Revenue Code 402: Taxation of Retirement Plan Distributions

Internal Revenue Code Section 402 establishes the framework for how distributions from employer-sponsored retirement plans, such as 401(k)s and pension plans, are taxed. While contributions and earnings within a qualified plan grow tax-deferred, this section ensures that the funds are taxed when paid out to the participant or their beneficiaries. It provides the rules that determine when and how these distributions are included in an individual’s gross income.

General Taxability of Plan Distributions

The default rule is that any amount distributed from a qualified retirement plan is taxable to the recipient in the year of the distribution. Funds from pre-tax contributions, like those in a traditional 401(k), are included in the individual’s gross income and taxed at ordinary income rates.

An exception to this rule involves “basis,” which is the amount of after-tax money a participant has contributed to their account. Since these funds have already been taxed, the portion of a distribution representing a return of basis is received tax-free.

When a distribution includes both pre-tax funds and after-tax basis, a pro-rata rule applies. Each payment is considered to contain a proportional share of taxable and non-taxable funds. For example, if an account with a $100,000 balance has a $10,000 basis, 10% of any distribution is a tax-free return of basis, while the remaining 90% is taxable.

The plan administrator calculates this and reports the total distribution and taxable amount on Form 1099-R, which the recipient uses for their tax return.

Tax Treatment of Rollovers

A rollover allows an individual to move funds from one eligible retirement plan to another without triggering current taxes, maintaining the savings’ tax-deferred status. There are two methods for executing a rollover: direct and indirect.

In a direct rollover, the distributing plan sends the funds directly to the new retirement account, such as another employer’s plan or an Individual Retirement Account (IRA). The participant never takes possession of the money, and this method avoids mandatory tax withholding.

An indirect rollover occurs when the plan pays the distribution to the participant, who then has 60 days to deposit the funds into another eligible retirement plan. With this method, the distributing plan must withhold 20% of the distribution for federal income taxes. The participant receives only 80% of their account balance.

To complete a tax-free rollover of the full amount, the participant must deposit the entire pre-withholding amount into the new account within 60 days, using personal funds to cover the 20% withheld. This withheld amount can be recovered when filing that year’s income tax return. Any shortfall not deposited is treated as a taxable distribution and may be subject to a 10% early withdrawal penalty if the participant is under age 59½.

Certain payments are not eligible to be rolled over, including required minimum distributions (RMDs), hardship withdrawals, and distributions that are part of a series of substantially equal periodic payments. Plan administrators must provide a written explanation of these rules, known as a 402(f) notice, before making an eligible rollover distribution.

Special Rules for Employer Securities

Special rules apply to distributions of employer stock from a qualified retirement plan, involving a concept called Net Unrealized Appreciation (NUA). NUA is the increase in the stock’s value from when the plan acquired it until it is distributed. This can offer a tax planning opportunity for those with highly appreciated company stock.

To qualify for NUA tax treatment, the stock must be part of a “lump-sum distribution.” This is a payment of a participant’s entire account balance from all of the employer’s similar qualified plans within one taxable year. The distribution must be made due to a specific event, such as:

• The employee’s separation from service
• Attainment of age 59½
• Disability
• Death

When these conditions are met, the stock’s cost basis—what the plan paid for the shares—is taxed as ordinary income in the year of distribution. The NUA is not taxed at distribution, but is deferred until the shares are sold.

Upon selling the stock, the NUA portion of the gain is taxed at long-term capital gains rates, regardless of how long the stock was held after distribution. Any appreciation after the distribution is taxed as a short-term or long-term capital gain based on the holding period. This can lead to tax savings compared to rolling the stock into an IRA, where its entire value would be taxed as ordinary income.

For example, an employee receives a lump-sum distribution of company stock with a cost basis of $100,000 and a market value of $500,000. The employee pays ordinary income tax on the $100,000 basis. The $400,000 of NUA is not taxed until the stock is sold, when it will be taxed at the long-term capital gains rate.

Taxation of Plan Loans

Many qualified retirement plans allow participants to borrow against their vested account balance. These loans are subject to rules under Internal Revenue Code Section 72 to prevent them from being used to avoid distribution taxes. A loan that complies with these rules is not a taxable event, but failure to meet the requirements results in a “deemed distribution.”

To avoid being a taxable distribution, a plan loan must meet several criteria. The loan amount cannot exceed the lesser of $50,000 or 50% of the participant’s vested account balance. The loan must be repaid within five years, unless used to purchase a primary residence, and must require substantially level payments made at least quarterly.

If a loan violates these rules, the outstanding balance becomes a deemed distribution and is treated as taxable income for that year. A deemed distribution is a tax event only and does not eliminate the legal obligation to repay the loan. The unpaid balance remains outstanding for calculating the maximum amount of any future loans.

A “loan offset” can occur when a participant separates from service with an outstanding loan. The plan may reduce the participant’s account balance by the outstanding loan amount, which is considered an actual distribution. A “qualified plan loan offset” (QPLO) allows the participant until their tax filing due date for that year, including extensions, to roll over the offset amount and avoid taxation.

Distributions from Designated Roth Accounts

Designated Roth accounts, such as Roth 401(k)s, are governed by Internal Revenue Code Section 402A. Contributions to these accounts are made on an after-tax basis, and “qualified distributions” are completely free from federal income tax.

A distribution from a Roth account is qualified if it meets two requirements. First, it must be made after a 5-taxable-year period has passed. This five-year clock begins on the first day of the taxable year of the participant’s first contribution to that specific plan, and it does not carry over when funds are rolled into a new Roth 401(k).

Second, the distribution must be made because the participant is at least age 59½, has become disabled, or the distribution is made to a beneficiary after the participant’s death. If both the five-year rule and one of these conditions are met, the entire distribution is received tax-free.

A key advantage of Roth 401(k)s is that the original owner is not required to take required minimum distributions (RMDs). This allows funds to grow tax-free throughout the owner’s lifetime, offering flexibility for retirement and estate planning.

If a distribution is not qualified, it is taxed on a pro-rata basis. Each payment is considered to have a proportional amount of tax-free contributions and taxable earnings. Unlike Roth IRAs, there is no ordering rule that allows for the tax-free return of all contributions before earnings are distributed.