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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.

6. Net unrealized appreciation of employer securities (NUA). Certain distributions of employer stock from a qualified retirement plan are eligible for deferred taxation at long-term capital gain rates rather than immediate taxation at ordinary income rates. This one also never applies to IRAs.

7. No tax when annuity contract is passed out. When the plan distributes an annuity contract, there is no tax payable at that time--provided the annuity contract the plan administrator has distributed to the participant (or beneficiary) complies with the minimum distribution rules and is nonassignable by the recipient. Instead, the participant (or beneficiary) pays income tax on the monthly distributions he or she later receives from the insurance company under the contract.

8. Return of IRA contribution. In some circumstances IRA contributions can be returned to the contributor tax-free before the extended due date of the income tax return.

9. Income tax deduction for certain beneficiaries. A beneficiary taking a distribution from an inherited retirement plan is entitled to an income tax deduction for federal estate taxes paid on the benefits, if any.

10. Distribution to charitable entity. If the beneficiary is income tax-exempt, it will not have to pay income tax on the distribution. This one clearly does not apply to an individual!

11. Qualified Health Savings Account Funding Distributions (QHSAFD). An IRA owner is permitted, once per lifetime, to transfer funds tax-free directly from an IRA to a Health Savings Account (HSA). But this option is not available for a beneficiary.

12. QDROs and divorce-related IRA divisions. An individual can transfer all or part of his qualified retirement plan benefits or IRA to his spouse without being liable for income taxes on the transfer if the transfer is pursuant to a "qualified domestic relations order" (QDRO) (in the case of a qualified plan) or similar divorce court order (in the case of an IRA).

In summary: Any retirement plan distribution, whether it's a lump-sum distribution of the entire account or a partial distribution, is taxable. That is to say, it is fully includible as ordinary income in the gross income of the participant or beneficiary who received it--unless one of the above 12 exceptions applies!

Where to read more: "¶" symbols refer to sections of Natalie Choate's book Life and Death Planning for Retirement Benefits (7th ed. 2011; http://www.ataxplan.com/). Regarding the income tax treatment of distributions from Roth IRAs and designated Roth accounts, see ¶ 5.2.03 and ¶ 5.7.04. See ¶ 2.6 for rollovers by the participant, ¶ 3.2 for rollovers by the surviving spouse, and ¶ 4.2.04 for rollovers by other beneficiaries. See ¶ 2.6.08 for why certain IRA-to-IRA transfers are not taxable because they are not considered to be distributions at all. Regarding the income tax treatment of distributions of and under qualified plan-owned life insurance policies, see Natalie Choate's Special Report: When Insurance Products Meet Retirement Plans (http://www.ataxplan.com/). See ¶ 2.2 regarding how aftertax contributions are recovered tax-free from a retirement plan. See ¶ 2.4.06 regarding special treatment of lump-sum distributions for individuals born before 1936. See ¶ 2.5 regarding special treatment of "NUA" in distributions of plan-owned employer stock. Regarding tax-free distribution of annuity contracts, see the Special Report: When Insurance Products Meet Retirement Plans. See ¶ 2.1.08(D), (F), regarding tax treatment of returned IRA contributions. See ¶ 4.6.04-¶ 4.6.08 regarding a beneficiary's income tax deduction for estate taxes paid on retirement benefits. See ¶ 7.5.01-¶ 7.5.04 and ¶ 7.5.08 regarding paying retirement plan death benefits to an income-tax-exempt (charitable) entity. Regarding the one-time ability to use an IRA distribution to directly fund a health savings account, see Internal Revenue Code § 223 and § 408(d)(9), and IRS Notice 2008-51, 2008-25 IRB 1163. For information regarding QDROs and divorce-related divisions of IRAs, see § 402(e)(1), § 414(p), and § 408(d)(6) of the Internal Revenue Code and Chapter 36 of The Pension Answer Book by Stephen Krass.

Natalie Choate will be speaking at a location near you if you live in: Evansville (Sept. 12, 2016) or South Bend (Oct. 27, 2016), Ind.; Baltimore, Md. (Sept. 20, 2016); Madison (Oct. 17, 2016) or Elkhart Lake (Oct. 18, 2016), Wis.; Santa Fe, N.M. (Nov. 10, 2016); Scottsdale, Ariz. (Nov. 11, 2016); Memphis, Tenn. (Dec. 7, 2016); Little Rock, Ark. (Feb. 16, 2017); Asheville, N.C. (May 4, 2017); or Waltham, Ma. (June 2, 2017). See all of Natalie's upcoming speaking events at http://www.ataxplan.com/seminars/schedule.cfm.

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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