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 2 of the treatise 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 2 of the treatise 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 2 of the treatise 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 2 and
10 of the treatise 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
2 and 4 of the treatise, 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 2 of the treatise 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 2 and 4 of the treatise 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 2 of the treatise
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.)
Distributions Must Comply with Qualified Plan Documents Despite Other Conflicting Claims.
– The U.S. Supreme Court has held that a plan must make distributions in strict conformity with
plan documents, even though the plan is presented with conflicting claims attributable to divorce
proceedings. In this case, a former spouse of the deceased participant in the plan had
disclaimed her interest in the plan as a part of divorce proceedings. The plan nevertheless paid
the benefits to the former spouse rather than to the participant’s estate since the deceased
participant had failed to remove the former spouse as the named beneficiary. The Court upheld
the plan’s payment as being in conformity with the plan documents – further noting that the
spouse’s disclaimer did not conform to the requirements of this particular plan.
However, the Court went on to find that the spouse’s disclaimer was not automatically invalid as
a matter of federal statutory or common law, even though the disclaimer could not control the plan’
s payment of benefits. That is, the Court pointedly stated that it was not deciding whether the
estate could subsequently bring an action in state or federal court against the former spouse to
recover the plan benefits after they were distributed. (Kennedy v. Plan Adm’r for DuPont Sav. &
Inv. Plan, 129 S. Ct. 865, 172 L. Ed. 2d 662 (2009).) See Chapter 2 of the treatise for the tax
treatment of distributions from qualified plans.
Election to Diversify Out of Employer Securities. – A retiree or beneficiary with an interest in a
defined contribution plan generally may elect to diversify out of employer securities and into
certain other investment options. However, the election is generally not available for plans of
employers that have not issued any publicly traded stock. Nor is the election generally available
for ESOPs or for plans that hold securities indirectly through regulated investment companies,
common trust funds, or pooled investment funds. Finally, the election is not available for certain
plans with a single participant. (Prop. Reg. Sec. 1.401(a)(35)-1.) See Chapter 2 of the treatise for
an explanation of the tax treatment of employer securities distributed by a qualified retirement
plan.
No Constructive Trusts for Attorneys Fees. – A qualified retirement plan generally may not
allow transfers of benefits to a person other than the retiree or a beneficiary. For example,
attorneys who recover plan benefits for plan participants may not assert constructive trusts or
common fund doctrines to collect their fees from the plan (rather than from the participants).
Similarly, a court generally cannot impose constructive trusts or set-offs for awards of attorney’s
fees to plan trustees. (Kickham Hanley P.C. v. Kodak Ret. Income Plan, 558 F.3d 204 (2d Cir.
2009); Martorana v. Board of Trs. of Steamfitters Local Union 420 Health, Welfare & Pension
Fund, 404 F.3d 797 (3rd Cir. 2005).) See Chapter 2 of the treatise for a discussion of the
prohibition of most assignments or transfers of qualified plan interests.
No Acceleration of Benefits for an IRS Levy. – Under an exception to the general prohibition of
assignments and transfers of plan interests, the IRS may levy on the present right to future
benefits under a qualified retirement plan. However, such an IRS levy cannot force a retiree to
take distributions of benefits before they are due. (Ltr. Rul. 200819001.) See Chapter 2 of the
treatise for a discussion of the prohibition of most assignments or transfers of plan interests.
Restitution under the Mandatory Victims Restitution Act. – Under the Mandatory Victims
Restitution Act, a court may require a criminal defendant to pay restitution from his or her qualified
retirement plan or IRA despite the general prohibition on assignments and transfers. (United
States v. Hosking, 567 F.3d 329 (7th Cir. 2009); United States v. Novak, 476 F.3d 1041 (9th Cir.
2007).)
Transfers from Qualified Retirement Plans to Foreign Plans – Transfers of amounts from U.S.
qualified retirement plans to nonqualified foreign plans are taxable to the affected participants.
However, the IRS has provided some relief for transfers prior to October 1, 2008 (or prior to
January 1, 2011 for transfers to certain Puerto Rican plans). (Rev. Rul. 2008-40, 2008-2 C.B.
166.) See Chapter 19 of the treatise for a discussion of the taxation of retirement benefits
received by foreign retirees.
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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 2 of the treatise 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 2 of the treatise 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 2 of the treatise 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 2 and
10 of the treatise 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
2 and 4 of the treatise, 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 2 of the treatise 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 2 and 4 of the treatise 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 2 of the treatise
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.)
Distributions Must Comply with Qualified Plan Documents Despite Other Conflicting Claims.
– The U.S. Supreme Court has held that a plan must make distributions in strict conformity with
plan documents, even though the plan is presented with conflicting claims attributable to divorce
proceedings. In this case, a former spouse of the deceased participant in the plan had
disclaimed her interest in the plan as a part of divorce proceedings. The plan nevertheless paid
the benefits to the former spouse rather than to the participant’s estate since the deceased
participant had failed to remove the former spouse as the named beneficiary. The Court upheld
the plan’s payment as being in conformity with the plan documents – further noting that the
spouse’s disclaimer did not conform to the requirements of this particular plan.
However, the Court went on to find that the spouse’s disclaimer was not automatically invalid as
a matter of federal statutory or common law, even though the disclaimer could not control the plan’
s payment of benefits. That is, the Court pointedly stated that it was not deciding whether the
estate could subsequently bring an action in state or federal court against the former spouse to
recover the plan benefits after they were distributed. (Kennedy v. Plan Adm’r for DuPont Sav. &
Inv. Plan, 129 S. Ct. 865, 172 L. Ed. 2d 662 (2009).) See Chapter 2 of the treatise for the tax
treatment of distributions from qualified plans.
Election to Diversify Out of Employer Securities. – A retiree or beneficiary with an interest in a
defined contribution plan generally may elect to diversify out of employer securities and into
certain other investment options. However, the election is generally not available for plans of
employers that have not issued any publicly traded stock. Nor is the election generally available
for ESOPs or for plans that hold securities indirectly through regulated investment companies,
common trust funds, or pooled investment funds. Finally, the election is not available for certain
plans with a single participant. (Prop. Reg. Sec. 1.401(a)(35)-1.) See Chapter 2 of the treatise for
an explanation of the tax treatment of employer securities distributed by a qualified retirement
plan.
No Constructive Trusts for Attorneys Fees. – A qualified retirement plan generally may not
allow transfers of benefits to a person other than the retiree or a beneficiary. For example,
attorneys who recover plan benefits for plan participants may not assert constructive trusts or
common fund doctrines to collect their fees from the plan (rather than from the participants).
Similarly, a court generally cannot impose constructive trusts or set-offs for awards of attorney’s
fees to plan trustees. (Kickham Hanley P.C. v. Kodak Ret. Income Plan, 558 F.3d 204 (2d Cir.
2009); Martorana v. Board of Trs. of Steamfitters Local Union 420 Health, Welfare & Pension
Fund, 404 F.3d 797 (3rd Cir. 2005).) See Chapter 2 of the treatise for a discussion of the
prohibition of most assignments or transfers of qualified plan interests.
No Acceleration of Benefits for an IRS Levy. – Under an exception to the general prohibition of
assignments and transfers of plan interests, the IRS may levy on the present right to future
benefits under a qualified retirement plan. However, such an IRS levy cannot force a retiree to
take distributions of benefits before they are due. (Ltr. Rul. 200819001.) See Chapter 2 of the
treatise for a discussion of the prohibition of most assignments or transfers of plan interests.
Restitution under the Mandatory Victims Restitution Act. – Under the Mandatory Victims
Restitution Act, a court may require a criminal defendant to pay restitution from his or her qualified
retirement plan or IRA despite the general prohibition on assignments and transfers. (United
States v. Hosking, 567 F.3d 329 (7th Cir. 2009); United States v. Novak, 476 F.3d 1041 (9th Cir.
2007).)
Transfers from Qualified Retirement Plans to Foreign Plans – Transfers of amounts from U.S.
qualified retirement plans to nonqualified foreign plans are taxable to the affected participants.
However, the IRS has provided some relief for transfers prior to October 1, 2008 (or prior to
January 1, 2011 for transfers to certain Puerto Rican plans). (Rev. Rul. 2008-40, 2008-2 C.B.
166.) See Chapter 19 of the treatise for a discussion of the taxation of retirement benefits
received by foreign retirees.
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| Copyright © 2005-2009 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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