The 401(k) plan's in-service distribution regulations are intricate and stringent. They are made to prevent workers from taking pre-retirement withdrawals of their funds unless certain circumstances apply. A number of additional in-service distribution methods were implemented with SECURE 2.0. Employers should be aware of their documentation, taxing, and repayment responsibilities before deciding whether or not to implement one or more of the new choices.
While some of the new in-service distribution options are already accessible, others won't be until later. They are applicable to long-term care costs, emergencies, domestic violence, and terminal illnesses. What you should know is as follows.
The fact that these new in-service distribution options are optional is the most crucial thing to understand. None of these alternatives must be included in a small business' 401(k) plan. Three characteristics are included in all of the new SECURE 2.0 options:
- Despite being taxable income, the options are not subject to the 10% early distribution penalty tax.
- Employees are not required to retain 20% of the dividend amount, but they are free to do so if they so choose.
- Possibility of returning the distribution to the 401(k) plan within three years.
For "affected employees" in federally designated catastrophes, a distribution of up to $22,000 may be provided. An "affected employee" is one who has suffered a financial loss as a result of the disaster and whose primary domicile is in the disaster area.
The option to spread out the taxation of the distribution over three years is one that an employee has, although it is not obligatory. Consider a worker who receives a $21,000 catastrophe dividend in 2023. In 2023, 2024, and 2025, that employee is allowed to submit $7,000 as taxable income.
Although in the past only certain types of federally declared major disasters were eligible for payments (up to $100,000), SECURE 2.0 now allows distributions for any major disaster that has been so declared (up to $22,000).
One payout of up to $1,000 per year may be made for emergency purposes starting in 2024. Employees have the option to certify on their own behalf that they are qualified for a distribution based on an "emergency". The term "emergency" refers to a sudden or pressing financial requirement for critical individual or family emergency expenses.
Before: An employee is not eligible to receive another distribution for emergency needs.
- Full repayment of the prior distribution to the 401(k) plan; or
- Making contributions to the 401(k) plan at least equivalent to the prior distribution; or
- It's been three years since the last payout.
Distributions for Terminal Illness
A distribution related to a terminal illness is exempt from the 10% early distribution penalty tax. If you have a medical disease or sickness that a doctor has diagnosed as terminal, it signifies that death is likely to occur in 84 months or less.
Employees are not permitted to obtain a distribution from a 401(k) plan merely to cover a terminal illness, unlike the other SECURE 2.0 in-service distribution choices. The distribution must be brought about by a distinct distributable event, such as a layoff. A potential penalty tax for an early distribution would not apply if a terminally sick employee received a dividend based on the termination of his or her employment.
Distribution of Emergency Savings
Emergency savings accounts (ESAs) are an option for 401(k) plans for non-highly compensated employees (NHCEs) starting in 2024. Roth contributions are the sole way to pay for this distinct ESA. The employer may designate a smaller amount; nevertheless, the account (not contributions) is capped at $2,500 (indexed for inflation).
Distributions up to $2,500 (inflation-adjusted) may be taken by NHCEs. The first four distributions per year cannot be charged for, and they must be permitted to accept at least one distribution each month. Due to the fact that the ESA is a Roth account, payouts will be regarded as qualified (profits excluded from taxable income) regardless of age or the timing of contributions.
Distributions for Domestic Abuse Victims
Domestic violence victims may be eligible for payouts starting in 2024. The most you can get is the lesser of (i) $10,000 (inflation-adjusted); (ii) 50% of the employee's vested account balance. Distributions would be accessible for the entire year starting from the employee's victimization. Employees who qualify for a distribution based on domestic violence may self-certify that they do so.
Distributions for Long-Term Care Premiums
Distributions may be used to cover an employee's or their spouse's eligible long-term care insurance premiums starting on or after December 28, 2025. The annual limit is the smaller of (i) the insurance premium paid or assessed, (ii) 10% of the employee's vested account balance, or (iii) $2,500 (inflation-adjusted). To receive the payout, the employee must give the company a statement of their long-term care premium.
When employees have no other options, in-service payments from a 401(k) plan might be a lifeline financially. With the assurance that a distribution is conceivable in unusual circumstances, employees might even increase their contributions to the plan.
The administrative complexity is increased by in-service distribution possibilities, though. If not carried out appropriately, these alternatives' additional layers of documentation, taxing, and reporting requirements might result in costly errors.
When deciding whether to offer in-service distributions, including the new alternatives created by SECURE 2.0, small enterprises should assess the benefit to the employees against the increased burden and cost.