401(k) Plan Distributions and Vesting

 

Distributions from 401(k) plans are defined by the terms of the plan. The plan document must comply with all legal requirements (including Internal Revenue Code requirements) regarding both the timing of distributions and how a distribution can be paid. Distributable events typically include retirement, death, disability or severance of employment. The plan may also provide for in-service distributions, such as for hardship or other special withdrawal purposes and/or upon attainment of age 59 ½. The plan may also allow certain amounts to be distributed at any time, such as certain rollover contributions and non-Roth after-tax contributions.

A participant’s actual distribution amount is determined based on his/her non-forfeitable, or vested, share of his/her account balance. Vesting means that a participant has earned a non-forfeitable right to benefits funded by employer contributions. The plan document will provide for a vesting schedule that is used to calculate the non-forfeitable, or vested, amount. As further explained in “Vesting Schedule” below, a participant’s 401(k) elective deferral contributions are always immediately, or 100%, vested, whereas a plan can be designed so that employer contributions become vested over time, according to a vesting schedule. Only fully vested amounts can be distributed.

Certain distributions are required to begin on the later of age 73 (prior to January 1, 2023, age 72) or retirement (see “Required Minimum Distributions,” below). Other distributions may be required if nondiscrimination tests are failed or if elective deferral limits are exceeded, as further explained, below.

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. These procedures should include steps to verify marital status and to obtain any spousal consent required under the law (see “Elections and Consents,” below) or the terms of the plan (for example, for loans).

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. (See “Tax Form Reporting,” below.)

Timing of Permissible 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:

• A participant’s termination from employment
• A participant’s death
• A participant’s total and permanent disability
• A participant’s attainment of age 59
• A participant’s financial hardship (as defined by the plan and as permitted by law)
• A participant’s military or disaster-relief distribution qualification
• Plan termination
• A participant’s incurring of certain “qualified birth or adoption” expenses (effective on and after January 1, 2020)
• A participant’s eligibility for a “qualified federally declared disaster” distribution (effective on and after January 26, 2021)
• A participant’s eligibility for a “terminal illness withdrawal” (effective on and after December 29, 2022)

NOTE: Effective after December 31, 2023, a participant’s eligibility for a withdrawal due to certain emergency expenses (added by the SECURE 2.0 Act). Very broadly stated, one distribution will be permissible per year, of up to $1,000, due to emergencies that are unforeseeable, or that constitute an immediate financial need relating to personal or family emergency expenses.

NOTE: Effective after December 31, 2023, a participant’s eligibility for a withdrawal in the event of self-certified cases of domestic abuse (added by the SECIRE 2.0 Act).

NOTE: “Coronavirus-related distributions” under the CARES Act (see “Congress Passes CARES Act in Response to COVID-19 Crisis, Contains 401(k) Ease-of-Access and Other Provisions” for details) and “Qualified Disaster Distributions” under the CAA (see “401(k): CAA Expanded Loan and Withdrawal Provisions Differ From CARES Act” for details) have now expired.

For other plan contribution types, like employer matching contributions or discretionary employer contributions, the plan can generally 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, “qualified nonelective contributions” (“QNECs”), and “qualified matching contributions” (“QMACs”) (each of these are contributions made in order to help the plan pass certain nondiscrimination tests) — but not Roth contributions — 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. For hardship distributions made in plan years beginning prior to December 29, 2022, 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, for hardship distributions made during such plan years, the plan sponsor is responsible for requesting and retaining documentation to substantiate the nature of the hardship.  Prior to the SECURE 2.0 Act, it was 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) was responsible for determining whether the hardship event had occurred and the amount necessary to alleviate the hardship. But effective for plan years beginning on and after December 29, 2023, plan administrators generally may now rely on a participant’s written self-certification that a “deemed” hardship distribution is due to an “immediate and heavy financial need” (see below), and that the amount of the distribution is limited to the amount required to satisfy such need. The plan sponsor generally 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; and (ii) 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.

Whether a need is immediate and heavy 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:

• Expenses for medical care for the employee or the employee’s spouse, children, dependents, or other individuals who qualify as a primary beneficiary under the plan
• Costs directly related to the purchase of the employee’s principal residence (excluding mortgage payments), including closing costs
• Payment of tuition, related educational fees, and room and board expenses for up to the next 12 months of post-secondary education for the employee or for the employee’s spouse, children, dependents, or other individuals who qualify has a primary beneficiary under the plan
• Payments necessary to prevent eviction from, or foreclosure on, the employee’s principal residence
• Payments for burial or funeral expenses for the employee’s deceased parent, spouse, children, dependents, or other individuals who qualify as a primary beneficiary under the plan
• Certain expenses for the repair of damage to the employee’s principal residence that generally would qualify for the casualty deduction under the Internal Revenue Code
• Expenses and losses (including loss of income) incurred by the employee as a result of a disaster declared by the Federal Emergency Management Agency (“FEMA”), as long as the employee’s principal residence or principal place of employment at the time of the disaster was located in an area designated by FEMA for Federal assistance.

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 hardship distribution may not exceed the amount of an employee’s need (including any amounts necessary to pay any Federal, state, or local income taxes or penalties)
• The employee must have obtained other available distributions under the employer’s plans (other than loans)
• For hardship distributions made in plan years beginning prior to December 29, 2022, the employee must represent that he or she has insufficient cash or other liquid assets to satisfy the financial need. A plan administrator may rely on such a representation unless the administrator has actual knowledge to the contrary (see second paragraph under “Hardship Distributions” above, for broader rules regarding self-certification of hardships, effective after December 29, 2022)
• Plans may establish certain additional criteria as well (including a requirement to first take out a participant loan from the plan – which, prior to January 1, 2019, was legally required).
• The old rule, which provided that the employee is prohibited from making elective deferral contributions to the plan for at least six months after receipt of the hardship distribution, has been eliminated.

401(k) Plan Loans to Participants

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 contributions designated in the plan document as 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 73 (prior to January 1, 2023, age 72). These distributions are referred to as Required Minimum Distributions or RMDs. Plans may allow participants, who are not 5% owners, to wait until retirement before receiving required minimum distributions.

NOTE: The SECURE 2.0 Act will change age 73 to age 75, beginning on January 1, 2033.

When a participant dies before RMDs have begun, detailed RMD rules apply to the participant’s beneficiary. The RMD requirements will depend on the identity of the participant’s beneficiary, including whether the beneficiary is the participant’s surviving spouse.

For more 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 installment payments. 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 (including a same-sex spouse), has the same rights as the participant and may roll over the distribution to another qualified plan or IRA.

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.

Some 401(k) plans feature 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 (see below) which complicates administration of the plan.

Elections and Consents

Participants in retirement plans, including 401(k) plans, generally must consent to distributions or their own, or their spouses’, plan accounts, or to elections of specific forms of benefits. For example, a 401(k) plan generally cannot force a participant to take, without his or her consent, a distribution of his or her account balance if it is above $5,000*. Participants and/or spouses must also consent to the distribution of their account balances in the form of certain single life annuities or joint and survivor annuities, if the plan features these annuities as optional forms of benefits.

*NOTE: Effective for distributions made after December 31, 2023. the SECURE 2.0 Act will increase the $5,000 “cash out” limit referenced above to $7,000.

Additionally, a participant’s spouse generally must consent if the participant designates a beneficiary other than such spouse to receive any portion of the 401(k) account balance in the event of his or her death. A plan may also require a spouse’s consent if the participant takes out a plan loan. For information regarding plan loans, click here.

Under the Internal Revenue Code and related regulations, the signature of the individual making the election or consent generally must be witnessed in the physical presence of either a plan representative or notary public (the “physical presence requirement”). Under the existing regulations, this is the default rule which applies in all cases where an exception or specific relief has not been granted.

COVID-19 Relief from “Physical Presence Requirement.” In recognition of the potential hardship the COVID-19 pandemic might have on the ability of plan participants, spouses and other beneficiaries to be physically present with a plan representative or notary public, the IRS has issued recent guidance which extends relief from the “physical presence requirement” to any participant election that otherwise requires the signature of an individual to be witnessed in the physical presence of such plan representative or notary public (for example, a spouse’s consent to a participant’s designation of a non-spouse beneficiary). Specifically, the relief authorizes the use of live audio-video technology, if certain prescribed requirements are met, as explained below.

Although the relief was originally set to expire as of December 31, 2020, the relief was later extended through June 30, 2021 and, most recently, through December 31, 2022.

Notably, the IRS recently has has issued proposed regulations that, if finalized, would permanently permit the use of electronic media to make participant elections and spousal consents if certain criteria are met.

Under the proposed regulations (which generally may be relied upon until they are finalized), participant elections and consents may be accomplished by means of live audio-video technology under the following terms and conditions:

Elections and Consents Witnessed by Plan Representative:

• The individual signing the participant election must present a valid photo ID to the plan representative during the live audio-video conference, and may not merely transmit a copy of the photo ID prior to or after the conference;
• The live audio-video conference must allow for direct interaction between the individual and the plan representative (i.e., a pre-recorded video of the person signing does not meet this requirement);
• The individual must transmit by fax or electronic means a legible copy of the signed document directly to the plan representative on the same date it was signed; and
• After receiving the signed document, the plan representative must acknowledge that the signature has been witnessed by the plan representative in accordance with the requirements of IRS Notice 2020-42, and transmit the signed document (including the acknowledgement) back to the individual, in accordance with existing regulatory requirements; and
• A recording of the audio-video conference during which the spousal consent was signed remotely must be made by the plan representative and must be retained by the plan in accordance with Internal Revenue Code rules relating to the maintenance of records.

Elections and Consents Witnessed by Notary Public:

• The signature of the person signing the election or consent must be witnessed by the notary public using live audio-video technology;
• The notarization must otherwise satisfy the requirements of participant elections and spousal consents under the applicable Treasury Regulations; and
• The notarization must be consistent with state law requirements that apply to the notary public.

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.

“Safe-harbor:” 401(k) plans have special vesting requirements. For details about safe-harbor plans, click here.

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 should he or she die or terminate employment. 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 (distributed) 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

The amount that a participant can contribute to a 401(k) plan in a calendar year, as regular 401(k) deferrals and/or designated Roth contributions, is limited by Internal Revenue Code Section 402(g). This amount, which is often referred to as the “elective deferral limit” or “402(g) limit,” may be updated annually by the IRS. The current limits can be found here.

However, a 401(k) plan might also allow participants who will be at least age 50 by the end of the calendar year to make additional deferrals. These additional deferrals are called “catch-up contributions.” This limit may also be updated annually by the IRS and the current limit is available here.

Because the limits are adjusted each year, it is important to develop internal control procedures for confirming the “402(g) limit” and “catch-up contribution limit” each year and ensuring that systems are updated at the beginning of the year to apply the correct limits.

If the total of a plan participant’s elective deferrals (including catch-up contributions, if applicable) for a calendar year exceeds the 402(g) limit plus the catch-up contribution limit, the excess amount is referred to as “excess deferrals.” These “excess deferrals” plus allocable earnings will need to be returned to the participant in accordance with the procedures included in the plan.

Note that the deferral limit and the catch-up limit are annual participant limits on contributions to all 401(k) plans for the year; however, plan administrators are generally not responsible for knowing about contributions participants in their plans might have made to other 401(k) plans during the year. It is possible, nevertheless, that a participant will notify the administrator that he or she has excess deferrals in the plan because he or she has also made contributions during the year to another 401(k) plan, and the total could exceed the annual deferral limit and/or catch-up limit. In such a case, the prudent thing for the plan administrator to do is to limit deferrals under the plan to avoid exceeding the limits, to avoid having to distribute excess deferrals after the end of the year, and even potential plan disqualification.

The general rule is that excess deferrals must be distributed to affected participants by April 15 of the year following the calendar year of the deferrals.  Excess deferrals not timely returned to the participant are subject to additional tax.

The following describes the differences between timely distribution and late distribution of “excess deferrals:”

Timely Distribution of Excess Deferrals (by April 15)

• Excess deferrals distributed from the plan by April 15 of the year following the year of deferral are taxable in the calendar year deferred.
• Earnings are taxable in the year they are distributed.
• There is no 10% early distribution tax, no 20% withholding and no spousal consent requirement for amounts timely distributed.

Consequences of a Late Distribution (after April 15)

• If the excess deferrals aren’t distributed from the plan by April 15, each affected plan of the employer is subject to disqualification and would need to go through the IRS Employee Plans Compliance Resolution System (“EPCRS”) to correct the operational error.
• Under EPCRS, these excess deferrals are subject to double taxation; that is, they’re taxed both in the year contributed to the plan and in the year distributed from the plan.
• These late distributions could also be subject to the 10% early distribution tax, 20% withholding and spousal consent requirements.

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. As previously explained, 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:

• Describing the benefits that are available;
• Identifying when benefits may be or will be paid; and
• Listing the steps that must be taken to receive the benefits (including when and how a participant should apply).

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 following termination of employment, 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) 2021-01.

NOTE: By no later than December 29, 2024, the SECURE 2.0 Act directs the Department of Labor and the Internal Revenue Service to create an online retirement “Lost and Found” to assist participants and beneficiaries with locating retirement benefits to which they may be entitled. Plan sponsors will be required to share updated contact information with the online database.

Notice requirements for a variety of 401(k) plan compliance purposes are explained in detail in a number of the compliance tasks and reference materials available on ComplianceDashboard.