What Is IRC 402 and How Does It Impact Retirement Distributions?

IRC Section 402 governs how retirement plan distributions are taxed, making it a key part of financial planning for anyone with an employer-sponsored retirement account. Understanding these rules helps individuals avoid unexpected tax liabilities and penalties when withdrawing funds.

Distribution Requirements

The IRS regulates when and how retirement funds can be withdrawn to ensure tax-advantaged accounts fulfill their purpose—providing income during retirement. One key rule is the Required Minimum Distribution (RMD), which mandates that individuals begin withdrawing a minimum amount from their accounts after reaching a specified age. As of 2024, the SECURE 2.0 Act has raised the RMD age to 73, with an increase to 75 set for 2033. Failing to take the required distribution results in a penalty of 25% of the amount that should have been withdrawn, though this can be reduced to 10% if corrected in a timely manner.

RMDs apply to tax-deferred accounts such as 401(k)s, 403(b)s, and traditional IRAs, but Roth IRAs are exempt during the account holder’s lifetime. The annual withdrawal amount is determined by dividing the account balance as of December 31 of the previous year by a life expectancy factor from IRS tables. These tables vary based on whether the account owner has a spouse who is more than 10 years younger and is the sole beneficiary.

Employer-sponsored plans may impose additional distribution requirements. Some require withdrawals to begin upon retirement, even if the individual has not yet reached the RMD age. Others offer flexible withdrawal options or structured payouts. Understanding these plan-specific provisions is important, as they can impact long-term tax planning and cash flow management.

Types of Retirement Distributions

Retirement distributions fall into several categories, each with different tax implications.

Lump-sum distributions provide the entire account balance in one payment. While this offers immediate access to funds, it can result in a large tax bill. Spreading withdrawals over multiple years can help manage tax liability.

Periodic distributions, such as annuitized payments or installment plans, provide income over time. This approach can help retirees maintain a steady cash flow while potentially lowering their overall tax burden by keeping annual taxable income within lower tax brackets. Many employer-sponsored plans offer structured payout options, including fixed-dollar or life-expectancy-based withdrawals.

Direct rollovers allow individuals to transfer funds from one retirement account to another without incurring immediate taxes. Moving a 401(k) balance into an IRA maintains tax-deferred status and often provides greater investment flexibility. Rollovers must be completed within 60 days if done manually, though direct trustee-to-trustee transfers eliminate this risk.

Qualified charitable distributions (QCDs) allow individuals aged 70½ or older to donate up to $100,000 per year directly from an IRA to a qualified charity. These withdrawals are excluded from taxable income and can satisfy RMDs, making them a tax-efficient strategy for charitable giving.

Tax Withholding

Taxes are often withheld at the time of withdrawal from employer-sponsored retirement plans and IRAs. The IRS requires a mandatory 20% withholding on taxable distributions from 401(k) and 403(b) plans unless the funds are directly rolled over into another tax-advantaged account. This withholding helps cover income tax liability, but it may not be sufficient depending on an individual’s tax bracket. If too little is withheld, additional taxes may be owed when filing a tax return, while excessive withholding results in a refund.

For IRAs, withholding rules are more flexible. The default withholding rate for traditional IRA distributions is 10%, but account holders can elect a higher rate or opt out entirely by submitting IRS Form W-4R. Choosing the appropriate withholding percentage depends on factors such as other sources of income, deductions, and expected tax liability. Underestimating tax liability can result in an underpayment penalty if sufficient estimated tax payments are not made.

Different types of distributions have varying withholding requirements. Nonperiodic withdrawals, such as one-time withdrawals from a retirement account, are subject to the 20% rule for employer-sponsored plans but only 10% for IRAs unless a different election is made. Periodic payments, such as those structured to last 10 years or more, are treated like wages and subject to withholding based on IRS tax tables. This can result in a lower withholding rate compared to lump-sum withdrawals, making them a more tax-efficient option for retirees seeking predictable income.

Early Distribution Penalties

Withdrawing funds from a tax-advantaged retirement account before reaching age 59½ generally results in a 10% penalty on the taxable portion of the distribution, in addition to ordinary income tax. This penalty discourages early withdrawals to preserve retirement savings. The penalty applies to withdrawals from employer-sponsored plans like 401(k)s and 403(b)s, as well as traditional IRAs, though the rules governing exceptions differ between account types.

Employer-sponsored plans allow penalty-free withdrawals for specific hardships, but the IRS has strict criteria for qualification. Exceptions include medical expenses exceeding 7.5% of adjusted gross income (AGI), permanent disability, and distributions under a Qualified Domestic Relations Order (QDRO). Traditional IRAs offer additional exemptions, such as withdrawals for first-time home purchases (up to $10,000), qualified higher education expenses, and health insurance premiums during periods of unemployment.

Exclusions from Gross Income

While most retirement distributions are taxable, certain withdrawals qualify for exclusion from gross income.

Roth IRA qualified distributions are tax-free if the account holder is at least 59½ and has met the five-year holding requirement. Unlike traditional retirement accounts, Roth IRA contributions are made with after-tax dollars, so qualified withdrawals—including both contributions and earnings—are not taxable. Designated Roth 401(k) accounts follow the same tax-free treatment for qualified distributions but are still subject to RMDs unless rolled into a Roth IRA.

Direct rollovers to another qualified retirement plan are also excluded from gross income. If a distribution is transferred directly between trustees, the funds maintain their tax-deferred status, preventing immediate tax liability.

Certain employer-provided benefits, such as payments to beneficiaries of a deceased employee under a life insurance plan or certain government-sponsored disability benefits, may also be excluded from taxable income depending on the circumstances.

Employer Reporting Obligations

Employers must ensure that retirement distributions are properly reported to the IRS and participants. Failure to comply with reporting requirements can result in penalties and increased scrutiny.

Form 1099-R is the primary document used to report retirement plan distributions. Employers and plan administrators must issue this form to any individual who receives a distribution of $10 or more from a retirement account. The form specifies whether the withdrawal is taxable, subject to early withdrawal penalties, or eligible for rollover treatment. Different distribution codes indicate the nature of the withdrawal, such as hardship distributions, disability payments, or required minimum distributions.

Employers must also ensure that proper withholding is applied to taxable distributions and that withheld amounts are remitted to the IRS in a timely manner. Failure to withhold the correct amount can lead to compliance issues and potential liability. Additionally, plan sponsors must provide participants with clear information about their distribution options, including tax implications and rollover opportunities, to help them make informed financial decisions.