Here are seven tips for employers to remain compliant regarding financial distributions from 401(k) plans:

1. Include language in your plan document regarding the circumstances for which distributions can occur. (Include definition of hardship distributions.)

2. If the loan document allows loans, then all nontaxable loans should be made prior to making a hardship distribution.

3. If a hardship distribution is made, be sure that the distribution does not exceed the total elective contributions.

4. Retain hardship application files in case of an IRS audit.

5. If an employee receives a hardship distribution, then he or she is prohibited from making elective contributions for at least six months after the distribution is received.

6. Participant account statements need to document elective contributions vs. other types of contributions, such as employer contributions.

7. File form 1099-R for all employees who receive distributions.

A common plan mistake that I see is plan sponsors not monitoring forfeiture accounts. Forfeiture accounts occur when monies are set aside to match employee contributions to retirement plans, but the employee terminates prior to fully vesting. The ‘forfeited’ money is supposed to be distributed within the terms of the plan. Generally, the balance held in the forfeiture account should be fully allocated at least once a year. Therefore, the balance of forfeiture accounts should be ‘zero’ at least sometime during the year. The IRS states those forfeitures may be used to:

-         Pay for a plan’s administrative expenses and/or

-         Reduce employer contributions

Here’s what you can to do make certain that your company is in compliance:

-         Put a provision in the plan document to detail the handling of forfeited monies.

-         Monitor forfeiture suspense accounts to be sure that monies are not carried into a subsequent plan year.

If you have already made the error, it’s possible to self-correct the mistake without penalty within a two-year period. See the Employee Plans Compliance Resolution System (EPCRS) for information about a Self-Correction Program and Voluntary Correction Program.

Most in-plan conversions will be taxable in the year they are rolled over, so employees may want to convert half of the desired amount in 2011 and the other half in 2012, thereby spreading the tax over two years. However, unlike converting from a traditional IRA to a Roth IRA, the decision cannot be rescinded, even within the tax year that the conversion decision was made. And, the converted amount is eligible for a 10% penalty tax if a withdrawal is made within five years and the participant is under age 59 ½.  The five-year timing begins upon conversion of funds to a Roth account.

Choosing to convert funds in a 401(k), 403(b) or 457(b) account is typically treated as a distribution, but there are some exceptions:

• A plan loan can be transferred without changing the repayment schedule or treating the loan as a new loan.
• Married plan participants are not required to obtain spousal consent to convert a plan account to a Roth account.
• An accrued benefit in excess of $5,000 is not automatically triggered. The participant has the right to defer receipt.
• A distribution right is not triggered with an in-plan Roth rollover.

Remember that employers are responsible for preparing Form 1099-R for each year that an in-plan conversion occurs for an employee.

Complete details of the IRS ruling can be found in Notice 2010-84.

IRS Tax Tip 2010-32

Some taxpayers may have needed to take an early distribution from their retirement plan last year. The IRS wants individuals who took an early distribution to know that there can be a tax impact to tapping your retirement fund.  Here are ten facts about early distributions.

1. Payments you receive from your Individual Retirement Arrangement before you reach age 59 ½ are generally considered early or premature distributions.
2. Early distributions are usually subject to an additional 10 percent tax.
3. Early distributions must also be reported to the IRS.
4. Distributions you rollover to another IRA or qualified retirement plan are not subject to the additional 10 percent tax. You must complete the rollover within 60 days after the day you received the distribution.
5. The amount you roll over is generally taxed when the new plan makes a distribution to you or your beneficiary.
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