Retirement Plan Distribution Rules

Distribution/Withdrawal Rules

Distributions taken from a qualified retirement plan are taxed as ordinary income. If taken prior to age 59½, the distribution is also subject to a 10% penalty. While it is not possible to avoid taxation, the 10% penalty will not be imposed if the distribution is due to:

• Death
• Disability
• Divorce
• Financial Hardship
• Qualified Higher Education Expenses
• Medical Expense Insurance Premiums for Unemployed Individuals
• Medical Expenses Exceeding 7.5% of AGI
• First-Time Home Buyer Expenses (up to $10,000)
• Substantially Equal Payments over Life Expectancy (age 55+)
• Rollover to Another Qualified Plan

If the reason for the distribution is death of the account owner and the beneficiary is the spouse of the deceased, the assets of a qualified plan may be rolled into the beneficiary’s qualified plan, further deferring taxes until retirement of the beneficiary.

The IRS also requires distributions from a qualified plan to begin no later than April 1st of the year following the year the owner of the account attains age 70½. The penalty for failing to take the required minimum distribution (RMD) is 50%.

Rollover and Transfer Rules

The assets in a qualified retirement plan can be transferred to another qualified plan with few restrictions. If the owner of the account takes possession of the funds, the transfer must be completed within 60 calendar days. This action is commonly referred to as a 60 day rollover. An individual is only allowed one 60 day rollover per year (12 rolling months, not calendar year). Further, if the funds are being “rolled” from a company-sponsored retirement plan, the corporation is required to withhold 20% of the distribution to be sent directly to the IRS.

To avoid the 20% withholding, the account owner may consider a direct transfer. In a direct transfer (trustee to trustee transfer), the funds move from one qualified plan directly to another, either electronically or by way of a check made out to the custodian of the receiving plan. There are no time restrictions or maximum number of direct transfers that can take place in a year. In fact, the IRS doesn’t even know it happened.

Nonqualified Retirement Plans

403(b) TSA and 457 Plans

A 403(b) is a defined contribution plan that may be established by a public school, state university, or nonprofit service organization. 457 plans are available to state and local government employees. Other than who is eligible to establish the plan, 403(b) plans and 457 plans work the same as a 401(k) plan. Also, 403(b) plans and 457 plans are not corporate retirement plans, therefore not regulated by ERISA rules. While they play by the same rules, these plans are not technically qualified plans.

Deferred Compensation Plan

A deferred compensation plan is a nonqualified retirement plan where an employee or business owner defers current compensation in exchange for a larger payout at retirement. Because the plan is nonqualified, it can discriminate, and commonly does. Deferred compensation plans are typically established by business owners for themselves and are not made available to the employees of the business. (Discriminatory–Nonqualified)

Individual Retirement Plans

While not technically qualified plans, many of the same rules apply here. IRAs provide an opportunity to save for retirement on a tax-deferred basis and may provide an immediate tax benefit through deductible contributions.

A Traditional IRA may be funded by anybody with earned income. If the individual making the contribution is not covered by a qualified retirement plan, the contribution to a traditional IRA is tax deductible. If the individual making the contribution is covered by a qualified plan, but has income below certain levels, the contribution is deductible in the year it is made.

A spousal IRA may be funded for the benefit of the nonworking spouse who has no earned income.

Traditional and spousal IRAs must be funded no later than April 15 of the year following the year for which the contribution is intended. Withdrawals are taxed as ordinary income and there is a 10% penalty for premature distributions prior to age 59½. Required minimum distributions begin no later than April 1 of the year following a year the account owner attains age 70½ and rollover/transfer rules are the same as qualified plans.

Roth IRAs are available to anyone with Adjusted Gross Income (AGI) under certain IRS limitations, and if married, files jointly. The contribution limits are the same as they are for traditional and spousal IRAs, but the contribution will never be tax-deductible in the year made. Distributions from a Roth IRA, however, are tax-free, provided the account owner has attained age 59½. Amounts attributable to contributions may also be distributed tax- and penalty-free if the money has been in the account for at least 5 years.

With the introduction of the Roth IRA account, the IRS made it possible for a person with an AGI below certain levels to convert a traditional IRA into a Roth IRA. A person converting a traditional to a Roth IRA may have a tax liability in the year of conversion. Generally, the favorable tax treatment of distributions from a Roth IRA outweighs the initial tax liability of conversion. Therefore, it has become quite common to convert traditional IRAs to Roth IRAs. The infrequent process of converting a Roth back into a traditional IRA is called recharacterization.

Lesson Summary

Distribution/Withdrawal Rules:

• Penalties apply if distributions occur before a specific age and not for qualified reasons
• Rollovers are an option for transferring assets between qualified plans

Nonqualified Retirement Plans:

• 403(b) and 457 Plans, Deferred Compensation Plans

Individual Retirement Plans:

• IRAs provide tax benefits for retirement savings
• Traditional, spousal, and Roth IRAs have different features and taxation rules

Chapter Vocabulary