Tax Planning for Retirees

Tax-Favored Employer Retirement Plans: Part 1

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, 2005-1 C.B. 962.) 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, 2007-1 C.B. 395.)

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 are normally defined benefit plans that 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.)

Phased Retirement Payments Taxed as Non-Annuity Payments. – On an employee’s regular retirement date, his or her employer may offer the employee a phased retirement arrangement under a qualified defined benefit plan. The employee continues to work part-time and also receives a percentage of the payment he or she would have received on complete retirement. Normally, the employee’s future full retirement date is uncertain and subject to agreement with his or her employer. Thus, the amount of additional accrual of retirement benefits during the phased retirement period is also uncertain. The employee generally does not have a choice of the form of payment during the phased retirement period, but may elect the form of payment at full retirement.

Under these conditions, the IRS has provided that the payments received by the employee during the phased retirement period are taxed as non-annuity payments. The IRS has further provided that the investment recovery percentage applicable to the phased payments is determined by dividing (1) the investment in the plan at the beginning of the phased retirement by (2) the then total value of the employee’s accrued benefit in the plan. At full retirement, the retirement payments are taxed as an annuity. See Chapter 2 of the treatise for a more complete discussion of the taxation of plan distributions. (Notice 2016-39, 2016-26 I.R.B. __.)

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 21 of the treatise for a discussion of the taxation of retirement benefits received by foreign retirees.

IRS Lien Not Extinguished by Rollover to Another Plan or IRA. – If the IRS files a tax lien that attaches to IRA funds, an owner cannot extinguish the lien merely by rolling over the funds from the IRA to a qualified plan. (Miles v. Commissioner, T.C. Memo 2007-208, aff’d by unpublished opinion, 2010-2 U.S.T.C.  50,661 (9th Cir. 2010)). See Chapter 2 of the treatise.

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 recognized and 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.

» Tax-Favored Employer Retirement Plans: Part 2