IRS Quick Tip: 401(k) Plans

A 401(k) plan, also called a deferred compensation plan allows you to have your contribute part of your wages to the plan on a pretax basis. These wages called elective contributions are not subject to income tax at the time they are deferred from your paycheck. This means they are not included on your W2 as taxable wages and therefore not reported on your 1040/tax return. They are, however, included as wages subject to withholding for social security and Medicare taxes. Also, your employer has to report these contributions as wages for federal unemployemnet tax purposes.

The IRS only allows you to contribute so much to a 401(k) plan. For 2015 it is $17,500 and generally increases to account for inflation. The IRS set’s this amount each year. You can find your contributions for the year listed as an informational item on your W-2 on line 12. Employers can take a look at Publication 560, Retirement Plans for Small Business (SEP, SIMPLE, and Qualified Plans), for more info about setting up and maintaining retirement plans for employees, including 401(k) plans.

Distributions from a 401(k) plan can qualify for either a lump-sum distribution or a rollover as long as they meet the requirements. More information can be found on Lump-Sum distributions can be found here – How to take a lump-sum distribution from a 401(k). (ADD LINK) And more info on Rollovers can be found here – How to Rollover your $ from a 401(k) Plan.

Some 401(k) plans allow employees to make a “hardship withdrawal” for a few different reasons but need to be considered “immediate and heavy financial needs.” And hardship distributions from a 401(k) plan are limited to the amount of the employees' elective contributions only. This does not include any income earned on the deferred amounts. Hardship distributions are not treated as eligible rollover distributions which means they will still be subject to tax but not the penalty. Some examples of hardships include:

  • Totally disabled.

  • Debt for medical expenses exceeds 7.5% of your AGI (adjusted gross income).

  • Required by court order to give the money to your divorced spouse, a child, or a dependent.

  • Separated from service (through permanent layoff, termination, quitting or taking early retirement) in the year you turn 55, or later.

  • Separated from service and you have set-up a payment schedule to withdraw money in substantially equal amounts over the course of your life expectancy. (Once you begin taking this kind of distribution you are required to continue for five years or until you reach age 59 1/2, whichever is longer.) This is called a 72-T distribution.

Typically distributions must be taken after you are age 59 and a half. If they are taken before this age (without a hardship exemption) you will have to pay 10% penalty on the distributions. Distributions received before age 59½ are subject to a 10% additional tax unless an exception applies. 

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