meeting her RMD, so she owes the IRS $9,000 ($38,000 - 20,000 = $18,000; $18,000 x 0.5= $9,000). |
Jane must pay the excess-accumulation penalty when she files her federal tax return. If she feels that the failure was due to reasonable circumstance, she may write to the IRS and request that the penalty be waived. If the request is approved, the IRS will return the payment to Jane.
Next: 403(b) Plan: Conclusion
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