3977 / What general rules apply to withholding of income tax from qualified retirement plan benefits?

The withholding rules that apply to a distribution depend on whether it constitutes an eligible rollover distribution ( Q 3998). An eligible rollover distribution from a qualified retirement plan is subject to mandatory income tax withholding at the rate of 20 percent unless the distribution is directly rolled over to an eligible retirement plan ( Q 4000). An employee receiving an eligible rollover distribution may not otherwise elect out of this withholding requirement.¹

On the other hand, a recipient may elect out of withholding with respect to distributions that do not qualify as eligible rollover distributions.² The amount to be withheld on periodic payments that are not eligible rollover distributions is determined at the rate applicable to wages.³ Non-periodic payments that are not eligible rollover distributions are subject to income tax withholding at the rate of 10 percent.⁴

Withholding applies to amounts paid to a beneficiary of a participant as well as to the participant. Withholding does not apply to amounts that it is reasonable to believe are not includable in income.

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Planning Point: The IRS has released guidance providing that when a check for a fully taxable distribution from a qualified plan is mailed to a plan participant, but not cashed, it is considered to have been “actually distributed” from the plan and is taxable to the participant in the year of distribution. The fact that the participant failed to cash the check is irrelevant. Further, the failure to cash the check does not change the plan administrator’s withholding obligations with respect to the distribution and does not change the obligation to report the distribution on Form 1099-R (assuming the distribution exceeds the applicable reporting threshold). Despite these findings, the IRS was careful to note that it continues to consider the issue of uncashed distribution checks in situations involving missing participants.⁵

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The maximum amount withheld cannot exceed the sum of the money plus the fair market value of property received other than employer securities.⁶ Thus, a payor will not need to dispose of employer securities to meet the withholding tax liability. Loans treated as distributions (i.e., deemed distributions) continue to be subject to withholding as non-periodic distributions at a rate of 10 percent. The IRS has stated that loans deemed to be distributions are not subject to the 20 percent mandatory withholding requirement because a deemed distribution cannot be an eligible rollover distribution. Where a participant’s accrued benefit is reduced or offset to repay a plan loan, such as when employment is terminated, the offset amount may constitute an eligible rollover distribution.⁷ Withholding is not required on the costs of current life insurance protection taxable to plan participants under Table 2001 or previously P.S. 58 ( Q 3948).