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A 401K Plan can be elected for use by employees and self-employed individuals (Individual 401K). Any size company can participate in a 401K plan. This contribution is called an “elective deferral” because participants elect to set aside the money, and get deferred tax on the money, until their distribution. Trust Administration Services offers both a profit sharing and money purchase pension plan prototype documents.
The amount that an employee may choose to defer is limited and may be based on the terms of your 401K plan. For example in 2006, the basic limit on deferrals was $15,000. If, this is combined with other plans and exceeds this limit, the difference is included in the employee’s gross income. It can also allow the participants that are 50 or over at the end of the calendar year, to make catch-up deferrals, which was $5,000 in 2006.
An amount paid to participants from a qualified plan is called a distribution. Distributions may be nonperiodic or lump sum. They can also be periodic such as annuity payments or certain loans. See IRS Publication 575 in Publications (link to Publications) for more information. A qualified plan must provide so that each participant, will receive their entire interest in the plan, by the required beginning date or regular periodic distributions. These distributions rules apply to each qualified plan. That means that you cannot take a distribution from one plan to apply for another.
If the account balance is to be distributed, the plan administrator must figure the minimum amount required to be distributed each calendar year. This is figured by dividing the account balance by the appropriate life expectancy. Distributions must also meet the minimum distribution incidental benefit requirement. Which means, the plan is used to provide retirement benefits to the employee. Distributions cannot be made until:
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The employee retires, passes away, become disabled; |
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The plan end and no other plan is established or if it is part; |
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As part of a profit-sharing plan and the employee reaches 59 1/2 or suffers financial hardship. |
Tax Treatment of Distributions
Distributions from a qualified plan, minus a prorated part of the costs basis, are subject to tax in the year the distribution takes place. In few instances, does a participant have cost basis. An exception is a rollover in a traditional IRA or eligible retirement plan. An eligible rollover is not any of the following:
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A required minimum distribution: |
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A series of equal payments made at least once a year over the employees life expectancy, the joint lives of the employee and beneficiary or a period of 10 years: |
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Hardship distribution: |
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A portion that represents the employee’s nondeductible contributions: |
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A corrective distribution: |
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Loans: |
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Dividends: |
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The cost of insurance coverage. |
If a participant is expected to receive $200 or more from a plan, the payer must withhold 20% for federal income tax. If the participant chooses instead to have the plan pay it to an IRA or another eligible plan, no withholding is required. If no income tax is withheld and no rollover occurs, the recipient may have to make estimated tax payments.
There is a 10% early withdrawal tax if there are distributions before the age of 59 1/2 unless the following circumstances prevail:
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A beneficiary receives the funds when the employee passes away; |
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A qualifying disability for the employee; |
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It is a part of a series of equal periodic payments after separation of service, at least annually, for the life expectancy of the employee or their designated beneficiary; |
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If it is made during separation of serive when the employee reaches 55; |
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A domestic relations order; |
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For the employee as a medical expense deduction; |
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To reduce excess contributions; |
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To reduce employee or matching employer contribution; |
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To reduce deferrals; |
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An IRS Levy. |
To report the tax on early distributions, file Form 5329.
For more information, consult the Department of Treasury, Internal Revenue Service Publication 560 Retirement Plans For Small Businesses listed under Publications. |
