TAXATION OF DISTRIBUTIONS FROM QUALIFIED PLANS

TAXATION OF DISTRIBUTIONS FROM QUALIFIED PLANS

I. PERIODIC PAYMENTS

A. Ordinary Income. Periodic payments from qualified plans paid out over more than one year are taxed under the general annuity rules of the Code.

1. Code Section 402 states the general rule that amounts actually distributed from a qualified plan are taxable in the year distributed, as provided in Code Section 72. For a plan that has accepted no employee contributions, provides no life insurance, and is not covered under the special rules of Code Section 402, each distribution from the qualified plan is taxed in full as ordinary income.

2. Payments that do not meet the definition of a "lump sum distribution" under Code Section 402, even though they do not technically meet the definition of an "amount received as an annuity" under Code Section 72, are still taxable under Code Section 72, even though such payments are not paid in periodic installments at regular intervals.

3. In the case of defined contribution or individual account plans, periodic payments may be made from the individual account until it is exhausted. Such periodic payments are treated as annual distributions under Code Section 72.

4. In the case of defined benefit plans, periodic distributions are typically in the form of life annuities, that is, the payments continue for the lifetime of the recipient, or the recipient and his or her beneficiaries. The total amount payable is determined on the basis of actuarial assumptions of mortality and interest.

B. Return of Tax Basis.

1. Participants may recover, tax-free, their tax basis, which typically consists of employee after-tax contributions or insurance-related P.S. 58 costs. Recovery is made on a pro rata basis.

2. Prior to the Tax Reform Act of 1986 (the "1986 Act"), tax basis could be recovered either pro rata or under the "three-year rule)". If the total annuity distributions expected over three years were at least equal to the participant' s basis, then the three-year rule applied.

3. The participant could receive his or her tax basis back first, i.e., the first distributions were recovered tax-free. After the 1986 Act, the pro rata rule

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applies to all distributions except those which were grandfathered under the 1986 Act.

C. Pro Rata Rule. The pro rata rule is used to determine what part of an annuity distribution is excluded from income. It provides that a percentage of each distribution is treated as a return of the employee's basis.

1. To determine the percentage of the distribution which is taxable, the total after-tax employee contribution is divided by the total anticipated payments over the term of the annuity. The anticipated payments are determined by referring to tables in the Code. Both the Small Business Act of 1996 ("1996 Act") and the Taxpayer Relief Act of 1997 ("1997 Act") simplified the method of determining the nontaxable portion of each payment received. The nontaxable portion is determined by dividing the investment in the contract (as of the annuity starting date) by a designated number of monthly payments. The number of monthly payments is determined by reference to tables in the Code. Prior the 1997 Act, one table was used for single as well as joint and survivor annuities. Effective for annuity starting dates beginning after December 31, 1997, a separate table is used where benefits apply to the life of more than one annuitant. See Code Section 72(d)(1)(B)(iv).

2. Items which constitute "basis" in an annuity are: nondeductible employee contributions not previously withdrawn, P.S. 58 costs included by the participant in income annually as attributable to life insurance protection, employer contributions which have already been taxed, and amounts paid by an employee as principal payments on any loans that were treated as distributions. Note: Prior to the 1996 Act, the $5,000 death benefit exclusion allowed under Code Section 101(b)(1) would have been a nontaxable distribution. However, that exclusion was repealed, effective as of the date of enactment of the 1996 Act.

3. If a plan participant has no items of tax basis, all annuity payments are fully taxable.

II. LUMP SUM DISTRIBUTIONS

A. Definition. A lump sum distribution or payment from a qualified retirement plan (401(a) plan or 403(a) plan) that is:

1. A payment or distribution within one tax year of the recipient; 2. A payment or distribution of the "balance to the credit" of an employee; and

3. Amount payable on one of four possible triggering events.

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a. On account of the employee's death;

b. After the employee attains age 592;

c. On account of the employee's separation from service; or

d. After the employee has become disabled (within the meaning of Code Section 72(m)(7)). I.R.C. ?402(e)(4)(D).

4. Note that there must be a direct casual relationship between the distribution and one of the triggering events listed above.

Example:

A receives a periodic payment after attaining age 592. Later, in another year, the plan is amended to provide lump sum distributions and A receives a single-sum payment. The direct cause of the distribution is the amendment, not a triggering event.

B. Five and Ten-Year Averaging. Prior to the 1986 Act, a recipient of a lump-sum distribution could allocate the distribution between the capital gain (pre-1974) and the ordinary income (post-1973) portions of the distribution. The ordinary income portion of the distribution was taxed separately and was eligible for special ten-year averaging. The recipient of the lump-sum distribution also had the option to calculate the tax on the entire lump-sum distribution using the ten-year averaging method. After the 1986 Act, ten-year averaging was generally no longer available. Instead, recipients of lump sum distributions were able to elect five year averaging only.

1. Effective for tax years beginning after December 31, 1999, five year averaging is repealed.

2. Grandfather rule. An employee who was 50 years old before January 1, 1986, and who elects income averaging treatment may elect ten-year averaging. If the taxpayer elects ten-year averaging, the 1986 tax rates must be used. Further, a taxpayer who is eligible for the transition rule may elect to have any portion of the distribution allocable to pre-1974 participation in the plan treated as long term capital gain and taxed at rate of 20%.

C. Employer Securities. If a lump-sum distribution includes securities of the sponsoring employer, the entire amount of any net unrealized appreciation in the securities is excluded from the taxpayer's income in the year of the distribution. Net unrealized appreciation is taxable at the time the securities are liquidated. I.R.C. ?402(e)(4)(A)

III. DOMESTIC RELATIONS ORDERS

A. Distributions from Qualified Plans Under Qualified Domestic Relations Orders (" QDROs"). Generally, qualified plans may pay benefits only to participants. Special

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rules exists for persons receiving payments pursuant to certain domestic relations orders ("DROs").

1. A QDRO is a DRO that creates or recognizes the existence of an alternate payee's right to, or assigns to an alternate payee the right to receive all or a portion of the benefits payable with respect to a participant under a plan, and meets requirements with respect to the specificity of certain facts, and does not alter the amount or form of benefit or require payment of benefits to an alternate payee that are required to be paid to another alternate payee under a prior QDRO. I.R.C. ?414(p).

2. Distributions to a spouse or former spouse who is an "alternate payee" (any spouse, former spouse, child, or other dependent of a participant who is recognized by a DRO as having a right to receive all, or a portion of, the benefits payable under a plan with respect to such participant. I.R.C. ? 414(p)(8)) under a QDRO generally are includable in the income of that spouse or former spouse. The alternate payee becomes subject to all taxes, as if the account belonged to the alternate payee from the beginning. I.R.C. ? 402(a), 402(e)(1)(A); In Clawson v. Comm'r, T.C. Memo 1996-446, the alternate payee was taxed on the distribution she received under a QDRO even though the QDRO provided that the participant would pay the taxes owing on the distribution. See also Swoboda v. Swoboda, 2000 Tex. App. Lexis 2185 (Tex. Ct. App. 2000) (alternate payee liable for taxes on ex-spouse's plan account even though QDRO did not specify liability).

a. For an alternate payee other than a spouse or former spouse, any distribution is generally includable in the gross income of the participant rather than the alternate payee. I.R.S. Notice 89-25, 1989-1 C.B. 662, Q&A 3.

b. A plan participant's basis is allocated between the participant and the alternate payee if the alternate payee is a spouse or former spouse. The basis is allocated, pro rata, between the present value of the distribution made to the alternate payee and the present value of all other benefits payable to the participant to which the QDRO relates. I.R.C. ?72(m)(10).

c. If the alternate payee is not a spouse or former spouse, then the basis is recovered by the participant and the distribution is includable in the participant's income.

3. Amounts paid from a qualified plan under a QDRO are not subject to the 10% tax on premature distributions. This is so regardless of whether payments are made to a spouse or nonspouse alternate payee. I.R.C. ? 72(t)(2)(C).

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