Chapter 6: Distributions

Mandatory minimum distributions begin when a participant reaches the age of 70 1/2. If, at 70 1/2, the participant is still employed by the company, he or she can elect to defer distributions until retirement. When any participant reaches age 70, your 401k administration software alerts you through a pop-up window at the beginning of the program so that you can begin to process minimum distributions as necessary.

Other distributions are made upon the death or total disability of the participant, if the plan is terminated, or if the company is sold and the replacement company chooses not to merge the company's plan into its 401k plan.

401k loans are described in Chapter 5 and rollovers in Chapter 7. This chapter treats the other withdrawals and distributions.

All forms submitted for withdrawals or distributions must be reviewed by the Plan Administrator for accuracy and completeness (name, address, withholding election, signature, spousal consent, etc.). The pertinent plan administration software forms include complete instructions, as well as space for spousal consent and the accompanying notarizations/witness signatures when they are required.

Spousal Consent for Distributions

The Retirement Equity Act of 1984 (REA) requires, among other things, spousal consent for certain distributions from an employee's 401k plan. Your 401k administration software forms include space for spousal signature whenever spousal consent is needed. You should always verify that the required signature is present.

Reporting Mandatory Backup Withholdings from Lump Sum Distributions

Most distributions made from your plan are subject to the following IRS distribution requirements:

• You must give the employee the choice of having the distribution deposited directly into a traditional IRA or to another qualified plan (called a direct rollover). Most distributions are eligible for rollover; exceptions include life annuities, payments distributed over 10 years or more, and payments of minimum required distributions after age 70 1/2. Please see the Special Tax Notice contained in the 401k Distribution Pacs of your software (from the "Main Menu" click on Reports, then on Forms--Outgoing Assets, then on either the 401k Distribution Pac or 401k Distribution Pac (Over 59 1/2); the Special Tax Notice takes up the final eight pages of each document.

• You must give the employee a written explanation of these distribution choices and explain the 20% withholding provision. A copy of the Special Tax Notice is sufficient. The written explanation must be given to the employee a reasonable period of time before the distribution is made.

• If the employee defaults on a 401k loan or chooses to have the distribution paid directly to him or her rather than rolled over into a traditional IRA or another qualified plan, you must withhold 20% of this lump sum distribution and report it on Form 945 as income tax withholding. The withholding is mandatory even if the employee says the distribution will be rolled over into an IRA.

Hardship Withdrawals

In addition to borrowing money through a 401k loan, in the event of an emergency an employee has a second way of accessing funds in his or her plan: a hardship withdrawal. Unlike loans, hardship withdrawals do not have to be paid back -- however, they may involve taxes and penalties that result in a loss of approximately 50 cents on each dollar taken out, and there are other restrictions, as described below.

According to the IRS, hardship withdrawals must satisfy two fundamental requirements: (1) the employee must demonstrate an “immediate and heavy” financial need (called the “events” test) and (2) a hardship distribution must be necessary to satisfy that need (called the “needs” test). In other words, the hardship request must be a last resort (an employee can not apply for a hardship withdrawal if a 401k loan is available, for example).

The Plan Administrator approves or denies hardship requests, and has the responsibility to determine that the need is immediate and heavy. The IRS can be pretty strict about what constitutes immediate and heavy, and has provided a “safe harbor” standard for the “events” test (“safe harbor” meaning the IRS will not question it). Under this safe harbor standard, hardship distributions are allowable for the following:

• Medical expenses of the employee or the employee's spouse or dependent(s)

• Purchase of a principal residence for the employee (but not mortgage payments)

• Payment of tuition for the next 12 months of postsecondary education for the employee, spouse, children, or dependent(s)

• Payment to prevent eviction from the employee's principal residence or foreclosure of a mortgage on the residence.

• Payments for burial or funeral expenses for your deceased parent, spouse, children, or other dependents; or

• Expenses for the repair of damages to your principal residence that would qualify for the casualty deduction under the Internal Revenue Code.

Under your 401k plan, hardship withdrawals are authorized for distribution only for the above reasons.

There are no dollar limitations on the amount of the hardship distribution, except that the IRS says it may not exceed the employee's total elective contributions less any previous hardship distributions. Employer contributions such as Qualified Non-Elective Contributions (QNEC) or testing "safe harbor" contributions are not available.

IRS-defined safe harbor provisions also exist for the "needs" test:

• The distribution cannot exceed the amount necessary to satisfy the financial need. However, the distribution amount can include federal and state taxes, plus the 10% penalty on early distribution (distribution made before the participant is 59 1/2 years old). This penalty does not apply for withdrawals for medical and educational needs.

• The employee must have already made all withdrawals and obtained all nontaxable loans available from employer deferred compensation plans.

• The employee cannot contribute to the 401k plan for six months after the hardship distribution.

There is a further disadvantage of hardship distributions: once the money has been withdrawn it cannot be returned — future contributions are limited to the standard annual contribution ceilings.

Additionally, certain states require state income tax withholding on hardship withdrawals.

The 401k Hardship Withdrawal Pac contains all the terms and conditions for this form of distribution, plus the step-by-step procedures and relevant forms. Make sure you read it carefully and understand its contents before giving a copy to an employee considering a hardship withdrawal. Make sure he or she understands it, too, especially what charges (a.k.a., exit fees) are likely to be assessed by the investment account company and what withholdings are required. (The borrower is responsible for reporting the 10% penalty for early distribution, if applicable.) Also, the employee should contact the investment account company for its charges so he or she can calculate the exact amount of distribution desired.

NOTE…Hardship withdrawals made on or after January 1, 1999 are no longer treated as eligible rollover distributions (per the Internal Revenue Restructuring and Reform Act of 1998). One consequence is that the withdrawals are no longer subject to mandatory 20% income tax withholding. Instead, hardship withdrawals are subject to the general 10% voluntary withholding -- and the participant can elect that no withholding apply.

The following are the steps for processing a hardship withdrawal:

1. Print out the 401k Hardship Withdrawal Pac. Give it to the employee and review it with him or her.

2. When the completed application is returned, review it carefully to ensure that all required information has been supplied.

3. Based on the information in the application, decide if a distribution should be made on account of a hardship. It should satisfy both the “events” test and the “needs” test.

4. If the request is granted, follow the procedures below. If it is rejected, inform the participant in writing of the decision.

5. Inform the investment account company that a hardship distribution is to be made. Use the Asset Liquidation Authorization form for this (accessed via Reports, Forms--Outgoing Assets, Asset Liquidation Authorization), indicating on the form that the distribution is a hardship withdrawal.

6. Instruct the investment account company to send the proceeds check directly to you, the Plan Administrator, not to the employee-participant.

7. Deposit the check in the plan trust bank account.

8. Issue a check from the plan trust bank account to the employee for the final amount.

9. Enter the transaction into your 401k administration software via Employee Information: Select the employee's name, then click on Activity to bring up the “Employee Activity” window. Click on New to bring up the “New Activity” window. The entry date (current 2-digit day, month, 4-digit year) and Posted to 401k period (2-digit month and 4-digit year) will appear; the month the transaction will be posted to the investment account also appears. Select “Distribution” from the Type pull-down menu and the portfolio from which the distribution was made from the Portfolio pull-down menu. The Account number automatically appears. Enter the negative (minus sign) amount of the distribution and click on Post. The transaction will be added to the “Employee Activity” screen.

The Notes field in the “New Activity” window or in the “Employee Information” window is a good place to put the reminder that the employee cannot make contributions to the plan for six months after the hardship withdrawal. This reminder can then be tracked through the “Employee Activity” or “Employee Information” screen.

10. Instruct Payroll that the employee’s contributions will cease for six months.

11. When the 12-month period is about to end, instruct Payroll to resume employee contribution deductions.

Voluntary Distributions at Age 59 1/2

Participants have the right to withdraw money from their 401k accounts when they reach the age of 59 1/2. When a participant makes such a request, give him or her a copy of the 401k Distribution Pac (Over 59 1/2) and review it together. The participant completes the form and returns it to you.

The procedure for processing the request is as follows:

1. Review the request for cash distribution to ensure that it is complete.

2. Inform the investment account company via the Asset Liquidation Authorization form to liquidate the desired amount of assets.

3. Instruct the investment account company to send the distribution check directly to you, the Plan Administrator, not to the employee-participant.

4. Deposit the check in the plan trust bank account.

5. Issue a check from the plan trust bank account for the distribution to the employee.

6. Enter the distribution into your 401k administration software by the same procedure as described for hardship withdrawals above. Again, you can use the Notes field to identify the distribution as a 59 1/2 year or older employee withdrawal.

Distributions at Termination of Employment/Retirement

An employee terminating employment with the company may elect to roll over tax-free his or her account balance into an IRA or to a new employer's 401k plan. He or she may also choose a lump-sum distribution, which would be subject to federal (and state, if applicable) taxes.

If the vested benefit under the plan currently exceeds $1000, or did so at the time of any prior distribution, the employee must give written consent before any distribution can be made. Amounts of $1000 or less can be distributed without the need for consent.

Your 401k administration software automatically determines whether or not the participant will be credited with a year of service for vesting purposes in the plan year of termination, as well as whether he or she will receive employer contributions for that year. (An employee becomes automatically 100% vested when he or she turns 65, or when he or she dies. Also, in the case when a plan is terminated by an employer, all employees become automatically 100% vested.)

The form used by the employee (or beneficiary) to request a distribution upon retirement, termination of employment, death, or disability is the 401k Distribution Pac. The 401k Distribution Pac includes instructions, signature forms, and explanations of the tax consequences of the various distribution choices.

By law, employees with balances over $1000 can leave their money in your company's 401k plan. We strongly advise that you discourage terminating employees from doing this, however. Persons who leave their money behind (1) cause many unintended problems, including the fact that the person may move and not leave a forwarding address; (2) will have difficulty changing investments; and (3) saddle your company with the responsibility of trusteeing a former employee's property indefinitely. Your 401k administration software forms are designed to encourage automatic rollovers or distributions.

The procedure for processing a 401k distribution upon termination is as follows:

1. Make sure the terminating employee receives a 401k Distribution Pac as part of his or her termination, with instructions to complete it and return it to you.

2. When the filled-in application is returned, review it carefully to ensure that it is complete.

IMPORTANT…Do not process the termination distribution until you are sure all contributions from all sources have been made and entered into the employee's account. A waiting period of 90 days is usually sufficient, unless there will be a year-end contribution (e.g., employer matching), in which case the wait time can be longer. This will prevent your having to reinstate the participant and make two distributions.

3. If the terminating employee has chosen a direct automatic IRA rollover to the same investment account company, or a rollover to a newly appointed custodian/trustee/insurer, follow the procedures detailed in Chapter 7.

4. If the terminating employee has chosen a lump-sum distribution:

a. Inform the investment account company via the Asset Liquidation Authorization to liquidate the assets, indicating on the form that this is a lump-sum liquidation.

b. Instruct the investment account company to send the proceeds check directly to you, the Plan Administrator, not the employee.

c. Deposit the check in the plan trust bank account (assets less any investment account charges).

d. Issue a check from the plan trust bank account to the employee for the final amount (proceeds less a mandatory 20% income withholding tax and any applicable premature distribution penalties).

5. If the terminating employee chooses an installment payment, he or she must instruct you as to the amount to be sent out, at what frequency, and from what funds. Because this option is so time-consuming and administratively difficult for you and your company (as well as requiring you to follow an ex-employee's instructions regarding investment decisions), we strongly advise you to try to convince the ex-employee that a distribution to an IRA is the better choice. Most companies do not wish to have ongoing financial ties to ex-employees.

6. To enter the termination and distribution into your 401k administration software, go to the “Employee Information” window. Enter the termination date next to Termin. Check “yes” in the pop-up window asking if the employee has been terminated and the check mark next to Participant will disappear. “Terminated” will appear in the lower right-hand corner. Click on Activity, click New, select Distribution as the Type, select each portfolio in turn, and enter the negative amount of each distribution.

Distributions Due to Qualifying Disability

In the event of a participant's total and permanent disability before reaching his/her retirement date or other termination of employment, all amounts in the participant's plan account become fully vested. Upon notification of permanent disability [by means of the 401k Distribution Pac], the Plan Administrator directs the investment account company to distribute all amounts in the same manner as if the participant had retired.

Distributions Due to Death

The 401k Distribution Pac is also used if a participant dies and there is a benefit payable to a surviving spouse, alternate payee, or other named beneficiary. The rules for such a distribution are given in the Distribution Pac and are not repeated here.

Death benefits payable to a beneficiary who is neither a surviving spouse nor alternate payee are not eligible for rollover treatment. Therefore, the distribution this undesignated beneficiary receives is subject to the mandatory 20% federal tax withholding rules.

If multiple beneficiaries will receive benefits, each beneficiary who is not a minor must include his or her social security number and mailing address in the returned 401k Distribution Pac.

If any beneficiary is a minor, his or her birth date must also be included, along with a copy of the guardianship/conservatorship papers (court-approved papers allowing payment to a legal representative/guardian).

If a participant was not married upon death and did not designate a beneficiary, payment is made to the estate of the participant. Court approved papers naming an executor of the estate must be submitted in order for the account to be liquidated.

The procedure for processing a distribution to a spouse, alternate payee, or beneficiary is as follows:

1. When notified of the death of a participant, the Plan Administrator sends a copy of the 401k Distribution Pac to the spouse (if applicable), alternate payee (if applicable), or each beneficiary designated on the enrollment form. The beneficiary completes the form, specifying the method of payment. A certified copy of the participant's death certificate must be submitted along with the completed form.

2. The Plan Administrator notifies the investment account company to make a distribution according to the direction of the spouse, alternate payee, or beneficiary as follows:

a. Liquidate the account and forward the lump-sum check directly to you, the Plan Administrator, not the beneficiary. The Asset Liquidation Authorization is used in this case. The procedure is the same as for a terminating employee, above.

b. Roll over the account into a new account in the spouse or alternate payee's name. The Rollover or Deposit to a New Account form is used. The procedure described in Chapter 7 applies.

c. Roll over the account to a newly-appointed custodian/trustee/insurer (alternate payee only). The alternate payee must complete the relevant sections of the Distribution Pac. The Asset Liquidation Authorization is used to instruct the investment account company to liquidate the account and send the check to you, the Plan Administrator. Deposit the investment account company's check in the plan trust bank account and write a check to the new custodian.

3. Enter the distribution into your 401k administration software by the method described above.

Mandatory Minimum Distributions at Age 70 1/2

As of 1997, plan participants must begin taking minimum distributions on April 1 of the calendar year following the later of:

• The calendar year in which the employee reaches 70 1/2

• The calendar year in which the employee retires

In other words, participants (except for 5% owners) are no longer required to begin receiving distributions at 70 1/2 if they are still working for the employer. Five percent owners continue under the pre-1997 rule and must begin receiving distributions no later than April 1 of the calendar year following the year in which they turn 70 1/2.

Subsequent distributions must be taken annually. The amount of the distribution is calculated based on the life expectancy of the participant or the participant and his/her designated beneficiary. Because calculating a participant's annual distributions is now very complex and depends on the number and types of qualified retirement savings programs the participant has, you should recommend that the participant consult a tax advisor, especially if he or she has other qualified retirement savings programs in addition to your company's 401k plan.

The procedure for processing required minimum distributions is as follows:

1. When any participant reaches the age of 70, your 401k administration software displays a notice that appears when you open up your 401k administration software. You should immediately send a copy of the Mandatory Distribution Fact Sheet (Over 70 1/2) form to the participant with a mandatory return date and a warning of how much time is needed to process the request. The participant, in turn, in conjunction with his/her tax advisor, must define the amount of the mandatory distribution (or other distribution) and return the completed form.

TIP…If the participant has no tax advisor and/or finds he or she can not calculate the mandatory minimum amount, the Plan Administrator can request a one-tenth distribution, which is the allowable minimum amount.

2. The Plan Administrator notifies the investment account institution in writing of the amount to be distributed and the portfolio it's to come from.

3. The investment account company sends the check to you, the Plan Administrator.

4. You deposit the check in the plan trust bank account and issue a check to the participant.

5. Enter the distribution in your 401k administration software in the same manner as described above.

6. You must request a distribution from the investment account company each year.

Distributions Relating to Plan Termination or Sale of Sponsoring Company

Elective contributions may be distributed upon termination of a 401k plan only if the employer does not maintain a successor plan. Distribution must be in the form of either an IRA rollover or a lump-sum payment. Please contact us if such a situation occurs at your company.

NOTE…You must furnish a benefit statement to a terminated participant within 180 days after the close of the plan year in which the participant terminates employment. If there are no nonforfeitable benefits you must furnish a statement of nonvested status.

Qualified Domestic Relations Order Distributions

A qualified domestic relations order (QDRO) is an order issued by a court, usually in connection with a divorce or legal separation. It relates to the provision of alimony, child support, or marital property rights, including the division of community property, and entitles an alternate payee to receive some or all of a participant's benefits under a 401k plan. The alternate payee must be the spouse, former spouse, child, or other dependent of a participant.

When you receive a domestic relations order, you first notify the participant and alternate payee that one has been received. You then review the QDRO to ensure that it is clear and complete (for example, that there is an as-of date specified and the instructions specify exactly the percentage or value of the assets to be liquidated). The alternate payee is sent a 401k Distribution Pac to specify the kind of distribution desired (lump sum, rollover to IRA, etc.) and returns it to you. When you receive it, you review it for correctness and completeness and then process it according to the kind of distribution it is, documenting in the “Notes” field of the participant's your 401k administration software file that it is a QDRO distribution.