7. Distributive Rules, Alternatives and Taxation

Question 1

Planning Retirement Distribution Questions

Answer 1

• What kinds of distributions does the plan itself allow? Should review plan documents, Summary Plan Description (SPD), to determine what options are available
• Should the distribution be made in a lump sum/ periodic payout?
• Can or should the distribution be rolled over?
• If periodic payments are chosen, what kind of payment schedule is best? It is important to note that spousal consent is required for a payment option that cuts out the spouse.
  -Are the minimum distribution requirements satisfied?
• Is the payment subject to a 10% early distribution penalty?
• How will the payments be taxed?
• If a lump sum payment is chosen, is it eligible for 10-year averaging? If eligible, is the election of 10-year averaging beneficial?
  -If the participant was in the plan before 1974, is election of capital gain treatment beneficial? How much tax is payable?
  -What are the potential future estate tax consequences of the form of distribution chosen?

Question 2

Qualified pension plans provisions for spousal benefits

Answer 2

All qualified pension plans must provide two forms of survivorship benefits for spouses:
-Qualified Preretirement Survivor Annuity (QPSA): monthly payment to the surviving spouse of a plan participant who dies before reaching retirement age. The benefit received by the spouse is %age (50%) of what plan participant would have received if they had retired- may have option of lump sum payment rather than annuity payment for life
-In DB plan, then the survivor annuity payable =amount paid under qualified joint and survivor annuity if participant -retired on day before death or separated from service on earlier of separation/death and survived earliest retirement age, then retired with immediate joint and survivor annuity
-Under DC plan, the qualified preretirement survivor annuity is an annuity for the life of the surviving spouse.
-Qualified Joint and Survivor Annuity: must not be 50-100% of the annuity payable during the joint lives of the participant and spouse. Election to waive the joint and survivor form must be made during the 90-day period ending on the annuity starting date.

Question 3

Automatic benefit

Answer 3

preretirement survivor annuity must be communicated to all vested participants 32+- spouse must write, acknowledge effect of waiver and be witnessed if benefit is to be given up/to someone else.

Question 4

All qualified pension plans must provide two forms of survivorship benefits for spouses, the preretirement survivor annuity and the joint and survivor annuity. The plans that need not provide for such survivorship benefits for spouses, if the participant’s nonforfeitable account balance is payable as a death benefit to that spouse, are which of the following?

Answer 4

Stock bonus plans, profit sharing plans and ESOPs generally need not provide these survivorship benefits for the spouse if the participant’s nonforfeitable account balance is payable as a death benefit to that spouse.

Question 5

Defined Benefit Plan Distribution Provisions

Answer 5

-Period-Certain Option
-Other than spouse beneficiary- if much younger, would be limited

Question 6

Defined Contribution Plan Distribution Provisions
profit sharing, 401(k) and money purchase plans.
money purchase plans, target benefit plans, Section 403(b) tax-deferred annuity plans

Answer 6

-Period-Certain Option
-Other than spouse beneficiary- if much younger, would be limited

Don’t need to meet above rules if:
There is no annuity option, and
The plan participant’s account balance is payable to the participant’s spouse in the event of the participant’s death.

Often lump sum, may offer at will. If balance >$5,000, the plan can’t force anyone to remove money from the account; otherwise will provide notice and if between $1-5K, can transfer to IRA. <$1k, may distribute assets to participant

Question 7

Participant’s cost basis
*If the plan trustee cashes in a life insurance contract before distribution, this cost basis amount is not available. For a person who is now or was self-employed, the cost of life insurance protection is not includable in basis. The annual value of the life insurance coverage is determined using Table 2001 and is attributed to the participant each year.

Answer 7

-after-tax contributions made by the employee to a contributory plan
-cost of life insurance protection actually reported as taxable income on federal income tax returns by the participant, if the plan distribution is received under the same contract that provides the life insurance protection,
-employer contributions previously taxed to the employee
-employer contributions attributable to foreign services performed before 1963,
-plan loans included in income as a taxable distribution

Question 8

After-tax contribution time line and withholding

Answer 8

Pre-1987, possible to withdraw after-tax money first; however after 1987, distribution is split into nontaxable (basis) and taxable amounts; also mandatory 20% withholding applies to qualified plans

Question 9

Net Unrealized appreciation of employer stock distribution from Nonqualified /401K/Profit sharing

Answer 9

At distribution: Stock appreciation (NUA taxed @ LTCG) +employer stock contribution (taxed at ordinary income)= total account balance

Question 10

Grandfathered rules for lump sum distributions

Answer 10

10 year averaging from 1974-1986. If turned 50 before 1/1/1986, may use 10 yr averaging using 1984 tax rates. Cap gain rate 20% attributable to pre-1974 accumulations to participants who turned 50 before 1/1/1986

Also applies to death benefits

Question 11

Treatment of qualified plans account as part of decedent’s gross estate for Federal taxes

Answer 11

Includable, although qualified plan may be designed to include life insurance Section 2042 where decedent does not have incidents of ownership and would not be subject to taxation, eg using separate trusts or subtrusts under the plan for holding insurance policies, together with irrevocable beneficiary designations.

Question 12

Taxable part of a plan distribution is determined by the total cost basis divided by the total payout. The cost basis includes:

Answer 12

cost basis includes employee after-tax contributions, cost of life insurance reported as taxable income, employer contributions taxed to employee and plan loans included as taxable income

Question 13

Advantages of lump sum distribution

Answer 13

Provisions for 10-year averaging if born before 1936 and a choice of investment options.

Question 14

Advantages of deferred payout

Answer 14

tax deferral, tax shelter and security of income and if proceeds are rolled over/direct transfer, a choice of investment options.

Question 15

Factors in determining payout

Answer 15

age and health of the participant, return on investment, expected tax rates, income requirements and the size of the total amount of the benefit.

Question 16

Benefits of Leaving retirement assets in plan

Answer 16

Mutual funds with low institutional expense ratios
Fund are regularly monitored and replaced if necessary
Website support and assistance
ERISA protection from creditors
Post age 55 separation from service withdrawals without 10% penalty

Question 17

Requirements of Code Section 4975(d)(1) to be exempt from penalties as prohibited transactions (Loans from qualified plan/Section 403(b))

Answer 17

-available to all participants and beneficiaries on a reasonably equivalent basis
-not made available/in greater amounts to HCE as opposed to other employees
-in accordance with specific provisions regarding such loans
-bear reasonable interest rates
-adequately secured

Question 18

Requirements of Code Section 72(p) to be exempt from penalties as prohibited transactions (Loans from qualified plan/Section 403(b))

Answer 18

aggregate loans cannot exceed $10,000 or the lesser of:
-$50,000 reduced by excess of highest loan balance in preceding year over outstanding balance on date when loan is made
- one half of present value of participant’s vested account balance or accrued benefit (DB plan)
-repayable in 5 years, with consumer interest which is not deductible (unless proceeds used to acquire principal residence and if not 401k/403b plan

Question 19

When are interest deductions from loans prohibited

Answer 19

• key employee
• secured by 401k/403b tax-deferred annuity plan account based on salary reductions

Question 20

Treatment of QDRO distribution for alternate payee/spouse

Answer 20

Not subject to the 10%, pre-59.5 early withdrawal excise tax; but if not rolled over, then subject to income tax

Question 21

Early Distribution Penalty for different plans

Answer 21

-10% if from qualified plans, Section 403(b) tax-deferred annuity plans, IRAs and SEPs
-25% for first 2 years of participation from SIMPLE IRAs

*None from 457 prior to 59.5

Question 22

Minimum distribution requirements and penalty

Answer 22

RMDs from qualified plans, Section 403(b) tax-deferred annuity plans, IRAs, SEPs, SIMPLE IRAs, and Section 457 governmental deferred compensation plans must begin not later than April 1 of the calendar year following the later of turning 73. If take less, then 25% penalty on amount not withdrawn

Question 23

Tax treatment of rollovers

Answer 23

• Distributions from qualified plans are eligible for a rollover not subject to 20% withholding if RMD beg at 70.5, one of a series of substantially equal periodic payments or hardship distribution

Distributions from a rollover IRA are not eligible for 10-year averaging. They are subject to the same rules as all traditional IRA distributions. Loans from a rollover IRA are not permitted.

Question 24

Failure to roll over the distribution within 60 days subjects it to income taxes, even if the employee may be eligible to elect 10-year averaging. Which of the following gives the Secretary of the Treasury the right to waive the 60-day rule? (Select all that apply)

Answer 24

The Secretary of the Treasury may waive the 60-day rule where it would be against equity or good conscience to enforce it, including cases of disaster, casualty or other events beyond the participant’s control.

Question 25

Larry, age 50, has a vested account balance in a Section 401(k) plan of $300,000. Larry has accepted a new job and is taking a lump-sum distribution from his Section 401(k) plan and has notified his plan administrator he intends to rollover the distribution within 60 days. What amount will Larry receive in the lump-sum distribution?

Answer 25

If the direct transfer method is not chosen in the case of a distribution from a qualified plan, Section 403(b) plan, or eligible Section 457 governmental plan, the distribution is subject to mandatory withholding at 20%. Larry will receive $240,000 and $60,000 with be withheld for federal income taxes.

Question 26

Patty is retiring this year and has a Section 401(k) account balance of $500,000, of which $200,000 is invested in employer stock. The employer basis in the stock when contributed was $50,000. If Patty takes a lump-sum sum distribution from the plan and makes a net unrealized appreciation (NUA) election, what amount is taxed as long-term capital gain this year?

Answer 26

$0
The employer basis in the stock is taxed as ordinary income in the year of the lump-sum distribution and the gain at the time of the distribution is taxed as long-term capital gain when the stock is subsequently sold. In this example, $50,000 is taxed as ordinary income this year and $150,000 is taxed as long-term capital gain when Patty sells the stock. The example does not state Patty sold the stock this year.

Question 27

in-service partial plan distribution made from a qualified plan

Answer 27

• includes both nontaxable and taxable amounts.
• will be subject to mandatory federal income tax withholding at 20%.
• may be subject to the early distribution penalty.
• may be transferred to an eligible retirement plan by means of a direct transfer rollover

Question 28

If a qualified plan participant has reached age 73 and commenced required minimum distributions (RMDs), what is the maximum possible penalty if less than the RMD amount is distributed?

Answer 28

25% of the amount that should have been distributed but was not distributed

Question 29

Larry, age 50, has a vested account balance in a Section 401(k) plan of $300,000. Larry and his spouse are in the process of finalizing a divorce and 50% of Larry’s Section 401(k) plan balance will be transferred to his soon-to-be former spouse under a Qualified Domestic Relations Order (QDRO).

If Larry is in a 22% marginal income tax bracket, what is the total income tax and penalty will Larry owe on the distribution?

Answer 29

Larry is not subject to income tax or penalty for funds distributed under a QDRO. If not rolled over, the recipient is subject to regular income tax on the distribution but distributions under a QDRO are exempt from the 10% early withdrawal penalty tax.

Question 30

Larry, age 50, has a vested account balance in a Section 401(k) plan of $300,000. He occasionally takes loans from the account to finance various purchases. Ten months ago, he borrowed $10,000 for a cruise and finished repaying the loan last month. Now, Larry wants to borrow the maximum amount from the plan to make a down payment on a new home.

What is the maximum loan Larry make take from the plan today?

Answer 30

the maximum loan Larry may take today is $40,000. IRC Section 72(p) provides that aggregate loans from qualified plans to any individual plan participant cannot exceed the lesser of:

$50,000, reduced by the excess of the highest outstanding loan balance during the preceding one-year period over the outstanding balance on the date when the loan is made, or
One-half the present value of the participant’s vested account balance or accrued benefit, in the case of a defined benefit plan.

Question 31

Identify the correct treatment for Non-Qualified Distributions from Roth IRAs that are applied to Regular Roth Contributions. (Select all that apply)

Answer 31

No Income Tax
No Penalty

Question 32

The mandatory federal tax withholding from a direct transfer rollover from a qualified plan to an IRA is:

Answer 32

0: Federal tax withholding is not required for a direct transfer rollover from a qualified plan to an IRA. A traditional rollover from a qualified plan requires 20% mandatory withholding.

Question 33

Alicia, age 59, is transferring several retirement accounts to a new firm. She is transferring the IRAs using the direct transfer method and she is transferring the 401(k) account using the traditional rollover method as she may temporarily use some of the funds before depositing them into an IRA within 60 days. Alicia is in a 22% marginal federal tax bracket and a 15% average tax bracket.

Traditional IRA with a balance of $50,000
Rollover IRA holding her previous Section 401(k) funds with an account balance of $100,000
Roth IRA with an account balance of $20,000
Section 401(k) account still held at a previous employer with an account balance of $75,000
What total amount Alicia will take possession of in executing these transfers?

Answer 33

A traditional rollover from the Section 401(k) account still held at a previous employer will require a mandatory 20% withholding. This reduces the amount she will receive by $15,000 and she will take possession of $60,000. The IRAs do not require mandatory withholding.

Question 34

Alicia, age 59, is transferring several retirement accounts to a new firm. She is transferring the IRAs using the direct transfer method and she is transferring the 401(k) account using the traditional rollover method as she may temporarily use some of the funds before depositing them into an IRA within 60 days. Alicia is in a 22% marginal federal tax bracket and a 15% average tax bracket.

Traditional IRA with a balance of $50,000 (100% deductible contributions)
Rollover IRA holding her previous Section 401(k) funds with an account balance of $100,000
Roth IRA with an account balance of $20,000
Section 401(k) account still held at a previous employer with an account balance of $75,000
If she completes the 401(k) traditional rollover with the funds received within 60 days what will be the amount of tax owed pertaining to the rollovers this year?

Answer 34

A traditional rollover from the Section 401(k) account still held at a previous employer will require mandatory 20% withholding. This reduces the amount she will receive by $15,000. Alicia did not replace the $15,000 before redepositing the rollover into an IRA. Therefore, the $15,000 withheld will be deemed a distribution and subject to ordinary income tax and 10% early withdrawal penalty. The IRAs do not require mandatory withholding.

Question 35

Catastrophic illness coverage provides for accelerated death benefit payments towards each of the following catastrophic illnesses EXCEPT:

Renal Failure
Undiagnosed Cancer
Heart Attack
Stroke

Answer 35

Catastrophic illness coverage provides for accelerated death benefit payments on approximately the same terms and conditions as terminal illness coverage. The difference is the insured must have been diagnosed as having one of several listed catastrophic illnesses.

Question 36

When funds from a Traditional IRA are withdrawn before age 59 ½ for qualified educational expenses, which of the following apply?

10% early withdrawal penalty
ordinary income tax

Answer 36

When funds from a Traditional IRA are withdrawn before age 59 ½ for qualified educational expenses the 10% early withdrawal penalty is waived, but the funds are taxed as ordinary income.

Question 37

Yang, age 40, files taxes as single. He has MAGI of $100,000 in 2023. Yang is a participant in his employer’s Section 401(k) plan under which his employer matches contributions dollar-for-dollar up to 5%. Plan forfeitures are used to offset employer plan expenses. He suspended contributions to the plan last year but made the maximum allowable contribution to a traditional IRA for 2023. How much of the IRA contribution is deductible for 2023?

Answer 37

Yang may deduct the $6,500 contribution to the traditional IRA. Yang is not considered an active participant for IRA contribution deduction purposes because no annual additions were made to his Section 401(k) account in 2023.

Question 38

Khan, age 55, is leaving his current employer of 10 years after accepting a new position with a different company. He is relocating to an area with a much lower cost of living and Khan is excited to be purchasing his first home after leasing homes in the city. To make the down payment, Khan is liquidating an IRA with an account balance of $50,000, of which $10,000 is basis. He is also executing a traditional rollover of his Section 401(k) account from his former employer, which has an account balance of $100,000. Khan is keeping $20,000 of the Section 401(k) funds to add to the home down payment.

How much in early withdrawal penalties will Khan pay?

Answer 38

Khan is age 55 and separating from service with his employer, therefore, the $20,000 distribution from the Section 401(k) is not subject to penalty. Of the $50,000 IRA distribution, $40,000 is taxable. The first-time home purchase penalty exception applies but is subject to a lifetime $10,000 limit, leaving $30,000 subject to a 10% early withdrawal penalty.

Question 39

exceptions to the early withdrawal penalty for distribution from a qualified plan

Answer 39

Disability
Age 55 and separation from service from the employer
Medical expenses in excess of 7.5% of adjusted gross income