Planning with Retirement Benefits

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. 

Summary

As 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.

Distribution of Plan Assets to the Participant

How are plan benefits distributed after retirement?

Generally, participants are provided with distribution forms on the participant's "normal retirement date," as defined in the controlling plan document.  Although optional forms of distribution might be offered, if the plan is a defined benefit plan (such as a traditional pension plan), then the normal form of benefit is usually a life annuity for a single participant and a joint and survivor annuity if the participant is married.  If the plan is a defined contribution plan (such as a 401(k) plan or a profit sharing plan), then the normal form of benefit generally is a single distribution of the entire account balance which can be transferred (or "rolled") into an IRA within 60 days after the distribution.  These elections are irrevocable, and these options should be discussed as part of the retirement planning sessions before any decision are made by the participant.

How are required minimum distributions (RMDs) determined?

In most cases, the RMD is determined using the uniform lifetime table contained in Treasury Department Regulations.  (RMD regulations appear in the Code of Federal Regulations ("C.F.R."), beginning at 26 C.F.R. section 1.401(a)(9).)  The uniform lifetime table is based on the joint life expectancy of the participant and a beneficiary 10 years younger than the participant.  However, if the participant named a spouse as the sole beneficiary and the spouse is more than 10 years younger than the participant, the actual joint life expectancy of the participant and the participant's spouse, calculated each year, is used. 

Summary

As previously mentioned, participants generally should not withdraw plan contributions before reaching age 59-1/2 to avoid the 10% tax penalty.  Participants, however, should withdraw required minimum distributions after reaching the required beginning date to avoid the 50% tax penalty.

Distribution of Plan Assets After the Participant's Death

How are plan benefits distributed after a participant's death?

Upon a participant's death, plan assets are distributed to the participant's beneficiaries in accordance with the participant's written beneficiary designation submitted to the plan or IRA.  For RMD purposes, the participant's designated beneficiary is especially important as the RMD rules change depending on the beneficiary's identity and the participant's date of death.

Who is considered a "designated beneficiary" under the RMD rules?

A designated beneficiary is the individual designated as the beneficiary under the participant's plan.  Plans generally permit participants to file formal designations specifying particular persons as beneficiaries, although a participant need not file a formal designation for RMD purposes as long as the official plan document identifies a beneficiary in the absence of the participant's affirmative designation (e.g., the participant's spouse).

Can a participant list a trust or an estate as designated beneficiary?

A participant's estate generally will not be considered as a designated beneficiary under the RMD rules.  A trust, however, can be named as a designated beneficiary only if drafted and communicated in accordance with the strict provisions in the Treasury Regulations.  If a trust complies with the RMD rules for trusts, the trust beneficiaries generally become eligible to receive the participant's benefit after death.

Are there any special distribution options for designated beneficiaries who are spouses?    

If the participant's spouse is the sole designated beneficiary, the spouse can roll over the plan benefit to a new IRA, giving the spouse the ability to use the spouse's own life expectancy and name a new designated beneficiary, thereby achieving even greater deferral.  If the participant died before the participant's RBD (and the participant's spouse is the sole designated beneficiary), the spouse also may be able to delay the start of RMDs until the later of (i) the end of the year after the year that the participant died or (ii) the end of the year that the participant would have reached age 70-1/2.

What are the distribution options for designated beneficiaries who are not spouses?

If the participant's sole designated beneficiary is not the participant's spouse, the distribution options will depend on whether the participant dies before or after the RBD.  Assuming the beneficiary is a designated beneficiary, the beneficiary can withdraw the plan benefit over the beneficiary's life expectancy if the participant dies before the RBD.  If the participant dies after the RBD, the designated beneficiary must withdraw the plan benefit over the longer of (i) the beneficiary's life expectancy or (ii) the deceased participant's remaining life expectancy.  As an alternative to these two, new tax rules allow non-spouse beneficiaries to roll over a deceased participant's plan benefit to an IRA.  Note, however, that if a designated beneficiary fails to take the RMD by December 31 of the year after the year the participant dies, the tax rules require the designated beneficiary to receive a total distribution of the participant's entire plan benefit within 5 years after the participant's death.

What happens if the participant does not have a designated beneficiary?

If the participant dies before the RBD and the participant does not have a beneficiary or the beneficiary is not a "designated beneficiary" (for example, an estate), the tax rules require a total distribution of the participant's entire plan benefit within 5 years after the participant's death.  If the participant dies after the RBD, the beneficiary must withdraw the plan benefit over the participant's remaining life expectancy.  IRS and Department of Labor rules generally require plans to make diligent efforts to locate missing participants and plan beneficiaries. 

Summary

The naming of a designated beneficiary is a complicated procedure.  Different plans will require different processes, and different estate planning clients normally require different advice.  You should consult a competent estate planning attorney for additional details.

Estate Tax Considerations

In addition to the income tax concerns described above, a participant's assets in a plan generally are included in the participant's estate when the participant dies and will be used to determine estate tax liability.  The plan assets could be subject to federal and state estate taxes, unless the participant's beneficiary is the participant's spouse or a charity (so that the marital or charitable deduction applies.  If assets are withdrawn from the plan to pay this tax, the plan withdrawal generally will generate income tax liability on top of the estate tax liability.

Planning Considerations

You should consult a competent tax accountant or tax attorney for tax and estate planning advice.  Considering the information above, following are some items that may be helpful to review with your tax and estate planning advisor(s):

  • Beneficiary Designation Form Governs

Participants routinely (and wrongly) assume that their wills govern the distribution of plan assets.  Plan assets are distributed to the beneficiary named on the applicable plan form, or according to the default method specified in the plan document, regardless of the provisions in a participant's will.  Be sure to review your beneficiary designations, at least annually, or when there is a major life event (such as the death of a spouse).  Note, however, that a qualified domestic relations order (QDRO) may prohibit changing the beneficiary for your plan account.  Consult your advisor for additional details concerning this.

  • Always Name a Designated Beneficiary

As noted above, without a designated beneficiary, the ability to defer withdrawals from a plan by beneficiaries may be limited.

  • Review the Plan Periodically, and Always Just Before the Required Beginning Date

As previously mentioned, the beneficiary designation should be reviewed at regular intervals, and after a major life event such as divorce or a death in the family.

  • Advanced Planning

If a participant has a large plan account balance or a complicated estate plan that involves, for example, distributing plan assets to trusts for minor children or partially to charity and partially to children, the participant should consider working with an expert in this area to obtain the best tax planning advice.



Disclaimer

The materials on this website are provided for informational purposes only, do not constitute legal advice, and do not necessarily reflect the opinions or views of the American Bar Association, the Section of Real Property, Trust and Estate Law or any member of the Section. Transmission of the information is not intended to create, and receipt does not constitute, an attorney-client relationship between any attorney and any other person, group or entity. No representations or warranties whatsoever, express or implied, are given as to the accuracy or applicability of the information contained herein. No one should rely upon the information contained herein as constituting legal advice. The information may be modified or rendered incorrect by future legislative or judicial developments and may not be applicable to any individual reader’s facts and circumstances.

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