Taxation Of Distributions

March 13, 2024

3969 / What is an early distribution from a qualified plan, and what penalties relate to it?

<div class="Section1"> Except as noted below, amounts distributed from qualified retirement plans before the participant reaches age 59½ are early or premature distributions subject to an additional tax equal to 10 percent of the amount of the distribution includable in gross income.<a href="#_ftn1" name="_ftnref1">1</a> To the extent that they are attributable to rollovers from a qualified retirement plan or a Section 403(b) plan, amounts distributed from Section 457 plans ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3584">3584</a>) generally will be treated as distributed from a qualified plan, for purposes of the early distribution penalty.<a href="#_ftn2" name="_ftnref2">2</a> The 10 percent penalty tax does not apply to distributions: (1)  made to a beneficiary, or the employee’s estate, on or after the death of the employee; (2)  attributable to the employee’s disability;<a href="#_ftn3" name="_ftnref3">3</a> (3)  that are part of a series of substantially equal periodic payments made at least annually for the life or life expectancy of the employee or the joint lives or joint life expectancies of the employee and his or her designated beneficiary, and beginning after the employee separates from the service of the employer ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3679">3679</a>); (4)  made to an employee after separation from service during or after the year in which the employee attained age 55, or age 50 for distributions to qualified public safety employees from a governmental plan as defined in IRC Section 414(d);<a href="#_ftn4" name="_ftnref4">4</a> (5)  made to an alternate payee under a qualified domestic relations order ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3915">3915</a>); (6)  made to an employee for medical care, but not in excess of the amount allowable as a deduction to the employee under IRC Section 213 for amounts paid during the year for medical care, determined without regard to whether the employee itemizes deductions for the year; (7)  made to reduce an excess contribution under a 401(k) plan ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3808">3808</a>); (8)  made to reduce an excess employee or matching employer contribution, that is, an excess aggregate contribution ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3808">3808</a>);<a href="#_ftn5" name="_ftnref5">5</a> (9)  made to reduce an excess elective deferral ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3760">3760</a>);<a href="#_ftn6" name="_ftnref6">6</a> (10)  that are dividends paid with respect to stock of a corporation described in IRC Section 404(k) (ESOPs) ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3824">3824</a>); (11)  made on account of certain levies against a qualified plan;<a href="#_ftn7" name="_ftnref7">7</a> or (12)  that are qualified reservist distributions, which are distributions of elective deferrals made to reserve members of the U.S. military called to active duty for 180 days or more at any time after September 11, 2001. Reservists have the right to rollover the amount of any distributions to an individual retirement plan for two years following the end of active duty.<a href="#_ftn8" name="_ftnref8">8</a> (13)  made on account of qualified births or adoptions under the SECURE Act (see below for more details). (14)   beginning in 2024, qualifies as an emergency distribution under the rules discussed below. (15)   beginning in 2024, made on account of domestic violence if the participant certifies that they have been a victim of domestic violence by a spouse or domestic partner within the one-year period prior to the withdrawal (see below). (16)   beginning in 2025, made to cover the costs of long-term care insurance (see below). (17)   made on account of the taxpayer’s being diagnosed with a terminal illness. <hr> Planning Point: Note that many clients mistakenly believe that the penalty does not apply to certain distributions used to fund the purchase of the taxpayer’s home. This exception applies only with respect to IRA distributions—the 401(k) rules do not provide for a similar exception. <hr> Planning Point: Early distribution penalties are generally waived in the event of natural disasters, and were waived in response to COVID-19-related distributions for 2020. <hr> The IRS has approved three methods for determining what constitutes a series of substantially equal periodic payments in the exception discussed in (3) above. If the series of payments is later modified, other than because of death or disability, before the employee reaches age 59½, or if after the employee reaches age 59½, within five years of the date of the first payment, the employee’s tax for the year in which the modification occurs is increased by an amount equal to the tax that would have been imposed in the absence of the exception, plus interest for the deferral period. For an explanation of the calculation under each method, the definition of “modified,” and related rulings, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3679">3679</a>. The exception for distributions pursuant to a QDRO (see (5) above) was not applicable where a participant took a distribution from the plan following a trade of other marital property rights for his or her spouse’s waiver of rights in his or her plan benefits.<a href="#_ftn9" name="_ftnref9">9</a> <hr> Planning Point: A participant who separates from service during or after the year he or she attains age 55 but is not yet age 59½ should generally leave plan accounts in the plan if permitted rather than transferring or rolling the accounts to an IRA or other qualified plan. This allows the participant to take distributions from the account as permitted by the plan without being subject to the 10 percent tax. A transfer to an IRA would subject the money transferred to the 10 percent tax while a transfer to another qualified plan would subject it to the new plan’s restrictions on distributions and the 10 percent tax. <hr> A court determined that a distribution originating from an arbitration award was subject to the 10 percent penalty because the amounts attributable to the award were thoroughly integrated with benefits provided under the state retirement plan.<a href="#_ftn10" name="_ftnref10">10</a> The involuntary nature of a distribution does not preclude the application of the tax, provided that the participant had an opportunity, such as by a rollover, to avoid the tax.<a href="#_ftn11" name="_ftnref11">11</a> The IRS has stated that the garnishment of an individual’s plan interest under the Federal Debt Collections Procedure Act to pay a judgment for restitution or fines as discussed in (11) above, will not trigger the application of the 10 percent penalty.<a href="#_ftn12" name="_ftnref12">12</a> The cost of life insurance protection included in an employee’s income ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3948">3948</a>) is not considered a distribution for purposes of applying the 10 percent penalty.<a href="#_ftn13" name="_ftnref13">13</a> The Civil Service Retirement System is a qualified plan for purposes of the early distribution penalty.<a href="#_ftn14" name="_ftnref14">14</a> A plan is not required to withhold the amount of the additional income tax on an early withdrawal.<a href="#_ftn15" name="_ftnref15">15</a> Distributions that are rolled over ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3996">3996</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="4019">4019</a>) generally are not includable in income, and, thus, the 10 percent penalty does not apply. In the case of a distribution subject to 20 percent mandatory withholding, the 20 percent withheld will be includable in income, however, to the extent required by IRC Section 402(a) or IRC Section 403(b)(1), even if the participant rolls over the remaining 80 percent of the distribution within the 60-day period ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="4016">4016</a>). Thus, an employee who rolls over only 80 percent of a distribution may be subject to the 10 percent penalty on the 20 percent withheld.<a href="#_ftn16" name="_ftnref16">16</a> Qualified Birth and Adoption Distributions The SECURE Act amended the IRC to allow qualified plan participants to withdraw up to $5,000 for a qualified birth or adoption without becoming subject to the 10 percent penalty on early distributions. The distribution must be taken within the one-year period following the birth or adoption. IRS guidance clarifies that an “eligible adoptee” does not include the child of the participant’s spouse (in other words, step-parent adoptions do not count).<a href="#_ftn17" name="_ftnref17">17</a> Notice 2020-68 also clarifies that each parent is entitled to take a distribution with respect to the same child. Parents are also eligible to take distributions more than once—i.e., for multiple children over time. Parents of twins are entitled to double the $5,000 limit. However, plans are not required to provide the option for qualified birth or adoption distributions. If the plan permits distributions for qualified birth or adoption, it must also permit recontribution of those amounts. <hr> Planning Point: The SECURE Act 2.0 clarified that taxpayers who take penalty-free withdrawals for qualifying birth or adoption expenses do not have an unlimited amount of time to repay those amounts.  Instead, the repayment must be made within three years of the date of the withdrawal.  For qualifying birth or adoption withdrawals that were taken before the new law was enacted, the repayment period ends December 31, 2025. <hr> A qualified birth or adoption distribution is not treated as an eligible rollover distribution for purposes of the direct rollover rules of Section 401(a)(31), the notice requirement under Section 402(f), and the mandatory withholding rules under Section 3405. Thus, the plan is not required to offer an individual a direct rollover with respect to a qualified birth or adoption distribution. In addition, the plan administrator is not required to provide a Section 402(f) notice. Finally, the plan administrator or payor of the qualified birth or adoption distribution is not required to withhold an amount equal to 20 percent of the distribution, as generally is required in Section 3405(c)(1). However, a qualified birth or adoption distribution is subject to the voluntary withholding requirements. If the plan does not permit qualified birth or adoption distributions and an individual receives an otherwise permissible in-service distribution that meets the requirements of a qualified birth or adoption distribution, the individual may treat the distribution as a qualified birth or adoption distribution on the individual’s federal income tax return. The distribution, while includible in gross income, is not subject to the 10 percent additional tax. If the individual decides to recontribute the amount to an eligible retirement plan, the individual may recontribute the amount to an IRA. In the case of a recontribution made with respect to a qualified birth or adoption distribution from an applicable eligible retirement plan other than an IRA, an individual is treated as having received the distribution as an eligible rollover distribution (as defined in Section 402(c)(4)) and as having transferred the amount to an applicable eligible retirement plan in a direct trustee-to-trustee transfer within 60 days of the distribution.<a href="#_ftn18" name="_ftnref18">18</a> Emergency Distributions Beginning in 2024, the SECURE Act 2.0 will also allow retirement plan participants to take emergency distributions from their retirement savings accounts without penalty (currently, a 10 percent penalty plus ordinary income tax applies if an early distribution does not qualify for an exception). These emergency distributions will be limited to $1,000 each year.  Also, taxpayers who take emergency distributions must repay the distribution within a three-year period or will be prohibited from taking another $1,000 distribution during the following three-year period.  Non-highly compensated employees may be entitled to contribute the lesser of (1) 3 percent of compensation or (2) $2,500 to emergency savings accounts using after-tax dollars. Long-Term Care Insurance The SECURE Act 2.0 allows taxpayers to withdraw up to $2,500 each year to cover the costs of long-term care insurance without triggering the 10 percent early withdrawal penalty (these withdrawals will still be subject to ordinary income taxation). The funds can be used to pay for standalone long-term care insurance or for certain life insurance or annuity contracts that also provide for meaningful financial assistance in the event that the insured person requires long-term care in a nursing home or home-based long-term care. This new provision is effective for tax years beginning after December 31, 2024 (the $2,500 annual limit will also be adjusted for inflation). Domestic Violence Beginning in 2024, plan participants are entitled to take penalty-free withdrawals if the participant certifies that they have been a victim of domestic violence by a spouse or domestic partner within the one-year period prior to the withdrawal.  The withdrawal will be limited to the lesser of $10,000 (the amount will be indexed for inflation) or 50 percent of the participant’s vested account balance.  Plan participants who take advantage of this withdrawal provision will be permitted to repay the amounts withdrawn within three years. Terminal Illness Taxpayers who have been certified by a physician as being terminally ill will also be permitted to take penalty-free withdrawals beginning immediately (the withdrawals can also be repaid within three years).  The distribution is not exempt from income tax. The IRS clarified that self-certification is not sufficient and the employee must provide evidence and documentation as required by the employer.  That evidence must include the certifying physician’s name and contact information, as well as a description of the evidence used to conclude that the individual suffers from a terminal illness. The IRS also clarified that terminal illness means that the individual has been certified by a physician as having an illness or physical condition that can reasonably be expected to result in death in 84 months or less after the date of the certification. While plans are not strictly required to offer the terminal illness exception, the employee may elect to treat an otherwise permissible in-service distribution as a distribution based on terminal illness via Form 5329, filed with their income tax return.<a href="#_ftn19" name="_ftnref19">19</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC § 72(t). <a href="#_ftnref2" name="_ftn2">2</a>.  IRC § 72(t)(9). <a href="#_ftnref3" name="_ftn3">3</a>.  As defined in IRC Section 72(m)(7). <a href="#_ftnref4" name="_ftn4">4</a>.  IRC § 72(t)(10) as modified by Pub. L. 114-26. <a href="#_ftnref5" name="_ftn5">5</a>.  IRC § 401(m)(7). <a href="#_ftnref6" name="_ftn6">6</a>.  IRC § 402(g)(2)(C). <a href="#_ftnref7" name="_ftn7">7</a>.  Under IRC § 6331. <a href="#_ftnref8" name="_ftn8">8</a>.  IRC § 72(t)(2)(G). <a href="#_ftnref9" name="_ftn9">9</a>.  O’Brien v. Comm., TC Summary Opinion 2001-148. <a href="#_ftnref10" name="_ftn10">10</a>.  Kute v. U.S., 191 F.3d 371 (3d Cir. 1999). <a href="#_ftnref11" name="_ftn11">11</a>.  Swihart v. Comm., TC Memo 1998-407. <a href="#_ftnref12" name="_ftn12">12</a>.  Let. Rul. 200426027. <a href="#_ftnref13" name="_ftn13">13</a>.  Notice 89-25, 1989-1 CB 662, A-11. <a href="#_ftnref14" name="_ftn14">14</a>.  Roundy v. Comm., 122 F.3d 835, 97-2 USTC ¶ 50,625, aff’g TC Memo 1995-298; Shimota v. U.S., 21 Cl. Ct. 510, 90-2 USTC ¶ 50,489 (Cl. Ct. 1990). <a href="#_ftnref15" name="_ftn15">15</a>.  General Explanation—TRA ’86, p. 716. <a href="#_ftnref16" name="_ftn16">16</a>.  Treas. Reg. §§ 1.402(c)-2 A-11, 1.403(b)-2. <a href="#_ftnref17" name="_ftn17">17</a>.  Notice 2020-68. <a href="#_ftnref18" name="_ftn18">18</a>.  IRC § 72(t)(2)(H)(v)(III). <a href="#_ftnref19" name="_ftn19">19</a> Notice 2024-02. </div></div>

March 13, 2024

3960 / What special rules apply to residence loans from a qualified plan?

<div class="Section1"> If a plan has a program to invest in residential mortgage loans, loans made in the ordinary course of the program are not subject to the rules that apply to plan loans. Loans that benefit an officer, director, or owner of the employer maintaining the plan or their beneficiaries are not treated as made under an investment program and are subject to the limitations of IRC Section 72(p) ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3954">3954</a>). An investment program exists if the plan has established that a certain percentage or amount of plan assets will be invested in residential mortgages available to persons who satisfy commercially customary financial criteria.<a href="#_ftn1" name="_ftnref1">1</a> If a loan is to acquire a dwelling unit that is to be, within a reasonable time, the principal residence of the participant, it will not be subject to the otherwise applicable 5-year term requirement ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3954">3954</a>).<a href="#_ftn2" name="_ftnref2">2</a> The determination of whether the unit is to be used, within a reasonable time, as the participant’s principal residence is made when the loan is made. Legislative history indicates that a dwelling unit includes a house, apartment, condominium, or mobile home not used on a transient basis. The determination of whether plan loan proceeds are used for the purchase or improvement of a principal residence is made using the tracing rules under IRC Section 163(h)(3)(B).<a href="#_ftn3" name="_ftnref3">3</a> A principal residence loan can include a plan loan used to repay a third-party loan used to pay a portion of the purchase price if the plan loan would qualify as a principal residence loan without regard to the third-party loan.<a href="#_ftn4" name="_ftnref4">4</a> For example, on July 1, 2023, a participant requests a plan loan to acquire a principal residence to be paid in level monthly installments over 15 years. On August 1, 2023, the participant acquires a principal residence, paying a portion of the purchase price with a bank loan. On September 1, 2023, the plan makes the loan and the participant uses it to repay the bank loan. The regulations state that the plan loan qualifies as a principal residence loan, considering the IRC Section 163(h)(3) tracing rules.<a href="#_ftn5" name="_ftnref5">5</a> Interest paid on residence loans may be deductible if the general requirements for deducting mortgage interest are met and the deduction is not denied based on the participant’s status as a key employee or the loan is secured by amounts attributable to elective deferrals. ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3965">3965</a>) <hr> Planning Point: If a participant wants to give the plan a mortgage to qualify for the mortgage interest deduction, the participant should verify with the plan that the plan will record the mortgage and that the mortgage in favor of the plan will not violate the terms of any other mortgage secured by the residence. <hr> Planning Point: Because the 2017 tax reform legislation increased the standard deduction and limited the state and local tax deduction to $10,000 through 2025, many people will no longer be able to deduct mortgage interest, even if the interest otherwise qualifies. <hr> No specific time limit is placed on residential loans, but the loans must provide for substantially level amortization, with payments to be made at least quarterly.<a href="#_ftn6" name="_ftnref6">6</a> This requirement does not preclude repayment or acceleration of the loan prior to the loan period, or the use of a variable interest rate.<a href="#_ftn7" name="_ftnref7">7</a> All loans, regardless of when made, must provide for a reasonable repayment schedule to qualify as a loan exempt from the prohibited transaction rules ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3980">3980</a>). A loan need not be secured by the residence to be considered a principal residence plan loan.<a href="#_ftn8" name="_ftnref8">8</a> Assuming that a loan is otherwise a bona fide debt and the other requirements for deducting the plan loan interest as mortgage interest are met, a taxpayer may deduct interest paid on a mortgage loan from his or her qualified plan, even though the amount by which the loan exceeded the $50,000 limit of IRC Section 72(p) was deemed to be a taxable distribution. ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3965">3965</a>).<a href="#_ftn9" name="_ftnref9">9</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.  Treas. Reg. § 1.72(p)-1, A-18. <a href="#_ftnref2" name="_ftn2">2</a>.  IRC § 72(p)(2)(B)(ii). <a href="#_ftnref3" name="_ftn3">3</a>.  Treas. Reg. § 1.72(p)-1, A-7. <a href="#_ftnref4" name="_ftn4">4</a>.  Treas. Reg. § 1.72(p)-1, A-8(a). <a href="#_ftnref5" name="_ftn5">5</a>.  Treas. Reg. § 1.72(p)-1, A-8(b). <a href="#_ftnref6" name="_ftn6">6</a>.  IRC § 72(p)(2)(C). <a href="#_ftnref7" name="_ftn7">7</a>.  General Explanation — TRA ’86, p. 728. <a href="#_ftnref8" name="_ftn8">8</a>.  Treas. Reg. § 1.72(p)-1, A-6. <a href="#_ftnref9" name="_ftn9">9</a>.  FSA 200047022. </div></div>

March 13, 2024

3972 / How is net unrealized appreciation taxed when employer securities are distributed from a qualified plan?

<div class="Section1"> Net unrealized appreciation (“NUA”) is the excess of the fair market value of employer securities at the time of a lump sum distribution over the cost or other basis of the securities to a qualified plan trust.<a href="#_ftn1" name="_ftnref1">1</a> Employer securities for this purpose include shares of a parent or subsidiary corporation.<a href="#_ftn2" name="_ftnref2">2</a> If employer securities are distributed as part of a lump sum distribution ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3971">3971</a>) from a qualified plan, the net unrealized appreciation is excluded from the employee’s income at the time of distribution to the extent that the securities are attributable to employer and nondeductible employee contributions. Taxation of NUA following a lump sum distribution is deferred until the securities are sold or disposed of, unless the employee elects out of NUA treatment.<a href="#_ftn3" name="_ftnref3">3</a> The election is made on the tax return for the year in which the distribution must be included in gross income and does not preclude an election for special income averaging.<a href="#_ftn4" name="_ftnref4">4</a> On a sale or other disposition of employer securities, the NUA amount is treated as long-term capital gain, regardless of the distributee’s actual holding period. The taxpayer’s basis in the stock is the same as the basis in the hands of the qualified plan trust; that is, it does not include the NUA amount.<a href="#_ftn5" name="_ftnref5">5</a> Gain accruing after distribution of the securities and before the later disposition of them is treated as long-term or short term capital gain, depending on the holding period after distribution.<a href="#_ftn6" name="_ftnref6">6</a> The distributee’s holding period begins the day after the day the plan trustee delivers the stock to the transfer agent with instructions to reissue the stock in the distributee’s name.<a href="#_ftn7" name="_ftnref7">7</a> An employer’s shares, if acquired and credited to an employee’s account, still are considered employer stock, even if later transferred to the trust of an acquiring or subsidiary corporation.<a href="#_ftn8" name="_ftnref8">8</a> The basis does not change.<a href="#_ftn9" name="_ftnref9">9</a> The balance of the value of the stock is taxable to the recipient under the regular rules for taxing lump sum distributions ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3971">3971</a>).<a href="#_ftn10" name="_ftnref10">10</a> Unrealized appreciation that is excluded from income is not includable in the recipient’s basis in the stock for the purpose of computing gain or loss upon a later sale or other taxable disposition.<a href="#_ftn11" name="_ftnref11">11</a> If part or all of the unrealized appreciation is excluded as something other than unrealized appreciation, only the part excluded as unrealized appreciation is not added to basis.<a href="#_ftn12" name="_ftnref12">12</a> Unrealized appreciation realized on sale of the stock by the recipient of a distribution on account of the death of the employee or by a person inheriting the stock from the employee is income in respect of a decedent. It is taxed as long-term capital gain and a deduction may be taken for the estate tax attributable to the inclusion of any part of the appreciation prior to distribution in the deceased employee’s estate.<a href="#_ftn13" name="_ftnref13">13</a> <hr> Planning Point: NUA treatment may not be the best option for a distribution of employer securities. Each situation should be analyzed based on factors including the amount of unrealized appreciation, the outlook for the employer’s securities, and whether the participant can pay the tax on the basis without selling some of the employer securities. <hr> NUA in employer securities distributed in other than a lump sum distribution is excludable only to the extent that the appreciation is attributable to nondeductible employee contributions.<a href="#_ftn14" name="_ftnref14">14</a> Thus, a rollover of employer securities to an IRA will preclude the taxpayer from receiving NUA treatment. A transfer to an IRA of less than all of a participant’s account under an ESOP, with a distribution of the balance to the participant, does not bar treatment as a lump sum distribution, however. The IRS determined that a participant could exclude the net unrealized appreciation on the stock distributed outright to the participant until the participant disposes of it.<a href="#_ftn15" name="_ftnref15">15</a> Similarly, a participant who had received a series of substantially equal periodic payments ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3679">3679</a>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3960">3960</a>) from his plan account prior to retirement was not precluded from treating a distribution of the remaining amounts, including stock, in his plan account as a lump sum distribution ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3968">3968</a>), nor from excluding net unrealized appreciation on the stock.<a href="#_ftn16" name="_ftnref16">16</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.  Treas. Reg. § 1.402(a)-1(b)(2)(i). <a href="#_ftnref2" name="_ftn2">2</a>.  IRC § 402(e)(4)(E). <a href="#_ftnref3" name="_ftn3">3</a>.  IRC § 402(e)(4)(B). <a href="#_ftnref4" name="_ftn4">4</a>.  IRC § 402(e)(4). <a href="#_ftnref5" name="_ftn5">5</a>.  Treas. Reg. § 1.402(a)-1(b)(1)(i). <a href="#_ftnref6" name="_ftn6">6</a>.  See Treas. Reg. § 1.402(a)-1(b); Notice 98-24, 1998-1 CB 929; see also Rev. Rul. 81-122, 1981-1 CB 202. <a href="#_ftnref7" name="_ftn7">7</a>.  Rev. Rul. 82-75, 1982-1 CB 116. <a href="#_ftnref8" name="_ftn8">8</a>.  Rev. Rul. 73-29, 1973-1 CB 198; Let. Rul. 201242019. <a href="#_ftnref9" name="_ftn9">9</a>.  Rev. Rul. 80-138, 1980-1 CB 87. <a href="#_ftnref10" name="_ftn10">10</a>.  Rev. Rul. 57-514, 1957-2 CB 261. <a href="#_ftnref11" name="_ftn11">11</a>.  Treas. Reg. § 1.402(a)-1(b). <a href="#_ftnref12" name="_ftn12">12</a>.  Rev. Rul. 74-398, 1974-2 CB 136. <a href="#_ftnref13" name="_ftn13">13</a>.  Rev. Rul. 69-297, 1969-1 CB 131; Rev. Rul. 75-125, 1975-1 CB 254. <a href="#_ftnref14" name="_ftn14">14</a>.  IRC § 402(e)(4)(A). <a href="#_ftnref15" name="_ftn15">15</a>.  Let. Ruls. 9721036, 200038057. <a href="#_ftnref16" name="_ftn16">16</a>.  Let. Rul. 200315041. </div></div>

March 13, 2024

3958 / Are there limits on the amount that can be borrowed under a qualified plan loan?

<div class="Section1"> Editor’s Note: The CARES Act relaxed the rules to provide relief for qualified plan participants with existing plan loans. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a>.  The SECURE Act 2.0 amended the rules governing loans taken from retirement plans due to a federal disaster.  The limit on such loans is increased to the lesser of $100,000 or 100 percent of the individual’s vested account balance when the participant (1) lives in a federal disaster area, (2) suffers an economic loss due to the disaster and (3) takes the distribution within 180 days of the date the disaster occurs.  Existing loan payments that are due within 180 days of the disaster can be delayed for up to one year (and the five-year repayment deadline may also be extended). The amount of the loan, when added to the outstanding balance of all other loans, whenever made, from all plans of the employer, may not exceed the lesser of (1) $50,000 (reduced by the excess of the highest outstanding balance of plan loans during the one-year period ending on the day before the date when the loan is made over the outstanding balance of plan loans on the date when the loan is made), or (2) one-half of the present value of the employee’s non-forfeitable accrued benefit under the plans, determined without regard to any accumulated deductible employee contributions. A plan may provide that a minimum loan amount of up to $10,000 may be borrowed, even if it is more than one-half of the present value of the employee’s non-forfeitable accrued benefit.<a href="#_ftn1" name="_ftnref1">1</a> For valuation purposes, a valuation within the prior 12 months may be used, if it is the latest available.<a href="#_ftn2" name="_ftnref2">2</a> If a loan does not meet the dollar limitation, distribution of the amount in excess of the dollar limit is deemed to occur when the loan is made.<a href="#_ftn3" name="_ftnref3">3</a> If the outstanding loan balance meets the dollar limitation immediately after the date when the loan is made, the loan will not be treated as a distribution merely because the present value of the employee’s non-forfeitable accrued benefit subsequently decreases.<a href="#_ftn4" name="_ftnref4">4</a> In determining the outstanding balance and the present value of the non-forfeitable accrued benefit under a plan, an employer’s plans include plans of all members of a controlled group of employers, of trades and businesses under common control, and of members of an affiliated service group ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3933">3933</a>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3935">3935</a>).<a href="#_ftn5" name="_ftnref5">5</a> The plans include all qualified pension, profit sharing, and stock bonus plans, all Section 403(b) tax sheltered annuities, and all Section 457 deferred compensation plans of aggregated employers.<a href="#_ftn6" name="_ftnref6">6</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC § 72(p)(2)(A). <a href="#_ftnref2" name="_ftn2">2</a>.  Notice 82-22, 1982-2 CB 751. <a href="#_ftnref3" name="_ftn3">3</a>.  Treas. Reg. § 1.72(p)-1, A-4(a). <a href="#_ftnref4" name="_ftn4">4</a>.  General Explanation—TEFRA, p. 296. <a href="#_ftnref5" name="_ftn5">5</a>.  IRC § 72(p)(2)(E)(i). <a href="#_ftnref6" name="_ftn6">6</a>.  IRC § 72(p)(2)(E)(ii). </div></div>

March 13, 2024

3971 / What is a lump sum distribution? What special tax treatment is available for a lump sum distribution from a qualified plan?

<div class="Section1"> A distribution is a lump sum distribution if it: (1)  is made in one taxable year; (2)  consists of the balance to the credit of an employee; (3)  is payable on account of the employee’s death, after the employee attained age 59½, disabled or on account of the employee’s separation from service; and (4)  is made from a qualified pension, profit sharing, or stock bonus plan.<a href="#_ftn1" name="_ftnref1">1</a> The classification will be relevant to certain distributions of employer securities that consist of net unrealized appreciations. <hr> Planning Point: As interest rates have risen significantly, and it is widely expected that they will soon be lowered, plans that offer a lump sum option should begin planning for an influx in early retirements. The value of lump sum payments fluctuates with interest rates. With lower interest rates, the participant will receive a larger lump sum payment. With higher rates, the value of the payment decreases. Plans are required to update the interest rate on a monthly, quarterly, or annual basis. Now that interest rates have stabilized, many participants may elect to take a lump sum once rates begin to fall (and may elect to leave employment sooner than expected to take advantage of lower interest rates). That may increase the plan’s liquidity needs and also decrease the plan’s funding status. A significant decrease in funding status could subject the plan to IRC Section 436’s prohibition or limitations on paying lump sums. <hr> The distinction between lump sum distributions has become less important as fewer participants are able to use the pre-ERISA grandfather provisions for capital gain treatment of pre-ERISA accounts under a plan and certain income averaging rules that were repealed in 1986 ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="623">623</a>). The following discussion applies to the grandfathered tax treatment of certain participant accounts that are conditioned on a distribution constituting a lump sum distribution. <hr> Planning Point: The IRS has released a ruling that impacts whether pension plan sponsors are permitted to provide lump-sum distribution options to plan participants who are already receiving plan benefits via regular annuity payments. The issue was whether, under the IRS required minimum distribution (RMD) rules, a lump-sum payment would constitute an impermissible increase in the payment amounts these participants were receiving. In 2015, the IRS reversed its previous position allowing these lump-sum payments to participants in pay status and stated its intent to amend the RMD rules to prohibit the lump-sum option for participants already receiving annuity payments. Now, the IRS has once again changed course and announced that, for the time being anyway, it is no longer planning to amend the RMD rules to prohibit lump-sum payments to pension plan participants already receiving annuity payments under the plan.<a href="#_ftn2" name="_ftnref2">2</a> <hr> The same requirements apply to distributions to self-employed individuals, except that full distributions made after a self-employed person has become disabled are considered lump sum distributions, and distributions made on account of “separation from service” are not. The balance to the credit includes all amounts in the participant’s account, including nondeductible employee contributions, as of the first distribution received after the triggering event.<a href="#_ftn3" name="_ftnref3">3</a> Certain eligible employees may elect ten-year averaging of certain lump sum distributions and special treatment of certain capital gains. For this purpose, an eligible employee is an employee who attained age 50 before January 1, 1986. Earlier IRC provisions that allowed for five year averaging of lump sum distributions were repealed for tax years beginning after 1999. Ten-year averaging. An eligible employee makes a special averaging election by filing Form 4972 with his or her tax return; the election may be revoked by filing an amended return.<a href="#_ftn4" name="_ftnref4">4</a> An eligible employee can make this election only once and it must apply to all lump sum distributions the employee receives for that year. Under ten-year averaging, the tax on the ordinary income portion of the distribution is 10 times the tax on 1/10 of the total taxable amount, reduced by the minimum distribution allowance. 1986 tax rates must be used, considering the prior law’s zero bracket amount.<a href="#_ftn5" name="_ftnref5">5</a> Generally speaking, the larger the distribution, the less likely that ten-year averaging will be advantageous. Long-term capital gain treatment. An eligible employee also may elect capital gain treatment for the portion of a lump sum distribution allocable to his or her pre-1974 plan participation.<a href="#_ftn6" name="_ftnref6">6</a> This portion is determined by multiplying the total taxable amount by a fraction, the numerator of which is the number of pre-January 1, 1974 calendar years of active plan participation and the denominator of which is the total number of calendar years of active plan participation. For these purposes, the minimum distribution allowance is the lesser of $10,000 or one-half of the total taxable amount. This must be reduced by 20 percent of the total taxable amount in excess of $20,000. Thus, if the total taxable amount is $70,000 or more, there is no minimum distribution allowance. The total taxable amount is the amount of the distribution that exceeds the employee’s cost basis ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3973">3973</a>). The employee’s cost basis is reduced by any previous distributions excludable from his or her gross income. <hr> Planning Point: It is particularly important to pay attention to the exact terms of a lump sum offer when considering whether to accept. Many plans offer a lump sum “window,” during which the participant must make a decision and may have an opportunity to revoke that decision. However, once the window is closed, courts generally will not allow the participant to change the final decision made during the window. <hr> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC § 402(e)(4)(D). <a href="#_ftnref2" name="_ftn2">2</a>.  Notice 2019-18. <a href="#_ftnref3" name="_ftn3">3</a>.  Let. Ruls. 9031028, 9013009. <a href="#_ftnref4" name="_ftn4">4</a>.  Treas. Reg. § 11.402(e)(4)(B)-1 (prior to removal in 2019). <a href="#_ftnref5" name="_ftn5">5</a>.  TRA ’86, § 1122(h)(5); TAMRA ’88, § 1011A(b)(15)(B). <a href="#_ftnref6" name="_ftn6">6</a>.  TRA ’86, § 1122(h)(3). </div></div>

July 14, 2020

3959 / What relief did the CARES Act provide to expand the availability of qualified plan loans in response to COVID-19?

<div class="Section1"> The CARES Act relaxed the rules to provide relief for qualified plan participants with existing plan loans in 2020 (the COVID-related relief was not extended into 2021). If a participant had an existing plan loan with a repayment obligation falling between March 27 and December 31, 2020, that repayment obligation was extended for one year. Any subsequent repayment obligations were then adjusted to reflect this extension. For plan participants who are “qualifying individuals,” the plan loan limits were increased to the greater of $100,000 or 100 percent of the vested balance in the participant’s account. Qualifying individuals are individuals (1) diagnosed with COVID-19, (2) whose spouse or dependent were diagnosed with COVID-19, or (3) who experienced adverse financial consequences as a result of (i) being quarantined, furloughed or laid off (or having work hours reduced) due to COVID-19, (ii) being unable to work due to lack of child care due to COVID-19, (iii) closing or reducing hours of a business owned or operated by the individual due to COVID-19, or (iv) other factors as determined by the Treasury.<a href="#_ftn1" name="_ftnref1">1</a> Later IRS guidance expanded the list of qualifying individuals to include anyone whose pay was reduced due to COVID-19 (regardless of whether hours were reduced or whether the individual was laid off). If a taxpayer was planning to start a new job and the start date was pushed back (or the offer was rescinded entirely) due to COVID-19, that taxpayer also qualified for relief. Further, if a spouse or member of the plan participant’s household suffered one of the effects described above, the participant was eligible for the expanded retirement account access.<a href="#_ftn2" name="_ftnref2">2</a> “Members of the participant’s household” was interpreted to include roommates or anyone who shares the participant’s primary residence. For example, if the participant’s live-in partner owned a business that was shut down due to COVID-19, the participant was eligible for the plan distribution relief. <hr /> Planning Point: Despite the increased loan limits during disasters, plan sponsors must remember the one-year lookback rule. In reality, the $100,000 limit is reduced by (a) the excess of the employee’s highest outstanding plan loan balance during the one-year period ending on the day before the loan is made, over (b) the employee’s outstanding balance of any plan loan on the date the loan is made (this calculation also includes loans from any other plans maintained by the employer or member of a controlled group). <hr /> The IRS also released Q&A guidance on the CARES Act retirement-related provisions. The IRS confirmed that plan sponsors could look to past guidance issued in response to Hurricane Katrina in 2005 and the RMD waiver in 2009 for help implementing the CARES Act provisions. IRS Q&A clarified that increased loan limits were available between March 27, 2020 and December 31, 2020. Further, the loan and distribution relief was optional for plan sponsors—and sponsors could elect to adopt one provision and not another (including the loan repayment option). Plan sponsors could rely on the participant’s certifications that they were eligible for the relief. COVID-19 related distributions are reported on Form 1099-R (even if the distribution was repaid in the same year).<a href="#_ftn3" name="_ftnref3">3</a> The IRS confirmed that the plan loan or hardship distribution amount did not have to directly correspond to the participant’s financial losses. As a result, plan sponsors did not have to obtain documentation to substantiate the amount of the financial hardship and plan participants did not have to prove the amount of their loss.<a href="#_ftn4" name="_ftnref4">4</a> The expanded plan loan and hardship withdrawal options were completely optional for plan sponsors. However, IRS Notice 2020-50 clarified that plan participants were eligible to claim the tax benefits regardless of whether the plan sponsor opted to amend the plan in accordance with the CARES Act relief options. If the plan allowed delayed repayment for outstanding loans as of March 27, 2020, the payments could be deferred until 2021 with the remaining amounts re-amortized beginning with the first payment date after January 1, 2021. The re-amortization period began January 1, 2021 and runs through the date that is one year after the loan was originally due. The re-amortization period will begin January 1, 2021 and run through the date that is one year after the loan was originally due. IRS guidance also notes that there may be other reasonable methods to handle the loan repayment deferral. For example, the plan could resume loan repayments according to the loan recipient’s original amortization schedule. The plan could then re-amortize the principal and accrued interest as of the anniversary date when the first loan repayment was paused. </div> <div class="refs"> <hr align="left" size="1" width="33%" /> <a href="#_ftnref1" name="_ftn1">1</a>. Pub. Law No. 116-36, CARES Act, § 2202(b). <a href="#_ftnref2" name="_ftn2">2</a>. Notice 2020-50. <a href="#_ftnref3" name="_ftn3">3</a>. IRS FAQ, as updated periodically, available at: https://www.irs.gov/newsroom/coronavirus-related-relief-for-retirement-plans-and-iras-questions-and-answers <a href="#_ftnref4" name="_ftn4">4</a>. Notice 2020-50. </div>