In previous posts we have discussed the unique characteristics of defined contribution plans (such as profit-sharing plans and 401(k) plans) and IRAs. We noted that a person is usually better off delaying distributions from a defined contribution plan or IRA as long as possible.
There are some situations where deferring distributions is not a good strategy. A few of those situations are described below. While there are other situations where deferral is not beneficial, the following exceptions warrant special attention.
1. When the distribution includes employer securities.
- Assume John is a beneficiary of the XYZ Corporation profit-sharing plan. The profit-sharing plan purchased XYZ stock at $15 per share. John retires and receives the XYZ stock when it is trading at $100 per share. Only the $15 is subject to tax in the year of distribution. The $15 is taxed at ordinary income rates, and John will have a $15 basis in the stock.
- If John sells the stock for an amount between $15 and $100, he will pay tax at long-term capital gains rate on the sale price in excess of $15. If he sells the stock within one year of the distribution, any proceeds in excess of $100 will be taxed as short-term capital gain. John will recognize long-term capital gain on all of the gain if he holds the stock for longer than one year after the date of distribution.
As with most assets, the basis in the stock steps up (or down) to fair market value on the date of the owner’s death. If the stock in the example is worth $110 on John’s death, the basis in the stock would step up to $110. John’s heirs could sell the stock for $110 and pay no tax.
Beneficiaries will lose this advantageous treatment for employer securities if they roll a qualified plan distribution into an IRA. Only distributions of employer securities from a defined contribution plan benefit from this provision.
There are a couple of rules to keep in mind if a beneficiary wants to take advantage of this provision for employer securities. The beneficiary only gets this benefit if he receives the employer securities and pays tax on them. If the beneficiary is under 59 and 1/2 years old, he could be subject to a 10% penalty if the distribution is treated as an early distribution.
The beneficiary also does not receive the special treatment for employer securities unless the distribution is a “lump sum distribution.” This term has a technical meaning.
To be a lump sum distribution, the beneficiary must receive his entire defined contribution plan balance from the employer and other defined contribution plans related to that employer in the same year. If the distribution is not a lump sum distribution, the beneficiary is taxed on the unrealized appreciation in the employer securities.
2. When the beneficiary will have a substantial estate tax.
If the beneficiary’s estate is subject to significant estate tax, the recipients of the retirement benefits will be entitled to an income tax deduction for the estate tax paid on the benefits. In this situation, it may be better to take distributions as soon after the beneficiary’s death as possible.
With the federal estate tax exemption amount being in excess of $5 million, the deduction may not come into play as often anymore, but the provision could apply to some situations.
3. When “grandfather” rules apply.
There are some special grandfathering rules that can apply. These rules apply to relatively few people but have a major impact if they do apply. Some of these rules provide very favorable tax treatment on distributions from a plan.
Qualified plan beneficiaries (but not IRA beneficiaries) born before 1936 may be entitled to a special low tax rate on distributions.Beneficiaries that made an election prior to 1984 may get favorable tax treatment on distributions. The benefits of these grandfather rules typically are lost for beneficiaries that roll the proceeds to an IRA.
4. When the beneficiary will be able to take distributions at a low tax rate.
The beneficiary may want to take the distribution (or a large portion of it) in a year when her tax rate is especially low. Assume someone has a large net operating loss in one year. That person may want to take a large distribution in that year. Note, however, that a 10% penalty may apply to distributions to persons who are not at least 59 and 1/2 years old.
5. When a qualified plan may not allow for lengthy payout.
Certain plans may not allow for lengthy benefit payouts. Usually it is possible to work around these restrictions by rolling the account to an IRA. However, there are times when this is not possible.
6. When long-time deferral conflicts with another beneficiary goal.
Sometimes the requirements for long-term deferral conflict with the beneficiary’s other goals.
For example, a husband may want to leave an interest in a retirement plan to a trust that provides benefits to his wife during her life. The husband may want any plan balance left at his wife’s death to go to his children. He does not want his wife to control where the asset goes when she dies. (This may be a particular concern when the husband has children from a former marriage.) The husband’s desires may conflict with obtaining the longest possible deferral.We will talk about this situation more in a later post.
Next week’s post will explore more issues with retirement plan benefits.
As always, this post discusses general rules and is not specific legal or tax advice for you to rely on. Please consult a qualified advisor to discuss your specific situation.