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Home>Practice Management>Retiring With Natalie Choate>Catch 22 Situations With Retirement Plans

Catch 22 Situations With Retirement Plans

Plan rules or tax laws don’t always mesh with client needs.

Natalie Choate, 07/14/2017

Sometimes you need a particular form of distribution to achieve a certain tax result, but the retirement plan doesn't allow it. Or sometimes the tax law seems to say opposite things about the same distribution.

Here are a few such Catch 22 situations when it comes to retirement plans.

Retiring between age 55 and age 59 1/2. If you take a retirement plan distributionbefore reaching age 59 1/2, you have to pay (in addition to income taxes) a 10 percent "penalty" for withdrawing your retirement benefits "prematurely"--unless, that is, you qualify for an exception. One exception to the 10 percent penalty is for distributions from your employer's qualified retirement plan if you retire from that employer’s service at age 55 or older. This is usually nicknamed the "early retirement" exception.

Aware of the "early retirement" exception, Jim retires at age 56 with $1 million in his employer's 401(k) plan. He plans to live on penalty-free plan distributions from the 401(k) plan until he reaches age 59 1/2, then roll over his remaining benefits into an IRA. So he asks the plan to send him $36,000 a year until he reaches age 59½. The plan says, "Sorry, Jim, but the only form of distribution we allow is a lump sum distribution!" But Jim doesn't want a lump sum. He wants a penalty-free early retirement pension for a few years, just as the law seems to allow. Unfortunately, Jim can't get what he wants, because the plan pays lump sums only. So he can take a one-time penalty-free distribution right now and roll over the rest of his $1 million into an IRA--but once the money is in the IRA, he can't take additional penalty-free distributions until he's 59 1/2 (unless he qualifies for some other penalty exception).

For Jim, the "early retirement" penalty exception is just an illusion--it doesn't enable an early penalty-free pension.

401(k) hardship distribution subject to the 10% penalty. Generally, if you are in a 401(k) plan and you elect to have part of your salary placed into your 401(k) account rather than paid out to you, that deferred income is subject to special restrictions. One such restriction is, the plan cannot pay that money out to you until you either have reached age 59 1/2 or you have terminated employment. There’s one exception to that rule: If you meet certain tax-code-defined requirements of "hardship," the 401(k) plan can pay you some of your deferred salary account as an official "hardship distribution," even though you are under age 59 1/2 and still employed. 

But now for the Catch 22: Although there is a "hardship exception" to the no-in-service-distributions rule applicable to 401(k) accounts, there is no "hardship exception," as such, to the 10% penalty! So when you receive a hardship distribution from your 401(k) plan (where Congress went to all the trouble to define just how tough things really are for you, so tough they let you get at your deferred salary early), you get socked with the 10 percent penalty. Unless you happen to qualify for some other penalty exception, a hardship distribution from a 401(k) plan is subject to the 10% penalty.

Estate wants to use the five-year payout. Mary dies at age 63, leaving her 401(k) plan benefit to her estate. (She didn't really mean to do that, she just forgot to fill out a beneficiary designation.) Her estate is stuck with a maximum payout period of about five years under the "five-year rule" applicable to participants who die before their required beginning date with no designated beneficiary. The estate figures, "Well, at least we can spread out the distributions over five years and reduce income taxes a little bit that way." But actually, they can't. The 401(k) plan says, "We only pay a lump sum distribution--no installment payouts!"

Natalie Choate practices law in Boston with Nutter McClennen & Fish LLP, specializing in estate planning for retirement benefits. Her book, Life and Death Planning for Retirement Benefits, is a leading resource for professionals in this field.

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar. The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.

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