Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
Copyright 2011, The National Underwriter Company 1
Planning Retirement Distributions for Qualified Plans
• complex rules • distinct federal income tax treatment• use careful planning to avoid adverse tax
consequences
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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Helpful to consider questions:
1. What distributions does plan allow?
2. Can and should distribution be rolled over?
3. If choose periodic payment, which form is best?
– spousal consent needed?
– early distribution penalty?
– minimum distribution requirements?
– how are payments taxed?
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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Helpful to consider questions (cont’d):
4. If lump sum payment is chosen– eligible for 10 yr. averaging?– if so, is election beneficial?– how much tax payable?
5. What are the estate planning consequences of payment choice?
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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Plan Provisions:Required Spousal Benefits
Federal law
– protects the economic interest of the spouse
– ensures that benefit changes affecting the spouse are made with the spouse’s full knowledge and consent
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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Plan Provisions:Required Spousal Benefits
Two forms:
– Qualified Pre-retirement Survivor Annuity [QPSA]
– Qualified Joint and Survivor Annuity [QJSA]
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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Plan Provisions:Required Spousal Benefits
• Stock bonus plans• Profit sharing plans• ESOPs
Generally do NOT need to provide survivorship benefits for spouse IF participant’s nonforfeitable balance is payable as a death benefit to that spouse
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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Qualified Pre-Retirement Survivor Annuity
surviving spouse can have actual property rights in deceased participant’s vested benefits
QPSA is an automatic provision, any change in payout or beneficiary REQUIRES consent of nonparticipant spouse
– in writing– acknowledging effect of waiver– witnessed by plan representative or notary public
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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Survivor Annuity in Defined Benefit Plans:
Amount that would have been paid under a QJSA IF participant
– retired on day before death (if < retirement age)
or– separated from service on the earlier of the actual time
of separation or death and survived to the plan’s earliest retirement age, then retired with an immediate joint and survivor annuity
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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Survivor Annuity in Defined Contribution Plans:
Annuity for life of the surviving spouse that is the actuarial equivalent of at least 50% of the participant’s vested account balance, determined as of the date of death
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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Qualified Joint and Survivor Annuity
Provides annuity for life of participant and survivor annuity for life of surviving spouse
Survivor annuity must not be < 50% nor > 100% of annuity payable during the joint lives of the participant and spouse
Survivor annuity continues if spouse remarries
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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Qualified Joint and Survivor Annuity
Waiver of QJSA REQUIRES nonparticipant spouse consent
– in writing– acknowledging effect of waiver– witnessed by plan representative or notary public
90 day period after ‘annuity starting date’ to waive QJSA
Can revoke waiver during same 90 days
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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Plan Provisions:Other Benefit Options
Qualified plans can offer wide range of distribution options
In practice, employers limit options– more choice → more administrative costs
– IRS makes it difficult to change choices
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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Other Benefit Options forDefined Benefit Plans
Automatic optionsjoint and survivor annuity (if married)life annuity (if single)
Optionsperiod certain annuity – 10 or 20 yearsjoint annuity with someone other than spouse
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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Other Benefit Options forDefined Contribution Plans
Money purchase plans, target benefit plans, Section 403(b) tax deferred annuity plans subject to ERISA must meet pre-retirement and joint and survivor annuity rules
Other defined contribution plans do not have to meet these rules if
– there is no annuity option– the plan participant’s account balance is available to
surviving spouse at participant’s death
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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Other Benefit Options forDefined Contribution Plans
• If purchase an annuity, the joint and survivor options apply
• Lump sum distribution
• Non-annuity distributions
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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Tax impactNontaxable and Taxable Amounts
Taxes reduce participant’s financial security; need to minimize
Retirement plan distributions subject to federal, state and local income tax laws
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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To determine tax, first determine participant’s cost basis in plan benefit; basis can include…
– total after-tax contributions made by the employee to a contributory plan
– total cost of life insurance reported as taxable income by participant
– employer contributions previously taxed to employee
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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Basis can also include…
– certain employer contributions attributable to foreign services performed before 1963
– amount of any plan loans included as income in taxable distribution
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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In-service (partial) distributions
Partial distributions containing both nontaxable and taxable amounts are taxed as:
Nontaxable amount = distribution x employee’s cost basis
total account balance
‘Grandfather’ rule for pre-1987 after-tax contributions to the plan
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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In-service (partial) distributions
taxable in-service distribution may also be subject to an early distribution penalty
in-service withdrawals generally subject to mandatory 20% withholding unless a direct rollover is used
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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Total distributions
if begin annuity payments based on entire account balance
Nontaxable amount = distribution x employee’s cost basis
total annuity payments
expect to receive
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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Total distributions
taxable in-service distribution may also be subject to an early distribution penalty
in-service withdrawals generally subject to mandatory 20% withholding unless a direct rollover is used
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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Tax impact:Taxation of Annuity Payments
Employee has no cost basis
include full amount of annuity as ordinary income
Employee has some cost basis
table values used to determine the excludable portion of each monthly payment
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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Tax impact:Taxation of Lump Sum Distributions
lump sum distributions …
from some qualified plans are technically not ‘lump sum’ – IRAs, SEPs, Sec. 403(b)
may be subject to early distribution penalty
generally subject to mandatory 20% withholding
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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Tax impact:Taxation of Lump Sum Distributions
‘Grandfather rules’ if age 50 before Jan 1, 1986
– can use 10 year averaging at 1986 tax rates if take lump sum distribution
– pay capital gain rate of 20% for capital gain portion of distributions (the portion attributable to pre-1974 accumulations, if any), if elect capital gain treatment; not beneficial after recent tax law changes
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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Tax impact: Taxation of Death Benefits
Generally taxed the same as lifetime benefits
For a lump sum distribution if employee was age 50 before January 1, 1986, the beneficiary can elect 10 year averaging even if participant was not 59 ½ at time of death
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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Tax impact: Taxation of Death Benefits
Annuity distribution
– taxation follows annuity rules
If death benefit paid under life insurance contract held by qualified plan
– pure insurance portion excluded from income tax
– Table 2001 rates used to determine value of life insurance after 2000; prior years use ‘P.S. 58’ rates
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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Tax Impact: Federal Estate Tax
Entire value of a qualified plan death benefit is subject to inclusion in decedent’s gross estate for federal estate tax purposes
Only high-income plan participants subject to estate tax
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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Tax Impact: Federal Estate Tax
Federal estate tax avoidance important if– estate very large– participant single OR married and unwilling to
pay death benefit to spouse
If spouse close to decedent’s age, delay but not avoid federal estate tax
Use of life insurance to exclude death benefits from decedent’s estate is questionable
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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Loans
• avoid 10% penalty tax on early distributions
• increase administrative cost
• deplete plan funds available for pooled investments
• plan must specifically permit loans
• IRAs and SEPs cannot have loans
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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Loans
Exempt from prohibited transaction rules if
– available to participants and beneficiaries on reasonably equivalent basis
– not available to highly compensated in amount greater than amount made available to other employees
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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Loans
• are made according to specific provisions in plan
• must bear reasonable rates of interest
• are adequately secured
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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Loans
Code Section 72(p): To avoid tax, aggregate loans from qualified plan to any individual plan participant cannot exceed LESSER of
– $50,000, reduced by excess of the highest outstanding loan balance during the preceding one-year period over the outstanding balance on the date when the loan is made
or– one-half the present value of the participant’s vested
account balance (or accrued benefit if defined benefit plan)
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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Loans
• can loan < $10,000 even if amount is more than 1/2 of participant’s vested benefit
• repay within 5 years (unless for home purchase)
• interest treated as consumer interest
• interest deductions prohibited in special cases
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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Qualified Domestic Relations Orders (QDROs)
A decree, order, property settlement under state law relating to
– child support– alimony– marital property rights
that assigns part or all of participant’s plan benefits to spouse, former spouse, child, or other dependent of the participant
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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Qualified Domestic Relations Orders (QDROs)
• QDRO cannot assign a benefit the plan does not provide
• cash settlements generally require equivalent cash to ex-spouse while benefits remain with plan participant
• a spouse or former spouse receiving a distribution under a QDRO can roll it over just as if he or she were the participant
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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Penalty Taxes: Early Distribution Penalty
Early distributions from– qualified plans– Section 403(b) tax deferred annuity plans– IRAs– SEP’s
are subject to a 10% penalty withdrawal
Penalty for SIMPLE IRAs is 25% for first 2 years of participation
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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Penalty Taxes: Early Distribution Penalty
The penalty does NOT apply IF distributions are:
– made on or after attainment of age 59½
– made to the plan participant’s beneficiary or estate on or after the participant’s death
– attributable to the participant’s disability
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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Penalty Taxes: Minimum Distribution Requirements and Penalty
Must begin no later than April 1 of calendar year following latter of
– the calendar year employee attains 70½– the year the employee retires
50% penalty if distribute less than should
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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Penalty Taxes: Minimum Distribution Requirements and Penalty
Special issues:
– spouse > 10 years younger
– at participant’s death, minimum distribution based on remaining life expectancy
– designated beneficiary for after death distributions determined Sept 30 of year following year of participant’s death
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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Retirement Plan RolloversWhen are rollovers used?
To defer tax on:
– part or all of plan distribution
– large lump sum from terminated plan
– transfer of funds to different investment vehicle
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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Retirement Plan RolloversTax Treatment of Rollovers
1. Can roll over any distribution from “eligible retirement plan” EXCEPT
– required minimum distribution
– series of substantially equal payments for > 10 years or life or life expectancy of employee or employee and a designated beneficiary, or
– ‘hardship’ distribution
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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Retirement Plan RolloversTax Treatment of Rollovers
2. If do not use direct rollover and fail to roll over in 60 days, distribution subject to income tax
3. Distribution from rollover IRA not eligible for forward averaging
4. Distribution rules for rollover IRA same as for traditional IRA; early distributions subject to 10% early withdrawal penalty
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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Retirement Plan RolloversTax Treatment of Rollovers
5. Loans not permitted
6. If participant dies before withdrawing all from rollover IRA, death benefit subject to estate tax
7. Use of separate ‘conduit IRA’ to hold qualified plan funds for transfer from one qualified plan to another no longer necessary
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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Retirement Plan RolloversAlternatives to Rollovers
Leave $ in existing qualified plan
Select an annuity payout if available
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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True or False?
1. A profit sharing plan must have a qualified joint and survivor annuity.
2. A participant’s cost basis in a qualified retirement plan can include the amount of any plan loans included in income as a taxable distribution.
3. The entire value of a qualified death benefit is always excluded from the decedent’s gross estate for federal income tax purposes.
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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True or False?
4. If a loan made from a qualified plan bears a reasonable rate of interest and is adequately secured, it will probably avoid being classified as a prohibited transaction rule.
5. A participant’s plan benefits cannot be part of the negotiable assets in domestic disputes.
6. A plan distribution made at age 60 is subject to a 10% penalty for early withdrawal because it was made before age 65.
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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True or False?
7. A direct rollover is a rollover distribution that is paid directly to another eligible retirement plan for the benefit of the distributee.
8. A direct rollover must be completed within 90 days.
9. A hardship distribution from a qualified plan is eligible for a rollover.
10. Loans from a rollover IRA are prohibited.
Qualified Plans: Distributions and Loans
Chapter 8Employee Benefit & Retirement Planning
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Discussion Questions
Joe Walters, age 51, lost use of his left arm after a stroke, making it impossible for him to continue working as an electrician with Goodenuf Construction. Joe has a qualified retirement plan with his employer.
•What are the pros and cons of Joe taking an early distribution from his qualified retirement plan to cover his living expenses for a few months while he gets some training to try another line of work?
•How and why would your answer change if Joe was not disabled, but only wanted the distribution to buy a new 4x4?