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Chapter 8: qualified plans: distributions and loans.


I.    Planning Retirement Distributions
II.   Plan Provisions--Required Spousal Benefits
      A. Pre-retirement Survivor Annuity
      B. Qualified Joint and Survivor Annuity
III.  Plan Provisions--Other Benefit Options
      A. Defined Benefit Plan Distribution
      B. Defined Contribution Plan Distribution
IV.   Tax Impact
      A. Nontaxable and Taxable Amounts
      B. Taxation of Annuity Payments
      C. Lump Sum Distributions
      D. Taxation of Death Benefits
      E. Federal Estate Tax
V.    Loans
VI.   Qualified Domestic Relations Orders
VII.  Penalty Taxes
      A. Early Distribution Penalty
      B. Minimum Distribution Requirements and
VIII. Retirement Plan Rollovers
      A. When are Rollovers used?
      B. Tax Treatment of Rollovers
      C. Alternatives to Rollovers

I. PLANNING RETIREMENT DISTRIBUTIONS Distributions from qualified pension, profit sharing, employer stock plans, and Section 403(b) tax deferred annuity plans are subject to numerous special rules and distinctive federal income tax treatment. Advance consideration of all the potential implications of plan distributions is an important part of overall plan design.

Furthermore, in advising clients who are plan participants, a clear understanding of the qualified plan rules is important. A qualified plan or Section 403(b) tax deferred annuity plan can allow employees to accumulate substantial retirement benefits. Even a middle-level employee may have an account balance of hundreds of thousands of dollars available at retirement or termination of employment. Careful planning is important in order to make the right choices of payment options and tax treatment for a plan distribution, to obtain the right result in financial planning for retirement, and also to avoid adverse tax results or even a tax disaster.

The retirement plan distribution rules are astonishingly complicated. They are a maze full of tax traps that have developed in the law over many years, with Congress and the IRS adding new twists and turns almost every year. This chapter is only a basic outline of these rules, but even this basic outline is quite complex.

One way to thread the maze and give some structure to the subject is to look at the issue from the standpoint of advice to a plan participant who is about to retire. What questions need to be asked and what decisions must be made? Typically, the process might proceed by asking and answering these questions--

1. What kinds of distributions does the plan itself allow? The retiree's advisor should review plan documents, particularly the summary plan description (SPD), to determine what options are available. Sections II and III of this chapter discuss these issues.

2. Can and should the distribution be rolled over? (Section VIII and Chapter 9 explain the issues to be considered.)

3. If periodic payments are chosen, what kind of payment schedule is best?

--Note the requirement of spousal consent for a payment option that "cuts out" the spouse. (Section II.)

--Is the payment subject to a 10% early distribution penalty? (Section VII.)

--Are the minimum distribution requirements satisfied? (Section VII.)

--How will the payments be taxed? (Section IV, A and B.)

4. If a lump sum payment is chosen--

--Is it eligible for 10-year averaging and if so, is the election beneficial? (Section IV.)

--How much tax is payable? (Section IV.)

5. What are the potential future estate tax consequences of the form of distribution chosen? (Sections IV E and VII.)


All pension plans must provide two forms of survivorship benefits for spouses: (1) the "qualified pre-retirement survivor annuity" and (2) the "qualified joint and survivor annuity." Stock bonus plans, profit sharing plans, and ESOPs generally need not provide these survivorship benefits for the spouse if the participant's nonforfeitable account balance is payable as a death benefit to that spouse. (1)

Qualified Pre-retirement Survivor Annuity

Once a participant in a plan requiring these spousal benefits is vested, the nonparticipant spouse acquires the right to a pre-retirement survivor annuity, payable to the spouse in the event of the participant's death before retirement. This right is an actual property right created by federal law.

In a defined benefit plan, the survivor annuity payable under this provision of law is the amount that would have been paid under a qualified joint and survivor annuity if the participant had either (1) retired on the day before his or her death (in the case of the participant dying after attaining the earliest retirement age under the plan); or (2) 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 (in the case of the participant dying before attaining such age). (2) The calculation of joint and survivor annuity amounts is discussed below.

If the plan is a defined contribution plan, the qualified pre-retirement survivor annuity is an annuity for the 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. (3)

The pre-retirement survivor annuity is an automatic benefit. If no other election is made, a pre-retirement survivor annuity is provided. If the plan permits, a participant can elect to receive some other form of retirement survivorship benefit, including no pre-retirement survivorship benefit at all, or survivorship benefits payable to a beneficiary other than the spouse. However, the spouse must understand the rights given up and must consent, in writing, to the participant's choice of another form of benefit. (4)

The right to make an election of a benefit other than the pre-retirement survivor annuity must be communicated to all vested participants who have attained age 32. (5) The participant can elect to receive some benefit other than the pre-retirement survivor annuity at any time after age 35. (6) The participant can also change this election at any time before retirement.

Consideration of "electing out" of the pre-retirement survivorship benefit becomes more important as a participant nears retirement age. Electing out of the pre-retirement survivorship benefit will generally increase the participant's benefit after retirement, unless the plan specifically subsidizes the retirement benefit. Thus, a participant may want to elect out of the benefit to increase the size of the monthly check received during the post-retirement period. Alternatively, the participant may wish to provide a pre-retirement survivorship benefit for a beneficiary other than the surviving spouse.

Such elections must be considered very carefully, particularly by the nonparticipant spouse. Generally a nonparticipant spouse would (and should) not agree to waive this benefit unless the couple's overall retirement planning provides some compensating benefit to the spouse. The existence and amount of any such compensating benefit to the spouse should be documented in connection with the spouse's benefit waiver.

The consent of the nonparticipant spouse to waiver of the pre-retirement survivorship benefit in favor of an optional benefit form selected by the participant must (1) be in writing; (2) acknowledge the effect of the waiver; and (3) be witnessed, either by a plan representative or a notary public. (7) For this reason, full disclosure-in writing-to the nonparticipant spouse must be made, and the spouse should be advised to consult an independent legal (and possibly financial) advisor in connection with the waiver. For large benefits, this advice to the spouse is an extremely important consideration.

Qualified Joint and Survivor Annuity

A qualified joint and survivor annuity is a post-retirement death benefit for the plan participant's spouse. If the plan is subject to these requirements, it must automatically provide, as a retirement benefit, an annuity for the life of the participant with a survivor annuity for the life of the participant's spouse. The survivor annuity must not be less than 50% nor greater than 100% of the annuity payable during the joint lives of the participant and spouse. (8) For example, if $1,000 per month is payable during the joint lives, the annuity to the surviving spouse can be any specified amount from $500 per month to $1,000 per month. The spouse's annuity must be continued even if the spouse remarries. (9)

As with the pre-retirement survivor annuity, a participant may elect to receive another form of benefit if the plan permits. However, as with a qualified preretirement survivor annuity, the spouse must consent in writing to the election. (10) An election to waive the joint and survivor form must be made during the 90-day period ending on the "annuity starting date"-the date on which benefit payments should have begun to the participant, not necessarily the actual date of payment. (11) The waiver can be revoked-that is, the participant can change the election during the 90-day period. Administrators of affected plans must provide participants with a notice of the election period and an explanation of the consequences of the election within a reasonable period before the annuity starting date. (12)

Since the joint and survivor annuity must be the actuarial equivalent of other forms of benefit, the participant may wish to increase the monthly pension by waiving the joint and survivor annuity and receiving a straight life annuity or some other form of benefit. Just as in the case of the pre-retirement survivorship benefit, discussed above, the nonparticipant spouse's consent to waiver of the joint and survivor annuity in favor of an optional benefit form selected by the participant must (1) be in writing; (2) acknowledge the effect of the waiver; and (3) be witnessed, either by a plan representative or a notary public. (13) It is extremely important that spouses are made aware of what they are giving up if they consent to some other benefit form.


A qualified plan can offer a wide range of distribution options. Participants benefit from having the widest possible range of options, because this increases their flexibility in personal retirement planning. However, a wide range of options increases administrative costs. Also, the IRS makes it difficult to withdraw a benefit option once it has been established. (14) Consequently, most employers provide only a relatively limited "menu" of benefit forms for participants to choose from.

In addition, a qualified plan generally must provide for "direct rollovers" of certain distributions. (15) Failure to elect a "direct rollover" will subject the distribution to mandatory 20% withholding. Plan administrators must provide a written explanation to the distributee of his right to elect a "direct rollover" and the withholding consequences of not making the election. (16) See "Tax Treatment of Rollovers," under Section VIII.

Defined Benefit Plan Distribution Provisions

Defined benefit plans must provide a married participant with a joint and survivor annuity as the automatic form of benefit, as described earlier. For an unmarried participant, the plan's automatic form of benefit is usually a life annuity-typically monthly payments to the participant for life, with no further payments after the participant's death.

Many plans allow participants to elect to receive some other form of benefit from a list of options in the plan. However, to elect any option that eliminates the benefit for a married participant's spouse, the spouse must consent on a notarized written form to waive the spousal right to the joint and survivor annuity. As discussed earlier, this is not just a legal formality; in consenting to another form of benefit, the spouse gives up important and often sizable property rights in the participant's qualified plan benefit that are guaranteed under federal law.

Typically, plans offer, as an option to the joint or single life annuity, a period-certain annuity. A period-certain annuity provides payments for a specified period of time-usually 10 to 20 years-even if the participant, or the participant and spouse, both die before the end of that period. Thus, the period-certain annuity makes it certain that periodic (usually monthly) benefits will continue for the participant's heirs even if the participant and spouse die early. Because of this guarantee feature, the annual or monthly payments under a period-certain option are less than they would be under an option where payments end at death (see the typical equivalency table below).

As the above comparison indicates, a period-certain option should be chosen if the participant wants to make sure that his heirs are provided for in case both he and his spouse die shortly after retirement. The reduction in monthly income is relatively small, since it is based on the average life expectancy of all annuitants and assumes that the average annuitant (male or female) lives about 20 years after attaining age 65. Thus, the participant and spouse should consider a period-certain option if they are both in poor health, or if they want to make sure that children (or other heirs) with large financial needs are provided for in the event of their deaths. On the other hand, if the participant wants the largest possible monthly income from the plan, a life annuity should be chosen.

Defined benefit plans may allow a participant to choose a joint annuity with a beneficiary other than a spouse-for example, an annuity for the life of a participant with payments continuing after the parent-participant's death to a son or daughter. Treasury regulations limit the amount of annuity payable to a much younger beneficiary in order to ensure that the participant personally receives (and therefore is taxed on) at least a minimum portion of the total value of the plan benefit and that plan payments are not unduly deferred beyond the participant's death. (See the minimum distribution rules discussed below in Section VII.) Thus, a much younger beneficiary (except for a spouse) generally would not be allowed to receive a 100% survivor annuity benefit.

Defined Contribution Plan Distribution Provisions

Defined contribution plans include such plans as profit sharing, 401(k), and money purchase plans. Section 403(b) tax-deferred annuity plans also have distribution provisions similar to defined contribution plans. Some defined contribution plans provide annuity benefits like those in defined benefit plans. In fact, money purchase plans, target benefit plans and Section 403(b) tax deferred annuity plans subject to ERISA must meet the pre-retirement and joint and survivor annuity rules discussed above. Other defined contribution plans do not have to meet these rules if (1) there is no annuity option; and (2) the plan participant's account balance is payable to the participant's spouse in the event of the participant's death. (17) Avoiding the required joint and survivor provisions simplifies plan administration and therefore reduces the plan's cost.

Annuity benefits are computed by converting the participant's account balance in the defined contribution plan into an equivalent annuity. In some plans, the participant can elect to have his account balance used to purchase an annuity from an insurance company. The same considerations in choosing annuity options as have already been discussed would then apply. If the plan offers annuity options, the required joint and survivor provisions apply, as discussed earlier.

Defined contribution plans often provide a lump sum benefit at retirement or termination of employment. Defined contribution plans often also allow the option of taking out non-annuity distributions over the retirement years. That is, the participant simply takes out money as it is needed, subject to the minimum distribution requirements discussed later. Such distribution provisions provide much flexibility in planning.


For many plan participants, retirement income adequacy is more important than minimizing taxes to the last dollar. Nevertheless, taxes on both the federal and state levels must never be ignored, since they reduce the participant's "bottom line": financial security. The greater the tax on the distribution, the less financial security the participant has.

A qualified plan distribution may be subject to federal, state, and local taxes, in whole or in part. This section will focus only on the federal tax treatment. The federal tax treatment is generally the most significant, because federal tax rates are usually higher than state and local rates. Also, many state and local income tax laws provide a full or partial exemption or specially favorable tax treatment for distributions from qualified retirement plans.

Nontaxable and Taxable Amounts

Qualified plans often contain after-tax employee money-that is, contributions that have already been taxed. These amounts can be received by the employee free of federal income taxes, although the order in which they are recovered for tax purposes depends on the kind of distribution.

The first step in determining the tax on any distribution, then, is to determine the participant's cost basis in the plan benefit.

The participant's cost basis can include: (18)

* the total after-tax contributions made by the employee to a contributory plan;

* the total cost of life insurance protection actually reported as taxable income on federal income tax returns by the participant, if the plan distribution is received under the same contract that provides the life insurance protection (If the plan trustee cashes in the life insurance contract before distribution, this cost basis amount is not available. For a person who is now or was self-employed, the cost of life insurance protection is not includable in basis.); (19)

* any employer contributions previously taxed to the employee-for example, where a nonqualified plan later becomes qualified;

* certain employer contributions attributable to foreign services performed before 1963; and

* the amount of any plan loans included in income as a taxable distribution (see V, below).

In-service (Partial) Distributions. If a participant takes out a partial plan distribution before termination of employment (as is provided for in many savings or thrift plans), the distribution is deemed to include both nontaxable and taxable amounts; the nontaxable amount will be in proportion to the ratio of total after-tax contributions (i.e., the employee's cost basis) to the plan account balance (similar to the computation of the annuity exclusion ratio discussed below). (20 Expressed as a formula it looks like this:

nontaxable amount = distribution x employee's cost basis/total account balance

However, there is a "grandfather" rule for pre-1987 after-tax contributions to the plan. If certain previously existing plans include contributions made before 1987, it is possible to withdraw after-tax money first. That is, if a distribution from the plan is made (at any time, even after 1987) that is less than the total amount of pre-1987 after-tax contributions, the entire distribution is received tax free. Once a participant's pre-1987 amount (if any) has been used up, the regular rule applies. (21)

A taxable in-service distribution may also be subject to the early distribution penalty, discussed later. In addition, in-service distributions generally will be subject to mandatory withholding at 20%, unless the distribution is transferred to an eligible retirement plan by means of a "direct rollover" (see "Retirement Plan Rollovers," below). (22)

Total Distributions. If the participant begins annuity payments based on the entire account balance, the nontaxable amount will be proportionate to the ratio of total after-tax contributions (i.e., the employee's cost basis) in the plan to the total annuity payments expected to be received (see below). If the participant withdraws his or her entire account balance, the distribution may be eligible for the lump sum distribution treatment discussed below. Total distributions may also be subject to the early distribution penalty, discussed below. In addition, certain distributions may be subject to mandatory withholding at 20%, unless such distributions are rolled over by means of a "direct rollover" (see "Retirement Plan Rollovers," below).

Taxation of Annuity Payments

An employee who has no cost basis (described above) for his interest in the plan must include as ordinary income the full amount of each annuity payment (i.e., periodic plan distributions made over more than one taxable year of the employee in a systematic liquidation of the participant's benefit).

If the employee has a cost basis, one of two tables is used to determine the excludable portion of each monthly payment. (23) If the annuity is payable over one life, the table set forth following the paragraph below is used.
                                      Number of
Age on annuity starting date     anticipated payments

Not more than 55                         360
More than 55-60                          310
More than 60-65                          260
More than 65-70                          210
More than 70                             160

Example: Franco retires at age 65 with a pension of $2,000 per month payable on a single life basis. His cost basis in the plan is $52,000. From the table, the number of anticipated payments is 260. Franco is deemed to recover $200 ($52,000 divided by 260) of cost basis from each payment. Therefore, of each $2,000 monthly payment, $1,800 is taxable ($2,000 minus $200) and the remaining $200 is recovered tax free. After the entire cost basis is recovered (after Franco receives 260 payments), the entire amount of each subsequent monthly payment is taxable.

If the annuity is payable over two or more lives, the excludable portion of each monthly payment is determined by dividing the employee's investment in the contract by the number of anticipated payments, based on the combined ages of the recipients, as follows:
Combined age of annuitants            Number of payments

Not more than 110                            410
More than 110 but not more than 120          360
More than 120 but not more than 130          310
More than 130 but not more than 140          260
More than 140                                210

These tables do not apply if the annuitant is age 75 or over, unless there are fewer than five years of guaranteed payments under the annuity. (24) If a lump sum is paid to the taxpayer in connection with the commencement of the annuity payments, it will be taxable as an amount not received as an annuity under Section 72(e), and treated as received before the annuity starting date. Such a taxpayer's investment in the contract will be determined as if the lump sum payment has been received. (25)

After the cost basis is fully recovered, payments received subsequently are taxable in full. (26) If the participant dies before the cost basis is fully recovered, an income tax deduction for the unrecovered basis is allowed on the participant's final income tax return. (27)

If the annuity starting date was before November 19, 1996, different rules were applicable. (28)

Lump Sum Distributions

In some cases, participants may with to take out the entire amount of their retirement benefit from a qualified plan or IRA for retirement purposes. Generally, they will want to roll this distribution over to an IRA or other eligible retirement plan, in order to avoid current taxation on the benefit. There are, however, two special tax benefits for lump sum distributions (from qualified plans only) that are not rolled over and that qualify as "lump-sum distributions" under Code Section 402:

* Lump-sum distributions of employer stock from a profit-sharing plan, k stock bonus plan, or ESOP can avoid current taxation of unrealized appreciation; see Chapter 18.

* Certain benefits under prior law are "grand-fathered" to individuals who attained age 50 before 1986. Obviously the significance of this tax benefit is gradually diminishing with the passage of time.

The tax break for lump sum distributions was "10year averaging" from 1974 through 1986. For an individual who attained age 50 before January 1, 1986, the 10-year averaging provision is "grandfathered." Such an individual may elect to use 10-year averaging using the 1986 tax rates (taking into account the prior law zero bracket amount). (29)

A further elective grandfather rule imposes a tax rate of 20% for the portion of distributions (attributable to pre-1974 accumulations, if any) to participants who attained age 50 before January 1, 1986. Distributees should elect this treatment only if it produces a lower overall tax.

Taxation of Death Benefits

In general, the same income tax treatment applies to death benefits paid to beneficiaries as to lifetime benefits payable to participants. The special lump sum provision can be used by the beneficiary. If the employee had attained age 50 before January 1, 1986, the beneficiary may elect 10-year averaging, even if the participant was not 591/2 or older at his or her death. (30) For an annuity distribution, the beneficiary uses the same annuity rules described earlier.

There are also some additional income tax benefits available.

If the death benefit is payable under a life insurance contract held by the qualified plan, the pure insurance amount of the death benefit is excludable from income taxation. (31) The pure insurance amount is the difference between the policy's face amount and its cash value at the date of death.

Example: Ellen Employee, aged 64, dies in 2007 before retirement. Her beneficiary receives a lump sum death benefit of $100,000 from the plan. The $100,000 is the proceeds of a cash value life insurance contract; the contract's cash value at Ellen's death was $60,000. Ellen reported a total of $10,000 of Table 2001 (formerly P.S. 58) insurance costs for this contract on her income tax returns during her lifetime. The taxable amount of the $100,000 distribution to the beneficiary is $100,000 less the following items:

* the pure insurance amount of $40,000 ($100,000 less the cash value of $60,000),

* Ellen's cost basis of $10,000.

The taxable amount of this benefit is therefore $50,000.

Table 2001 rates are generally used in determining the value of life insurance protection after 2000. (32) For prior years, "P.S. 58" rates were used to calculate the value of the protection. (33)

An additional factor in the treatment of death benefits involves rollovers to an IRA; see the discussion later in this chapter.

Federal Estate Tax

The entire value of a qualified plan, IRA, or Roth IRA death benefit is generally subject to inclusion in the decedent's gross estate for federal estate tax purposes, since there is no specific statutory exclusion for these benefits. However, only high-income plan participants will actually be subject to estate tax. First, there is a substantial minimum tax credit applicable to the estate tax. This essentially eliminates estate taxes for gross estates of less than $3,500,000 for 2009. In 2010, the estate tax is repealed for a year. Finally, in 2011, the exemption equivalent of the unified credit reverts to $1,000,000 (as it was scheduled to increase before the law changed). (34) In addition, the unlimited marital deduction for federal estate tax purposes defers federal estate tax on property transferred at death to a spouse in a qualifying manner until the death of the second spouse. (35)


Because of the 10% penalty tax on "early" distributions from qualified plans (see below), a plan provision allowing loans to employees may be attractive. This allows employees access to plan funds without extra tax cost. However, a loan provision increases administrative costs for the plan and may deplete plan funds available for pooled investments.

For participants to borrow from a plan, the plan must specifically permit such loans. Any type of qualified plan (or Section 403(b) tax deferred annuity plan) may permit loans. Loan provisions are most common in defined contribution plans, particularly profit sharing plans. There are considerable administrative difficulties connected with loans from defined benefit plans because of the actuarial approach to plan funding. Loans from IRAs and SEPs are not permitted.

Loans to participants are generally prohibited transactions, subject to penalties unless such loans (1) are exempted from the prohibited transaction rules by an administrative exemption; or (2) meet the requirements set out in Code section 4975(d)(1). The requirements of that section are met if:

(1) loans made by the plan are available to all participants and beneficiaries on a reasonably equivalent basis;

(2) loans are not made available to highly compensated employees in an amount greater than the amounts made available to other employees;

(3) loans are made in accordance with specific provisions regarding such loans set forth in the plan;

(4) the loans bear reasonable rates of interest; and

(5) the loans are adequately secured. (36)

Plan loans may be made from a qualified plan to a sole proprietor, a more-than-10% partner in an unincorporated business, and an S corporation employee who is a more-than-5% shareholder in the corporation. (37) A loan from a qualified plan (or a Section 403(b) tax deferred annuity) will be treated as a taxable distribution if it does not meet the requirements of Code section 72(p). Section 72(p) provides that aggregate loans from qualified plans to any individual plan participant cannot exceed the lesser of:

* $50,000, reduced by the 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, in the case of a defined benefit plan).

A loan of up to $10,000 can be made, even if this is more than one-half of the participant's vested benefit. (38) For example, a participant having a vested account balance of $17,000 could borrow up to $10,000.

Loans must be repayable, by their terms, within five years, except for loans used to acquire a principal residence of the participant.

Interest on a plan loan, in most cases, will be consumer interest, which is generally not deductible by the employee, unless the loan is secured by a home mortgage. Interest deductions are specifically prohibited in two situations: (1) if the loan is to a key employee, as defined in the Code's rules for top-heavy plans (Section 416); or (2) if the loan is secured by a Section 401(k) or Section 403(b) tax deferred annuity plan account based on salary reductions. (39)


In general, a qualified plan benefit cannot be assigned or "alienated" by a participant, voluntarily or involuntarily. (40) The idea behind this rule is to protect the participant's retirement fund from attachment by creditors. However, after a series of conflicting state court cases, an exception to this rule was added for the claims of spouses and dependents in domestic relations situations.

This exception permits an assignment of a qualified plan benefit under a qualified domestic relations order (QDRO), as defined in Code section 414(p). A QDRO is a decree, order, or property settlement under state law relating to child support, alimony, or marital property rights, which assigns part or all of a participant's plan benefits to a spouse, former spouse, child, or other dependent of the participant. Consequently, a participant's plan benefits are generally part of the negotiable assets in domestic disputes. The Internal Revenue Code does not indicate how such benefits are to be divided; this is a matter of state domestic relations law and the negotiation between the parties. The QDRO provisions of the Code simply provide a means by which state court domestic relations orders can be enforced against plan trustees.

To protect plan administrators and trustees from conflicting claims, a QDRO cannot assign a benefit that the plan does not provide. Also, a QDRO cannot assign a benefit that is already assigned under a previous order. (41)

If, under the plan, a participant has no right to an immediate cash payment from the plan, a QDRO cannot require the trustees to make such a cash payment. If an immediate cash settlement is desired, the parties will generally agree to allow the participant to keep the entire plan benefit and pay compensating cash to the nonparticipant spouse. (Such compensating cash payments are not, however, treated as qualified plan distributions to the nonparticipant spouse.) If compensating cash payments are not possible, QDROs have been used to segregate plan assets into a subtrust for the benefit of the spouse making the claim, with cash distributions made at the earliest time that the plan provisions would permit distributions to the participant.

An alternate payee who is the spouse or former spouse of the participant and who receives a distribution by reason of a QDRO may roll over the distribution in the same manner as if he or she were the participant.


In addition to the complicated regular tax rules, distributions must be planned so that recipients avoid-or at least are not surprised by- tax penalties for withdrawals made too early or too late. These are summarized as follows.

Early Distribution Penalty

This is, in effect, a penalty for making distributions "too soon." Early distributions from qualified plans, Section 403(b) tax deferred annuity plans, IRAs, and SEPs are subject to a penalty of 10% of the taxable portion of the distribution. (42) In the case of SIMPLE IRAs, the penalty is increased to 25% during the first two years of participation.

The penalty does not apply to distributions:

* made on or after attainment of age 591/2.

* made to the plan participant's beneficiary or estate on or after the participant's death.

* attributable to the participant's disability.

* that are part of a series of substantially equal periodic payments made at least annually over the life or life expectancy of the participant, or the participant and a designated beneficiary (separation from the employer's service is required, except for IRAs).

* made upon separation from service after attainment of age 55 (not applicable to IRAs).

* made to a former spouse, child, or other dependent of the participant under a qualified domestic relations order (not applicable to IRAs).

* to the extent of medical expenses deductible for the year under Code section 213, whether or not actually deducted.

* to pay health insurance costs while unemployed (IRAs only).

* for higher education costs (tuition, fees, books, supplies, and equipment) for the taxpayer, spouse, child, or grandchild (IRAs only).

* to pay acquisition costs of a first home of the participant, spouse, child, grandchild, or ancestor of the participant or spouse, up to a $10,000 lifetime maximum (IRAs only).

"Qualified hurricane distributions" for Hurricanes Katrina, Rita, and Wilma are also exempt from the penalty. The aggregate amount that may be treated as qualified hurricane distributions of an individual (from all eligible retirement plans) is $100,000. (43)

In the case of the periodic payment exception, if the series of payments is changed before the participant reaches age 591/2 or, if after age 591/2, within five years of the date of the first payment, the tax is generally recaptured. In other words, the penalty that would have been imposed, but for the periodic exception, is imposed, with interest, in the year the change occurs. (44) Detailed guidance on the calculation of such payments and an exception for a "one time election" to lower the payments are set forth in IRS guidance. (45)

Minimum Distribution Requirements and Penalty

Minimum distributions from qualified plans, Section 403(b) tax deferred annuity plans, IRAs, SEPs, SIMPLE IRAs and Section 457 governmental deferred compensation plans must generally begin not later than April 1 of the calendar year following the later of: (1) the calendar year in which the employee attains age 701/2; or (2) the year the employee retires. (46) The second (retirement year) alternative is not available for a more-than-5% owner of the business sponsoring the qualified plan, (47) or for an IRA owner.

If the annual distribution is less than the minimum amount required, there is a penalty of 50% of the amount not distributed that should have been. (48) But a participant can always take out more than the required minimum. The required minimum distribution rules are designed to determine the rate at which income taxes must be paid on the retirement accumulation; the minimum distribution amounts do not have to be spent by the participant, but can be reinvested in a nonqualified investment medium.

Under current regulations, (49) the required minimum distribution each year is generally determined by dividing the account balance (determined as of the last valuation date in the preceding year) by the appropriate number in the lifetime required minimum distribution table set forth in the final regulations (see Figure 8.1). (50)

Example: Kermudgen reaches age 73 in 2008. His qualified account balance as of the end of 2007 was $400,000. Kermudgen's required distribution for 2008 is $16,194, ($400,000 divided by 24.7, the lifetime distribution factor for a 73-year old).

Note that this rule creates a hardship if the value of the account balance declines significantly during the year, since the minimum distribution will be greater fraction of the total than was anticipated. Because of the bad financial conditions during 2008, Congress provided a one-year moratorium on required minimum distributions from IRAs and qualified plans-for the year 2009 only. No relief was provided for 2008. (51)

The lifetime minimum distribution factors in Figure 8.1 are generally used regardless of who is named as beneficiary, but note the following:

* A more favorable minimum distribution (lower required annual amount) is available for a participant whose beneficiary is a spouse more than 10 years younger than the participant. In this case, a minimum distribution can be determined using the actual joint life expectancy of the participant and the spouse. (52)

* At the participant's death, the minimum distribution to the participant's designated beneficiary is generally based on the beneficiary's remaining life expectancy. Under the current minimum distribution rules, there is likely to be amounts remaining at the owner's death, so the minimum distribution rules for survivors are significant in retirement and estate planning. This is discussed further in Chapter 9.

* The designated beneficiary for purposes of after-death distributions is determined as of September 30 of the year following the year of the participant's death.


Tax-free "rollovers" of distributions to and from qualified plans, Section 403(b) tax deferred annuity plans, traditional IRAs, SEPs, and eligible Section 457 governmental plans are specifically allowed by the Internal Revenue Code. (53) Thus, rollovers between different types of plans are permitted-for example, from a qualified plan to a Section 403(b) tax deferred annuity. A rollover of a distribution from a SIMPLE IRA during the first two years of participation may be made only to another SIMPLE IRA, except in the case of distributions to which the premature distribution penalty does not apply (see above). (54) The most commonly-used form of rollover is a rollover to an IRA from an employer plan at the employee's termination of employment.

If a rollover is made within 60 days of receipt of the distribution and follows statutory rules, the tax on the distribution is deferred; in other words, the receipt is not a taxable event to the participant. However, "eligible rollover distributions" from qualified plans, Section 403(b) tax deferred annuity plans, and eligible Section 457 governmental plans are subject to mandatory withholding at 20%, unless the rollover is effected by means of a "direct rollover" (see "Tax Treatment of Rollovers," below.)

When Are Rollovers Used?

1. When a retirement plan participant receives a plan distribution and wants to defer taxes (and avoid any early distribution penalties) on part or all of the distribution.

2. When a qualified retirement plan, Section 403(b) tax deferred annuity plan or eligible Section 457 governmental plan is terminated by the employer, and an individual participant will receive a large termination distribution from the plan, has no current need for the income, and wishes to defer taxes on it.

3. When a participant in a qualified plan, Section 403(b) tax deferred annuity plan, eligible Section 457 governmental plan, or IRA would like to continue to defer taxes on the money in the plan, but wants to change the form of the investment or gain greater control over it.

4. When a spouse receives a death benefit from a plan.

Tax Treatment of Rollovers

1. Any distribution from an "eligible retirement plan "that is, a qualified plan, Section 403(b) tax deferred annuity plan, eligible Section 457 governmental plan, SEP, or IRA is eligible for rollover, except the following:

* a required minimum distribution (generally beginning at age 70 1/2),

* a distribution that is one of a series of substantially equal periodic payments payable (a) for a period of ten years or more, or (b) for the life or life expectancy of the employee or the employee and a designated beneficiary, or

* a "hardship" distribution. (55)

2. Eligible rollover distributions received from an eligible retirement plan must be either transferred to another eligible retirement plan by means of a "direct rollover," pursuant to the employee's election, or transferred by the participant to the other plan not later than the 60th day after the distribution from the plan. A "direct rollover" is defined as an eligible rollover distribution that is paid directly to another eligible retirement plan for the benefit of the distributee. It can be accomplished by any reasonable means of direct payment, including the use of a wire transfer or a check that is negotiable only by the trustee of the new plan or rollover IRA. (56) If the "direct rollover" method is not chosen in the case of a distribution from a qualified plan, Section 403(b) plan, or eligible Section 457 governmental plan, the distribution is subject to mandatory withholding at 20%. (57)

Failure to roll over the distribution within 60 days subjects it to income taxes (although certain employees may be eligible to elect 10-year averaging to cushion the blow, if the distribution qualifies for special averaging). The Secretary of the Treasury has the authority to waive the 60-day rule where it would be against equity or good conscience to enforce it, including cases of disaster, casualty, or other events beyond the participant's control. (58)

3. Distributions from a rollover IRA are subject to the same rules and limitations as all traditional IRA distributions, discussed in Chapter 5. To summarize, distributions must: (a) begin no later than April 1 of the year after the participant attains age 701/2, and (b) be made in minimum amounts, based on a life or joint life payout. Distributions are taxable as ordinary income, without 10-year averaging. Distributions prior to age 591/2 are also subject to the 10% early withdrawal penalty, subject to the exceptions discussed earlier in this chapter.

4. Loans from a rollover IRA, like loans from any other IRA, are not permitted.

5. If a participant dies before withdrawing all of the rollover IRA account, the death benefit is includable in the deceased participant's estate for federal estate tax purposes. If payable to the participant's surviving spouse in a qualifying manner, the marital deduction will defer estate taxes.

6. If a surviving spouse is the beneficiary of a decedent's IRA or qualified plan, the spouse has unique opportunity to roll over the benefit to the spouse's IRA and, in effect start over as if the benefit were the surviving spouse's own IRA from its inception. Minimum distributions do not need to begin until the spouse's own age 701/2, and the spouse can name a new beneficiary for the IRA. This greatly helps with minimum distribution planning because the plan benefit can, in effect be spread over three life expectances; for example, husband, wife, and child. See Appendix J.

7. A nonspouse beneficiary cannot roll a qualified plan benefit over to the nonspouse beneficiary's own IRA at the participant spouse's death. However, the nonspouse beneficiary can roll a qualified plan benefit to an IRA in the name of the decedent. This can help with financial planning, but it does not change the minimum distribution requirements for the decedent's plan benefit.

8. Beginning in 2008, direct rollovers (conversions) to Roth IRAs are permitted from qualified plans, Section 403(b) tax deferred annuity plans, and eligible Section 457 governmental plans. See Chapter 6 ("Roth IRAs") for more information.

Alternatives to Rollovers

In cases where a rollover IRA is an alternative to leaving the money in the existing qualified plan, it may be better-or no worse-to leave the money in the plan if the participant is satisfied with the qualified plan's investment performance and the payout options available under that plan meet the participant's needs.

Results similar to a rollover IRA can be achieved if the qualified plan distributes an annuity contract to a participant in lieu of a cash distribution. The annuity contract does not have to meet the requirements of an IRA, but the tax implications and distribution restrictions are generally similar.


1. Tax Facts on Insurance & Employee Benefits, National Underwriter Co., Cincinnati, OH; revised annually.

2. IRS Publications 575, Pension and Annuity Income, and 590, Individual Retirement Arrangements, available from local IRS offices.


(1.) IRC Section 401(a)(11).

(2.) IRC Section 417(c)(1).

(3.) IRC Section 417(c)(2).

(4.) IRC Section 417(a).

(5.) IRC Section 417(a)(3)(B).

(6.) IRC Section 417(a)(6)(B).

(7.) IRC Section 417(a)(2)(A).

(8.) IRC Section 417(b).

(9.) Treas. Reg. [section]1.401(a)-11(b)(2). See also Treas. Reg. [section]1.401(a)11(g).

(10.) IRC Section 417(a)(2).

(11.) IRC Section 417(a)(6)(A).

(12.) IRC Section 417(a)(3)(A).

(13.) IRC Section 417(a)(2)(A).

(14.) IRC Section 411(d)(6)(B)(ii); Treas. Reg. [section]1.411(d)(4), Q&A 1, Q&A 2. This "anti-cutback" rule was eased somewhat for plan years beginning after 2001. IRC Section 411(d)(6). However, all provisions of EGTRRA 2001 are scheduled to sunset, or expire, after December 31, 2010.

(15.) IRC Section 401(a)(31).

(16.) IRC Section 402(f). The notice must include an explanation of the tax consequences and any restrictions on distributions from the eligible plan receiving the distribution that are different from those applicable to the distributing plan. IRC Section 402(f)(1) (E).

(17.) IRC Section 401(a)(11)(B)(iii).

(18.) IRC Section 72(f); Regs. [section][section]1.72-8, 1.72-16(b)(4), 1.402(a)-1(a)(6), 1.403(a)-2; Rev. Rul. 72-149, 1972-1 CB 218.

(19.) The IRS has stated that it will accept "Table 2001" rates generally for determining the value of life insurance protection after 2001. See Notice 2002-8, 2002-4 IRB 398. For details, see Chapter 13. Table 2001 rates replaced P.S. 58 rates as the proper measure of life insurance protection.

(20.) IRC Section 72(e)(8).

(21.) IRC Section 72(e)(8)(D).

(22.) IRC Section 3405(c)(1).

(23.) IRC Section 72(d)(1). This provision is effective for annuity starting dates (i.e., the first date for which an amount is payable) after 1997.

(24.) IRC Section 72(d)(1)(E). It would appear that for an annuitant who is 75 or older and whose contract provides for 5 or more years of guaranteed payments, the rules for annuities with a starting date after July 1, 1986 and before November 19, 1996 would be applied.

(25.) IRC Section 72(d)(1)(D).

(26.) IRC Section 72(b)(2).

(27.) IRC Section 72(b)(3).

(28.) See IRC Sections 402(a), 72, 403(a); Treas. Reg. [section]1.72-4(a).

(29.) Tax Reform Act of 1986, Section 1122(h).

(30.) Tax Reform Act of 1986, Section 1122(h)(5).

(31.) Treas. Reg. [section]1.72-16(c)(4).

(32.) Notice 2002-8, 2002-4 IRB 398.

(33.) Rev. Rul. 55-747, 1955-2 CB 228.

(34.) IRC Section 2010(c).

(35.) IRC Sections 2001(c), 2010(a), 2505(a), 6018(a).

(36.) IRC Section 4975(d)(1). Loans from Section 403(b) tax deferred annuity plans are subject to the prohibited transactions rules and penalties if the plan is subject to ERISA. ERISA Sections 408(b), 502(i); Labor Reg. [section]2550.408b-1.

(37.) IRC Section 4975(f)(6)(iii). A similar provision was added to ERISA. For years prior to 2002, such loans were prohibited transactions, subject to penalties. IRC Section 4975(f)(6), prior to amendment by EGTRRA 2001.

(38.) IRC Section 72(p)(2). However, additional security may be required in order to insure that such a loan meets the "adequate security" requirement. See Labor Reg. [section]2550.408b-1(f)(2).

(39.) IRC Section 72(p)(3).

(40.) IRC Section 401(a)(13).

(41.) IRC Section 414(p)(3).

(42.) IRC Section 72(t).

(43.) IRC Section 1400Q(a)(1); Notice 2005-92, 2005-51 IRB 1165.

(44.) IRC Section 72(t)(4).

(45.) Rev. Rul. 2002-62, 2002-42 IRB 710, modifying Notice 89-25, 1989-1 CB 662, A-12.

(46.) A minimum distribution is required for the year in which the participant attains age 701/2 or retires, even if the actual distribution is deferred until April 1 of the following year. However, all other minimum distributions must be made during the year to which they apply. So, for example, an individual who attains age 701/2 in 2004 and defers the initial minimum distribution to April 1, 2005 must receive two minimum distributions during 2005: the deferred 2004 distribution, and the 2005 distribution.

(47.) As defined in the top-heavy rules; see IRC Sections 401(a)(9), 403(b)(10), 408(a)(6), 408(b)(3), and 457(d)(2).

(48.) IRC Section 4974.

(49.) See TD 8987, 67 Fed. Reg. 18988 (4-17-02).

(50.) See Treas. Reg. [section]1.401(a)(9)-9, A-2. The rules described here are effective for distributions for calendar years beginning after 2002. Treas. Reg. [section]1.401(a)(9)-1, A-2. Distributions for 2002 could be made under the 2001 proposed regulations, the 2002 final regulations or earlier 1987 proposed regulations. The 1987 proposed regulations, in effect for years before 2001, were considerably more complicated.

(51.) Worker, Retiree, and Employer Recovery Act of 2008, Sec. 201; IRC Section 401(a)(9)(H).

(52.) See Treas. Reg. [section]1.401(a)(9)-5, A-4. This joint life expectancy is determined from the Joint and Last Survivor Life Expectancy Table set forth in the final regulations at Treas. Reg. [section]1.401(a) (9)-9, A-3.

(53.) IRC Section 402(c)(8)(B).

(54.) IRC Section 408(d)(3)(G).

(55.) IRC Section 402(c)(4)(C). Prior to 2002 only hardship distributions from Section 401(k) plans and Section 403(b) plans were prohibited from receiving rollover treatment. EGTRRA 2001 broadened this limitation to include hardship distributions from any eligible retirement plan.

(56.) Treas. Reg. [section]1.401(a)(31)-1, A-3.

(57.) IRC Section 3405(c)(1).

(58.) IRC Sections 402(c)(3), 408(d)(3)(I). Prior to amendments by EGTRRA 2001, there was no legislative basis for waiving the 60-day rule for pre-2002 distributions, even where the delays were the result of erroneous advice or the inaction of third parties.

Assumptions: plan participant aged 65, spouse aged 62, lump
sum equivalent at age 65 of $200,000

Form of annuity                  Monthly benefit

Life                                $1,818
Life--10 years certain               1,710
Life--20 years certain               1,560
Joint and survivor--50%              1,696
Joint and survivor--66 2/3%          1,626
Joint and survivor--100%             1,504

Figure 8.1


Age of     Distribution
Employee      Period

70             27.4
71             26.5
72             25.6
73             24.7
74             23.8
75             22.9
76             22.0
77             21.2
78             20.3
79             19.5
80             18.7
81             17.9
82             17.1
83             16.3
84             15.5
85             14.8
86             14.1
87             13.4
88             12.7
89             12.0
90             11.4
91             10.8
92             10.2
93              9.6
94              9.1
95              8.6
96              8.1
97              7.6
98              7.1
99              6.7
100             6.3
101             5.9
102             5.5
103             5.2
104             4.9
105             4.5
106             4.2
107             3.9
108             3.7
109             3.4
110             3.1
111             2.9
112             2.6
113             2.4
114             2.1
115             1.9
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Title Annotation:ERISA and Tax Rules for Qualified Plans
Publication:Tools & Techniques of Employee Benefit and Retirement Planning, 11th ed.
Date:Jan 1, 2009
Previous Article:Chapter 7: qualified plans: general rules for qualification.
Next Article:Chapter 9: estate and retirement planning with qualified plans and IRAs.

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