Participant Distributions & Loans
Federal laws are designed to discourage and, in some cases, prevent participants from withdrawing their money from their retirement savings plan prior to retirement. As a plan sponsor of a retirement savings plan, it is important to understand these limitations so that you can help your employees make good decisions. What are some of the rules governing distributions from your plan? Find out below!
Retirement Distributions:
Your retirement savings plan is intended to help your employees save for their retirement. As a result, when your employees do retire, their retirement savings can go with them. They can choose to rollover their funds into another qualified plan or IRA, or they can receive a cash distribution. If they take a cash distribution, the government requires 20% of the distribution to be withheld for federal tax purposes. Depending on the Participant’s tax bracket, this mandatory withholding may or may not fully satisfy the Participant’s tax obligation on this distribution. At retirement, an employee becomes fully vested in any employer contributions. Your plan will recognize a specific age for retirement. Most plans recognize 65 as the normal retirement age, but your plan may also recognize an earlier retirement age.
In-Service Distributions:
Since many employees are working past the normal retirement age, many plans also allow in-service distributions for their employees that are still working but are more than 59½ years old. Please check with one of our plan administration specialists to review your Plan’s offerings. If these distributions are rolled over into an IRA, the employee can continue to defer paying taxes on these funds. If they receive a cash distribution, the mandatory 20% withholding applies, which may or may not fully satisfy the Participant’s tax obligation. Since the participant is over 59½ years old, in-service distributions are not subject to penalty taxes.
Required Minimum Distributions:
Once a participant reaches 70½, they are required to take a minimum distribution from their qualified plan each year. In the year in which the participant turns 70½, the required distribution must occur by April 1 of the following year. In subsequent years, the required distribution must occur by December 31st of that year. If a participant is older than 70½, but is still working for your company and is not a company owner, s/he may delay these required distributions until they terminate.
Termination Distributions:
If a participant leaves your employment, s/he is also eligible to receive a distribution from your plan. S/he may rollover her vested account balance into a new employer’s qualified plan or an IRA and continue to defer paying taxes on these funds. If s/he chooses to take a cash distribution, the distribution is subject to a mandatory 20% withholding and also may be subject to a 10% penalty tax if the participant is less than 59½ years old. If the participant is not fully vested in any employer contributions, s/he forfeits the unvested portion of the account balance. If the Participant has an outstanding loan, the outstanding loan amount is defaulted and the participant will receive a 1099-R on the outstanding loan balance. Tax penalties may apply. To avoid default, a participant may pay off his outstanding loan balance at the time of termination.
Force-Out Distributions:
Many Plan Documents provide a force-out provision that allows a Plan Sponsor to require a terminated participant with an account balance of less than some threshold (typically $1,000) to distribute their funds from the Plan. Requiring such distributions reduces the Plan Sponsor’s administrative burden by eliminating the need to maintain records and accurate addresses for terminated employees and ensures that any unvested portion of the Participant’s account balance is forfeited in a timely manner. Participants are notified of the impending force-out and are given 30 days to elect whether to rollover their vested account balance or receive a cash distribution. If they fail to make an affirmative election, a cash distribution is processed and a check sent to the address of record. Cash distributions are subject to the mandatory 20% withholding and may be subject to a 10% tax penalty if the participant is less than 59 ½ years old.
Disability Distributions:
If an employee becomes permanently disabled and is unable to continue gainful employment, s/he is eligible for a disability distribution of her account balance. Your plan document will specify the standards to determine permanent disability. Participants qualified for a disability distribution may become fully vested in any portion of employer contributions that are not yet fully vested prior to distribution depending on your plan document. A disability distribution is subject to the mandatory 20% withholding, but is not subject to any penalty taxes.
Death Distributions:
If an employee dies, then their beneficiary is entitled to a distribution of the participant’s account balance. An employee becomes fully vested in any employer contributions at the time of death. If the beneficiary is a spouse, s/he may choose to rollover the participant’s vested account balance or receive a cash distribution. Other beneficiaries may only elect to receive a cash distribution (rollovers will be allowed beginning in 2007). Cash distributions are subject to the mandatory 20% withholding; penalty taxes do not apply. If a participant is married or becomes married and has designated a beneficiary other than their spouse, then the spouse retains their full rights as beneficiary unless the spouse’s notarized signature foregoing this right is on file with the plan sponsor.
Hardship Distributions:
Your plan may also allow distributions for reasons of hardship. The federal government requires that these distributions be limited to instances where the employee has an immediate and heavy financial need. Prior to a hardship distribution, an employee must exhaust all other distributions or nontaxable loans available under all plans maintained by their employer. A participant may not defer into the plan for 6 months after the hardship distribution. The safe harbor hardship reasons approved by the federal government of instances of immediate and heavy financial need include:
- Payment of deductible medical expenses by the employee or dependent
- Purchase of a primary residence
- Payment of tuition, room and board, and related educational expenses by the employee or dependents
- To prevent eviction from principal residence or foreclosure on the mortgage of that residence
- Payment of funeral expenses for parent, spouse, or dependent
- Payment of expenses for casualty loss to principal residence
Participant Loans:
If your plan allows participant loans, then your employees may take up to the lesser of 50% of their vested account balance or $50,000 as a tax-deferred loan against their retirement savings. Minimum amounts may apply. Loans for the purchase of a primary residence may be for a maximum duration of 15 years. Loans for all other reasons may not exceed 5 years. Your plan is required to charge a reasonable interest rate for the loan as defined in the Plan’s loan policy, but this interest is paid back into the participant’s account. Loan re-payments are made through payroll deduction and are made on an after-tax basis. Loans may be pre-paid with no penalties.
The government allows participants to borrow the money tax-free with the expectation that the money will be paid back into the Plan within the specified time period. If the funds are not paid back in a timely fashion (as specified by your Plan Document), the loan is defaulted and the participant must pay taxes on the outstanding loan balance and may also incur additional tax penalties. Terminated employees that can no longer make regular payments on their loan can avoid default and the adverse tax consequences by making a single lump-sum payment equal to their current payoff amount prior to the loan’s default.