402(f) Special Tax Notice: Options & Tax Consequences

When leaving a job or retiring, you will receive a 402(f) Special Tax Notice from your retirement plan administrator. This notice is required by federal law under Internal Revenue Code Section 402(f) and provides a written explanation of the tax rules for receiving a distribution from your employer’s retirement plan. The document is a mandatory disclosure to help you understand your choices.

The notice informs you about the options for your retirement funds and the tax implications of each choice. It explains the rules for rollovers, tax withholding, and how distributions are taxed if not moved to another retirement account, giving you time to make an informed decision.

Understanding Your Distribution Options

The 402(f) notice outlines several ways to handle your retirement funds. One option is a direct rollover, where the administrator of your old plan sends your money directly to a new retirement account, such as an Individual Retirement Arrangement (IRA) or a new employer’s 401(k). You never personally take possession of the funds during this transfer.

Another choice is the indirect rollover, also called a 60-day rollover. In this scenario, the plan administrator sends a check directly to you. You then have a 60-day window from the date you receive the funds to deposit them into a new, eligible retirement account. This option gives you temporary access to the money but has specific rules that must be met to maintain its tax-deferred status.

The final option is to take a cash distribution. This means you receive the money as a direct payment with no immediate intention of placing it into another retirement account. You are free to use the funds for any purpose.

Tax Consequences of Your Decision

Your choice of distribution directly impacts your tax situation. With a direct rollover, there are no immediate income taxes or penalties due. The money maintains its tax-deferred status, and you will not pay taxes on it until you take distributions from the new account in retirement.

An indirect rollover introduces mandatory withholding. Your former plan administrator is required to withhold 20% of your distribution for federal income taxes. For example, on a $20,000 distribution, you would receive a check for $16,000, with $4,000 sent to the IRS. To avoid taxes on the full $20,000, you must deposit the entire amount into a new retirement account within 60 days, which requires you to use personal funds for the withheld $4,000. You can recover the withheld amount when you file your annual income tax return.

If you take a full cash distribution, you also face the mandatory 20% federal tax withholding. The entire distribution amount is considered taxable income for that year and will be taxed at your ordinary income tax rate, which could push you into a higher tax bracket.

An additional tax applies if you take a cash distribution before reaching age 59 ½. The IRS imposes a 10% additional tax on early distributions on top of the regular income tax. While some exceptions to the 10% penalty exist, they are for specific circumstances and should be reviewed carefully.

Required Actions for Your Chosen Option

Once you decide how to handle your funds, you must take specific steps. For a direct rollover, your action is to establish an account with the new financial institution or confirm eligibility with a new employer’s plan. You then provide this information, including the new account number, to your old plan administrator, who will execute the transfer.

If you select an indirect rollover, you must deposit the funds into a new retirement account within the 60-day period, which starts when you receive the distribution. It is important to keep detailed records of the transaction, including the date you received the check and the date you deposited it, to prove you completed the rollover in time and to reclaim the 20% that was withheld.

For a cash distribution, you will receive a check for the amount minus the 20% federal tax withholding. Your former plan administrator will send you IRS Form 1099-R, which reports the distribution to you and the IRS. You must use this form to report the income and withholding on your tax returns.

Special Considerations and Related Payments

The 402(f) notice may also cover less common scenarios with unique rules. Payments made to a beneficiary after a plan participant’s death are subject to specific regulations. A non-spouse beneficiary has different rollover options than a spouse, and the rules for moving funds into an inherited IRA must be followed to maintain tax advantages.

Distributions under a Qualified Domestic Relations Order (QDRO) also have distinct tax treatments. A QDRO is a legal order, often in a divorce settlement, that assigns a portion of retirement benefits to an alternate payee, like an ex-spouse. An alternate payee receiving a distribution under a QDRO has the same rollover options as the participant, but the payments are not subject to the 10% early withdrawal penalty.

If your distribution includes employer stock, special tax rules for Net Unrealized Appreciation (NUA) may apply. NUA is the difference between the stock’s value when acquired by the plan and its market value at distribution. If you take a lump-sum distribution of the stock instead of rolling it over, you can pay ordinary income tax on the cost basis and defer capital gains tax on the NUA until you sell the shares. This can be a valuable tax-saving strategy, but it is complex and often requires professional guidance.