Tax Planning for Retirees


Qualified Plan Distributions Taxable on Receipt. –The IRS has ruled that a distribution check from a qualified retirement plan is taxable in the year of receipt of the check. It matters not whether the individual keeps the check, sends it back, destroys it, or cashes it in a later tax year. However, this rule does not apply if the recipient could not cash the check in the year received. Nevertheless, the rule has the intended effect of preventing a taxpayer from deliberately deferring taxation of the distribution to the year following the year of receipt. On the good side, the rule also guarantees that an annually required minimum distribution that is received in the correct tax year is also taxed in the correct year even if the taxpayer fails to cash the distribution check until the following year. (Rev. Rul. 2019-19, 2019-36 I.R.B. ___.) See Chapter 2 of the treatise.

Repeal of Recharacterizations of TQR Contributions. –After making a taxable qualified rollover contribution (TQR contribution) to a Roth IRA from a traditional IRA or other plan, a retiree may have second thoughts about the desirability of the transfer. In past years, the retiree could solve this problem by transferring some or all of the contributed funds to a traditional IRA from the Roth IRA that originally received the funds. The tax law then treated the recharacterized amount as retroactively rolled over to the traditional IRA from the originally distributing plan or IRA, in a nontaxable transaction. Unfortunately, the year 2017 was the last year a retiree could make a TQR contribution that was subject to recharacterization. Note that if a retiree wishes to recharacterize a 2017 TQR contribution, he or she must generally do so on or before October 15, 2018. (IRC § 402A(d)(6)(B)(iii); Tax Cuts and Jobs Act, Pub. L. No. 115-97, § 13611(b).) See Chapter 6 of the treatise.

View Joint Committee Statement on “Backdoor” Roth Contributions With Caution. –The Joint Committee on Taxation has acknowledged that a taxpayer may avoid the limitations on contributions to Roth IRAs by making contributions to an IRA and converting the IRA to a Roth IRA (so-called backdoor Roth contributions). The acknowledgement came in footnotes to the committee report for the Tax Cuts and Jobs Act of 2017. Unfortunately though, the committee report did not discuss or rule out application of the substance-over-form doctrine to certain preconceived backdoor plans intended to avoid Roth limits by making a Roth conversion immediately after an IRA contribution. Unfortunately also, statements in a committee report are far from binding on the IRS or the courts. For a detailed discussion of the substance-over-form issue, see here. (Conference Committee Report of the Tax Cuts and Jobs Act (HR 1)—Pub. L. No. 115-466_Individual Tax Reform, E.1, footnotes 268, 269, 276, and 277.)

Extended Rollover Period for Some Loan-Offset Distributions Made by Tax-Favored Plans. –Normally, a retiree has only 60 days after a qualified plan makes a loan-offset distribution (i.e., an offset of a plan loan against plan funds) to roll over the distribution to another plan or IRA. Congress has now provided that a retiree may roll over some such distributions any time before the due date (including extensions) of the tax return for the year of the distribution. This extended rollover period is available only for loan-offset distributions after the year 2017, and only if the distribution is due to termination of the distributing plan or failure to satisfy repayment terms because of severance of the participant’s employment. (IRC § 402(c)(3)(C); Tax Cuts and Jobs Act, Pub. L. No. 115-97, § 13613.) See Chapter 2 and Chapter 4 of the treatise.

Qualified Stock or RSUs Derived from Qualified Equity Grants. – For years after 2017, a participant in a qualified equity plan may elect to defer the tax on the bargain element in “qualified stock.” The qualified stock must be issued to a “qualified employee” pursuant to an equity grant awarded by an “eligible corporation.” Such equity grants consist of either stock options or restricted stock units (RSUs), but not both. If an employee receives qualified stock under such a grant, the employee may be able to defer payment of tax on the bargain element for as long five years after the date of vesting. However, the deferral can end earlier upon the occurrence of certain events. (IRC § 83(i); Tax Cuts and Jobs Act, Pub. L. No. 115-97, § 13603.)

Only an “eligible corporation” may award the qualified equity grants. Among other requirements for eligibility, the corporation must have a written plan that provides grants of stock options or RSUs to at least 80 percent of the corporation’s employees. The IRS has announced that the corporation must grant these options or RSUs during the year of corporate eligibility. That is, the corporation cannot take into account grants in other years for purposes of satisfying the 80 percent rule.

When the deferral period ends, the bargain element becomes subject to income tax withholding at the maximum individual tax rate. The IRS has announced that, to guarantee that the employer can withhold income taxes, the employer must put the deferral stock into an escrow, at least until the bargain element is includable in the employee’s income. The employer may then withdraw from escrow a sufficient number of shares to cover the income tax withholding, to the extent the withholding requirement has not otherwise been satisfied. The employer must then deliver the remaining escrowed shares to the employee. (Notice 2018-97, 2018-52 I.R.B. ___.) See Chapter 11 of the treatise.

The Basic Exclusion Increased for Gift and Estate Tax Purposes. –For years after 2017, Congress has increased the basic exclusion for gift and estate tax purposes from $5,000,000 to $10,000,000. For the estate of an individual dying in 2018, the applicable exclusion (after adjustment for inflation) is $11,200,000. (IRC § 2010(c)(2); Tax Cuts and Jobs Act, Pub. L. No. 115-97, § 11061.) See Chapter 20 of the treatise.

More Liberal Hardship Distributions from 401(k) Plans. –Before 2019, 401(k) plans could make hardship distributions only from elective deferrals. After 2018, a 401(k) plan may also make hardship distributions from qualified nonelective contributions, qualified matching contributions, and plan earnings. Also after 2018, a retiree need not exhaust plan loans before taking a hardship distribution. Note though that hardship distributions may be subject to the 10 percent additional tax on early withdrawals, unless an exception to the additional tax applies to the distribution. (IRC § 401(k)(14).) See Chapter 2 of the treatise.

Self-Certification of Permissible Reasons for Violating the 60-Day Rollover Requirement. – A retiree may be able to give a written certification to an IRA trustee that the he or she has permissible reasons for failing to satisfy the 60-day rollover requirement. The IRA trustee may then accept the rollover contribution despite violation of the 60-day requirement (unless the IRA trustee or plan administrator otherwise knows the rollover is not valid). For this purpose, the IRS has provided a list of permissible reasons for excusing a violation. (Rev. Proc. 2016-47, 2016-37 I.R.B. ___.) See Chapter 5 and Chapter 2 of the treatise.

Lump Sum Election by Members of the U.S. Military Under the Blended Retirement System (BRS). – U.S. military retirees may take part of their monthly retired pay as a taxable lump sum at retirement if they first joined a military branch after December 31, 2017, or if they otherwise opted into the retirement system as it was revised effective January 1, 2018 (the “BRS” system). The retiree may elect (more than 90 days before retirement) to take either a 25 percent or a 50 percent lump sum. The lump sum is calculated as 25 percent or 50 percent of the discounted retired pay otherwise due a member from the date of retirement until age 67. Monthly payments before age 67 are accordingly reduced by 25 percent or 50 percent, but revert to 100 percent at age 67. The lump sum payment is immediately taxable if it is not rolled over to another plan or IRA. (10 USC § 1415; 38 USC § 5304(d).). See Chapter 14 of the treatise for an explanation of the taxation of military retired pay.

Judicial Review of IRS Denials of Waivers of the 60-Day Rollover Rule. The Tax Court has held that IRS denials of waivers of the 60-day rollover requirement are subject to judicial review. The court concluded it may reverse an IRS denial of a waiver if it finds the IRS abused its discretion, i.e., acted “arbitrarily, capriciously, or without sound basis in law or fact.” However, the taxpayer must have actually requested the waiver (i.e., by ruling request, self-certification, or during an examination). A court generally will not find the IRS abused its discretion if it did not have an opportunity to exercise its discretion. (Trimmer v. Commissioner, 148 T.C. No. 14 (2017).) See Chapter 5 and Chapter 2 of the treatise.

Filing Election to Report Income on Receipt of Unvested Property. If a retiree has an interest in restricted property that has not yet vested, the retiree may have previously elected to report as ordinary compensation income the excess of the fair market value of the interest on the date of receipt over the amount paid for the interest (the bargain element). A retiree would normally have made this election if he or she wished to avoid reporting as ordinary compensation income any later pre-vesting increase in value of the property interest.

In the past, the retiree had to file an election statement with the IRS within 30 days after receiving the unvested interest and had to attach a copy of the statement to his or her tax return. However, for property transferred on or after January 1, 2015, a retiree need not attach the statement to his or her tax return. (Reg. Sec. 1.83-2(c), (f).) See Chapters 10 and 11 of the treatise.

Automatic Waiver of the 60-Day Rule for a Returned Federal Tax Levy. A waiver of the 60-day rollover rule is automatic for funds returned to a retiree after a federal tax levy on a plan or IRA. However, the rollover must be completed by the due date (not including extensions) of the return for the taxable year the funds were returned. (IRC § 6343(f); Bipartisan Budget Act of 2018, H.R. 1892, § 41104.) See Chapter 2, Chapter 4, and Chapter 5 of the treatise.

Purchase of Employer Stock from Employee at Less than Fair Market Value. Shares of employer stock or stock rights received by an employee are not deferred compensation under Section 409A merely because a restriction may require the employee to sell the stock at less than fair market value upon the employee’s involuntary separation from service, or if the sale is contingent on a condition within the employee’s control. (Prop. Reg. § 1.409A-1(b)(5)(iii)(A).) See Chapter 9 of the treatise.

Beneficiary Elections for Time of Payment of Deferred Compensation. An unfunded nonqualified plan may allow a beneficiary of a deceased participant to elect to change the time and form of payment of deferred compensation. Thus, the plan may allow a beneficiary to elect to defer payments to any of the types of permissible dates or events that were available to the participant. Furthermore, the accelerated payment rules will now not prohibit a beneficiary’s election to receive payments (1) on or relative to the death or disability of the beneficiary or (2) upon the beneficiary’s unforeseeable emergency. (Prop. Reg. § 1.409A-3(j)(1), (2) (on which a taxpayer may rely until the regulations become final).) See Chapter 9 of the treatise.

Time Allowed for Payment of Deferred Compensation after Death of Participant or Beneficiary. Compensation payable by reason of the death of a retiree or beneficiary may now be paid any time during the period beginning on the date of death and ending on the last day of the first full calendar year following death. Regardless of the terms of the plan, any payment made within such period is not subject to the restrictive rules applicable to subsequent deferral elections and is not an impermissible accelerated payment. Furthermore, so long as the payment is made within that period, the payment recipient is free to choose the taxable year of payment. (Prop. Reg. § 1.409A-3(b), (d)(2) (on which a taxpayer may rely until the regulations become final).) See Chapter 9 of the treatise.

Liberalization of the Test for Favorable Treatment of Recurring Part-Year Compensation under Section 409A and Section 457(f). Recurring part-year compensations generally loses its exclusion from Section 409A if a taxpayer defers more than a specified amount from one calendar year to the next (more than $18,000 for 2016). However, proposed regulations (on which taxpayers may now rely) provide that this limitation is satisfied for purposes of Section 409A if the employee’s total compensation for the year is less than a specified limit ($265,000 for 2016). This alternative is also effective now for purposes of Section 457(f) (where it entirely supplants the year-to-year deferral limit). The alternative will also entirely replace the deferral limit for purposes of Section 409A when the proposed regulations become final. (Prop. Reg. Sec. 1.409A-1(b)(13).) See Chapter 9 of the treatise.

Substantial Risk of Forfeiture Relating to the Purpose of Compensation under a Section 457(f) Plan. Compensation is deferred under unfunded nonqualified plans (Section 457(f) plans) of States and tax-exempt organizations as long as the compensation is subject to a substantial risk of forfeiture. For this purpose, the most common type of substantial risk of forfeiture relates to the required performance of substantial future services. However, proposed regulations (on which taxpayers may now rely) also make it clear that a substantial risk of forfeiture includes a condition related to a purpose of the compensation (e.g., related to the employer’s governmental or tax-exempt activities or organizational goals). (Prop. Reg. Sec. 1.457-12(e)(1)(i), (iii).) See Chapter 9 of the treatise.

Substantial Risk of Forfeiture Relating to Involuntary Severance of Employment under a Section 457(f) Plan. Proposed regulations (on which taxpayers may now rely) provide that taxpayers may condition payment of deferred compensation under Section 457(f) on involuntary severance from employment without cause. For this purpose, involuntary severance without cause includes a severance for “good reason,” (e.g., a severance due to unfavorable changes in an employee’s pay, authority, duties, or working conditions). (Prop. Reg. Secs. 1.457-12(e)(1), 1.457-11(d)(2)(ii).) See Chapter 9 of the treatise.

Substantial Risk of Forfeiture Relating to a Covenant Not to Compete under a Section 457(f) Plan. A covenant not to compete may now constitute a substantial risk of forfeiture under a 457(f) plan. However, to qualify, several conditions must be satisfied to guarantee that the covenant is bona fide. Caution: a covenant not to compete cannot constitute a substantial risk of forfeiture under Section 409A. (Prop. Reg. Sec. 1.457-12(e)(1)(iv).) See Chapter 9 of the treatise.

Extension of a Substantial Risk of Forfeiture under a Section 457(f) Plan. A taxpayer may now extend an existing substantial risk of forfeiture for two years or more under a Section 457(f) plan. However, the extension must occur at least 90 days before the lapse of the existing substantial risk of forfeiture and the extension must provide a materially greater benefit. Somewhat similar rules apply to initial deferrals of regular current compensation. Caution: retirees must still take care not to violate restrictions on the timing of elections and payments under Section 409A. (Prop. Reg. Sec. 1.457-12(e)(2)).) See Chapter 9 of the treatise.

Short-Term Deferrals Are Not Deferred Compensation under Either Section 457(f) or Section 409A. The proposed regulations governing Section 457(f) plans (on which taxpayers may rely) make it clear that short-term deferrals are not deferred compensation subject to Section 457(f). A deferral is generally short-term if an employer must make payment within the first 2½ months of the taxable year following the first year the compensation is not subject to a substantial risk of forfeiture. Although the definition of short-term deferral under Section 457(f) is substantially the same as under Section 409A, there are some differences in the definition of substantial risk of forfeiture. (Prop. Reg. Sec. 1.457-12(d)(2).) See Chapter 9 of the treatise.

Treatment of a Spouse’s Community Property Interest in an IRA Distribution to a Nonspousal Beneficiary. – The IRS has ruled that an IRA distribution to a nonspousal beneficiary may be taxable to the beneficiary even though the surviving spouse has enforceable property rights in the distributed funds under state community property laws. Proper planning for this anomaly might involve either (1) a lifetime conversion of the spouse’s community property rights into the separate property of the retiree or (2) designation of the surviving spouse as an IRA beneficiary to the extent of his or her community property rights. Or after decedent’s death, the nonspousal beneficiary might make a timely disclaimer of the IRA to the extent of the spouse’s community property interest. (Priv. Ltr. Rul. 201623001.) See Chapter 5 of the treatise for a discussion of community property interests in IRAs.

Refinancing to Cure a Default on a Five-Year Qualified Plan Loan. – In CCA 201736022, the IRS demonstrated how a retiree could cure a default on a five-year qualified plan loan by refinancing and folding the defaulted payments into the replacement loan. In such a case, though, the retiree must comply with much more difficult statutory dollar limitations applicable to the refinancing of loans, unless the term of the replacement loan ends no later than the five-year term that was available for the old loan. The retiree must also refinance before expiration of the period during which the retiree could cure the default by making late payments. See Chapter 2 of the treatise.

Relief from Section 409A for Deferrals Grandfathered Under Section 457A. – Nonqualified deferred compensation payable by certain partnerships or foreign corporations with largely untaxed income is generally taxable under Code Section 457A when the compensation is no longer subject to a substantial risk of forfeiture (i.e., when vested). However, Section 457A does not apply to such amounts deferred before 2009 (grandfathered deferrals). Nevertheless, taxpayers were required to include such grandfathered deferrals in gross income before the beginning of taxable year 2018, or during the year vested if later. The IRS has announced that, if actual payment of the grandfathered deferrals would normally be a violation of Section 409A, the plan may nevertheless make a partial payment that does not exceed the income tax withholding that would have been required by all taxing authorities if the plan had actually paid the entire grandfathered amount. (Notice 2017-75, 2017-52 I.R.B. ___.) See Chapter 9 of the treatise.

Underwriters’ Commissions on IPO of Nonstatutory Stock Not Deductible from Option Exercise Income. –A participant exercising nonstatutory stock options and selling the acquired stock in an initial public offering (IPO) may not treat underwriters’ commissions on the IPO as expenses deductible from compensation income recognized on exercise of the options. Rather, the commissions are capital expenses taken into account in computing gain or loss on sale of the stock, even if the exercise of the options and sale of the stock are virtually simultaneous. (Hann v. United States, 2017-2 U.S.T.C. ¶ 50,308 (Cl. Ct.).) See Chapter 11 of the treatise for a discussion of the taxation of nonstatutory stock options received from an employer.

Sale of a Retiree’s Life Insurance Policy. – A retiree may decide to sell his or her life insurance policy to an unrelated purchaser (even thought the retiree is healthy). If so, the retiree recognizes income equal to the amount realized less the adjusted basis of the policy. In the past, the adjusted basis of the policy was the total premiums paid less distributions, loans forgiven, and the deemed cost of the prior insurance protection. Now, however, Congress has retroactively eliminated the requirement to reduce the adjusted basis for the amount of the deemed cost of prior insurance protection. (IRC § 1016(a)(1)(B).) See Chapter 19 of the treatise for a discussion of the sale of a life insurance contract.