402(f) Notice: Special Tax Rules on Distributions

The 402(f) notice is a document required by federal law that a retirement plan administrator must give to you before you receive a distribution from the plan. Its purpose is to explain the federal tax rules that apply to your payment, detailing your options for receiving the money and the tax implications of each choice, with a focus on rollovers.

This document is for your information and to help you make a decision about your retirement funds. You do not need to file the 402(f) notice with the Internal Revenue Service (IRS) or any other agency, as it is a guide to understand the consequences of your choice.

When the Notice is Provided

You receive a 402(f) notice because you are eligible to take an “eligible rollover distribution” from your retirement plan. This is commonly triggered by a separation from service, which includes quitting your job, being laid off, or retiring. Other qualifying events include the participant’s death, disability, reaching the age for Required Minimum Distributions (RMDs), or if the company terminates the entire retirement plan.

In some cases, a plan can pay out a former employee’s vested account balance without their consent, which also triggers the notice. For balances up to $7,000, a plan may perform an involuntary “cash-out” after you leave the company. If your balance is over $1,000, the plan is required to roll the funds into a default Individual Retirement Account (IRA) unless you elect to receive the cash or roll it over to an account of your choice.

Under IRS regulations, the plan administrator must provide you with the notice no more than 180 days and no less than 30 days before your distribution date. This 30-day window is designed to give you adequate time to consider your options. You can waive this waiting period if you have made a decision and wish to receive your funds sooner, but you must be informed of your right to the full consideration period.

Understanding Your Distribution Options

The 402(f) notice will outline several ways you can receive your retirement money. One primary option is a direct rollover. In a direct rollover, you instruct your current plan administrator to transfer your funds directly to another eligible retirement plan, such as an IRA or a new employer’s 401(k). You never personally receive the funds, as they move from one financial institution to another.

Another choice is to receive the payment directly, which can then be part of an indirect rollover. With this method, the plan administrator will issue a check payable to you. You then have 60 days from the date you receive the money to deposit it into another eligible retirement account. If you complete this deposit within the 60-day timeframe, the transaction is treated as a rollover for tax purposes.

The final option is to take a cash distribution without rolling it over. By selecting this, you choose to receive the funds for personal use, and they are not moved into another retirement savings vehicle. This choice has immediate tax consequences that are detailed in the notice.

Key Tax Consequences Explained in the Notice

A primary consequence detailed in the 402(f) notice is the mandatory 20% federal tax withholding. If you choose to have the distribution paid directly to you, whether you intend to cash it out or complete an indirect rollover, the plan administrator is required to withhold 20% of the taxable amount and send it to the IRS. For example, on a $20,000 distribution, you would receive a check for only $16,000, as $4,000 is sent to the IRS as a prepayment of your income tax. This withholding is avoided if you choose a direct rollover.

Any part of your distribution that is not successfully rolled over into another retirement plan is considered taxable income. This amount will be added to your other income for the year and taxed at your ordinary federal and, if applicable, state income tax rates. The 20% that was withheld is a prepayment; your actual tax liability on the distribution could be higher or lower depending on your total income and tax bracket.

If you are under the age of 59½ when you take the distribution, you may be subject to an additional 10% early withdrawal penalty on the taxable portion of the payment. This penalty is on top of the ordinary income tax you will owe. The notice will mention that certain exceptions to this penalty exist, for example, for distributions made on account of a terminal illness, for certain emergency expenses, or to public safety officers who are at least 50 years old or have 25 years of service.

The notice may also briefly describe special tax rules for unique situations. If your distribution includes company stock, you may be eligible for a tax treatment known as Net Unrealized Appreciation (NUA), which allows the appreciation in the stock’s value to be taxed at lower long-term capital gains rates. It will also mention rules for payments made to a former spouse under a Qualified Domestic Relations Order (QDRO).

Making Your Distribution Election

Once you have reviewed your options and their tax consequences, you must formally communicate your decision to the plan administrator. This is done by completing and submitting the distribution election forms that are provided along with the 402(f) notice. These forms are the official record of your choice and authorize the administrator to proceed with the payment.

The information required on the election form will depend on your choice. If you select a direct rollover, you will need to provide detailed information about the receiving account. This includes the name of the financial institution, its address, and the specific account number for your IRA or new employer’s plan. Ensure this information is accurate to prevent delays.

After completing the necessary paperwork, you must submit it to your plan administrator. The administrator will then process your request, either sending the funds directly to your chosen financial institution or issuing a check to you.