401(k) Plan Distributions and Vesting

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Distributions from 401(k) plans are defined by the terms of the plan. The plan document must comply with the legal requirements regarding both the timing of distributions and how a distribution can be paid. A participant’s actual distribution amount is determined based on his/her non-forfeitable, or vested, share of his/her account balance. The plan document will provide for a vesting schedule that is used to calculate the non-forfeitable, or vested, amount.

Additionally, certain distributions are required to begin on the later of age 72 (prior to January 1, 2020, age 70 1/2) or retirement. Other distributions may be required if nondiscrimination tests are failed or elective deferral limits are exceeded.

In order to verify that all distributions are being made according to the plan rules, it is important to develop internal control procedures for monitoring distribution requirements and processing distributions.

Plan Sponsors have annual requirements for preparing Form 1099-R for all participants or former participants who received a plan distribution during a calendar year. Additional reporting to the Internal Revenue Service is required for Form 1099-R, as well as Form 1096 and Form 945.

Timing of Distributions

In general, 401(k) plans may not make plan distributions to participants until a distributable event occurs. The distributable events must be defined in the plan document and, specifically, are based on the type of contributions involved. For 401(k) elective deferrals (including Roth deferrals), distributable events are quite restrictive and are limited to the following events:

For other plan contribution types, like employer matching contributions or discretionary employer contributions, the plan can be written to allow for less restrictive requirements for distribution. However, most 401(k) plans are written so that the same distribution requirements apply to all contribution types so that plan administration is simpler.

Hardship Distributions

A 401(k) plan may, but is not required to, provide for hardship distributions.  If permitted by the plan, hardship distributions are made while the participant is still working for the employer in order to help the participant address a financial hardship.  401k plans are permitted to apply the hardship distribution rules to 401(k) elective deferrals, safe-harbor contributions, QNECs, and QMACs, along with earnings on these amounts, regardless of when the amounts were contributed.

Generally, if a 401(k) plan provides for hardship distributions, the plan will specify what information must be provided by the participant to the employer to demonstrate a hardship.  It is important that the plan sponsor retain records of all information used to determine whether a hardship event has occurred and that the amount distributed was the amount necessary to alleviate the hardship.  The IRS has clarified that the plan sponsor is responsible for requesting and retaining documentation to substantiate the nature of the hardship.  It is not permissible to simply allow the participant to self-certify the nature of the hardship and to agree to retain documentation. The plan sponsor (not the participant) is responsible for determining whether the hardship event has occurred and the amount necessary to alleviate the hardship. If the participant leaves employment or fails to keep the necessary records, the plan sponsor would not be able to produce the necessary records in the event of an IRS audit.

The only thing the participant can self-certify is that the participant does not have other resources to satisfy the need (see below).  The plan sponsor may rely on this self-certification unless the sponsor knows the certification is incorrect.

For a distribution from a 401(k) plan to be on account of hardship, it must be: (i) made on account of an immediate and heavy financial need of the employee; (ii) and the amount must be necessary to satisfy the financial need. The need of the employee generally includes the need of the employee’s spouse, dependent, or other individual who qualifies as a primary beneficiary under the plan.  The amount required to satisfy the financial need may include amounts necessary to pay any taxes or penalties that may result from the hardship distribution.

It is important to note that a same-sex spouse is considered the participant’s spouse for purposes of the hardship distribution rules, but this does not apply to individuals in other formal relationships, such as registered domestic partnerships or civil unions.  However, if permitted under the terms of the plan, a participant has the option of naming these individuals as their primary beneficiary under the plan in order to ensure that the expenses of these individuals are eligible for consideration under the hardship withdrawal provisions of the plan.

Whether a need is immediate and burdensome depends on the facts and circumstances. Effective as of January 1, 2019, certain expenses are deemed to create an immediate and heavy financial need, including:

IMPORTANT: The CARES Act permits eligible individuals to withdraw penalty-free up to a total of $100,000 from their 401(k) retirement plan accounts during 2020 in a “coronavirus-related distribution.” See Congress Passes CARES Act in Response to COVID-19 Crisis Contains 401(k) Ease-of-Access and Other Provisions for more details.

For these purposes, a “primary beneficiary under the plan” is an individual who is named as a beneficiary under the plan and has an unconditional right, upon the death of the employee, to all or a portion of the employee’s account balance under the plan.

Effective January 1, 2019:

A 401(k) plan may also permit loans to plan participants.  For information regarding plan loans, click here.

Qualifying Distributions From Designated Roth Accounts

If a plan includes Roth contributions, there are additional special distribution timing rules for the designated Roth account which must be followed in order for the special tax advantages to apply. In general, a 5-year period must be measured from the first day of the first year during which designated Roth contributions are made. If a participant takes a distribution from a designated Roth account before the end of the 5-year period that applies for the participant, the earnings on the Roth contributions become taxable and must be included in gross income at the time of distribution. If a participant takes a distribution from a designated Roth account after the end of the 5-year period that applies for the participant, the earnings on the Roth contributions remain tax-free on distribution. For more information regarding designated Roth contributions, click here.

Required Minimum Distributions

Participants are generally required to begin taking distributions from 401(k) plans at the later of their retirement or age 72 (prior to January 1, 2020, age 70 1/2). These distributions are referred to as Required Minimum Distributions or RMDs. For detailed information regarding “required minimum distributions,” click here.

Distribution Payment Options

Plan Sponsors may choose a variety of payment options when they set up their plan design. Typically, 401(k) plans provide for just a few, simple distribution options like single sum distributions, direct rollovers and/or installments. If a participant elects a direct rollover of a single sum distribution to another qualified plan or an IRA, the plan should have procedures in place to process the rollover.

Beneficiaries of deceased participants also have the right to roll over single sum distributions.  A beneficiary who is the participant’s spouse, has the same rights as the participant and may roll over the distribution to another qualified plan or IRA.  It is important to note that a same-sex spouse has  the same rollover rights as a participant’s opposite-sex spouse. This does not apply to individuals in other formal relationships, such as registered domestic partnerships or civil unions.

A non-spouse beneficiary is only permitted to elect a direct rollover to an inherited IRA.  An inherited IRA must be established in a manner that identifies it as an IRA with respect to a deceased plan participant, and distributions from the inherited IRA are subject to the distribution rules for beneficiaries.

The Internal Revenue Service has provided a model tax notice explaining direct rollovers which must be included with the distribution election form provided to the participant. For more information regarding this required tax notice, click here.

Certain 401(k) plans may choose to offer other types of distributions, such as single life annuities or joint and survivor annuities. If distributions are offered in the form of annuity payments, the plan must meet detailed notice and consent requirements which complicates administration of the plan.

Vesting Schedule

All qualified plans are required to define a vesting schedule for all plan contribution types. The vesting schedule is used to calculate the nonforfeitable, or vested, portion of the participant’s account balance. The law requires that 401(k) elective deferral contributions, including regular deferral contributions and designated Roth contributions, are always 100%, or fully, vested. If the 401(k) plan permits rollover contributions or after-tax contributions, they must also be fully vested.

The plan can provide that other contribution types (like employer matching contributions and/or discretionary employer contributions) are subject to a vesting schedule. The vesting schedule provides for a percentage of ownership of these contributions based on the number of “years of service” with the employer.

The plan document must define how “years of service” will be determined under the plan.  Although other definitions may be used, it is very common for a plan to require 1,000 hours of service during a 12-month period in order to earn a year of service.  It is important to develop internal control procedures for accurately tracking employment data (and, if applicable under the plan terms, hours of service) in order to accurately determine “years of service” for vesting.

The legal requirements of the Internal Revenue Code provide for two specific minimum vesting schedules that can be used in plan documents. One option is to use a 3-year cliff vesting schedule, which provides for 0% vesting for the first 2 years and then 100% vesting after 3 years of service. The second option is to use a 6-year graded vesting schedule, which provides for an increased vested percentage after each year of service (20% after 2 years, 40% after 3 years, 60% after 4 years, 80% after 5 years, and 100% after 6 years of service). An employer may choose to include a vesting schedule which is more generous than these two options, such as full vesting after 2 years of service, but an employer cannot include a vesting schedule that vests more slowly than these two options.

If a participant terminates employment before becoming 100% vested in employer contributions, the nonvested portion of his employer contribution accounts will be forfeited in accordance with the forfeiture timing rules provided under the plan. This means that the forfeited amounts will no longer belong to the plan participant. The plan will address how forfeiture amounts are to be used under the plan. The most common plan provisions allow forfeitures to be used to pay plan administrative expenses or to offset employer contributions in the year of forfeiture or, at the latest, in the following year. The plan is not permitted to maintain an ongoing forfeiture account, so it is important that forfeitures are used in the year forfeited or in the following plan year. In recent guidance, the IRS has clarified that it will not allow forfeitures to be used to correct plan mistakes or correct testing failures.

Tax Form Reporting

At the end of each calendar year, tax reporting for plan distributions during the year is due to both participants (through Form 1099-R) and the government (through Forms 945, 1099-R, and 1096).

For more information on the tax reporting requirement to participants using Form 1099-R, click here.

For more information on the tax report requirement to the IRS using Forms 1099-R and 1096, click here.

For more information on the tax report requirement to the IRS using Form 945, click here.

Refunds of Excess Contributions

At the end of each plan year, 401(k) plans are required to perform nondiscrimination tests to confirm that the average contribution rates for highly compensated participants do not impermissibly exceed the average contribution rates for rank and file participants. If these tests (referred to as 401(k) tests or ADP tests) are not passed, then the excess amounts (called Excess Contributions) are required to be returned to certain highly compensated participants (unless the plan allows the employer to make additional contributions on behalf of the rank and file participants in order to pass the tests). For more information regarding the ADP and ACP tests, click here.

Refunds of Excess Deferrals

Additionally, Internal Revenue Code Section 402(g) imposes annual limits on the total amount that participants can defer into a 401(k) plan during a calendar year. If these limits are exceeded, then refunds of excess amounts (called Excess Deferrals) must be made on or before April 15 of the next following year. For more information on the annual limits, click here.

Participant’s Spouse

It is important to note that a same-sex spouse is considered the participant’s spouse for purposes of any spousal consent required by the plan. This does not apply to individuals in other similar, formal relationships, such as registered domestic partnerships or civil unions.

Participant Notice

The documents provided to participants who are no longer working should contain sufficient information for participants to understand their benefits and how to apply for them. The documents should contain information:

Additional Notice Obligations

Married but separated participants with balances are to receive individual packages sent to their own addresses containing all required participant disclosure notices. Plan administrators and/or administrative service providers engaged on behalf of the Plan must take care to ensure this unique group of participants is communicated with properly during the course of operating and administrating the Plan.

If the Plan allows separated participants to keep their 401(k) account with the plan, Plan administrators must take steps to ensure they separately receive all of the required participant disclosure notices in a timely manner. These notices may include, for example, the quarterly fee and expense disclosure notice, the Plan’s summary annual report, safe-harbor notice (if applicable), and any other notices required to be provided to participants.

When dealing with missing participants (any participants who did not respond to the notice of distribution options and election forms), considerable care must be taken by plan fiduciaries when handling the participant’s account. The U.S. Department of Labor has provided guidance for employers in their Field Assistance Bulletin (FAB) 2014-01.