Lump Sum Rollover of Retirement Account Not as Simple as Expected

At our seminar held on December 8, 2011 (Planning Your Whole Estate—Coordinating Life Insurance, Employee Benefits and Other Nonprobate Property with the Rest of Your Estate Plan), a question was asked about distributions from a qualified retirement plan account which contained both after-tax and pre-tax contributions.

You can see a podcast/slideshow of the seminar here: Planning Your Whole Estate—Coordinating Life Insurance, Employee Benefits and Other Nonprobate Property with the Rest of Your Estate Plan.

The question related to distributions that might occur at the time of retirement when the participant would roll the account into a rollover IRA.

I answered that the participant should be able to receive the after-tax portion without the imposition of income tax and should be able to rollover the pre-tax portion to the rollover IRA.

I’ve been thinking about how complicated the applicable rules are so I thought I should offer some clarification. I plan to prepare a more complete post to this blog in the future and we will notify you when it is posted.  For now, I offer this.  I hope it is helpful.

The general rule relating to distributions from a qualified retirement plan account is that the distribution will be part after-tax and part pre-tax. There is an exception to the general rule which allows the participant to take a distribution from the plan; rollover an amount equal to the pre-tax portion to a rollover IRA within 60 days of the distribution; and retain the balance as the after-tax distribution. Although the after-tax distribution would not be subject to income tax, the pre-tax portion of the distribution would be subject to mandatory 20% tax withholding.

As an example, suppose the value of the account as of retirement is $150,000 and that $50,000 is after-tax and $100,000 is pre-tax. If the participant were to take a lump sum distribution, it would be subject to mandatory withholding of 20% ($20,000 of the $100,000 pre-tax portion of the distribution). In that case, if, within 60 days, the participant were to roll over $100,000 to an IRA, the participant would defer income tax on that portion.

That would leave the participant with $30,000 of cash out of the $50,000 after-tax portion (the $50,000 after-tax portion would have been reduced by the tax withholding of $20,000).  In addition, the participant would have a tax credit of $20,000.

In effect, therefore, the participant would have accomplished the goal of receiving the after-tax portion free of tax and rolling over the entire pre-tax portion to an IRA.

Although the tax withholding would have been an inconvenience, it represents an asset which the participant would receive as a refund assuming all other tax obligations were satisfied.

This is a narrow exception to the general rule that applies to distributions from qualified retirement plans. Accordingly, it should not be generalized to other situations. There are other exceptions to the general rule.  We plan to cover some of the other exceptions in future posts.

The IRS has published a number of positions on the subject, some of which appear to contradict each other. Plan administrators have developed their own ways of dealing with the uncertainty.

Posted on 12/26/2011 by Richard S. Land, Member, Chipman, Mazzucco, Land & Pennarola, LLC.

Notice: To comply with U.S. Treasury Department rules and regulations, we inform you that any U.S. federal tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction, tax strategy or other activity.

We frequently post articles relating to estate planning, estate settlement and elder law issues to this blog. We also post notices about our client seminars here. When we do, we send out notices to clients and friends of the firm. If you would like to get our notices, please join our mailing list by clicking below.

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