Distributions

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As with other qualified profit-sharing or pension arrangements, one advantage of a 401k plan is that taxes on compensation can be deferred until the time it is actually received -- presumably upon retirement. In general, 401k plans are taxed in the same way as other qualified plans:

However, unlike other qualified plans, 401k allow for "premature withdrawals" to participants experiencing financial hardship. In addition, an important feature of many 401k plans is the availability of loans from 401k plans to participants.

The Retirement Equity Act of 1984 imposed a special requirement on married participants. This law requires plans to pay retirement benefits to married participants in the form of joint and last survivor annuities. This protects an employee's spouse from being "left with nothing" if the retired employee dies. Since the employee's spouse is entitled to certain plan benefits, any distributions from the account require the consent of the spouse. A married plan participant may select a payout option other than joint and last survivor annuity, however, the spouse must consent to such a change, in writing.

If the participant elects the first option, the balance in the qualified plan is distributed in a lump sum. The amount distributed must be reported as income but may receive special income tax treatment.

If the participant elects the second option, he or she receives distributions based upon life expectancy or joint life expectancy. Naturally, the participant can change his or her mind at a later date and accelerate the payments.

Like other qualified profit-sharing or pension arrangements, one advantage of a 401k plan is that contributions are not taxed when they are made to the plan. Instead, taxation is deferred until amounts from the 401k plan are distributed to the participant.

The simplest type of distribution is the lump-sum payment, which is a distribution of an employee's entire account balance within a single year. Lump-sum distributions may be eligible for special tax treatment (10-year forward averaging), if it is due to death, separation from service, disability, or attainment of age 59½. However, distributions due the plan's termination (or sale of the business or subsidiary) are not eligible for forward averaging (unless the participant has reached age 59½).

The employee will receive distribution of any voluntary (after-tax) contributions free of tax. Distributions of any other amounts -- i.e., from employee elective deferrals, all employer contributions and earnings on all contributions -- will be taxable to the recipient.

In addition to these options, beneficiaries who receive a lump-sum distribution upon the death of a plan participant are entitled to exclude the first $5,000 of the distribution from taxes as a "death benefit exclusion".

The employee may choose to include the entire taxable distribution in his or her gross income. If the employee does this, the taxable distribution will be combined with all other gross income and, after deductions, will be taxed at the current rates that tax year.

This method divides the distribution by 10 and applies the tax rate for individual taxpayers in effect in 1986 to that amount. That result is multiplied by 10 to find the total tax liability -- which is owed in the year of distribution. This method is available only to those who were born before January 1, 1936 and have participated in the plan for at least five years prior to the distribution. A taxpayer may use this "ten year averaging" method once in his/her lifetime. Ten-year averaging is available if the lump-sum is paid upon death, disability, separation of service or upon reaching age 59½. It is not an option if the payout is due to termination of the plan.

Some employees receive distributions from their accounts over a number of years (sometimes called installment or periodic distributions). A common method is by an annuity over the life of the employee or possibly over the lives of the employee and a designated beneficiary. If the employee is married, the automatic form of payout is a qualified joint and survivor annuity -- unless waived in writing by the spouse.

Regardless of whether the payout is over the life of one person, the lives of two people, or a fixed number of years, the amount of the tax due is determined under the annuity rules. Under these rules, a portion of each payment -- corresponding to after-tax contributions -- is received tax free. The remainder is taxed as ordinary income.

Example: Della Street, an employee of Mason & Associates Co., has contributed to its 401k plan for a number of years. She retires in 2007. At the time of her retirement her account balance is $174,000, of which $45,000 is due to her voluntary after-tax contributions. The remaining $129,000 is the total of all elective, matching, and nonelective contributions plus all earnings allocated to her account (including earnings on the voluntary after-tax contributions). She is taking her benefits in the form of an annuity, which her employer purchases from an insurance company. The annuity pays $25,000 per year for ten years. The taxable portion of each annual payment is determined as follows:

In the case of lifetime annuities, the expected return is determined by using IRS life expectancy tables. For annuities starting after 1986, if an employee's after-tax contributions have been recovered, the entire annuity payment is taxable. This generally occurs if the annuitant outlives the life expectancy. However, if the annuitant dies before recovering all after-tax contributions, the annuitant's estate may claim a deduction on the annuitant's final income tax return for the unrecovered contribution.

As with lump-sum payouts, a beneficiary of a participant who receives an annuity because of the participant's death is entitled to a $5,000 death benefit exclusion. The exclusion is taken by increasing the employee's investment in the contract.

An employee who withdraws funds from the account before a final distribution is made (either by a lump-sum distribution or the beginning of annuity payments) must calculate the portion of the withdrawal that came from after-tax contributions, i.e. the tax-free portion. The remainder is taxable. This calculation is similar to the annuity rule discussed above, except that the employee's contributions and the earnings attributable to those contributions may be treated as an account that is separate and apart from the employer's contributions (and earnings thereon). A plan documents will designate from which account an in-service distribution is made.

Example: Assume the same facts as the previous example, except that, instead of retiring, Della withdraws $12,000 from her account at age 58. The plan's accounting shows that Della's $45,000 after-tax contributions had earned $15,000. The plan document designates that in-service distributions will be made first from the employee's separate account of voluntary contributions and earnings. The source of the $12,000 distribution is a $60,000 separate account, consisting of the $45,000 after-tax contributions and the $15,000 earnings. In this case the exclusion ratio is the $45,000 cost basis divided by the total value of $60,000, or 75%. So, 75% of the $12,000 distribution or $9,000 is excludable from Della's gross income, only $3,000 is taxable. Since Della was under age 59½ , the taxable portion of the withdrawal ($3,000) would have also been subject to a 10% penalty tax.

Funds held in 401k plans are meant to be used for retirement purposes. Consequently, the tax code imposes a 10% penalty tax for withdrawals from such a plan prior to "retirement" - this is in addition to any other taxes owed on the distribution. The general rules for qualified plans is that funds may be withdrawn penalty-free:

Unlike other qualified plans, 401k plans can permit "early" withdrawals due to financial hardship. To qualify for this type of withdrawal the participant must have an immediate and heavy financial need, and lack other readily available resources to meet that need. Withdrawals for this reason are limited to the amount needed to satisfy the hardship. Each plan decides whether hardship distributions are permitted, and if so, factors to determine whether the a financial hardship exists and its size. Financial hardships need not be "emergencies" they may exist even if they were foreseeable or voluntarily incurred - such as the purchase of a residence or college tuition.

Other types of expenses may also qualify depending on the circumstances of the case. For example, the IRS has said that funeral expenses for a family member would ordinarily qualify but that the purchase of a boat or a television would not qualify. The amount distributed for hardship reasons may include funds necessary to pay any federal, state, or local income tax and penalties resulting from the distribution.

The Pension Protection Act of 2006 expands the scope of hardship distributions. Previously, the hardship had to affect the plan participant, his or her spouse, children or dependents. Now, that list can include named beneficiaries. This allows hardship distributions to now be taken for financial emergencies affecting parents, siblings, domestic partners or other non-dependents who are named as a beneficiary of the plan. The new law allows the expanded list, but does not require it. If employers wish to offer this more liberal provision, the plan documents must be amended.

An employee's resources include assets of the employee's spouse and minor children that are reasonably available to the employee. Employers may rely upon the employee's representation that the hardship cannot be relieved:

As a condition of the hardship distribution, the plan and all other plans maintained by the employer, may not accept elective or voluntary contributions from the employee for at least 6 months after the hardship distribution. The assumption is that a participant who can continue to defer funds under any type of plan has resources that can be directed to meet the financial burden. For purposes of the suspension provision, the term "all other plans" refers to all qualified and nonqualified deferred compensation plans maintained by the employer, other than the mandatory employee contribution portion of a defined benefit plan. This definition encompasses stock option, stock purchase, or similar plans.

Although it is not mandatory to verify that one of the "hardship events" has actually occurred, a plan administrator should do so - and keep documentation available in case of audits.

If the participant dies, the retirement savings pass to the beneficiary or estate. Although the beneficiary must report the benefits as income, distributions to beneficiaries under the age of 59½ will not be considered premature. nor subject to the 10% penalty tax.

If the beneficiary receives the retirement benefits in a lump sum, the income tax liability may be reduced by a $5,000 death benefit exclusion and by any cost basis the participant had in the plan.

The participant may designate a beneficiary to receive benefits after his or her death. The participant may name more than one beneficiary and the beneficiary may be a human being or other entity (such as a charity). At the participant's death, the benefits pass to the primary beneficiary. If the primary beneficiary is dead, the benefits become payable to the contingent or secondary beneficiary. If the participant fails to name a beneficiary or the named beneficiaries die before the participant, the benefits become payable to the participant's estate.

In general, beneficiaries must withdraw the entire balance in the qualified plan within five years after the participant's death. The beneficiary will report that as income in the year of withdrawal. This 5-year requirement does not mean that the beneficiary must withdraw the entire amount in a lump sum. To soften the tax blow, the beneficiary may withdraw a portion of the savings each year for five years. If the beneficiary is a charity or the participant's estate, the payout must be accomplished within five years.

For beneficiaries who are human beings, there are alternatives to the general rule. Beneficiaries may choose to accept distributions over their life expectancies. If a trust is named as beneficiary, the ultimate beneficiaries of the trust are treated as the plans beneficiaries under this rule. Charities and estates (which do not have life expectancies) must follow the 5-year rule.

withdraw the savings over the surviving spouse's life expectancy, provided the distributions begin no later than the date the deceased participant would have attained age 70½, or

withdraw all or a portion of the savings in the plan and roll it over to an IRA established in his or her name, and delay minimum distributions until the spouse reaches age 70½.

Beginning in 2007, non-spousal beneficiaries may transfer the distribution into an IRA. Unlike a spouse (who may wait until age 70½ to begin withdrawals), non-spousal beneficiaries must begin to take distributions in the year following death based on their single life expectancy. This new provision applies to children, siblings, domestic partners and even trusts (which use the life expectancy of the trust beneficiary to determine the amount of the annual withdrawals).

Please note: while the tax code has long permitted lifetime payouts from a plan, many plans do not offer this option due to the administrative complexity and cost. The new IRA option will offer nonspousal beneficiaries the opportunity to minimize current tax consequences in many "real world" situations.

In cases where the holder dies after the start of the required maximum distributions (at age 70½) the distribution must continue to be paid to the beneficiary. In the case of human beings, the beneficiary may take the distribution in the same manner as if the account holder dies before the age of 70½ (see list above) or based on the beneficiary's life expectancy. In the case of non-human beneficiaries, such as charities or estates, periodic distributions must be based on the deceased owner's life expectancy.

The law defines a "disabled person" as one who is "unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long continued or indefinite duration." This definition is very broad, making it difficult to qualify for distributions on the grounds of disability. To establish disability, the participant must furnish a medical report certified by a licensed physician to the IRS. Once disability has been established, the 10% penalty tax is waived - the participant can receive distributions, even before age 59½, but must report them as income.

Distributions may be received, penalty-free, prior to age 59½ if the distribution is the result of a divorce decree ("qualified domestic separation order" or QDSO). The former spouse receiving the distribution has two options:

Retiring before the age of 65 is becoming increasingly popular. Special provisions in the tax laws address this issue. A distribution made to a participant will not be treated as premature if:

Distributions from a qualified plan may be received, without penalty, before age 59½ if the payments are made in a series of substantially equal installments over the participant's life expectancy (or joint life expectancy). However, the payments must be made at least annually and the participant faces severe penalties if the payment schedule is changed before he or she reaches the age of 59½.

Like other qualified plans, a 401k plan is required to be "permanent". However, this does not mean that a plan must continue indefinitely. An employer has the right to change or terminate the plan or to discontinue contributions. However, the IRS views termination within a plan's first few years as evidence that it was not a bona fide program for the benefit of employees.

Business reorganization. An employer that is merging with another business, expanding its business, acquiring the assets of another business, or being acquired by another business often terminates its 401k plan. Often this is done because the consolidation entails coverage of an increased group of employees. Sometimes it is done because both of the consolidating businesses have plans and the resulting employer wants to have a single plan for all employees.

Excessive cost. An employer may find the costs of administering the plan and making contributions to it are too high. This problem generally does not occur with 401k plans that consist strictly of elective contributions because almost the entire cost of the plan is borne by employees through salary reductions or bonus deferrals. Plans that provide for nonelective contributions are similarly immune from this problem because those types of plans usually link nonelective contributions to profits earned by the employer. When there are no profits, no contributions are required. Matching contributions, on the other hand, do represent a fixed commitment by an employer, and the cost of meeting that commitment may be too great for an employer that is having financial difficulty.

Employers may not use a termination of a 401k plan to recapture plan assets that are not vested. The law requires that all accrued benefits must become vested and distributed when a plan is terminated.

An employer who terminates a plan must file documentation with the IRS. A plan termination can be a complicated affair. The consequences of an improper plan termination can be devastating, particularly if the IRS determines that the plan was not a permanent plan. If a plan is improperly terminated, the employer loses its tax deduction retroactively for plan contributions and the IRS taxes the plan's earnings. In addition, employees may have to pay back taxes on plan contributions (elective, matching, and nonelective) that were excluded from their income.

Employers may make a distribution, due to termination, only if no successor plan is established within the next 12 months. Otherwise, the terminated plan's assets must be "rolled over" into the new plan. A successor plan is any other defined contribution plan, other than an ESOP or simplified employee pension (SEP), maintained by the same employer -- regardless of whether the plan includes a 401k feature. A replacement plan covering at least 2% of the employees eligible to participate in the terminated 401k plan qualifies as a "successor plan".

A lump-sum distribution due to the sale of the business (at least 85% of the assets) or subsidiary is permitted under certain circumstances. In order to make a distribution for this reason:

Distributions made due to the plan's termination, or in connection with the sale of the business or disposition of assets of a subsidiary, must be in the form of a lump-sum payment of the participant's entire interest and made within one year. Distributions for these reasons are not subject to the 10% penalty tax on premature withdrawals, regardless of the participant's age. However, the distribution is taxed as ordinary income in the year it is received, unless rolled over into an IRA or other qualified plan.

The savings in a qualified plan are for retirement purposes. Therefore, the law requires distributions to be made once the employee reaches a certain age. The savings cannot be kept in a perpetual tax shelter. Mandatory annual distributions to the participant must start no later than when the participant retires or by April 1 following the year the participant turns age 70½, although the tax code permits most older workers to delay the initial distribution until the year they retire (any 5%+ owner of the employer must begin mandatory distributions at age 70½).

The April 1st deadline applies to the initial mandatory distribution only. Subsequent annual distributions must be taken by the close of the participant's tax year -- usually December 31st of each year.

Please note: if a participant delays the initial distribution, he or she will take two distributions in the same tax year (2008 in the above example). There may be a tax disadvantage in delaying the initial distribution until April 1. Both distributions are reported as income in one year, perhaps pushing the participant into a higher tax bracket, increasing the taxable portion of his Social Security benefits, or disqualifying him from other income-based benefits. Although he may delay the first payment until April 1, 2008, it may be in his best interest to take the first distribution by December 31, 2007.

To determine when a 70-year-old participant must receive the initial distribution, check his or her birthdate. If it falls before July 1, the participant will attain age 70½ before the close of the tax year (December 31). Therefore, he or she must receive the initial distribution for that year. On the other hand, if the birthday falls on or after July 1, the participant will not attain age 70½ until the following year. As a result, the initial distribution does not have to be made until the following year.

Example: Sandra Taylor was born on May 20, 1937. Since her birthday falls before July 1, Taylor will attain age 70½ by the close of the 2007 tax year. As a result, her initial distribution must be made by April 1, 2008. On the other hand, if Taylor's birthday were November 27, 1937, she did not attain age 70½ until the 2008 tax year. Therefore, her initial distribution could be delayed until April 1, 2009.

To encourage participants to use the savings in their qualified plan for retirement purposes, the law imposes a 50% penalty tax on distributions that fail to meet the minimum requirements. This 50% penalty tax is imposed on the difference between the amount that should have been distributed and the amount that was actually distributed.

The amount that should have been distributed, based on the participant's life expectancy, is called the "minimum distribution allowance". The difference, if any, between the minimum distribution allowance and the amount actually distributed is called an excess accumulation. The 50% penalty applies to the excess accumulation.

The following illustration shows how to calculate the penalty tax for excess accumulations when the minimum distribution allowance is $8,000, but the participant only withdrew $3,000.

The penalty tax imposed on excess accumulations is harsh. It is very important that required distributions are calculated properly to avoid this penalty. Plan administrators have the responsibility to perform this task but it may be delegated to others.

To calculate the proper amount to be distributed under an insurance or annuity contract, you simply look at the annuity tables in the contract. Life insurance companies are the only institutions that can offer lifetime or joint lifetime payouts.

To calculate the proper amount to be distributed over a participant's life expectancy or joint life expectancy, use the IRS tables. Life expectancy payouts cannot be made over a longer period of time than the participant's life expectancy or joint life expectancy. On the other hand, payments can be made over a period of time that is shorter than life expectancy. In other words, the payments can be accelerated.

To calculate a participant's minimum distribution allowance for any given year simply divide his or her life expectancy into the balance of the qualified plan as of the end of the previous tax year (December 31).

Example: A man or woman who is 70½ years old has a life expectancy of 26.2 years. If the balance in his or her qualified plan is $131,000 on December 31 of the previous year, the minimum distribution allowance for this year is $5,000 ($131,000 / 26.2 years).

Beginning in 2002, the IRS simplified the rules: participants now simply apply the life expectancy from the table based on their current age. So each year, the participants divides the balance in the account as of the end of the last year by the current life expectancy in the tables to find the minimum distribution allowance.

The "single life expectancy" table is actually based on life expectancy of the participant and a beneficiary who is similar in age. In those cases when a spousal beneficiary is considerably younger, the IRS permits use of a joint life expectancy table. This table may be used only if the the participant's spouse is the sole beneficiary of the plan and the participant is 10 or more years older than the spouse. (Prior to 2002, joint life tables could have been used for non-spousal beneficiaries -- this is no longer the case.) The joint life table may be used only when the spouse is at least 10 years younger than the participant. This table has much longer "life expectancies" and therefore allows for slower (reduced) distribution of benefits -- and lower current tax liability on the reduced distributions.

LIFE EXPECTANCY TABLE FOR JOINT LIVES If participant and beneficiary are:
	55	56	57	58	59	60
70	29.9	29.1	28.4	27.6	26.9	26.2
71	29.7	29.0	28.2	27.5	26.7	26.0
72	29.6	28.8	28.1	27.3	26.5	25.8
73	29.5	28.7	27.9	27.1	26.4	25.6
74	29.4	28.6	27.8	27.0	26.2	25.5
75	29.3	28.5	27.7	26.9	26.1	25.3

The required distribution for a "single" 70-year-old participant with a $131,000 in a qualified plan (the earlier example), is $5,000 ($131,000 divided by 26.2 years). But the joint life expectancy payout for a husband at age 70 and wife, age 55, is only $4,381 ($131,000 divided by 29.9).

This table may only be used, if the spouse is named as sole beneficiary. If the spouse is named as a "joint beneficiary" with others, the participant must use the single life table above.

To provide taxpayers relief from the 50% penalty tax, the IRS may waive the penalty if the participant establishes that the excess accumulation was due to a reasonable error and that appropriate steps are being taken to correct the error. The IRS has taken the position that "reasonable error" includes:

Although the IRS has been very lenient and has waived the penalty for almost any reasonable error, the participant must still pay the penalty tax, request a waiver and the reason for the waiver, and attach the payment and the waiver request to his or her tax return. If the waiver is granted, the IRS will refund the penalty tax paid.

Elective contributions to a 401k plan are excluded from the employee's income for federal income tax and income tax withholding purposes. However, elective contributions are included in the FICA (Social Security and Medicare) and FUTA (federal unemployment tax) wage bases, for both withholding purposes and to determine the employer's contribution to these taxes.

Any voluntary contributions made by employees in excess of the deferral limit are subject to FICA and FUTA taxes. However, matching contributions and nonelective contributions (i.e., amounts contributed to the plan by an employer which the employee could not have elected to receive in the form of cash or other taxable benefit) are not subject to FICA, FUTA or federal income taxes.

Plan administrators must withhold income tax on the taxable portion of amounts from a 401k plan that are distributed to an employee or beneficiary. The amount of withholding varies, however, depending on whether the distribution is a periodic or a nonperiodic distribution.

For periodic payments, such as annuities, the tax is withheld as if the payments were wages. By default, recipients are treated as a married person claiming three exemptions for withholding purposes. However, a recipient may elect to not have income tax withheld (unless payments are paid outside of the United States). A recipient should furnish the plan administrator with a Form W-4P to change his or her withholding status.

Income tax withholding is imposed at a 20% rate on any nonperiodic distribution that is eligible for rollover treatment but not transferred directly to an eligible qualified plan or IRA. A nonperiodic distribution is one that is not part of a series of substantially equal payments made over the participant's life (or the joint lives of the participant and his or her spouse) or over a specified period of 10 years or more.

Withholding is mandatory on non-periodic distributions; recipients may not elect out of the withholding as they can for periodic distributions payments. If a recipient rolls over (not a direct transfer) a distribution into a another plan within 60 days, 20% withholding is imposed. To achieve a "full rollover" of the entire amount, the recipient would have to contribute the withheld amount out of his or her own resources and apply for a tax refund. To offset this rather harsh result, IRS rules require plan administrators to give recipients notice of distribution options within a reasonable time before the distribution. Qualified plans must permit participants to directly transfer (without the withholding) eligible nonperiodic distributions to a qualified plan or IRA specified by the participant.

As a general rule, distributions from qualified retirement plans may be moved tax-free to another plan or an IRA. There are two methods in which assets may be moved from a qualified plan: rollover and transfer.

In a transfer, the trustee of the plan sends the plan's assets directly to the trustee or custodian of the IRA or other plan. In a direct transfer, no distribution of retirement savings is made to the participant. The participant simply instructs the sponsor to transfer the savings directly to a successor trustee or custodian. Qualified plans must provide recipients with the option of having eligible rollover distributions paid in a direct transfer rollover to an eligible retirement plan. A transfer is different from a rollover in that the funds are paid directly from the 401k plan to an IRA or defined contribution plan, rather than being paid to the recipient who then deposits the funds in another plan.

In a rollover, the plan's assets are distributed to the participant -- who then deposits them in with the other plan or in an IRA. Since the participant actually takes possession of the plan's assets, rollovers are subject to strict regulation. In making a tax-free rollover from a qualified plan to an IRA, the participant receiving the distribution must roll it over to the IRA within 60 days. Individuals may rollover (as opposed to a direct transfer) retirement plan assets only once in any 12 month period.

If done properly, distributions from qualified plans that are rolled over or transferred will not be subject to income taxation in the year of the distribution (although rollovers will be subject to withholding -- which is refunded when the participant files his or her tax return). Participants who receive a distribution from a qualified plan before reaching age 59½, will not be taxed or subject to "premature penalty" if it is properly rolled over or transferred. For these purposes, the definition of a "qualified plan" includes:

An employee who receives a lump-sum distribution form a 401k plan may defer tax on the distribution by transferring (rolling over) all or part of it to another qualified employer-sponsored plan or to an IRA. Under old tax rules, any portion of a distribution that represented an employee's voluntary after-tax contributions could not be rolled over; now, the "tax-free" portion of the distribution can be rolled over into another qualified retirement plan -- provided the new plan allows for such rollovers and makes separate accounting for after-tax contributions. Movement of after-tax contributons must be accomplished via a direct transfer (not rollover) to the new plan's custodian.

The recipient may elect to divide the eligible rollover distribution -- roll over or transfer a portion of the eligible rollover distribution and receive the balance. However, a plan administrator may require that the transfer equal at least $500. Also, a plan is permitted (but not required) to have a transfer paid to more than one recipient plan or IRA.

Distributions that are transferred to an eligible retirement plan are not included in the recipient's gross income. However, if the recipient elects to rollover the distribution (i.e., have the distribution payable to him or herself and then redeposit it in another plan) the rollover distribution is subject to 20% income tax withholding. This can lead to some inconvenience to the participant attempting to rollover a distribution that is not present in a driect transfer. If a participant takes a lump sum or partial distribution, the plan administrator will withhold 20%. This applies whether the participant intends to "rollover" the distribution or not. The only way to avoid the withholding requirement is to directly transfer the distribution into an IRA or another qualified plan.

Because participants may not elect out of the withholding requirement, employees who actually receive distributions will be paid only 80% of their account. The 20% is held as "hostage" and will be refunded after the employee files a tax return, as long as the distribution is rolled over into an IRA properly. The 20% withheld is treated as a taxable distribution so the employee must make up the 20% amount from personal funds to accomplish a 100% tax free roll-over. Otherwise, the 20% is treated as a taxable distribution, and subject to a 10% penalty tax if the employee is under age 59½. The mandatory 20% withholding applies to hardship withdrawals as well as regular lump-sum distributions.

An important feature of many 401k plans is a provision that allows employees to borrow against their account balances. A loan provision is particularly useful in encouraging low-paid employees to participate in a 401k plan. Without such a provision, these employees may be reluctant to tie up funds that they may need to purchase a car, for medical expenses, or for other large or unexpected expenses.

Qualified plans are permitted to make loans to participants - as long as such loans do not favor highly compensated participants*. Loans, up to five years, can provide participants with a low-cost source of emergency cash in time of financial need. The maximum amount of all loans from the plan may not exceed the lesser of:

For purposes of the plan loan rules, multiple plans of an employer or plans of commonly-controlled employers (such as parent company and subsidiary) are treated as a single plan -- i.e., a maximum total loan of $50,000 (or 50% of benefits) is permitted from all plans as a group.

Loans from qualified plans must be secured by collateral - usually the value of the retirement account is sufficient collateral. Married participants must obtain their spouse's written consent before pledging the account as collateral. ( When a participant borrows more than the vested interest -- i.e., the $10,000 exception -- the plan would need to obtain additional collateral, as the vested benefits would not sufficiently secure the loan.)

Loans from qualified plans must be repaid within five years. The law also requires the loan to be amortized (paid off) on at least a quarterly basis. So "balloon" payments are prohibited. If the loan is not repaid according to this schedule, the entire amount of the loan is treated as a taxable distribution (and possibly subject to the 10% penalty on premature distributions). The 5-year repayment schedule does not apply to loans used for the acquisition of the participant's primary residence (but does apply to loans for reconstruction or rehabilitation).

Please note: interest on loans taken from a 401k for purchase of a primary residence are not tax-deductible (the tax deduction is premised on the loan being secured by the residence, and 401k loans are secured by the participant's vested interest in the plan, not the residence).

The Pension Protection Act of 2006 allows plan administrators to suspend the repayment of loans taken by members of the U.S. Armed Services called to duty between September 11, 2001 and December 31, 2007. Repayment of these loans is postponed until two years after the borrower leaves active duty. The Act also limits the interest rate to a maximum of 6% on loans to members of the U.S. Armed Services.

[ *Prior to 2002, owner-participants of the employer were prohibited from borrowing against their 401k balances. This applied to sole proprietors and those holding more than 10% ownership in partnership, or those holding more than 5% ownership in an S corporation. In 2002, this prohibition was eliminated -- owner-participants may now borrow from their 401ks under the same rules as other employees. ]

Any loan that does not meet the above requirements is treated as a currently taxable distribution, In addition, if the participant is not age 59½, or otherwise entitled to an early distribution, the 10% tax on early distribution applies. If the loan satisfies the repayment, level amortization, and enforceable agreement requirements, but exceeds the dollar limits, only the amount of the loan in excess of the applicable limit is deemed a distribution, at the time the loan is made. Similarly, if the loan initially satisfies the applicable rules, but the participant fails to make the required payments, a distribution equal to the amount of the default occurs at the time of default.

Loans by the 401k plan are assets of the plan until repaid. Even loans that, for whatever reason, are treated and taxed to the employee as "distributions" continue to exist as a loan until it is repaid. The loan remains a plan asset until it is repaid, and interest continues to accrue on the loan until it is totally repaid -- principal and interest.

Plans typically require an employee to repay the any outstanding loan balance upon the termination of employment. A plan may also allow a terminated employee to carry an outstanding loan balance. However, because a 401k loan is a loan from the plan, and not from the individual participant to himself, the participant must still repay the loan. In addition, the tax code prohibits a participant from using any remaining vested account balance to repay the loan.

Example: Ed, a 33 year old, non-disabled employee takes a $10,000 loan from his employer's 401k plan to buy a car, when his vested account balance is $24,000. At age 35, Ed terminates employment with the company, receiving the $30,000 vested account balance, which he elects to rollover to his new employer's pension plan. However, Ed's outstanding loan balance is $5,000. He must repay the loan, or be subject to ordinary tax and the 10% premature distribution tax. He may not apply $5,000 from his $30,000 vested account balance to repay the loan.

Before 1984, participants in a qualified retirement plan could select any form of distribution they desired. In many cases, participants would take a lump-sum, or an annuity paid over their lifetime. This led to problems for surviving spouses. If the participant died, so would the retirement benefits. To correct this situation, the law was changed in 1984. Now, most qualified plans are required to provide a qualified joint and survivor annuity (QJSA) payout to the participant and spouse unless they elect otherwise. (Some profit sharing plans are exceptions to this rule and do not require a QJSA payout.)

The tax code does not define the term "joint-and-survivor-annuity" precisely, but it means a series of fixed, periodic payments over a period of time paid either to the participant or beneficiary. The period of time can be fixed, such as ten years, or it can be uncertain, such as for the life of the participant and beneficiary. This type of annuity takes its name from the fact that periodic payments will be made over the joint lives of the married participant and his or her spouse. The participant receives periodic payments of a fixed amount until death, and then the spouse receives periodic payments until death in an amount equal to at least 50% of the periodic payment which was paid during the participant's life.

This is the automatic form of payout for married participants, unless the participant waives the right to a joint and survivor annuity and the spouse consents in writing. This joint-and-survivor annuity rule prevents a participant from dying after electing a "life only" annuity and thus leaving his or her spouse, unknowingly, with no retirement benefits. It also prevents a participant from receiving a distribution and hiding it from his or her unsuspecting spouse. A plan administrator must receive written consent from the spouse unless the participant's vested interest in the plan is less than $5,000.

Example: Walter and Barbara Leigh are married. Walter participates in a qualified plan. When Walter retired, his vested balance in the plan is $225,000 and he elected a lump sum distribution. Since the automatic form of payout is a qualified joint and survivor annuity, the plan administrator must have Walter sign a waiver and get written consent from Barbara before making the lump sum distribution.