Understanding withholding requirements for 401(k) plan distributions can be challenging. In this insight, learn more about the key aspects of withholding requirements, including distributions, periodic and nonperiodic payments, loans to participants, and other information crucial for plan sponsors to stay apprised of.
Distribution Withholding Requirements
A participant may receive a distribution from their vested account balance when one of the following below occurs:
- Participant reaches the age of 59½
- The participant dies, becomes disabled, or terminates employment
- The Plan terminates and no successor defined contribution plan is established or is maintained by the Plan Sponsor
- The participant has a financial hardship and the Plan allows for hardship distributions
Depending on the distribution type, federal and state income taxes may be required to be withheld and vary based on how the distribution is made and elected.
Each state has its own rulings regarding state income tax withholdings of 401(k) retirement plan distributions. For example, some states have mandatory income withholding requirements, while other states allow participants to voluntarily withhold income taxes, and there are some states that do not impose a state income tax on distributions.
Distributions of pre-tax employee elective contributions and employer contributions from a retirement plan are subject to a mandatory federal income tax of 20%. However, there are certain circumstances where a participant may not be subject to the 20% federal tax withholding from their distribution.
Early Distributions
Distributions made before the participant is age 59 1/2 are subject to an additional 10% tax unless an exception is met.
Hardship Distributions
Hardship distributions are subject to income taxes unless those distributions are from Roth contributions. Therefore, they are subject to a 20% federal tax and may be subject to a 10% additional tax on early distributions.
Rollover Distributions
If a participant elects to roll their distributions into another retirement plan, then no tax withholding on distributions is required. To qualify, the distribution must be rolled over to another qualified retirement plan or traditional IRA within 60 days of the date of the distribution. The following types of distributions are not eligible to be rolled over:
- A distribution that is one of a series of payments based on life expectancy or paid over a period of ten years or more
- Required minimum distribution
- Corrective distribution
- Hardship distribution
- Dividends on employer securities.
Periodic Payments
Periodic payments are payments made in installments at regular intervals (monthly or annuity) over a period of more than 1 year that are not eligible rollover distributions. Equal periodic payments are made over the life of the participant and/or beneficiary or for 10 years or more. For withholding purposes, these payments generally are treated as if they were wages, and the amount of the withholding can be determined by using the recipient’s completed Form W-4P, Withholding Certificate for Periodic Pension or Annuity Payments, or the recipient can elect not to have withholding apply for their periodic payments.
Nonperiodic Payments
Unless a recipient chooses another withholding rate, the default withholding rate for a nonperiodic distribution (a payment other than a periodic payment), that is not an eligible rollover distribution, is 10% of the distribution. A recipient can ask the payer to withhold at any rate (from 0% to 100%) using Form W-4R, Withholding Certificate for Nonperiodic Payments and Eligible Rollover Distributions.
Loans to Participants
Loans to participants are not subject to federal and state income taxes at the time of the distribution; however, they are taxable if the loan is deemed distributed for nonpayment. The remaining balance is treated as a distribution that is subject to income tax and may be subject to the 10% early distribution tax.
Secure 2.0 Added Exceptions to the 10% Early Distribution Tax
Generally, an additional 10% tax applies to early distributions from tax-preferred retirement accounts except for the following:
- Section 115 – Withdrawals for certain emergency expenses, which are unforeseeable or immediate financial needs relating to personal or family emergency expenses. Only one distribution is permissible per year of up to $1,000, and a taxpayer has the option to repay the distribution within 3 years. No further emergency distributions are permissible during the 3-year repayment period unless repayment occurs. This section is effective for distributions made after December 31, 2023.
- Section 311 – Individuals are permitted to receive distributions from their retirement plan in the case of birth or adoption. The distributions can be recontributed to a retirement plan, limited to 3 years, and treated as rollovers. This provision is effective for distributions made after the enactment of this Act.
- Section 314 – Provides for a penalty-free withdrawal (the lesser of $10,000 or 50% of the participant’s account) from retirement plans for individuals in situations of domestic abuse. A participant may self-certify that they experienced domestic abuse to qualify for this type of distribution. Additionally, the participant can repay the withdrawn money from the retirement plan over 3 years and will be refunded for income taxes on money that is repaid. This section is effective for distributions made after December 31, 2023.
- Section 326 – Terminally ill individuals are provided an exception to the penalty on early distributions from retirement plans. This provision if effective for distributions made after the enactment of this Act.
- Section 331 – Provides that a participant may request a distribution of retirement funds of up to $22,000 in connection with a qualified federally declared disaster. Such distributions are not subject to the 10% additional tax and are considered as gross income over 3 years. This section is effective for disasters occurring on or after January 26, 2021.
- Section 333 – Eliminates the additional 10% tax on corrective distributions of excess contributions.
- Section 334 – Provides that a participant may request a distribution of up to $2,500 per year for the payment of premiums for certain specified long-term care insurance contracts. These distributions would be exempt from the additional 10 percent tax on early distributions. This provision is effective 3 years after the enactment of this Act.