Taxation Of Distributions

March 13, 2024

3951 / How is the amount of taxable income determined when life insurance protection is purchased under a contributory plan?

<div class="Section1"> Life insurance protection purchased under a contributory plan is considered to have been paid first from employer contributions and trust earnings, unless the plan provides otherwise. Thus, the P.S. 58 (currently Table 2001) costs are taxed to the employee unless the plan provides that employee contributions are to be applied to the insurance cost.<a href="#_ftn1" name="_ftnref1">1</a> If amounts attributable to deductible employee contributions, including net earnings allocable to them, are used to purchase life insurance, the amount used, not the P.S. 58 (currently Table 2001) cost, is included in the employee’s gross income.<a href="#_ftn2" name="_ftnref2">2</a> It is unclear whether such amounts are subject to a premature distribution penalty; the IRS has specifically exempted P.S. 58 (currently Table 2001) costs of life insurance protection included in income from such a penalty ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3969">3969</a>). Although the deduction for any contribution used to purchase life insurance is not disallowed, it is, in effect, offset. Loans under the policy would be considered a distribution, including automatic premium loans on default of payment of a premium. <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.  Rev. Rul. 68-390, 1968-2 CB 175. <a href="#_ftnref2" name="_ftn2">2</a>.  IRC § 72(o)(3)(B). </div></div>

March 13, 2024

3970 / How is an employee taxed on postretirement distributions from a qualified plan?

<div class="Section1"> The tax treatment of distributions received at or after retirement depends on the time and manner of distribution. If a distribution is rolled over to an IRA or other eligible retirement plan, taxation of the amounts rolled over is deferred until it is distributed in the future ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3996">3996</a>). If a lump sum distribution is made, it is subject to the treatment explained in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3971">3971</a> and, in the case of net unrealized appreciation on employer securities, as explained in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3972">3972</a>. If an employee receives annuity payments, the benefits are taxed as explained in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="613">613</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="618">618</a>. The employee’s cost basis, if any, is determined under the rules set forth in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3973">3973</a>. If a distribution is received prior to age 59½, it may trigger the 10 percent penalty on early or premature distributions unless one of the exceptions applies ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3969">3969</a>). </div>

March 13, 2024

3950 / How is the amount of taxable income determined when term insurance is provided under a qualified plan?

<div class="Section1"> Where individual or group term life insurance is provided under a qualified plan, the cost of the entire amount of protection is taxable to employees. No part of the coverage of group term insurance is exempt under IRC Section 79 ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="246">246</a>).<a href="#_ftn1" name="_ftnref1">1</a> Moreover, the cost of the insurance protection cannot be determined by use of the special group term rates that are applicable to taxing excess group term life insurance purchased directly by an employer.<a href="#_ftn2" name="_ftnref2">2</a> It is not settled whether the taxable amount is the actual premium or the P.S. 58 (now Table 2001) cost. <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC § 79(b)(3). <a href="#_ftnref2" name="_ftn2">2</a>.  Treas. Reg. §§ 1.79-1(a)(3), 1.79-3(d)(3). </div></div>

March 13, 2024

3954 / What requirements must a qualified plan loan meet to avoid taxation as a distribution?

<div class="Section1"> To avoid being taxed as a distribution, a loan made from a plan to a participant or beneficiary must be made pursuant to an enforceable agreement ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3955">3955</a>) that meets certain requirements with respect to the term of the loan ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3956">3956</a>), its repayment ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3957">3957</a>), and the dollar amount loaned ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3958">3958</a>).<a href="#_ftn1" name="_ftnref1">1</a> Under the SECURE Act, plan loans cannot be repaid via credit card or similar arrangements.<a href="#_ftn2" name="_ftnref2">2</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC § 72(p)(2); Treas. Reg. § 1.72(p)-1, A-3(a). <a href="#_ftnref2" name="_ftn2">2</a>.  IRC § 72(p)(2)(D). </div></div>

March 13, 2024

3965 / How does the interest deduction apply to qualified plan loans?

<div class="Section1"> An employee is not allowed an interest deduction with respect to a loan (otherwise meeting the requirements explained in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3954">3954</a>) made after 1986 during the period on or after the first day on which the borrower is a key employee ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3931">3931</a>) or in which the loan is secured by elective contributions made to a 401(k) plan or tax sheltered annuity.<a href="#_ftn1" name="_ftnref1">1</a> Loans from a qualified retirement plan do not qualify as a qualified education loan for which an interest deduction is available.<a href="#_ftn2" name="_ftnref2">2</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC § 72(p)(3). <a href="#_ftnref2" name="_ftn2">2</a>.  Treas. Reg. § 1.221-1(e)(3)(iii). </div></div>

March 13, 2024

3967 / Are deemed distributions treated as outstanding loans?

<div class="Section1"> Yes. For purposes of the dollar limitation on loans under IRC Section 72(p) ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3954">3954</a>), a loan treated as a deemed distribution is considered an outstanding loan until it is repaid.<a href="#_ftn1" name="_ftnref1">1</a> Regulations place two conditions on loans made while a deemed distribution loan remains unpaid. First, the subsequent loan must satisfy the rules for qualifying plan loans. Second, the loan must either be repayable under a payroll withholding arrangement enforceable under applicable law or the participant must provide the plan with adequate collateral for the loan in addition to the participant’s accrued benefit. The payroll withholding arrangement may be revocable, but should the participant revoke it, the outstanding loan balance is treated as a deemed distribution. If, for any reason, the additional collateral ceases to be in force before the subsequent loan is repaid, the outstanding balance of the subsequent loan is treated as a deemed distribution. If these conditions are not satisfied, the entire subsequent loan is treated as a deemed distribution under IRC Section 72(p).<a href="#_ftn2" name="_ftnref2">2</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-19(b)(1). <a href="#_ftnref2" name="_ftn2">2</a>.  Treas. Reg. § 1.72(p)-1, A-19. </div></div>

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

3973 / How is an employee’s cost basis determined for an interest in a qualified plan?

<div class="Section1"> An employee normally will have no cost basis if a plan is noncontributory and does not provide life insurance protection. If life insurance protection has been provided under a cash value policy, the employee usually will have some cost basis, namely, the aggregate one year term costs that have been taxed to the employee, even though the plan is noncontributory.<a href="#_ftn1" name="_ftnref1">1</a> A self-employed person who is an owner-employee cannot include in his or her cost basis the annual one year costs of life insurance protection under Table 2001 or previously under P.S. 58 ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3948">3948</a>), even though these costs were not deductible.<a href="#_ftn2" name="_ftnref2">2</a> No self-employed person, whether or not an owner-employee, can include in cost basis the cost of any health insurance features under the plan. A common law employee’s cost basis consists of: (1)  total nondeductible contributions made by the employee if the plan is contributory and amounts contributed by an S corporation for years beginning before January 1, 1984, on behalf of a more-than-5-percent shareholder-employee in excess of the excludable amount; (2)  the sum of the annual one year term costs of life insurance protection under Table 2001 or previously P.S. 58 ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3948">3948</a>) that have been includable as taxable income if payment is being received under the contract that provided the life insurance protection( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3952">3952</a>); (3)  any other employer contributions other than excess deferrals ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3760">3760</a>) that already have been taxed to the employee, such as where a nonqualified plan was later qualified; (4)  certain employer contributions attributable to foreign services performed before 1963; and (5)  the amount of any loans included in income as taxable distributions ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3953">3953</a>). In addition, although amounts attributable to deductible employee contributions are not part of basis, it would seem they should be included in basis if benefits are received under the contract to the extent that they have been taxable to the employee because they were used to purchase a life insurance contract ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3952">3952</a>). This cost basis must be reduced by any amounts previously distributed to the employee that were excludable from gross income as a return of all or part of the employee’s basis.<a href="#_ftn3" name="_ftnref3">3</a> A self-employed person’s cost basis consists of (1) the nondeductible 50 percent of contributions made before 1968, after subtracting the cost of incidental benefits, if any, such as waiver of premium and health insurance benefits, and, in the case of an owner-employee, the costs of life insurance protection under Table 2001 or previously P.S. 58 ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3948">3948</a>), (2) contributions on behalf of owner-employees under the three year average rule for determining contributions to level premium insurance and annuity contracts in excess of the deductible limit, in effect for years beginning before 1984, and (3) nondeductible voluntary contributions, if any, to a contributory plan. In addition, any amounts taxed to an individual because they were attributable to deductible voluntary employee contributions used to purchase life insurance, if benefits are received under the contract, probably should be included. <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC § 61(a)(1); Treas. Reg. § 1.61-2(a)(1). <a href="#_ftnref2" name="_ftn2">2</a>.  IRC § 72(m)(2); Treas. Reg. § 1.72-16(b)(4). <a href="#_ftnref3" name="_ftn3">3</a>.  IRC § 72(f); Treas. Reg. §§ 1.72-8, 1.72-16(b)(4), 1.402(a)-1(a)(6), 1.403(a)-2. See also Rev. Rul. 72-149, 1972-1 CB 218. </div></div>

March 13, 2024

3975 / How is a beneficiary taxed on life income or installment payments of a death benefit under a qualified plan when an employee dies before retirement?

<div class="Section1"> If a beneficiary has no cost basis for the payments, each payment will be fully taxable as ordinary income when received. The beneficiary’s cost basis generally is the same as the employee’s cost basis ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3973">3973</a>). In the case of decedents dying before August 21, 1996, the $5,000 death benefit exclusion was included in the beneficiary’s cost basis.<a href="#_ftn1" name="_ftnref1">1</a> If the beneficiary does have a cost basis, payments are subject to the rules that follow, depending on whether the death benefits come from life insurance proceeds. If death benefit payments do not come from life insurance proceeds, the beneficiary is taxed as the employee would have been taxed had the employee lived and received the periodic payments ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3968">3968</a>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3969">3969</a>). The beneficiary’s cost basis, rather than the employee’s cost basis, is used. Depending on the annuity starting date, an exclusion ratio may have to be determined; if so, the beneficiary’s cost basis is used as the investment in the contract (for an explanation of the basic annuity rule and its application to various types of payments see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="527">527</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="552">552</a>). For annuities with a starting date on or before November 19, 1996, if a beneficiary elected the simplified safe harbor method for taxing annuity payments ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="613">613</a>) and increased the investment in the contract by any employee death benefit exclusion allowable, the beneficiary had to attach a signed statement to his or her income tax return stating that the beneficiary was entitled to such exclusion in applying the safe harbor method.<a href="#_ftn2" name="_ftnref2">2</a> After such date, if the annuitant is under age 75, the simplified method is required, rather than optional.<a href="#_ftn3" name="_ftnref3">3</a> When more than one beneficiary is to receive payments under a plan, the cost basis, including the $5,000 exclusion, if available, is apportioned among them according to each beneficiary’s share of the total death benefit payments. If death benefit payments do come from life insurance proceeds, the proceeds are divided into two parts: the amount at risk, which are proceeds in excess of the cash surrender value immediately before death, and the cash surrender value.<a href="#_ftn4" name="_ftnref4">4</a> The portion of the payments attributable to the amount at risk is taxable under IRC Section 101(d) as life insurance proceeds settled under a life income or installment option, as the case may be ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="71">71</a>). The amount at risk generally is prorated over the payment period, whether for a fixed number of years or for life, and the prorated amounts are excludable from the beneficiary’s gross income as a return of principal. Where payments are for life, the beneficiary’s life expectancy generally is taken from IRS unisex annuity tables V and VI.<a href="#_ftn5" name="_ftnref5">5</a> The portion of the payments attributable to the cash surrender value is taxed in the same manner as any other periodic payments from a qualified plan. Example: The widow of an employee who died on June 1, 2024 elects to receive $25,000 of life insurance proceeds in 10 annual installments of $3,000 each. The cash surrender value of the policy immediately before the insured’s death was $11,000. The employee made no contributions to the plan and the aggregate one-year term costs of life insurance protection that were taxed to the employee amounted to $940. The widow must include $1,506 of each $3,000 installment, computed in the following manner. <table border="1" align="center"> <tbody> <tr> <td width="359">Face amount of insurance contract</td> <td style="text-align: center;" width="148">$25,000</td> </tr> <tr> <td width="359">Cash value immediately before death</td> <td style="text-align: center;" width="148">11,000</td> </tr> <tr> <td width="359">Excludable as life insurance proceeds</td> <td style="text-align: center;" width="148">$14,000</td> </tr> <tr> <td width="359">Portion of each installment attributable to life insurance proceeds (14/25 of $3,000)</td> <td style="text-align: center;" width="148">$ 1,680</td> </tr> <tr> <td width="359">Excludable as return of principal ($14,000 ÷ 10)</td> <td style="text-align: center;" width="148">1,400</td> </tr> <tr> <td width="359">Includable in gross income</td> <td style="text-align: center;" width="148">$ 280</td> </tr> <tr> <td colspan="2" width="507"></td> </tr> <tr> <td style="text-align: center;" colspan="2" width="507">(If the beneficiary is the surviving spouse of an employee who died before October 23, 1986, the $280 would be excludable under the $1,000 annual interest exclusion)</td> </tr> <tr> <td colspan="2" width="507"></td> </tr> <tr> <td colspan="2" width="507">Portion of each installment attributable to cash surrender value</td> </tr> <tr> <td width="359">of the contract (11/25 of $3,000)</td> <td style="text-align: center;" width="148">$ 1,320</td> </tr> <tr> <td width="359">Beneficiary’s cost basis ($940)</td> <td style="text-align: center;" width="148">$ 940</td> </tr> <tr> <td width="359">Expected return (10 x $1,320)</td> <td style="text-align: center;" width="148">$13,200</td> </tr> <tr> <td width="359">Exclusion ratio ($940/$13,200)</td> <td style="text-align: center;" width="148">7.12%</td> </tr> <tr> <td width="359">Amount excludable each year (7.12% of $1,320)</td> <td style="text-align: center;" width="148">$ 93.98</td> </tr> <tr> <td width="359">Includable in gross income ($1,320 - $93.98)</td> <td style="text-align: center;" width="148">$ 1,226.02</td> </tr> </tbody> </table> The beneficiary may be entitled to an income tax deduction for any estate tax attributable to the decedent’s interest in the plan ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3993">3993</a>).<a href="#_ftn6" name="_ftnref6">6</a> It would seem that the deduction would be prorated over the beneficiary’s life expectancy, in the case of life income payments, or over a fixed period, in the case of installment payments ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="544">544</a>). <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.  Rev. Rul. 58-153, 1958-1 CB 43. <a href="#_ftnref2" name="_ftn2">2</a>.  Notice 88-118, 1988-2 CB 450, obsoleted by Notice 98-2, 1998-2 I.R.B. 22 below. <a href="#_ftnref3" name="_ftn3">3</a>.  Notice 98-2, 1998-1 C.B. 266. <a href="#_ftnref4" name="_ftn4">4</a>.  Treas. Reg. § 1.72-16(c). <a href="#_ftnref5" name="_ftn5">5</a>.  Treas. Reg. § 1.101-7. <a href="#_ftnref6" name="_ftn6">6</a>.  IRC § 691(c). </div></div>

March 13, 2024

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

<div class="Section1"> The withholding rules that apply to a distribution depend on whether it constitutes an eligible rollover distribution ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3998">3998</a>). 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 <a href="javascript:void(0)" class="accordion-cross-reference" id="4000">4000</a>). An employee receiving an eligible rollover distribution may not otherwise elect out of this withholding requirement.<a href="#_ftn1" name="_ftnref1">1</a> On the other hand, a recipient may elect out of withholding with respect to distributions that do not qualify as eligible rollover distributions.<a href="#_ftn2" name="_ftnref2">2</a> The amount to be withheld on periodic payments that are not eligible rollover distributions is determined at the rate applicable to wages.<a href="#_ftn3" name="_ftnref3">3</a> Non-periodic payments that are not eligible rollover distributions are subject to income tax withholding at the rate of 10 percent.<a href="#_ftn4" name="_ftnref4">4</a> 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. <hr> 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.<a href="#_ftn5" name="_ftnref5">5</a> <hr> The maximum amount withheld cannot exceed the sum of the money plus the fair market value of property received other than employer securities.<a href="#_ftn6" name="_ftnref6">6</a> 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.<a href="#_ftn7" name="_ftnref7">7</a> 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 <a href="javascript:void(0)" class="accordion-cross-reference" id="3948">3948</a>). <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC § 3405(c). <a href="#_ftnref2" name="_ftn2">2</a>.  IRC §§ 3405(a)(2), 3405(b)(2). <a href="#_ftnref3" name="_ftn3">3</a>.  IRC § 3405(a)(1). <a href="#_ftnref4" name="_ftn4">4</a>.  IRC § 3405(b)(1). <a href="#_ftnref5" name="_ftn5">5</a>.  Rev. Rul. 2019-19. <a href="#_ftnref6" name="_ftn6">6</a>.  IRC § 3405(e)(8). <a href="#_ftnref7" name="_ftn7">7</a>.  Notice 93-3, 1993-1 CB 293. </div></div>