Code Section 402: Taxation of Plan Distributions

Internal Revenue Code Section 402 provides the tax rules for money taken from employee retirement plans, such as 401(k)s and traditional pension plans. These regulations determine when and how distributions are subject to federal income tax. Understanding these principles is important for managing personal finances and retirement planning, as the rules directly impact the net amount an individual receives and must report to the Internal Revenue Service (IRS).

General Taxation of Plan Distributions

The rule for distributions from qualified retirement plans is that any amount distributed is included in the recipient’s gross income in the year it is received and taxed at ordinary income rates. This treatment applies because the plan was funded with pre-tax contributions, and all investment earnings have grown on a tax-deferred basis.

Some participants may have made after-tax contributions to their plan, which creates a “basis.” Since this money has already been taxed, it can be recovered tax-free upon distribution. The non-taxable portion is calculated on a pro-rata basis, meaning each payment is a partial return of after-tax contributions and a partial distribution of taxable funds.

For example, consider an account with a total value of $100,000, of which $10,000 is after-tax contributions. If the participant takes a $20,000 distribution, the non-taxable portion is based on the ratio of after-tax contributions to the total account balance. In this case, 10% of the distribution, or $2,000, would be a tax-free return of basis, and the remaining $18,000 would be included in gross income.

Financial institutions report distributions to the recipient and the IRS using Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. The form is issued if the total distribution for the year is $10 or more. Box 1 of the form shows the gross distribution amount, while Box 2a indicates the taxable amount, which taxpayers use to report their income on their federal tax return.

Rollover Contributions

A rollover is the primary method for moving funds from one retirement account to another without triggering an immediate tax liability, though it is a reportable event. This process allows retirement savings to continue growing on a tax-deferred basis in a new plan or an Individual Retirement Account (IRA).

The simplest method is a direct rollover, where funds are transferred from the old plan’s administrator to the new account’s custodian. This is often done via wire transfer or a check made payable to the receiving institution. A direct rollover has no mandatory tax withholding, ensuring the entire account balance is moved and eliminating the risk of mishandling funds.

An alternative is the indirect, or 60-day, rollover. The plan administrator issues a distribution check payable to the participant, who then has 60 days to deposit the money into another eligible retirement plan. If this deadline is missed, the entire distribution is considered taxable income and may be subject to a 10% early withdrawal penalty if the individual is under age 59½.

An indirect rollover from an employer-sponsored plan is subject to mandatory 20% federal income tax withholding. To defer tax on the entire original balance, the individual must use personal funds to make up for the 20% that was withheld. For example, on a $50,000 distribution, the participant receives $40,000, and to avoid tax, must deposit the full $50,000 into a new retirement account within 60 days.

Not all payments from a retirement plan are considered “eligible rollover distributions.” Payments that cannot be rolled over include required minimum distributions (RMDs), hardship withdrawals, and certain annuity-like payments spread over a long period.

Special Rules for Employer Stock

A unique set of tax rules applies to in-kind distributions of employer stock from a qualified plan, centered on Net Unrealized Appreciation (NUA). NUA is the difference between the cost basis of the stock (the price the plan paid) and its fair market value on the date of distribution. This provision can offer a tax advantage for individuals with highly appreciated company stock.

When an employee receives a distribution of company stock, the cost basis of the shares is taxed as ordinary income in the year of distribution. The NUA, however, is not taxed at that time. Tax on the NUA is deferred until the employee sells the stock, at which point it is taxed at long-term capital gains rates, regardless of how long the stock was held after distribution.

To qualify for this NUA treatment, the distribution of employer stock must be part of a “lump-sum distribution.” This is defined as the distribution of the employee’s entire account balance from all of the employer’s similar qualified plans within a single taxable year. The distribution must be made on account of a specific triggering event, such as:

• Separation from service
• Death
• Disability
• Attaining age 59½

An individual must decide whether to use the NUA strategy or roll the employer stock over into an IRA. A rollover defers all taxes until funds are withdrawn from the IRA, at which point the entire amount is taxed as ordinary income. The NUA strategy requires paying ordinary income tax on the stock’s basis immediately but allows the appreciated value to be taxed at lower long-term capital gains rates later. For example, if stock with a $20,000 basis is worth $100,000 at distribution, the NUA strategy means paying ordinary income tax on $20,000 now and capital gains tax on the $80,000 NUA when sold.

Other Taxable Events and Special Provisions

Plan Loans Treated as Distributions

Retirement plans may offer loans to participants that are not taxable if they adhere to rules under Internal Revenue Code Section 72. A loan is non-taxable if the amount does not exceed the lesser of $50,000 or 50% of the participant’s vested account balance. It must also be repaid in substantially level payments at least quarterly over a term of no more than five years, unless used for a primary residence.

If these rules are violated, such as by defaulting on payments, the loan becomes a “deemed distribution.” The entire outstanding loan balance is treated as a taxable distribution in the year of the default. This amount is subject to ordinary income tax, but it does not eliminate the participant’s legal obligation to repay the loan.

Distributions from Non-Qualified Trusts

The tax rules for non-qualified plans differ from those for qualified plans. For these plans, an employee is taxed when their benefits become “substantially vested,” meaning their right to the assets is no longer subject to a substantial risk of forfeiture. If an employer contributes to a non-qualified trust on behalf of an employee, the value of that interest is included in the employee’s gross income as soon as it vests.

This means an employee could owe taxes on compensation held in a non-qualified trust before they actually receive any cash. The economic benefit is recognized when it becomes secure, not when it is paid out.

Cost of Life Insurance Protection

If a qualified retirement plan provides life insurance coverage, a portion of the premium is a current taxable benefit. The value of this pure life insurance protection, often called the “P.S. 58 cost,” must be included in the employee’s gross income each year, even if no cash is received. The cumulative P.S. 58 costs that have been taxed to the employee create a basis in the life insurance contract, which can be recovered tax-free from future plan distributions.