Top Ten Tax Traps for Your Fund Protecting a Plan s Qualified Status and Providing the Best Tax Treatment for Members Benefits Terry A.M. Mumford Eric D. Swank
10 Tax Traps (and Opportunities!) 1. DROP Benefit Taxation 2. Non-Taxable Disability Benefits 3. Non-Taxable Death Benefits 4. Required Minimum Distributions 5. Retiree Health Care Options 6. Automatic Rollovers of Involuntary Distributions 7. 415(b) Limits 8. Phased Retirement 9. 457(b) Plan Amendment 10. Abusive Tax Avoidance Transactions
No. 1: DROP Benefits Part of a Deferred Retirement Option Plan ( DROP ) Benefit May Be Non-Taxable. How much of the DROP benefit is non-taxable? If a member made post-tax contributions, some or all of those contributions (depending on plan structure) will be included in the DROP benefit. Thus, the member will not be taxed on the full amount of the DROP benefit.
No. 1: DROP Benefits (cont'd) How much of the DROP benefit can be rolled over? The taxable amount can be rolled-over to an employer plan or an IRA. The non-taxable amount can be rolled-over to an IRA or to a defined contribution plan that will separately account for the non-taxable amount. If any part of the DROP is a minimum required distribution, that part cannot be rolled over. If the DROP benefit is distributed in a series of equal periodic payments for a period of 10 or more years or over a lifetime (or life expectancy), that part cannot be rolled over.
No. 1: DROP Benefits (cont'd) When does the early distribution tax penalty (10%) apply to the DROP payment by the plan? If a member withdraws the DROP distribution in a lump sum and the member is younger than age 55. If the member withdraws the DROP distribution in a form of payment that is not substantially equal periodic payments payable over a lifetime (or life expectancy) and the member is younger than age 55.
No. 1: DROP Benefits (cont'd) Are there limits on the amount of DROP benefits that can be paid? The limits on benefits payable by retirement plans set by Code Section 415 must be applied to DROP benefits. To test against the limits, the DROP benefit should be converted to single life annuity using actuarial factors required by the Code. A governmental plan could set up a special structure called a qualified excess benefit arrangement and use this to pay benefits in excess of the Code Section 415 limits.
No. 1: Strategy for DROP Benefits Analyze tax status of DROP benefits. Advise members of 10% tax penalty. Determine amount that can be rolled over. Apply Code requirements for minimum distributions and testing. Consider adopting a qualified excess benefit arrangement. Consider private letter ruling filing and/or determination letter filing.
No. 2: Non-Taxable Disability Benefits Benefits paid to members who become disabled in the line-of-duty may qualify as non-taxable. What are the IRS requirements for tax-free lineof-duty disability benefits paid from a retirement fund? Disability benefits paid pursuant to a statute that is in the nature of worker s compensation benefits are non-taxable. IRS regulations requires that benefit provisions be separately stated from non-line-of-duty benefits. Benefits cannot be based upon age, years of service, or employee contributions.
No. 2: Disability Benefits (cont'd) How should non-duty related disability benefits paid from a retirement fund be handled? Non-duty disability benefits are treated as fully taxable until earliest retirement age. At earliest retirement age, basis recovery applies. Line-of-duty disability benefits may convert to taxable retirement benefits or they may continue as non-taxable for the life of the member and survivors, depending on plan s terms.
No. 3: Non-Taxable Death Benefits What are the requirements for non-taxable lineof-duty death benefits? Code Section 101(h) states requirements for annuity payments for spouse and children of public safety officer killed in line-of-duty. Exceptions if intentional misconduct, suicide, intoxication, gross negligence involved. Lump sum payments and payments to other relatives or beneficiaries will have to be evaluated under standards for disability benefits, because Code Section 101(h) only covers surviving spouses and children.
Nos. 2 and 3: Strategy for Death and Disability Benefits Analyze line-of-duty death and disability benefits to see if they meet requirements for non-taxation. Treat non-line of duty disability payments as fully taxable before earliest retirement eligibility. Consider whether changes in plan design could lead to better tax treatment for death or disability benefits. Consider private letter ruling.
No. 4: Required Minimum Distributions Benefits have a required beginning date Benefits have to begin by April 1 of the calendar year following the year in which the member reaches age 70 ½ or leaves employment (whichever is later). 50% tax penalty applies to member who doesn t receive benefits on time. Tax can be abated if taxpayer makes reasonable showing.
No. 4: Minimum Required Distributions (cont'd) Annuity benefits must be non-increasing with a certain exceptions: Plan amendments. Lump sum payments of value of employee contributions. COLAs that meet certain requirements.
No. 4: Minimum Required Distributions (cont'd) Joint and Survivor Annuities must meet requirements Surviving spouse may receive any percentage of member s benefit including the same benefit as member (100% Joint/Survivor). If Beneficiary is not surviving spouse, 50% Joint/Survivor is the safe harbor. Any greater benefit must meet limits, depending on age of retiree and age difference between member and beneficiary.
No. 4: Minimum Required Distributions (cont'd) Regulations are generally effective January 1, 2003. Governmental plans have grandfathered treatment for benefit options in effect April 17, 2002. Transitional relief is available until 2006.
No. 4: Strategy for Required Minimum Distributions Institute procedures to comply with required beginning date. Analyze all benefit options to determine compliance with Final Regulations: Determine if grandfathered status is needed and identify those benefits. Determine if transitional period will be used for amendments. Consider determination letter filing.
No. 5: Retiree Health Benefits How can retiree health benefits be paid from a retirement fund? A 401(h) Account. Benefit payments are limited to medical care for the retiree, spouse, and dependents. Separate accounting must be applied to the account. Can be a defined benefit or defined contribution structure. Excess pension assets can be transferred to account.
No. 5: Retiree Health Care (cont'd) How are these benefits taxed? Employer contributions to the account and benefits payable from the account for medical care are not taxable to the employee. IRS is considering pick-ups. New IRS ruling restricts use of funds contributed taxfree into medical reimbursement account. Funds may not be: Paid to beneficiary upon member s death. Cashed out by member or contributed to retirement plan.
No. 5: Strategy for Retiree Health Care Follow tax code and regulations to establish 401(h) account or other structure. Determination letter. Be aware of IRS guidance on taxation of health reimbursement plans.
No. 6: Automatic Rollovers Funds with mandatory distributions, must consider automatic rollover rules. These involuntary payouts must be rolled over automatically to an IRA. Applies to mandatory distributions to a participant before the later of age 62 or normal retirement. Only applies of distributions that exceed $1000. Does not apply to mandatory distributions to surviving spouse, alternate payee, or other beneficiaries.
No. 6: Automatic Rollovers (cont'd) What is required? Establishment of IRA. Plan sponsor enters into agreement. Notice to member.
No. 6: Automatic Rollover (cont'd) There is an extended compliance date for governmental plans. For private sector plans, automatic rollover requirements applied to mandatory distributions made on and after March 28, 2005. For governmental plans where a legislative body has the authority to amend the plan, the automatic rollover requirements apply to mandatory distributions made on and after the close of the legislative session that begins after January 1, 2006.
No. 6: Strategy for Automatic Rollovers Clear out mandatory distributions prior to effective date. Consider options to change mandatory distribution provisions so compliance with burdensome automatic rollover rules is not required. Amendment must be adopted by effective date. If maintain mandatory provisions so that automatic rollovers are required: Adopt good faith amendment. Work with financial institution to establish IRAs. Provide required notice.
No. 7: Tax Code Limits on Benefits How do automatic COLAs affect annual limits on amount of pension benefits testing? IRS has issued private letter ruling stating that an automatic COLA must be factored in up front in determining if 415(b) annual pension limit is exceeded. Taking into account now the value of future increases can have the result of greatly overstating a member s benefits, and more benefits will fail. Excess benefits can be paid from QEBA.
No. 7: Strategy for Testing Determine whether automatic COLA is present Determine impact on benefit limits Note: IRS has stated that regulations under Code Section 415 will be issued this year. This testing rule may be addressed.
No. 8: Phased Retirement Are your members interested in working parttime and receiving part of their benefits? IRS proposed regulation permit the adoption of a phased retirement program. Under current proposal, only available at age 59 or later, but before normal retirement. The percentage reduction in hours is the percentage of benefit that is payable. Example: 20% reduction in hours; 20% benefit is payable.
No. 9: 457(b) Plan Amendments IRS has proposed Model Amendments for 457(b) plan: Definitions. Participation and Contributions. Limitations on Amounts Deferred. Loans. Distribution of Benefits. Rollovers & Transfers. Trust Fund. Miscellaneous Administrative Matters.
No. 9: 457(b) Plan Amendments IRS has not provided model amendments in two hot areas: Conversion of sick and vacation pay. Purchase of permissive service credit. The only guidance in this area is in the final regulations.
No. 9: 457(b) Plan Amendments, Cont. IRS also issued revenue procedure on requirements imposed on employers who have more than one vendor: Monitor deferral limits. Monitor plan loan provisions. Establish normal retirement age.
No. 9: Strategy for 457(b) Plan Amendments Compare plan language to model amendments. Use final regulations for plan language where no model is provided. Consider coordination issues if multiple vendors. Consider private letter ruling for plan.
No. 10: Abusive Tax Transactions IRS is aggressively pursuing tax avoidance transactions. Included as listed transaction is complicated transactions designed to use tax exempt status of pension plans and charitable organization. Temporary transfer of certain stock was made to tax exempt entity such as a governmental plan along with other complicated steps that were intended to shift income away from others. IRS guidance is intended to shut down this activity.
No. 10: Abusive Tax Transactions (cont'd) Priority of IRS is deterring abuse in tax-exempt area. This includes governmental pension plans.
Questions? Top Ten Tax Traps for Your Fund Protecting a Plan s Qualified Status and Providing the Best Tax Treatment for Members Benefits Terry A.M. Mumford Eric D. Swank