Chapter 2 — Distributions

In 401(k) plans, contributions are invested and grow tax-deferred. When funds are withdrawn, the distribution is subject to tax based on how the original contribution was made:

• Before-tax contributions (elective, matching, nonelective) — the employee was never taxed on these amounts, so the full withdrawal including earnings is taxable as ordinary income in the year received.
• Voluntary after-tax contributions — made from income already taxed, so only the earnings portion is taxable. The exclusion ratio determines what portion of each distribution is tax-free return of basis. (See Chapter 1 — Distributions for the exclusion ratio formula.)

Distributions from a Roth 401(k) designated account are tax-free if the account has been held for at least five years and the participant is age 59½ or older (or disabled, or deceased). See Roth 401(k) for details.

Elective contributions are fully and immediately vested — employees have complete ownership at all times. However, because 401(k) accounts are intended for retirement, the tax code imposes a 10% penalty tax on withdrawals before age 59½, in addition to ordinary income tax on the distribution.

Funds may be withdrawn penalty-free in the following circumstances:

• the employee reaches age 59½,
• the employee retires or separates from employment,
• the employee dies or becomes permanently disabled,
• pursuant to a qualified domestic relations order (QDRO) following divorce,
• the employee retires 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 life expectancy,
• to pay deductible medical expenses (in excess of 7.5% of AGI),
• taken as a plan loan (if permitted by the plan),
• as a rollover contribution to another qualified plan or IRA,
• upon plan termination without establishment of a successor plan, or
• if the employer disposes of assets or a subsidiary and the employee continues with the purchaser.

Corrective distributions of excess ADP or ACP amounts are not subject to the penalty tax, nor are rollover distributions. If elective contributions are rolled over to another qualified plan, premature distribution restrictions continue to apply — unless the amounts could have been distributed at the time of transfer for a reason other than hardship.

One important advantage of 401(k) plans over other qualified plans is the availability of hardship distributions — described in the next section — and plan loans, both of which make 401(k) plans more accessible than most other retirement vehicles.

Unlike most other qualified plans, 401(k) plans allow early withdrawals due to financial hardship. To qualify, the participant must have an immediate and heavy financial need and lack other readily available resources to satisfy that need. Hardship withdrawals need not be emergencies — even foreseeable or voluntarily incurred expenses (such as purchasing a home or paying tuition) can qualify.

The IRS recognizes the following as immediate and heavy financial needs that may qualify for hardship distributions:

• medical expenses incurred by the employee, spouse, or dependents — or amounts necessary to obtain medical care;
• costs related to the purchase of a principal residence (not regular mortgage payments);
• tuition and related educational fees (including room and board) for the next 12 months of post-secondary education for the employee, spouse, or dependents;
• payments to prevent eviction from or foreclosure on the employee’s principal residence;
• funeral or burial expenses for a family member; and
• expenses to repair damage to the employee’s principal residence (added by SECURE Act 2.0).

Other expenses may qualify depending on the circumstances. The IRS has stated that purchasing a boat or television would not qualify. The amount distributed may include funds necessary to pay any federal, state, or local income taxes and penalties resulting from the distribution itself.

The plan administrator may distribute the lesser of:

• the actual financial need (less any other readily available resources), or
• the total amount of the employee’s elective contributions to the plan, minus any amounts previously distributed for hardship.

An employee’s available resources include assets of the employee’s spouse and minor children that are reasonably accessible. The employer may rely on the employee’s representation that the hardship cannot be relieved through:

• insurance reimbursement or other compensation,
• reasonable liquidation of assets (to the extent that liquidation would not itself cause immediate financial hardship),
• other plan distributions or nontaxable loans, or borrowing from commercial sources on reasonable terms, or
• cessation of elective contributions or voluntary contributions to the plan.

A hardship distribution may not be rolled over to another plan or IRA. Prior to 2002, plans were required to suspend elective contributions for 12 months following a hardship distribution. This mandatory suspension was eliminated in 2002 — however, individual plan documents may still impose such a restriction.

A 401(k) plan may be amended to add, modify, or eliminate hardship distribution provisions without violating the prohibition on plan amendments that reduce accrued benefits. For example, a plan may be amended to specify which resources an employee must exhaust before qualifying, or to require additional documentation of the hardship.

Many 401(k) plans allow participants to borrow against their account balances. A loan provision can encourage lower-paid employees to participate by giving them access to funds in emergencies without permanent distribution. However, a loan that fails the applicable requirements is treated as a taxable distribution — and potentially subject to the 10% premature penalty.

A 401(k) loan is not treated as a taxable distribution if:

• the plan offers loans to all participants on an equal basis,
• the loan is secured and carries a reasonable rate of interest, and
• the loan is repaid within five years (this repayment requirement does not apply to loans used to purchase the participant’s principal residence).

Loans must be amortized at least quarterly — balloon payments are prohibited. If the loan is not repaid on schedule, the outstanding balance is treated as a taxable distribution (and subject to the 10% penalty if the participant is under age 59½).

The tax code limits the total outstanding loan balance to no more than the lesser of:

• $50,000, or
• 50% of the participant’s vested account balance.

For small accounts where the vested balance is less than $20,000, the participant may borrow up to $10,000 (even if 50% of the vested balance is less), provided the plan obtains additional collateral. For purposes of this limit, all plans of the same employer or commonly controlled employers are treated as a single plan — the $50,000 maximum applies across all plans combined.

Interest paid on a 401(k) loan secured by the employee’s elective deferrals is not tax-deductible — even if the loan proceeds are used to purchase a principal residence. This particularly affects newer plan participants whose vested balance is predominantly composed of elective contributions.

Employees seeking loans to purchase a home should consider securing the loan with a mortgage on the property rather than by their 401(k) interest, in order to preserve the potential mortgage interest deduction.