Any financial advisor working with retirees will invariably be asked about pension distributions. The questions could be about choosing a distribution option, the tax treatment of distributions, rollovers, or the minimum distribution rules. Here is a checklist of key questions to ask each time you advise a participant about taking a distribution from a plan. If you follow this structure, you'll be sure not to miss any major tax issues.
1. What type of plan is the distribution coming from?
Interestingly, the participants aren't always sure. Ask to see a summary plan description, plan document, distribution option form, or, at least, a 1099R form to get the right information. The tax treatment of distributions from qualified plans (i.e., profit sharing, 401(k)s, defined benefit, money purchase, stock bonus, ESOPs [employee stock option plan], cash balance, and target benefit plans) as well as SEPs (simplified employee pensions), SIMPLEs (savings incentive match plan for employees), 403(b), 457 government plans, and IRAs are pretty similar to one another. In many cases, the entire distribution is included as ordinary income for federal income tax purposes. (Note that for state tax purposes there are some variations. This article will focus only on the federal tax implications.)
However, there are just enough differences in the tax treatment of distributions from these plans that it is crucial to identify the type of plan involved. For example, if the distribution is a lump sum distribution from a qualified plan, then special tax rules may apply (see questions 6 and 7). Differences also apply to the application of the exceptions to the Sec. 72(t) early withdrawal 10 percent excise tax (question 2), the method of recovering cost basis (question 3), and income tax withholding (question 5).
The more serious issue is that the plan may not fall within one of these categories, in which case the tax treatment could be quite different. For example, Roth IRA distributions may be entirely tax-free, and certain types of nonqualified deferred compensation or special executive bonus plans like stock option programs work quite differently.
2. Is the benefit payable to an individual who has not attained age 59-1/2?
All tax-advantaged retirement plans are subject to the Sec. 72(t) 10 percent early withdrawal penalty tax. Any distribution to an individual who has not yet attained age 59-1/2 is subject to the tax unless one of the specific exceptions apply. Be very careful here; not all exceptions apply to all types of plans. For example, college education expenses for a family member is an exception that applies to IRAs (including SEPs and SIMPLEs) but does not apply to withdrawals from a qualified plan like a 401(k).
3. Is a portion of the distribution attributable to amounts that have already been taxed?
Although most distributions do not contain amounts that have already been taxed, after-tax employee contributions in a qualified plan, income associated with a life insurance policy, and nondeductible contributions to an IRA are treated as cost basis and will not be taxed twice. Form 1099R, which is provided to the recipient with a distribution, will communicate that amount. The methodology for recovering the cost basis is complicated and depends on the type of plan and the source of the cost basis involved.
4. Is the distribution going to the plan participant or to a beneficiary?
You don't want to make the assumption that the individual withdrawing benefits is the initial plan participant. We will be seeing more and more inherited IRAs as baby boomers age. The reason that the distinction is important is that the recipient of a death benefit may receive a tax break. Distributions are still subject to income tax, but if the decedent's estate paid estate taxes on the value of the pension, the death beneficiary is entitled to a corresponding deduction on any withdrawal.
5. What is the appropriate amount of the distribution to withhold for federal income taxes?
Qualified plans, 403(b) annuities, and 457 government plans are required to withhold 20 percent of the distribution in most cases. Participants sometimes think this is the actual tax rate, but it is simply required withholding. Distributions from IRAs, SEPs, and SIMPLEs are not subject to mandatory withholding, but the participant should consider doing so anyway to avoid withholding penalties at the end of the year.
6. If the distribution is from a qualified plan, is it payable as a lump sum to an individual born before 1936?
An individual born before 1936 receiving a lump sum distribution from a qualified plan may be entitled to a special tax rate under a grandfathered tax rule referred to as 10-year averaging. A lump sum is the receipt of the balance to the participant's credit in one tax year. Because individuals born before 1936 are now age 70 or older, the grandfathered tax rule does not apply in many cases. Still if you have an older participant receiving a lump-sum that is under $300,000, the tax rate could be quite attractive.
7. If the distribution is from a qualified plan, is some or all of the distribution attributable to stock of the sponsoring entity?
Profit sharing, stock bonus, and ESOPs often have employer stock accounts. If a participant takes a lump sum distribution that includes any employer stock (in kind), a special tax rule may allow the deferral of the recognition of what is referred to as the "net unrealized appreciation at the time of the distribution." The rule may provide a valuable benefit if the stock has been held by the participant for a long time and the stock has appreciated significantly in value. The net unrealized appreciation is not taxed until the stock is sold and the nature of the unrealized appreciation is long-term capital gains and not ordinary income.
Advising a client about the tax treatment of a pension distribution is quite simple, but the exceptions can be complex. This is compounded by the fact that the exceptions, if they do apply, can have a significant impact on an individual's tax situation. Ensure that you uncover all of the potential pitfalls by asking all of the relevant questions.
David A. Littell, JD is the Joseph E. Boettner research chair and a professor of taxation at The American College. Professor Littell is responsible for the academic content of the college's new Chartered Advisor for Senior Living(TM) (CASL(TM)) designation program. For more information, visit www.theamericancollege.edu or call 888-263-7265.
