(b)lines Ask the Experts – Explaining Tax Withholding on Plan Distributions

October 21, 2014 (PLANSPONSOR (b)lines) – “As the primary administrator for our 403(b) plan, I have difficulty explaining to participants the significance of the 20% tax withholding requirement when a participant receives a plan distribution, and the required withholding notice is not written in a fashion that is helpful to the cause of communication.

“Most participants end up thinking that the 20% withholding is the actual tax that they pay. Any tips from the Experts?”  

Michael A. Webb, vice president, Cammack Retirement Group, answers:

Excellent question! The 20% withholding requirement for most types of distributions is an area of frequent misunderstanding for both plan sponsors and participants alike. The likely reason for this is that, though most participants are familiar with the concept of tax withholding from items such as their paychecks, they do not understand that the withholdings themselves are not the actual tax paid as you state. The misunderstanding extends to all types of withholdings, not just the mandatory 20% withholding for retirement plan distributions.

In order to address participant confusion, the Experts recommend a basic explanation of how withholding works. You can explain that the 20% withholding works exactly like the withholding from their paycheck; both represent a “down payment” on taxes owed when a participant’s tax return is filed. The actual tax participants owe is based on their income, tax deductions/credits, etc. If the amount withheld from their paycheck and other items such as retirement plan distributions is greater than the taxes they owe when filing their tax returns then they receive a refund. If the actual taxes owed exceeds the withholding, they will owe taxes when they file their tax return.

It should be explained to participants that, typically, receiving a distribution from a retirement plan will reduce the amount of a refund a participant will receive at the end of the year, or increase the amount of taxes a participant owes at the end of the year. The larger the distribution, the greater the impact.

Beyond that basic explanation, plan sponsors are NOT tax advisers and participants should be advised to consult with a tax adviser should they have specific questions regarding their individual tax situation.


NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.