As baby boomers are getting ready to retire over the next 20 years, one of the decisions they will need to make is how they will withdraw the retirement funds they have accumulated in qualified retirement plans. Careful consideration must be given to the distribution option chosen by the plan participant, as the choice can affect the tax consequences of the distribution and its integration with the retiree's Social Security benefits. If you're approaching retirement, this will be any issue for you - read on to find out how to tackle the distribution of your retirement funds. (For lots of information on types of retirement plans, see Introductory Tour Through Retirement Plans.)
Qualified Retirement Plan Distribution Options
Qualified plan distributions can be made in the following ways:
- a lump-sum distribution
- a series of periodic payments
- a rollover into another qualified plan or an IRA
For a distribution to be made as a lump sum, it must meet four conditions:
- It must be made in one tax year.
- It must represent the full balance of the retiree's credit from all qualified plans of a single type.
- The distribution must be payable at death, at attainment of age 59.5, or at separation from service.
- It must also be paid from a qualified plan. (For more, see Lump-Sum Versus Regular Pension Payments.)
Another available retirement distribution option is via a series of payments. These payments can be received either in a series of regular and equal payments (annuity) or a series of irregular and/or unequal (non-annuity/discretionary) payments.
If the payments are received in the form of regular and equal payments, the choice of available distribution method will vary depending on the retiree's marital status. If the retiree is single, qualified retirement plans must distribute retirement benefits in the form of a life annuity (unless the participant chooses another form of distribution), under which the retiree will receive a series of equal periodic payments over her/his entire lifetime. The size of each payment will be determined by the retiree's level of benefits (fund amount or account balance), the retiree's actuarially determined life expectancy and internal interest rate. (Learn more in An Overview Of Annuities.)
If the retiree is married, there are two distribution options available. The first option - which is automatic - is the qualified joint and survivor annuity (QJSA), which provides benefits to either the retiree or his or her spouse as long as one of them is alive. This type of annuity option is meant to protect the retiree's spouse and/or beneficiary by requiring certain types of qualified retirement plans to pay benefits to the survivor after the death of the retiree, and it is available from money-purchase pension plans, benefit pension plans and profit-sharing 401(k) plans. The level of payment to the surviving spouse is at least 50% of the joint annuity. (Read more in The Tax Benefits Of Having A Spouse.)
The second option is the qualified optional survivor annuity (QOSA), which is a requirement of the Pension Protection Act of 2006. It is available as of the year 2008 and only after the retiree has obtained spousal written consent and waived the QJSA option. The QOSA provides benefits for the life of the retiree with a survivor annuity for the life of the spouse.
If the QJSA pays the surviving spouse a benefit that is less than 75% of the annuity paid to the retiree and spouse when both are alive, then the QOSA must be a 75% QJSA annuity and pay out to the surviving spouse benefits equal to 75% of the amount that both were receiving when the retiree was alive. However, if the QJSA pays out benefits that are more than 75% of the annuity, then the QOSA must be a 505 joint and survivor annuity.
Not all qualified retirement plans are required to provide a QJSA and a QOSA option if they have met the following three conditions:
- The retirement plan does not allow for an annuity option.
- It does not accept direct transfers from other plans.
- The retiree's vested benefits are paid in full to his or her spouse in the event of the retiree's premature death.
Another distribution option of a qualified retirement plan is one that pays out irregular and discretionary/unequal payments. A retiree may choose to receive non-annuity payments from a qualified plan, provided that the plan administrator is willing to assume the cost of providing such an option.
The rollover option provides a retiree with the opportunity to postpone payment of taxes on plan distributions by rolling over or transferring all or part of the distribution funds to another qualified plan (if he or she continues employment with another employer) or to an IRA. To qualify for a tax-free rollover:
- The retirement funds should be transferred from the old account to a new account within a 60-day time frame.
- If the retirement assets are in the form of property, not cash, that same property must be transferred to the new account.
- If a tax-free rollover was made in the preceding 12 month-period, then a second transfer is not allowed. (For more, see Exceptions To The 60-Day Rollover Rule.)
The major rollover types used to implement such action are:
- the conduit rollover
- the direct rollover
- the trustee-to-trustee transfer
- the indirect rollover
- the spousal-beneficiary rollover
- the non-spouse beneficiary rollover
Qualified plans tend to provide many tax advantages for both employers and employees; however, in order for a retirement plan to be deemed "qualified", it must meet stringent requirements of the Internal Revenue Code (IRC) and the Employee Retirement Income Security Act of 1974 (ERISA). (Read about the definition of qualified plans under ERISA in What is the difference between qualified and non-qualified plans?)
The way in which a retiree elects to receive plan distributions may have its own tax consequences. Additionally, some questions that must be asked are:
- Is the retiree is eligible for 10-year forward averaging? This tends to mitigate the taxation on the distributions received over the next 10 years.
- Was the retiree a common-law employee, a part owner or self-employed?
A lump-sum distribution will be taxed as ordinary income (included in the gross income for the tax year it was received) at the applicable tax rates. However, if the distribution qualifies as a lump sum, it may be eligible for 10-year forward averaging, which will result in lower taxation over the 10 years following the distribution. For a retiree to qualify for 10-year forward averaging, the following three conditions must be met:
- The retiree was born before 1936. (Read more in Combining Your Plan Assets? Not So Fast!)
- He or she has elected the lump-sum distribution on all distributions received during the year.
- He or she has participated in the employer's qualified plan for at least five years. (For more, see Tax Treatment Of Roth IRA Distributions.)
If the distribution is received in the form of an annuity from a qualified plan, it may contain two portions - pre- and after-tax dollars - depending on the plan type. To avoid double taxation in such a case, the retiree, based on his or her cost basis to the retirement plan, can determine the nontaxable portion of each distribution in conjunction with the annuity schedule. This calculation is based on the retiree's age at the starting date of distribution and the number of the monthly payments.
If the retiree elects to receive the retirement benefits in a series of unequal/discretionary amounts on an irregular basis, the tax treatment on the distributions will depend on:
- Whether the amount was received under either an annuity contract or a life insurance or endowment contract
- Whether the amount was received on or after the "annuity starting date" or before it
- Whether the amount was in the nature of a refund in full discharge of the contractual obligation; a dividend; received on surrender, redemption, or maturity of the contract; or received under a modified endowment contract
Should the retiree elect not to receive retirement distributions and roll the funds over into another qualified plan or an IRA, the tax implications will depend on the type of rollover selected (conduit, direct, etc.).
Choosing the Appropriate Retirement Distribution Method
Selecting the appropriate retirement distribution method involves considering the following:
- The retiree's income requirements
- Inflation effects (Read Combating Retirement's Silent Killer for more.)
- Retirement plan distributions integrated with Social Security retirement benefits
- The tax implications of the available options and choices
Social Security pension plan integration with qualified retirement plans is seeking to ensure retirement income adequacy and equity for all covered employees, regardless of salary level. The approach to integration will depend on whether the qualified retirement plan is defined-benefit or defined-contribution, as certain defined-contribution plans, such as 401(k) plans, simplified employee pension (SEP) plans, and employee stock ownership plans (ESOPs) may not be integrated. (For further reading, see Should You Consider An ESOP?)
There are two integration approaches, the "offset" and the "step-rate"; each has a different impact on the size of the benefit received by the retiree.
- The offset approach reduces pension benefits for each dollar in Social Security benefits received, and the maximum allowable benefit reduction is one-half of the annual Social Security benefit.
- The step-rate approach allows discrimination in favor of highly compensated employees. It uses a prescribed wage level called the "integration level", which is set by law and cannot be higher than the maximum taxable earnings base in a given year.
Qualified retirement plan participants and beneficiaries should work with competent and knowledgeable tax and financial-services professionals to explore the best retirement distribution option available to them. The tax and/or financial professional should be able to review the participant's account statements and other communication from the employer to determine the distribution options available to the participant, whether any of the assets are eligible for favorable tax treatment and ways to achieve it.
For further reading, see Tough Times…Should You Disturb Your Qualified Plan's Assets?