As part of ThinkAdvisor’s Special Report, 21 Days of Tax Planning Advice for 2014, throughout the month of March, we are partnering with our Summit Professional Networks sister service, Tax Facts Online, to take a deeper dive into certain tax planning issues in a convenient Q&A format.
What restrictions apply to distributions from 401(k) plans?
Amounts held by the trust that are attributable to employer contributions made pursuant to the election to defer may not be distributed to participants or beneficiaries prior to:
(1) the employee’s death, disability, or severance from employment;
(2) certain plan terminations, without the establishment or maintenance of another defined contribution plan;
(3) in the case of a profit sharing or stock bonus plan, the employee’s reaching age 59½ or experiencing financial hardship; or
(4) in the case of a qualified reservist distribution, the date of the reservist’s order or call.
The final regulations cited here were published in December 2004 and are effective for plan years beginning on or after January 1, 2006.
These occurrences are referred to as “distributable events.” Amounts may not be distributable merely by reason of completion of a stated period of participation or the lapse of a fixed number of years. A qualified hurricane distribution will be treated as satisfying the distribution requirements of IRC Section 401(k)(2)(B).
The cost of life insurance protection as per Table 2001 or P.S. 58 costs provided under the plan is not treated as a distribution for purposes of these rules. Neither is the making of a loan that is treated as a deemed distribution even if the loan is secured by the employee’s elective contributions or is includable in the employee’s income under IRC Section 72(p).
The reduction of an employee’s accrued benefit derived from elective contributions (i.e., an offset distribution) by reason of a default on a loan is treated as a distribution. The IRS has privately ruled that a transfer of 401(k) elective deferrals or rollovers to purchase service credits would not constitute an impermissible distribution from the plan and are not a violation of the separate accounting requirement.
Restrictions on distributions of elective contributions generally continue to apply even if the amounts are transferred to another qualified plan of any employer. Amounts transferred to a 401(k) plan by a direct rollover from another plan do not have to be subject to these restrictions. Final regulations state that rollover amounts may be excepted from the timing restrictions on distributions applicable to a receiving plan, provided there is a separate accounting for such amounts.
If an eligible retirement plan separately accounts for amounts attributable to rollover contributions to the plan, distributions of those amounts are not subject to the restrictions on permissible timing that apply, under the applicable requirements of the Internal Revenue Code to distributions of other amounts from the plan. Accordingly, the plan may permit the distribution of amounts attributable to rollover contributions at any time pursuant to an individual’s request.
Thus, for example, if the receiving plan is a money purchase pension plan and the plan separately accounts for amounts attributable to rollover contributions, a plan provision permitting the in-service distribution of those amounts will not disqualify the plan.
What requirements apply to hardship withdrawals from a 401(k) plan?
Hardship withdrawals may be made from a 401(k) plan only if the distribution is made on account of an immediate and heavy financial need and the distribution is necessary to satisfy the financial need. The distribution may not exceed the employee’s maximum distributable amount. Hardship withdrawals generally may not be rolled over. The final regulations cited here took effect for plan years beginning on or after January 1, 2006.
The Pension Protection Act of 2006 called for regulations modifying the hardship requirements to state that if an event constitutes a hardship with respect to a participant’s spouse or dependent, it constitutes a hardship with respect to the participant, to the extent permitted under the plan.
An employee’s maximum distributable amount generally is equal to the employee’s total elective contributions as of the date of distribution reduced by the amount of previous distributions on account of hardship.
The determinations of whether the participant has “an immediate and heavy financial need” and whether other resources are “reasonably available” to meet the need are to be made on the basis of all relevant facts and circumstances. An example of “an immediate and heavy financial need” is the need to pay funeral expenses of a family member. A financial need will not fail to qualify as an immediate and heavy financial need merely because it was foreseeable or voluntarily incurred by the employee.