Employer Retirement Plans
Favorable Tax Treatment for Lump Sum Received Soon after Start of Pension. – A lump sum
distribution received from a qualified retirement plan after the commencement of annuity
(pension) payments is generally fully taxable. However, if the lump sum is received before, or “in
connection with,” the commencement of the annuity payments, it is nontaxable to the extent it
represents a recovery of the retiree’s contributions or other investment in the plan. In a favorable
letter ruling, the IRS treated a retiree’s lump sum distribution as received “in connection with”
the commencement of annuity payments – even though the retiree actually received the lump
sum 90 days later. (Ltr. Rul. 200419037.) See Chapter 3 of the Guide for a discussion of lump
sum distributions from qualified retirement plans.
Government Garnishments of Qualified Retirement Plan Benefits Are Limited. – The U.S.
Government may garnish benefits in a qualified retirement plan (1) to collect a fine imposed on
the participant or (2) to collect criminal restitution for itself or third parties. However, the federal
government may not collect fines or restitution any sooner (or in any greater amounts) than the
distributions the participant could obtain under the plan. Nor is the 10 percent penalty tax on
early distributions applicable to the collection of the fines or restitution. (Ltr. Rul. 200426027.)
See Chapter 3 of the Guide for a discussion of the restrictions on payments by qualified
retirement plans.
Some Plan Distribution Restrictions Not Applicable to Rolled-Over Amounts. – A qualified
retirement plan may make distributions from amounts rolled over to it from another plan or IRA
without regard to the plan's usual restrictions on early distributions – provided the plan
separately accounts for the rolled-over amounts. However, these distributions may be subject to
other requirements imposed on the recipient plan, such as (i) its spousal annuity requirements,
(ii) the 10 percent penalty tax on certain plan distributions, or (iii) the plan's minimum
distribution requirements. (Rev. Rul. 2004-12, 2004-7 I.R.B. 478.) Specifically, for example, the
minimum distribution requirements of the recipient plan replace any such requirements
previously applicable to the rolled-over amounts – for years following the rollover. (Ltr. Rul.
200453026.) See Chapter 3 of the Guide for a discussions of distributions by qualified
retirement plans.
Taxable Value of Life Insurance Distributed by an Employer Retirement Plan. – If an
employer retirement plan distributes a life insurance policy to a retiree, the retiree must
ordinarily pay tax on the policy's “fair market value." Unfortunately, the fair market value of the
policy or contract may be more than its cash value because of the pure insurance element
involved, or because of other features. Consequently, the retiree may need to use one of several
complicated alternative methods to determine fair market value – methods that will likely require
the help of the retiree's insurance company or tax advisor. (Rev. Proc. 2005-25, 2005-17 I.R.B.
___.) See Chapters 3 and 11 of the Guide for a discussion of life insurance provided by
employer retirement plans.
Protection from Bankruptcy for Funds in Retirement Plans. – An individual taxpayer’s funds in
qualified retirement plans are generally exempt from forfeiture in bankruptcy proceedings. The
exemption also extends to tax sheltered annuities and eligible governmental plans. (Bankruptcy
Abuse Prevention and Consumer Protection Act of 2005, Pub. L. No. 109-8, § 224.) See
Chapters 3 and 5 of the Guide, generally, for discussions of the taxation of funds in qualified or
eligible plans.
Rollover Allowed for Amount of Plan Funds Used to Offset Plan Loan. – The tax law allows
qualified retirement plans to make certain types of loans to employees. If an employee/retiree
defaults on the loan payments, the plan may then use his or her plan funds to offset the loan
balance. The plan and the employee/retiree must treat this loan offset as a plan distribution.
However, in a private letter ruling, the IRS allowed the employee/retiree to roll over the amount of
the offset tax-free to an IRA. (Ltr. Rul. 200617037.) See Chapter 3 of the Guide for a discussion
of plan loans, offsets, and rollovers.
Insurance Premium Payments by Plan Not Taxable to Police, Firefighters, or Emergency
Workers. – After 2006, a disabled or retired “public safety officer” may be able to elect to exclude
from taxable income certain amounts that his or her retirement plan withholds from distributions
to pay insurance premiums. The retirement plan must use the withheld amounts to pay
premiums for accident and health insurance or long-term care insurance covering the officer
and the officer's spouse and dependents. The exclusion is available only for distributions from
“eligible plans.” For this purpose, eligible plans are governmental plans that are qualified
retirement plans, section 403(b) tax sheltered annuities (TSAs), or eligible state and local
government plans.
The withheld amount a retired officer may exclude for a taxable year is limited to the lesser of (1)
$3,000, (2) the amount of the insurance premiums, or (3) the portion of plan funds otherwise
deemed potentially taxable. For this purpose, plan funds are deemed potentially taxable to the
extent (a) total funds of the officer in all the employer’s eligible plans exceed (b) the officer’s total
investment in all those plans. (In no event may the officer derive a second tax benefit from the
withheld and excluded distribution by claiming the related premium payment as a medical
deduction.)
To qualify for the exclusion, a public safety officer must have terminated his or her employment
because of disability or the attainment of normal retirement age. For purposes of this new
provision, the term “public safety officer” includes a law enforcement officer, a firefighter, a public
agency chaplain, or a member of an emergency crew.
See Chapters 3 and 5 of the Guide for a more complete discussion of the taxation of plan
distributions. (Pension Protection Act of 2006, Pub. L. No. 109-280, § 845(a), (b), (c); I.R.C. §§
402(l), 403(a)(2), 403(b)(2), 457(a)(3); Notice 2007-7, 2007-5 I.R.B. __.)
Pension Plan Distributions to Employees Working under Phased Retirement Programs. –
After 2006, the Pension Protection Act will allow qualified pension plans to provide for partial
distributions to employees who are working under phased retirement programs. Phased
retirement programs generally allow employees reaching normal retirement age to (1) reduce
the number of hours they customarily work and (2) receive a pro rata portion of their retirement
benefits based on the reduction in their work schedule.
For this purpose, a qualified pension plan is a qualified plan that (1) provides for payment of
determinable retirement benefits over a determinable period (e.g., for life). Such plans normally
base the amount of benefits on years of service and compensation. See Chapter 3 of the Guide
for a more complete discussion of the taxation of plan distributions. (Pension Protection Act of
2006, Pub. L. No. 109-280, § 905(a), (b), (c); I.R.C. § 401(a)(36); T.D. 9325, 5/22/07.)
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Favorable Tax Treatment for Lump Sum Received Soon after Start of Pension. – A lump sum
distribution received from a qualified retirement plan after the commencement of annuity
(pension) payments is generally fully taxable. However, if the lump sum is received before, or “in
connection with,” the commencement of the annuity payments, it is nontaxable to the extent it
represents a recovery of the retiree’s contributions or other investment in the plan. In a favorable
letter ruling, the IRS treated a retiree’s lump sum distribution as received “in connection with”
the commencement of annuity payments – even though the retiree actually received the lump
sum 90 days later. (Ltr. Rul. 200419037.) See Chapter 3 of the Guide for a discussion of lump
sum distributions from qualified retirement plans.
Government Garnishments of Qualified Retirement Plan Benefits Are Limited. – The U.S.
Government may garnish benefits in a qualified retirement plan (1) to collect a fine imposed on
the participant or (2) to collect criminal restitution for itself or third parties. However, the federal
government may not collect fines or restitution any sooner (or in any greater amounts) than the
distributions the participant could obtain under the plan. Nor is the 10 percent penalty tax on
early distributions applicable to the collection of the fines or restitution. (Ltr. Rul. 200426027.)
See Chapter 3 of the Guide for a discussion of the restrictions on payments by qualified
retirement plans.
Some Plan Distribution Restrictions Not Applicable to Rolled-Over Amounts. – A qualified
retirement plan may make distributions from amounts rolled over to it from another plan or IRA
without regard to the plan's usual restrictions on early distributions – provided the plan
separately accounts for the rolled-over amounts. However, these distributions may be subject to
other requirements imposed on the recipient plan, such as (i) its spousal annuity requirements,
(ii) the 10 percent penalty tax on certain plan distributions, or (iii) the plan's minimum
distribution requirements. (Rev. Rul. 2004-12, 2004-7 I.R.B. 478.) Specifically, for example, the
minimum distribution requirements of the recipient plan replace any such requirements
previously applicable to the rolled-over amounts – for years following the rollover. (Ltr. Rul.
200453026.) See Chapter 3 of the Guide for a discussions of distributions by qualified
retirement plans.
Taxable Value of Life Insurance Distributed by an Employer Retirement Plan. – If an
employer retirement plan distributes a life insurance policy to a retiree, the retiree must
ordinarily pay tax on the policy's “fair market value." Unfortunately, the fair market value of the
policy or contract may be more than its cash value because of the pure insurance element
involved, or because of other features. Consequently, the retiree may need to use one of several
complicated alternative methods to determine fair market value – methods that will likely require
the help of the retiree's insurance company or tax advisor. (Rev. Proc. 2005-25, 2005-17 I.R.B.
___.) See Chapters 3 and 11 of the Guide for a discussion of life insurance provided by
employer retirement plans.
Protection from Bankruptcy for Funds in Retirement Plans. – An individual taxpayer’s funds in
qualified retirement plans are generally exempt from forfeiture in bankruptcy proceedings. The
exemption also extends to tax sheltered annuities and eligible governmental plans. (Bankruptcy
Abuse Prevention and Consumer Protection Act of 2005, Pub. L. No. 109-8, § 224.) See
Chapters 3 and 5 of the Guide, generally, for discussions of the taxation of funds in qualified or
eligible plans.
Rollover Allowed for Amount of Plan Funds Used to Offset Plan Loan. – The tax law allows
qualified retirement plans to make certain types of loans to employees. If an employee/retiree
defaults on the loan payments, the plan may then use his or her plan funds to offset the loan
balance. The plan and the employee/retiree must treat this loan offset as a plan distribution.
However, in a private letter ruling, the IRS allowed the employee/retiree to roll over the amount of
the offset tax-free to an IRA. (Ltr. Rul. 200617037.) See Chapter 3 of the Guide for a discussion
of plan loans, offsets, and rollovers.
Insurance Premium Payments by Plan Not Taxable to Police, Firefighters, or Emergency
Workers. – After 2006, a disabled or retired “public safety officer” may be able to elect to exclude
from taxable income certain amounts that his or her retirement plan withholds from distributions
to pay insurance premiums. The retirement plan must use the withheld amounts to pay
premiums for accident and health insurance or long-term care insurance covering the officer
and the officer's spouse and dependents. The exclusion is available only for distributions from
“eligible plans.” For this purpose, eligible plans are governmental plans that are qualified
retirement plans, section 403(b) tax sheltered annuities (TSAs), or eligible state and local
government plans.
The withheld amount a retired officer may exclude for a taxable year is limited to the lesser of (1)
$3,000, (2) the amount of the insurance premiums, or (3) the portion of plan funds otherwise
deemed potentially taxable. For this purpose, plan funds are deemed potentially taxable to the
extent (a) total funds of the officer in all the employer’s eligible plans exceed (b) the officer’s total
investment in all those plans. (In no event may the officer derive a second tax benefit from the
withheld and excluded distribution by claiming the related premium payment as a medical
deduction.)
To qualify for the exclusion, a public safety officer must have terminated his or her employment
because of disability or the attainment of normal retirement age. For purposes of this new
provision, the term “public safety officer” includes a law enforcement officer, a firefighter, a public
agency chaplain, or a member of an emergency crew.
See Chapters 3 and 5 of the Guide for a more complete discussion of the taxation of plan
distributions. (Pension Protection Act of 2006, Pub. L. No. 109-280, § 845(a), (b), (c); I.R.C. §§
402(l), 403(a)(2), 403(b)(2), 457(a)(3); Notice 2007-7, 2007-5 I.R.B. __.)
Pension Plan Distributions to Employees Working under Phased Retirement Programs. –
After 2006, the Pension Protection Act will allow qualified pension plans to provide for partial
distributions to employees who are working under phased retirement programs. Phased
retirement programs generally allow employees reaching normal retirement age to (1) reduce
the number of hours they customarily work and (2) receive a pro rata portion of their retirement
benefits based on the reduction in their work schedule.
For this purpose, a qualified pension plan is a qualified plan that (1) provides for payment of
determinable retirement benefits over a determinable period (e.g., for life). Such plans normally
base the amount of benefits on years of service and compensation. See Chapter 3 of the Guide
for a more complete discussion of the taxation of plan distributions. (Pension Protection Act of
2006, Pub. L. No. 109-280, § 905(a), (b), (c); I.R.C. § 401(a)(36); T.D. 9325, 5/22/07.)
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| Copyright © 2005-2008 by Vorris J. Blankenship All Rights Reserved |
The author intends that this website provide accurate and authoritative information on the subject matter
covered. However, the information provided on this website is not a substitute for the advice of an attorney,
accountant, or other professional; and the author is not offering legal, accounting, or other professional
advice. The material presented on this website is not intended for use, and may not be used, to avoid tax
penalties. If you need legal advice or other professional help, you should seek (from an independent
attorney, accountant, or other competent professional) advice based on your own particular circumstances.
covered. However, the information provided on this website is not a substitute for the advice of an attorney,
accountant, or other professional; and the author is not offering legal, accounting, or other professional
advice. The material presented on this website is not intended for use, and may not be used, to avoid tax
penalties. If you need legal advice or other professional help, you should seek (from an independent
attorney, accountant, or other competent professional) advice based on your own particular circumstances.
Key Tax Developments Affecting Retirees
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