Key Points
Allowable Distributions
Distributions from qualified plans are generally subject to ordinary income taxation in the year of withdrawal. The plan document specifies the normal retirement age — the lowest age at which an employee may retire without employer consent and receive full retirement benefits. As a general rule, normal retirement age is 65, though participants may also receive distributions at early retirement or upon separation from service.
Generally, allowable distributions from a qualified plan begin at age 65, but may begin as early as age 59½ or earlier if the plan allows early retirement. A plan may also require 10 years of service before paying out benefits, or delay distributions until actual retirement.
A plan generally cannot make a distribution to a participant before age 62 unless the participant consents in writing.
Premature Distributions
Since qualified plans are intended as long-term retirement savings programs, participants are penalized for withdrawing savings before age 59½. In addition to ordinary income taxation, premature distributions are subject to a 10% penalty tax.
Wilma Flint, age 40, received a $10,000 distribution from her qualified plan. Her pre-distribution gross income was $60,000. After the distribution, her taxable income is $70,000 and she owes a penalty tax of $1,000 (10% × $10,000) in addition to ordinary income tax on the $10,000.
The 10% penalty is not imposed when the participant or beneficiary receives a distribution:
- upon the participant’s death or disability,
- as a result of a divorce decree (qualified domestic relations order — QDRO),
- as a result of retiring early between age 55 and 59½ under the plan’s early retirement provisions,
- as a series of substantially equal periodic payments (SEPPs) over the participant’s lifetime or life expectancy,
- to cover tax-deductible medical expenses (expenses exceeding 7.5% of AGI),
- taken as a plan loan, or
- to make a rollover contribution.
Additional exceptions added by SECURE Act 2.0 include distributions for terminal illness, domestic abuse (up to $10,000), emergency personal expenses (up to $1,000/year), and qualified disaster distributions (up to $22,000).
Participants in a 401(k) may also withdraw funds before age 59½ for financial hardship without the 10% penalty under certain plan provisions.
If the participant dies before distributions begin, the retirement savings pass to the named beneficiary or the participant’s estate. Distributions to beneficiaries are included in income but are not subject to the premature distribution penalty regardless of the beneficiary’s age.
The participant may name one or more primary beneficiaries and contingent (secondary) beneficiaries. If no beneficiary is named, or all beneficiaries predecease the participant, benefits pass to the participant’s estate.
The SECURE Act of 2019 replaced the old 5-year rule for most non-spouse beneficiaries with a 10-year rule: non-spouse “designated beneficiaries” must withdraw the entire inherited account balance within 10 years of the participant’s death. Subsequent IRS guidance (2022–2024) clarified that if the participant had already begun RMDs, non-spouse beneficiaries must continue annual RMDs during years 1–9 and fully distribute the balance by the end of year 10.
Exceptions to the 10-year rule (“eligible designated beneficiaries” who may still use life expectancy payouts):
- the surviving spouse,
- a child of the participant who has not yet reached majority (the 10-year rule applies once the child reaches majority),
- a disabled or chronically ill individual, and
- a beneficiary who is not more than 10 years younger than the participant.
If the beneficiary is a surviving spouse (sole beneficiary), additional options are available:
- withdraw the entire amount within 10 years,
- roll the plan assets over to an IRA in the surviving spouse’s own name and treat as own account, or
- withdraw the savings over the surviving spouse’s life expectancy, with distributions beginning no later than the date the deceased participant would have reached their RMD age.
Nancy Taggert, age 55, inherited the retirement savings in her deceased husband Bill’s qualified plan. As sole surviving spouse, she rolls the benefits into an IRA in her own name. She is not required to take RMDs until she reaches age 73 (or 75, if born after 1959). This allows her to defer distributions — and the resulting tax — for many years. Surviving spouses are the only beneficiaries with rollover rights into their own IRA.
| Beneficiary | Distribution Requirement |
|---|---|
| “Non-human” beneficiaries (charities, estates) | Must withdraw entire balance within 5 years of participant’s death |
| Non-spouse designated beneficiary (human) | 10-year rule — full balance distributed by end of 10th year after death; annual RMDs may be required during years 1–9 if participant had begun RMDs |
| Eligible designated beneficiary (disabled, chronically ill, within 10 years of age, or minor child) | Life expectancy distributions; 10-year rule applies once minor child reaches majority |
| Surviving spouse (sole beneficiary) | May roll over to own IRA; use life expectancy; or withdraw within 10 years. RMDs begin when spouse would have reached RMD age or when surviving spouse reaches own RMD age |
Distributions may be made before age 59½ without the 10% penalty if the participant becomes disabled. The legal definition of disability is broad: the participant must be unable to engage in any substantial gainful activity due to a medically determinable physical or mental impairment expected to result in death or to be of long continued or indefinite duration. A physician’s certification must be provided to the IRS.
Distributions may be received before age 59½ without penalty if made pursuant to a qualified domestic relations order (QDRO). The alternate payee (former spouse) may:
- receive the distribution and report it as income, or
- receive the distribution and roll it over to an IRA.
A distribution will not be treated as premature if the participant separated from service, the distribution was made under the plan’s early retirement provisions, and the participant attained age 55 in the year of separation. (For public safety employees, the age threshold is 50.)
Distributions may be received before age 59½ without penalty if they are made as a series of substantially equal periodic payments (at least annually) over the participant’s life expectancy or joint life expectancy. The participant faces severe penalties if the payment schedule is changed before reaching age 59½.
Elliott Groves, age 50, elected to receive his retirement benefits over his life expectancy as substantially equal periodic payments. Because he chose this distribution method, the payments are not treated as premature. However, Groves may not alter the scheduled payments until he reaches age 59½. Each year’s withdrawal is taxed as ordinary income.
Plan Loans
A qualified plan is permitted to make loans to participants — one of the advantages of qualified plans over non-qualified arrangements such as SEPs. Loans provide participants with a low-cost source of emergency funds. However, if a loan exceeds five years it is treated as a taxable distribution. The maximum loan amount is the lesser of:
- $50,000, or
- 50% of the participant’s vested interest in the plan (if 50% of the vested balance is less than $10,000, the participant may borrow up to $10,000).
Loans must be secured by collateral (typically the retirement account balance). Married participants must obtain their spouse’s written consent before pledging the account as collateral. Loans must be repaid within five years on at least a quarterly basis — balloon payments are not permitted. If the loan is not repaid on schedule, the entire outstanding balance is treated as a taxable distribution (and possibly subject to the 10% premature penalty).
Marvin Moody borrowed $30,000 from his qualified plan to remodel his home. Five years after the loan was made, a $1,000 balance remained unpaid. Because Moody did not repay the loan within five years, the entire $30,000 is treated as a taxable distribution and must be reported as income.
Mandatory Distributions (RMDs)
The law requires distributions to begin once the employee reaches a certain age — savings cannot be kept in a perpetual tax shelter. Under SECURE Act 2.0 (2022), mandatory annual distributions must start no later than April 1 following the year the participant turns age 73 (for those born 1951–1959). For those born after 1959, the RMD age will be 75, effective 2033.
Participants who are still working (other than 5%+ owners) may delay their initial RMD until the year they retire. 5% or greater owners must begin RMDs at age 73 regardless of employment status.
The April 1 deadline applies only to the initial RMD. Subsequent annual distributions must be taken by December 31 of each year.
Under SECURE Act 2.0, beginning in 2024, designated Roth accounts in 401(k) and 403(b) plans are no longer subject to RMDs during the owner’s lifetime. This aligns Roth 401(k) accounts with Roth IRA rules.
Failure to take a required minimum distribution results in a 25% excise tax on the shortfall (the amount that should have been distributed but was not). Under SECURE Act 2.0, this penalty is reduced to 10% if the missed RMD is corrected within two years.
The minimum distribution allowance for the year was $8,000, but the participant only withdrew $3,000. The excess accumulation is $5,000 ($8,000 − $3,000). The excise tax is $1,250 (25% × $5,000). If corrected within two years, the tax is reduced to $500 (10% × $5,000).
Each year, the RMD is calculated by dividing the account balance as of December 31 of the prior year by the participant’s life expectancy factor from the IRS Uniform Lifetime Table (Publication 590-B). The IRS updated its life expectancy tables effective 2022 to reflect longer life expectancies, reducing annual RMD amounts.
| Age | Distribution Period (Life Expectancy Factor) |
|---|---|
| 73 | 26.5 |
| 74 | 25.5 |
| 75 | 24.6 |
| 76 | 23.7 |
| 77 | 22.9 |
| 78 | 22.0 |
| 80 | 20.2 |
A participant age 73 has a qualified plan balance of $131,000 on December 31 of the prior year. Using the IRS Uniform Lifetime Table, the distribution period is 26.5 years. The RMD for the year is $4,943 ($131,000 ÷ 26.5).
If the participant’s sole beneficiary is a spouse who is more than 10 years younger, the participant may use the Joint and Last Survivor Table (IRS Table II), which produces a longer distribution period and thus a smaller RMD. This table may only be used when the sole beneficiary is a younger spouse — not for non-spouse beneficiaries.
The IRS may waive the excise tax on a missed RMD if the participant establishes that the shortfall was due to a reasonable error and that corrective steps are being taken. Reasonable error includes incorrect advice from a plan sponsor or consultant, calculation errors, or a misunderstanding of the applicable rules.
Distribution Options
When a participant elects to begin receiving distributions, three general methods are typically available:
- Lump sum — the entire plan balance distributed in one tax year,
- Installment distributions based on life expectancy or joint life expectancy, or
- Annuity from an insurance company providing a life annuity or joint life annuity.
Participants may accelerate distributions at any time. Installment payments may be received over a shorter period than life expectancy but not a longer one.
Taxation of Distributions
When plan savings consist entirely of employer contributions and pre-tax earnings, the full amount distributed is taxable as ordinary income in the year received.
When both employer and employee contributions are present, taxation is based on the participant’s “cost basis” — the amount of nondeductible (after-tax) contributions made to the plan.
A lump sum distribution is the distribution of the participant’s entire interest in the plan within one tax year. Triggering events include the participant’s death, separation from service, or attainment of age 59½. Amounts in excess of cost basis are fully taxable as ordinary income.
Special tax treatment (10-year forward averaging at 1986 rates) is available only to participants born before January 1, 1936, who have participated in the plan for at least five years. This is a once-in-a-lifetime election. Five-year averaging at current rates was repealed in 2000 and is no longer available.
If the participant has a cost basis (after-tax contributions), a portion of each installment payment represents a tax-free return of basis. The exclusion ratio is:
Cost basis ÷ Total plan value = Exclusion Ratio
Nancy Drew’s $100,000 plan balance consists of $20,000 employer contributions, $40,000 earnings on employer contributions, $15,000 nondeductible employee contributions, and $25,000 earnings on employee contributions. Her cost basis is $15,000 (the nondeductible contributions), so the exclusion ratio is 15% ($15,000 ÷ $100,000).
On a $20,000 distribution: $20,000 × 15% = $3,000 tax-free return of basis; the remaining $17,000 is taxable.
For annuity payouts, the same concept applies but the formula is:
Investment in contract ÷ Expected return = Exclusion Ratio
Using the same $15,000 cost basis, Nancy opts for an annuity paying $1,000/month for 10 years. Her expected return is $120,000 ($12,000/year × 10 years). Exclusion ratio = $15,000 ÷ $120,000 = 12.5%. Of each $1,000 monthly payment, $125 is tax-free return of basis; $875 is taxable.
If a qualified plan distributes an annuity contract, the annuity is not reported as income if it is not surrendered for its cash value in the year of distribution and is non-transferrable. When a life insurance policy is part of a lump sum distribution, it is not taxable if it is:
- converted to a nontransferable annuity within 60 days, or
- surrendered for its cash value and the proceeds rolled over to an IRA.
Fred Dillon received a $100,000 lump sum consisting of $20,000 cash and an annuity contract with an $80,000 cash surrender value. If the annuity is nontransferable and Dillon does not surrender it in the year of distribution, the annuity is not taxable that year. The $20,000 cash may qualify for available special tax treatment. However, the annuity loses its right to special tax treatment in the future and will be taxable when Dillon surrenders it or begins receiving annuity payments.
Joint and Survivor Annuities (QJSA)
Most qualified plans are required to provide a qualified joint and survivor annuity (QJSA) as the automatic form of payout to a married participant, unless both the participant and spouse consent in writing to an alternative form of distribution.
Under a QJSA, the participant receives periodic payments for life, and upon death the surviving spouse continues to receive payments equal to at least 50% of the periodic payment amount paid during the participant’s life. A plan administrator must receive written spousal consent before distributing more than $5,000 to the participant in any other form.
Walter and Barbara Leigh are married. When Walter retired, he elected a lump sum distribution. Since the automatic form of payout is the QJSA, the plan administrator must have Walter sign a written waiver and obtain written consent from Barbara before making the lump sum distribution.
In cases where each spouse is covered by their own retirement plan, waiving the joint payout may be appropriate. Where only one spouse is covered, the QJSA is usually the most protective option. The decision should consider all relevant factors: other plans, assets, health, ages, and income needs.
Rollovers & Transfers
Distributions from qualified retirement plans may generally be moved tax-free to another qualified plan or an IRA using either a direct transfer or a rollover:
- Direct transfer (trustee-to-trustee): the plan trustee sends assets directly to the receiving plan or IRA. The participant never takes possession. This is the preferred method — no withholding applies.
- Rollover: the plan distributes assets to the participant, who then deposits them into another plan or IRA within 60 days. Because the participant takes possession, the plan must withhold 20% of the distribution.
Plans eligible to receive rollovers include:
- corporate retirement plans (defined benefit, money purchase, profit sharing, stock bonus, 401(k), ESOPs),
- Keogh plans,
- IRAs (including SEP-IRAs),
- Section 457 deferred compensation plans (state and local governments), and
- tax-sheltered annuities (403(b) plans).
If a participant directly receives a lump sum or partial distribution (rather than using a direct transfer), the plan administrator must withhold 20% — even if the participant intends to roll over the full amount. To complete a 100% tax-free rollover, the participant must make up the 20% withheld from personal funds within 60 days. The withheld 20% is refunded after the participant files a tax return showing the completed rollover. Failure to deposit the full amount (including the withheld 20%) within 60 days results in the shortfall being treated as a taxable distribution, subject to the 10% premature penalty if under age 59½.
The following types of distributions may be rolled over:
- lump sum distributions,
- partial distributions (any size, since 1993), and
- termination distributions (from a terminated plan, even if the employee continues working for the same employer).
The following types of distributions may not be rolled over:
- annuity payouts over the participant’s lifetime,
- mandatory minimum distributions (RMDs), or
- hardship distributions from a 401(k) plan.
In a rollover, the participant must deposit the distribution into the receiving plan or IRA within 60 days of receipt. If the distribution is made in two or more installments, the 60-day period begins on the date of the final payment.
Paul Johnson retired on June 30 with a $100,000 profit-sharing plan balance. He received a $20,000 distribution on July 15, and the remaining $80,000 was distributed on August 1. The 60-day rollover period begins on August 1 (the date of the final payment). Johnson must deposit the entire $100,000 into an IRA by September 30 to complete a tax-free rollover.
When a participant rolls a lump sum distribution from a qualified plan into an IRA, the assets may later be “rolled back” into another employer’s qualified plan (if that plan accepts rollovers). When used this way, the IRA is sometimes called a “conduit IRA”. To preserve this option, the conduit IRA assets must not be commingled with other IRA contributions. There is no time limit on how long assets may remain in a conduit IRA.
Todd Whitman left ABC Corporation and rolled his lump sum distribution into a conduit IRA. Several months later he joined XYZ Corporation. Todd may roll the conduit IRA assets into XYZ’s 401(k) plan, provided XYZ’s plan allows incoming rollovers and the conduit IRA was not commingled with other IRA contributions.
A partial rollover occurs when the participant does not roll the entire distribution into an IRA. The portion not rolled over must be reported as taxable income. Since 1993, any distribution size may be partially rolled over — there is no minimum percentage requirement.
If a qualified plan distribution consists of property (other than cash), the participant may:
- roll over the same property to an IRA, or
- sell the property and roll over all or part of the cash proceeds (this option is available for rollovers from qualified plans but not for IRA-to-IRA rollovers).
Participants must withdraw their nondeductible employee contributions before completing a rollover to an IRA. Only amounts attributable to employer contributions, earnings on employer contributions, and earnings on employee contributions may be rolled over. The withdrawal of after-tax employee contributions is not taxable (since they were contributed with after-tax dollars).
Jake Grossman received his entire $100,000 profit-sharing plan distribution, of which $20,000 represented his nondeductible employee contributions. The maximum amount Grossman may roll over to an IRA is $80,000 ($100,000 − $20,000). The $20,000 withdrawal is not taxable.