Planning Retirement Distributions for Qualified Plans

1. Planning Retirement Distributions for Qualified Plans • complex rules • distinct federal income tax treatment • use careful planning to avoid adverse tax consequences

2. Helpful to consider questions: • What distributions does plan allow? • 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?

3. Helpful to consider questions (cont’d): • If lump sum payment is chosen • eligible for 10 yr. averaging? • if so, is election beneficial? • how much tax payable? • What are the estate planning consequences of payment choice?

4. 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

5. Plan Provisions:Required Spousal Benefits Two forms: • Qualified Pre-retirement Survivor Annuity [QPSA] • Qualified Joint and Survivor Annuity [QJSA]

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. Other Benefit Options forDefined Benefit Plans Automatic options joint and survivor annuity (if married) life annuity (if single) Options period certain annuity – 10 or 20 years joint annuity with someone other than spouse

14. Other Benefit Options forDefined Contribution Plans Money purchase plans, target benefit plans, Section 403(b) tax deferred annuity plans subject to ERISA mustmeet 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

15. Other Benefit Options forDefined Contribution Plans • If purchase an annuity, the joint and survivor options apply • Lump sum distribution • Non-annuity distributions

16. 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

17. 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

18. 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

19. In-service (partial) distributions Partial distributions containing both nontaxable and taxable amounts are taxed as: Nontaxable amount = distribution xemployee’s cost basis total account balance ‘Grandfather’ rule for pre-1987 after-tax contributions to the plan

20. 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

21. Total distributions if begin annuity payments based on entire account balance Nontaxable amount = distribution xemployee’s cost basis total annuity payments expect to receive

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

31. 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

32. Loans • are made according to specific provisions in plan • must bear reasonable rates of interest • are adequately secured

33. 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)

34. 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

35. 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

36. 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

37. 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

38. 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

39. 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

40. 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

41. 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

42. Retirement Plan RolloversTax Treatment of Rollovers • 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

43. Retirement Plan RolloversTax Treatment of Rollovers • If do not use direct rollover and fail to roll over in 60 days, distribution subject to income tax • Distribution from rollover IRA not eligible for forward averaging • Distribution rules for rollover IRA same as for traditional IRA; early distributions subject to 10% early withdrawal penalty

44. Retirement Plan RolloversTax Treatment of Rollovers • Loans not permitted • If participant dies before withdrawing all from rollover IRA, death benefit subject to estate tax • Use of separate ‘conduit IRA’ to hold qualified plan funds for transfer from one qualified plan to another no longer necessary

45. Retirement Plan RolloversAlternatives to Rollovers Leave $ in existing qualified plan Select an annuity payout if available

46. True or False? • A profit sharing plan must have a qualified joint and survivor annuity. • 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. • The entire value of a qualified death benefit is always excluded from the decedent’s gross estate for federal income tax purposes.

47. True or False? • 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. • A participant’s plan benefits cannot be part of the negotiable assets in domestic disputes. • A plan distribution made at age 60 is subject to a 10% penalty for early withdrawal because it was made before age 65.

48. True or False? • A direct rollover is a rollover distribution that is paid directly to another eligible retirement plan for the benefit of the distributee. • A direct rollover must be completed within 90 days. • A hardship distribution from a qualified plan is eligible for a rollover. • Loans from a rollover IRA are prohibited.

49. 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?