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12 No-Tax and Low-Tax Retirement Plan Distributions

If a recipient qualifies for one of these deals, the distribution may be taxed more favorably than as a 100% taxable chunk of ordinary income.

Natalie Choate, 08/12/2016

Question: A client has inherited a retirement plan account from the deceased participant. The client plans to cash out the account as soon as possible (he needs the money). He has asked me whether the distribution is taxable. My first reaction was yes, the distribution would simply be treated as ordinary income in the year received. But now I'm not sure--is that response correct?

Answer: The answer is probably yes--the distribution is probably fully includible as ordinary income in the recipient's gross income, but here's how to be sure: Run through the following checklist of no-tax and low-tax retirement plan distributions. If your recipient qualifies for one of these deals, the distribution may be taxed more favorably than as a 100% taxable chunk of ordinary income.

This checklist was prepared to cover ANY retirement plan distribution, so some of the items clearly don't apply to your guy. I have added in comments for your particular situation:

1. Roth plans. Qualified distributions from a Roth retirement plan are tax-free. Even nonqualified distributions are tax-free to the extent the distribution represents the return of prior contributions. Is this a Roth account?

2. Tax-free rollovers and transfers. Generally, distributions can be "rolled over" tax-free to another retirement plan, if various requirements are met. But the rollover option is not available to a beneficiary, unless he is the surviving spouse of the deceased IRA owner.

3. Life insurance proceeds, contracts. Distributions of life insurance proceeds from a qualified retirement plan after the participant's death are tax-free to the extent the death benefit exceeds the pre-death cash surrender value of the policy. Distribution of a life insurance policy on an employee's life to that employee during his lifetime may be partly tax-free as a return of his "investment in the contract."

4. Recovery of basis. If the participant has made or is deemed to have made nondeductible contributions to his plan account or IRA, these become his "investment in the contract" in the retirement benefits. This "investment" is nontaxable when distributed to the participant or beneficiary. The problem is figuring out how much, if any, aftertax money the decedent had in the account. For an IRA, start by checking the decedent's last-filed Form 8606 (attached to his/her income tax return). For other plans, ask the plan administrator.

5. Special averaging for lump-sum distributions. Certain qualified retirement plan lump-sum distributions of the benefits of individuals born before Jan. 2, 1936, are eligible for reduced tax. This one never applies to IRAs.

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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