The Distribution Pickle

By John Iekel • August 11, 2017 • 0 Comments
It’s a summertime trap: the poor baseball player trapped between bases who is going to be tagged out no matter which direction he goes. A recent blog entry argues that such a pickle faces employers and plan administrators too concerning distributions, but at any time of the year.

Any employer and plan administrator can readily attest that complying with and applying tax laws and regulations in running a retirement plan can be complex and challenging. Not only that, meeting employee desires and requests while at the same time remaining in compliance can replicate the experience of being trapped between second and third with nowhere to go.

In “Catch 22 Situations with Retirement Plans,” Morningstar’s Natalie Choate points out that there can be situations that arise concerning distributions that are complicated by laws and regulations that appear to conflict, or actually do. “Sometimes you need a particular form of distribution to achieve a certain tax result, but the retirement plan doesn't allow it. Or sometimes the tax law seems to say opposite things about the same distribution,” she writes.

Choate offers some scenarios that illustrate the challenges distributions can entail.

Retiring between age 55 and age 59½. Taking a distribution before age 59½ incurs a 10% penalty — unless. Unless the recipient qualifies for an exception, such as that for retiring at age 55 or older.

Thus, an employee whose age is between 55 and 59½ can take distributions from her or her 401(k) with no penalty, and then at age 59½ roll the balance into an IRA. If. If the plan terms state that the plan will make such distributions.

If a plan does not, the employee must receive their distributions in other amounts. For instance, if an employer requires that employees can only receive a lump sum, an early retiree between 55 and 59½ can receive a one-time penalty-free distribution and then a lump sum, but cannot receive penalty-free distributions from the IRA until he or she reaches age 59½.

So for such an employee, the plan terms render the early retirement penalty exception relatively meaningless.

401(k) hardship distribution subject to the 10% penalty. Generally, 401k) plans cannot make any distributions until an employee reaches age 59½ or terminates employment. Unless. Unless the employee qualifies for a hardship distribution.

But, writes Choate, there is a catch-22. She writes, “Although there is a ‘hardship exception’ to the no-in-service-distributions rule applicable to 401(k) accounts, there is no ‘hardship exception,’ as such, to the 10% penalty!” She notes, however, that it is possible that an individual may qualify for another penalty exception.

Estate wants to use the five-year payout. Suppose a plan participant dies at age 63 and did not designate a beneficiary — her 401(k) goes to her estate as a result. Under the five-year rule, writes Choate, the balance in such a situation will have to be paid out over five years — a plan that at least spells lower income taxes levied on the estate. Unless. Unless the plan provides for only lump sum payments, not payments by installment. In that case, the estate must accept a lump sum payment.