Planning with Retirement Benefits
More and more people are holding the bulk of their wealth in qualified plans and individual retirement accounts (IRAs). Although most plan participants know that these vehicles provide income tax-free growth for assets held in them, few participants understand the rules for plan distributions. With proper planning, participants can make the most of this income tax benefit and even pass some of that benefit on to their beneficiaries.
Income Taxation of Qualified Plans and IRAs
When are participants taxed on retirement plan contributions?Assets held in qualified plans (“plans”) and IRAs generate no current income tax liability. The distribution of those assets to a participant or a participant’s beneficiaries in a future tax year, however, generally triggers income tax liability at ordinary income tax rates.Is there a penalty for requesting a distribution from the plan before retirement?The IRS imposes a tax penalty on withdrawals made either too soon or not soon enough. For example, if a participant withdraws assets from a plan before reaching age 59-1/2, the participant will be responsible for paying ordinary income tax on the distribution, plus the 10% tax penalty on early distributions (unless a limited exception applies), plus state income tax if the participant lives in a state with an income tax. Are there any options for accessing the plan account balance before retirement?The tax rules allow plans to adopt certain features to allow participants to use their retirement plan account balances before reaching retirement. For example, a Plan may allow participants to request hardship withdrawals in the event of an immediate and heavy financial need. The tax rules also allow plans to make loans available so that participants can borrow against their account balances (up to a certain statutory limit) and make repayments directly to their plan accounts with interest added. Hardship withdrawals are taxed as early distributions, as previously mentioned, but plan loans generally have no income tax consequence unless the loans are not repaid to the plan as agreed. Two other distribution options in the Internal Revenue Code (Code) that a plan may elect to offer participants include are in-service distributions for participants who are age 59-1/2 and disability distributions. Participants should consult their plan administrators, official plan documents, and summary plan descriptions for additional details about whether their plans offer these and other distribution features. What happens if to the retirement plan account balance if a participant moves to a different employer?Plan terms generally govern when distributions may occur for a terminated participant, although the tax rules require tax-qualified retirement plans to permit terminated participants to roll over their vested account balances to an eligible retirement plan, such as another employer’s plan or an individual retirement account (IRA). Direct rollovers from one plan to another plan generally are tax-free rollovers. If a participant elects to receive the rollover check instead of conducting a “direct” rollover to an eligible retirement plan, mandatory 20% withholding normally applies. For small account balances totaling up to $1,000, many plans require participants to accept a lump sum distribution of the entire account balance. For balances between $1,000 and $5,000, most plans include the Code’s automatic IRA rollover rule that requires the plan to roll over the participant’s account balance to IRA established by the plan on behalf of the participant. Plans generally permit participants to retain in the plan any account balance that exceeds $5,000. Again, these distribution rules are plan-specific, so it is important to consult the official plan documents or the summary plan description for additional details about plan offerings.What happens if a participant does not start receiving plan benefits at retirement?More onerous than the early distribution tax penalty is an additional penalty tax imposed if a participant does not begin receiving certain minimum withdrawals, called “required minimum distributions” (“RMDs”), after the “required beginning date” (“RBD”). The tax rules require that participants begin receiving RMDs as of the RBD. The RBD generally is April 1 of the year after the year that the participant reaches age 70-1/2. (Separate RBD rules may apply to participants who remain employed after reaching age 70-1/2 or who are owner-employees.) If a participant elects to delay RMDs until April 1, instead of electing to receive the first RMD in the year that the participant reached age 70-1/2, the participant will be required to accept two RMD payments- one for the year that the participant reached age 70-1/2 and another for the year that includes the April 1 date. In other words, if the participant postpones RMDs until April 1 (generally, the latest date that the participant may postpone RMDs) the participant will be required to accept two RMDs for the first year of retirement. If a participant does not begin receiving RMDs, a 50% tax penalty is imposed on the amount that should have been distributed to the participant on top of the federal income (and, if applicable, state) taxes that ordinarily apply to plan distributions. For good cause, however, the IRS may waive the 50% penalty if the participant follows the guidelines explained in IRS Instructions to Form 5329 (Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts) and submits Form 5329. What happens if a participant receives more than one RMD (i.e., duplicate checks) for the same year?If a participant receives more than one RMD payment, the participant should contact the plan (and/or the plan’s recordkeeper) as soon as possible. Plan rules may allow participants to elect partial withdrawals so that, if desired, the plan may allow the participant to keep the second check. For participants who prefer to redeposit the funds back into the plan, options may be limited if the participant cashes the check. Under all circumstances, however, the participant should contact the plan for additional instructions. SummaryAs you can see, there is a potential tension between a participant who may not want to receive any plan withdrawals even after the RBD and the IRS which monitors the statutorily-mandated withdrawals (i.e., the RMDs). The good news is that, with proper planning, a participant can decrease the size of the RMD and increase the plan’s income tax benefit. Note that RMDs provide a floor, not a ceiling. Participants generally are free to withdraw more than the minimum amount if needed for living and health expenses after retirement.