A common message from financial planners, to young and old alike, is that to achieve a financially comfortable retirement, one must systematically save and invest throughout one’s career by taking full advantage of available defined-contribution qualified retirement plans. Investing through such plans is important today, because relatively few workers can rely on receiving benefits from a traditional defined-benefit pension plan on reaching retirement. In addition, no one should rely on Social Security as the sole means of providing a financially secure retirement. 

Part I of this two-part article, below, identifies the various types of defined-contribution qualified retirement plans commonly used by employers and self-employed individuals and the withdrawal restrictions that apply. Part II, in the June 2007 issue, will identify issues and strategies that may help enhance the value of distributions to account owners.

Commonly Used Plans

A plethora of account-balance-type retirement plans is available under the tax law. These plans can be used to accumulate retirement assets to provide beneficial tax treatment for individuals. Potential tax benefits include:

1. Exclusion by the employee of employer contributions to the plan.
2. Deduction or deferral treatment for employee contributions.¹
3. Tax deferral or tax-free treatment of plan earnings.

Participation in multiple types of retirement plans can maximize accumulated wealth. For example, a college professor who also operates a consulting practice may be able to participate in a defined-benefit plan of the employer, a Sec. 403(b) or 457 plan, a Keogh plan and/or a traditional IRA.

A financially astute taxpayer will likely also save a portion of his or her disposable income in taxable investments outside of qualified retirement plans. These funds can be accessed without the restrictions that apply to most such plans; many taxable investments are eligible for the favorable rates on capital gains and qualified dividends.

Employee Plans

These plans are commonly available to employees and self-employed individuals.²

Money-purchase plan: One type of defined-contribution plan, sometimes referred to as a money-purchase plan, allows for regular contributions (flat-dollar or formula-based)³ to an account maintained for the participant. Contributions may be made by the employer and/or employee.

Pension, profit-sharing and cash-match plans under Sec. 401(a): These plans provide for contribution of a stated or formula-based amount to an account for the employee’s benefit. Contributions may be made by the employer, the employee or both. Employee contributions may be voluntary or mandatory. Distributions must begin by the later of age 70½ or retirement, except in the case of certain business owners. “Late” distributions are those that begin (1) after the time required by statute or (2) on a timely basis, but the amount distributed is less than the amount required by statute. (In this article, “later of age 70½ or retirement” means the Sec. 401(a)(9)(C)(i) requirement that the distribution begin by April 1 of the calendar year following the later of the calendar year in which the employee (1) attains age 70½ or (2) retires.) 

Sec. 401(k) plan: This is a plan (sometimes referred to as a cash or deferred arrangement) in which employees of private employers have the option to set aside a portion of current compensation in a qualified retirement plan.⁴ Neither the portion of the salary deposited in the Sec. 401(k) plan, nor the earnings generated on the deposits, is taxed to the employee until withdrawn. In many Sec. 401(k) plans, the employer will “match” the employee’s contributions up to a certain percentage of salary. Like other retirement plans, access to the accumulated balance is restricted during the account owner’s career; required minimum distributions (RMDs) generally must begin by the later of age 70½ or retirement, under Sec. 401(a)(9)(C)(i).

Because of the RMD rule, the retirement assets in employer plans, such as a Sec. 401(k), should not be rolled over into a traditional IRA if the taxpayer plans to work past age 70½. RMDs must be made from a traditional IRA beginning at age 70½, even if the taxpayer is still working. By keeping the assets in the employer plan, the assets can continue to grow on a tax-deferred basis.

Sec. 403(b) plan: A Sec. 403(b) plan is a tax-sheltered annuity plan offered to an employee of a nonprofit or Sec. 501(c)(3) tax-exempt organization (e.g., church, college or university) or a public school. Under Sec. 402(g)(1), the 2007 contribution limit is $15,500 for a taxpayer under age 50 and $20,500 for a taxpayer age 50 or older. Distributions must begin by the later of age 70½ or retirement.

Sec. 457 plan: This is a deferred-compensation plan established for the benefit of government employees. Such plans are maintained by a state, a political subdivision of a state, or an agency or instrumentality of a state. Sec. 457 plans are also available to employees of certain nongovernmental organizations exempt from tax under Sec. 501 (e.g., trade associations, private hospitals, labor unions).⁵ Under Sec. 402(g)(1), the 2007 contribution limit is the same as that for Sec. 403(b) plans. Distributions must begin by the later of age 70½ or retirement.

Self-Employed Plans

The plans discussed below are commonly available to individuals with self-employment (SE) income.

Keogh plan: Such plans are commonly used by sole proprietors and partners to defer current taxation of income from their trade or business activities and by employees who also generate earned income from SE activities (e.g., a member of a corporate board of directors). Under Sec. 415(c)(1) and (d), the contribution limit for 2007 is the smaller of SE income or $45,000. Distributions must begin by the later of age 70½ or retirement, except in certain cases of benefits held for owners.

A cash-method taxpayer who receives compensation as a member of a board of directors may elect to defer it until retirement by making deductible contributions to a Keogh plan. Contributions can continue as long as the taxpayer is earning SE income, although distributions must begin by April 1 of the year following the year the individual turns 70½.

The annual deadline for making contributions to a Keogh plan is the tax return filing date, including extensions (i.e., April 15th for a calendar-year taxpayer). The plan must be established by the end of the tax year. However, making contributions as early as is economically feasible, rather than waiting until the deadline, lengthens the period of tax-deferred growth.

SEP plan: A simplified employee pension (SEP) is a type of IRA used by small businesses (sometimes referred to as a SEP/IRA). These accounts are similar to Keogh plans in that they accept retirement savings from nonemployee income, but generally are not subject to as many restrictions and offer greater flexibility.⁶ The maximum 2007 employer contribution for an employee is the lesser of $45,000 or 25% of the employee’s earned income.⁷ Elective deferrals by an employee are limited to the lesser of earned income or $15,500 for 2007. However, under Sec. 408(k)(6), starting in 1997, elective deferrals by an employee are permitted only if the employer plan was established before that year. Distributions must begin by the later of age 70½ or retirement.

Other Common Plans

Other commonly encountered retirement plans include:

Traditional IRA: IRAs are available primarily to individuals who receive earned income.⁸ They are designed primarily to benefit employees who do not qualify to participate in an employer’s qualified plan or who work for an employer that does not provide one. In addition, anyone generating compensation income can contribute to a traditional IRA. Depending on the taxpayer’s adjusted gross income (AGI), filing status and whether the taxpayer (or spouse) is an active participant in a qualified employer-sponsored retirement plan, the contributions may be deductible.⁹

The annual deadline for making contributions to a traditional IRA is the return filing date (i.e., April 15th for a calendar-year taxpayer). The IRA must be established by that date.

If a taxpayer is an active participant in an employer-sponsored retirement plan, the deduction for a traditional IRA contribution may be limited, depending on the taxpayer’s modified adjusted gross income (MAGI). This phaseout starts at MAGI over $52,000 if single and ends at $62,000 ($83,000 and $103,000 for a married couple filing jointly when both are active participants). 

If one spouse is an active participant in an employer-sponsored retirement plan and the other is not (e.g., unemployed or employed by an employer that does not provide a retirement plan), a deductible spousal IRA contribution can be made if the couple’s MAGI does not exceed $166,000 (phaseout starts at $156,000 and occurs over a $10,000 range). This threshold is indexed for inflation. Under certain circumstances, however, based on the above factors,¹⁰ the contributions are either nondeductible or only partially deductible.

Under Sec. 408(o)(2)(B)(ii), a taxpayer can elect to treat deductible contributions as nondeductible. A benefit of making this election is that the basis equals the contributions, rather than zero. However, earnings on assets held in a traditional IRA are still taxed when distributions occur. Thus, any taxpayer eligible for a Roth IRA would contribute to such a plan instead, because Roth IRA distributions avoid tax. However, if the taxpayer is not eligible for a Roth IRA, the election to forgo a traditional IRA deduction may be useful.

Even though the annual contribution level is relatively low ($4,000 in 2007 for a taxpayer under age 50; $5,000 for a taxpayer age 50 or older), investing in an IRA may give a taxpayer a greater variety of options than investing through an employer plan. One of the most important advantages of a traditional IRA is that it can accept rollovers from  other qualified plans (except Roth IRAs and nongovernmental Sec. 457 plans). This allows a taxpayer to consolidate other retirement accounts into a single IRA, hopefully leading to management efficiencies.

Taxpayers generally must wait until age 59½ to begin withdrawing penalty-free from a traditional IRA. On reaching age 70½, Sec. 401(a)(9)(C)(i) provides that taxpayers must begin taking RMDs, even if they are still working. Contributions cannot be made to a traditional IRA during or after the tax year in which the individual reaches age 70½, under Sec. 219(d)(1).

The normal starting point for RMDs from retirement plans is the later of age 70½ or retirement. For a traditional IRA (deductible or nondeductible), distributions must commence even if the taxpayer has not retired. The age provision affects not only traditional IRAs created by taxpayer contributions, but also other retirement plan balances rolled over into traditional IRAs.

The recently enacted PPA ’06 allows taxpayers who are at least age 70½ to contribute up to $100,000 of IRA assets to a qualified charity without triggering taxable income. In addition, the contribution counts towards the RMD requirement for the year. This opportunity is available, however, only for 2006 and 2007. This form of IRA distribution is discussed in greater detail later in Part II of this article.

Roth IRA: Like a traditional IRA, Roth IRA contributions are derived from compensation income (a spousal account option is also available). Contributions may be made depending on the taxpayer’s AGI, filing status and whether contributions were made to traditional IRAs during the year.¹¹

Like a traditional IRA, the permitted annual contribution is relatively low ($4,000 in 2007 for a taxpayer under age 50; $5,000 for a taxpayer age 50 or older). However, for taxpayers married filing jointly, Roth IRA contributions may be made as long as the taxpayer’s AGI does not exceed $166,000. For a single taxpayer, the phaseout begins at $99,000 and ends at $114,000. The income threshold is lower for a traditional deductible IRA (i.e., begins at $83,000 and ends at $103,000 for taxpayers married filing jointly when both are active participants in another plan).

A fundamental difference between a Roth IRA and a traditional IRA is that contributions to the former are nondeductible and qualified withdrawals are tax free; contributions to a traditional IRA are often deductible and withdrawals are taxable.¹² Another difference is that a Roth IRA offers more flexible withdrawal options. For example, even when taking nonqualified distributions (i.e., before age 59½), the 10% Sec. 72(t) penalty tax has little or no effect. The amount subject to the penalty is the amount included in gross income; in the case of an early Roth IRA withdrawal, this is the earnings withdrawn, not the original contributions. There are no RMDs when a taxpayer reaches age 70½.¹³

Unlike a traditional IRA, contributions to a Roth IRA may continue beyond age 70½ as long as the taxpayer generates compensation income and is not barred by AGI limits. The income generated by these contributions will receive tax-free treatment. A retired taxpayer who is age 70½ or over may want to work part-time, so that he or she can continue to make Roth IRA contributions.

Taxation of Plan Withdrawals

With the exception of Roth and nondeductible traditional IRAs, when withdrawals or distributions are made from qualified retirement accounts, the recipient must include the full proceeds (less basis created through after-tax contributions) in gross income at ordinary income rates. In addition, penalties may be levied if the distributions are “early” (usually defined as prior to the recipient reaching age 59½).

The penalty mechanism is at the heart of the government’s attempt to discourage early withdrawals from retirement accounts, so that assets will be available during retirement. As discussed later in this article (under “Distributions after Age 59½”), reasons other than penalty avoidance could prompt a taxpayer to make withdrawals from taxable investments prior to taking assets from qualified retirement accounts. Nonetheless, after considering all relevant issues, the penalty could be avoided simply because a taxpayer’s taxable accounts are sufficient to meet his or her cashflow requirements, thereby leaving qualified retirement accounts untouched.

Penalties may also be levied if distributions are “late,” generally after the later of age 70½ or retirement.

Distributions after Age 59½

With one transition rule exception (discussed below)¹⁴ and other exceptions that apply when a taxpayer has basis¹⁵ in a qualified retirement plan, any distribution from a retirement plan is subject to tax and classified as ordinary income.¹⁶ The amount included in gross income is subject to the taxpayer’s marginal tax rate (i.e., as high as 35%); however, under Sec. 72(t)(2)(A)(i), the 10% penalty does not apply.

The classification of such income as ordinary is a major disadvantage of accumulating assets and deferring their taxation within a retirement plan. If the funds were instead invested in taxable accounts (e.g., mutual funds, stocks, bonds, real estate), the amount included in gross income could be eligible for the beneficial 15%/5% rate on net capital gains and qualified dividends. In addition, on the sale or other disposition of taxable investments that generate a gain, only the amount realized in excess of basis is subject to tax. Moreover, recognized losses on the sale or other disposition of taxable investments can offset recognized gains, reducing tax exposure even further. Retirement account losses are not deductible. However, despite the advantages to investments held in taxable accounts, qualified retirement accounts usually provide a superior means of accumulating wealth, largely because of the tax-deferral advantages.

Averaging: Taxpayers born before 1936 who receive a lump-sum distribution are eligible for special tax relief. Rather than having the distribution included in gross income and effectively taxed at the marginal rate, it is eligible for two beneficial tax treatments. First, the portion that represents basis is not included in income. Instead, a separate tax liability calculation is made that permits the taxpayer to use averaging; see Exhibit 1 . Second, the taxpayer may be eligible to use beneficial capital gain rates. These rates are available only for distributions representing years of service (compared to total years of service) before 1974.

According to Sec. 402(e)(4)(D), a lump-sum distribution is a distribution or payment in one year of the recipient of the balance to the credit of an employee in a qualified retirement plan that becomes payable:

1. On account of the employee’s death,
2. After the employee attains age 59½,
3. On account of the employee’s separation from service or
4. After the employee has become disabled.

While this transition rule may enable part of a lump-sum distribution to be taxed at a 20% capital gain rate, the taxpayer can elect to treat the capital gain portion as ordinary income and thereby qualify it for 10-year averaging. Thus, the tax liability on the lump-sum distribution should be calculated both ways, to determine which results in the smaller overall tax.

Distributions before Age 59½

In general, amounts invested in an employer’s plan may not be accessible before the owner reaches age 59½, unless the employee terminates employment.¹⁷ Unless withdrawals are rolled over into another qualified plan, they are subject to ordinary income taxation. But, if an employee terminates employment and withdraws amounts from the qualified retirement account, they may be subject to penalty if they occur prior to age 55 or fail to meet the exception for substantially equal periodic payments made over a single or joint life expectancy under Sec. 72(t)(2)(A). Other qualified retirement accounts, such as IRAs, can be accessed at any time; however, if distributions are premature or early, the Sec. 72(t) penalty may apply. As a result, subject to the exceptions discussed below, 59½ is a critical age; distributions occurring before that age are generally subject to a 10% penalty under Sec. 72(t)(1). That penalty applies only to amounts included in gross income (i.e., it does not apply to distributions associated with a taxpayer’s after-tax contributions, which are tax-free returns of capital).

Penalty exceptions: There are many exceptions to the 10% penalty on pre-age 59½ distributions from qualified retirement accounts.¹⁸ Most are narrowly defined and may not be readily available to the typical taxpayer. Nonetheless, many taxpayers may be able to structure their affairs to qualify. Some of the more important exceptions are:

1. A distribution made to a designated beneficiary (or to the taxpayer’s estate) on or after the taxpayer’s death (Sec. 72(t)(2)(A)(ii)).
2. A distribution attributable to the taxpayer’s being disabled (Sec. 72(t)(2)(A)(iii)).¹⁹
3. A distribution that is part of a series of substantially equal periodic payments (SEPP) made for the life (or life expectancy) of the individual or the joint lives (or joint life expectancies) of such individual and his or her designated beneficiary (Sec. 72(t)(2)(A)(iv)).²⁰ This exception, which is available regardless of the taxpayer’s age, could be particularly valuable, enabling an individual to retire early and draw on his or her qualified retirement account without a penalty. However, under Sec. 72(t)(3)(B), a SEPP is not permitted for a particular plan while a taxpayer is still employed by the employer providing the plan. In the case of distributions from a traditional IRA, employment status is irrelevant. To qualify, payments must be made not less frequently than annually and must commence after the individual’s separation from service, except in the case of an IRA (in which case, the individual may maintain employment status).
4. Under Sec. 72(t)(3)(A) and (t)(2)(A)(v), the 10% penalty does not apply to distributions from qualified retirement accounts other than traditional IRAs and Sec. 457 accounts to taxpayers who are severed from employment for any reason (e.g., retire, resign) if they are at least age 55.²¹ In such case, the 10% penalty will not apply, even though these distributions are included in gross income. For this exception to apply, the taxpayer need not be age 55 on the day he or she leaves the job, as long as he or she turns age 55 by December 31 of the same year. This exception does not apply if a taxpayer leaves a job in a year that precedes the year in which he or she turned age 55, even if the distributions are deferred until after reaching age 55. This exception continues until the taxpayer reaches age 59½.
5. Under Sec. 72(t)(2)(B), the penalty does not apply to a distribution used to pay medical expenses that would be allowed as a deduction under Sec. 213. This exception is available only to the extent the distribution exceeds the 7½% AGI threshold for medical deductions.
6. Sec. 401(k) and other employer plans, including Sec. 457 plans, may allow loans. Because an offsetting obligation to repay the loan exists, no income tax or penalty arises on receipt of the loan proceeds. Employees should consider taking loans from eligible retirement plans (e.g., Sec. 401(k) and 457 plans) rather than early distributions. Inclusion in gross income is avoided, the 10% penalty on early distributions is avoided and any interest earned on the loan benefits the taxpayer’s retirement plan.
7. IRA distributions used to pay:
   • Health insurance premiums by an unemployed account owner for the taxpayer, spouse and dependents, if the (i) distribution occurs after separation from employment, as the result of such separation; (ii) individual has received unemployment compensation for at least 12 consecutive weeks; and (iii) distribution is made during a tax year in which unemployment compensation is paid to such individual (or the succeeding tax year) (Sec. 72(t)(2)(D)).
   • Qualified higher education expenses (QHEEs) for the taxpayer, his or her spouse, child or grandchild or spouse’s child or grandchild.
   • A first-time home purchase. A qualifying distribution is one in which the proceeds are used by the individual within 120 days of the distribution date for the acquisition of a principal residence; and the principal residence is acquired by the taxpayer, his or her spouse, or the taxpayer’s or taxpayer’s spouse’s child, grandchild or ancestor. This distribution is limited to a $10,000 lifetime amount (Sec. 72(t)(2)(F) and (t)(8)).²²
   While QHEEs may be funded with distribution proceeds for more than one taxpayer during the tax year, the $10,000 lifetime ceiling for qualified first-time home purchases is so low that it will likely apply to only one taxpayer.
8. A distribution from a retirement plan to a reservist called to active duty under Sec. 72(t)(2)(G).

For most taxpayers who wish to retire early (i.e., prior to age 59½) or otherwise begin withdrawing assets from a qualified retirement account, the exceptions most likely to be helpful are SEPPs and severance of employment at age 55.

Sec. 457 rules: The rules applying to distributions from Sec. 457 plans differ from those noted above. These plans are only subject to two general rules on distributions. First, a taxpayer is eligible to begin receiving withdrawals from a Sec. 457 plan only after he or she separates from his or her employer (for any reason and at any age). Second, distributions must begin on reaching age 70½, under Sec. 457(b)(5) and (d)(1)(A).²³ Distributions from Sec. 457 plans are never subject to the 10% penalty. Distributions from Sec. 457 plans are also permitted in the case of an unforeseeable emergency, under Sec. 457(d)(1)(A)(iii) and Regs. Sec. 1.457-6(c).²⁴

An “unforeseeable emergency” includes a severe financial hardship resulting from a sudden and unexpected illness or accident of the participant or his or her spouse or dependent, property loss due to a casualty, or other extraordinary and unforeseen circumstances arising from events beyond the participant’s control.

Roth IRA: Roth IRAs, which are relatively new retirement savings vehicles, are funded with after-tax dollars. Thus, under Sec. 408A(d)(1), contributions can be withdrawn tax free at any time. Because the 10% penalty applies only to amounts includible in gross income, its reach is limited with respect to Roth IRAs. The penalty can have an effect, however, on certain distributions of earnings. If distributions are made in excess of amounts contributed, the amount in excess is deemed made from account earnings. Under Sec. 408A(d)(2)(B) and (d)(4), only nonqualified or early distributions from a Roth IRA are subject to tax (see below), and then only to the extent of earnings distributed. In such an instance, the earnings portion of the early distribution is included in gross income and is subject to the 10% penalty.

Similar to other qualified retirement accounts, exceptions allow for early distributions from a Roth IRA without penalty. These exceptions include all of those that apply to traditional IRAs mentioned above. However, under Sec. 408A(d)(1)(B), a five-year nonexclusion-period rule provides that any distribution will be considered nonqualified or early if it is made within five years of the date on which the first contribution to the account was made.

Late Distributions

A late distribution from a qualified retirement is one that commences (1) after the time required by statute or (2) on a timely basis, but is less than the amount required by statute. To be a timely distribution, one of the following must be satisfied, under Sec. 401(a)(9)(A):

1. An employee’s entire interest will be distributed not later than the required beginning date.
2. An employee’s entire interest will be distributed, beginning not later than the required beginning date, in accordance with regulations, over the life of such employee or over the lives of such employee and a designated beneficiary (or over a period not extending beyond the life expectancy of such employee or the life expectancy of such employee and a designated beneficiary).

As previously discussed, under Sec. 401(a)(9)(C), the “required beginning date” generally is April 1 of the calendar year following the later of the calendar year in which the employee (1) attains age 70½ or (2) retires. However, as was previously discussed, there are exceptions.

From a planning perspective, a taxpayer should never purposefully take late distributions. This statement is always accurate because, under Sec. 4974(a), the excise tax (i.e., the penalty imposed on the recipient) is 50% of the amount of the late distribution (i.e., the excess of the amount distributed over the amount that should have been distributed during the tax year).

The IRS has statutory authority to waive this penalty under Sec. 4974(d), if (1) the shortfall in the distribution for the tax year was due to reasonable error and (2) reasonable steps are taken to remedy it. See Exhibit 2 for the critical ages and relevant events of which the taxpayer must be aware in managing retirement-plan distributions.

Conclusion

Part II, in the June 2007 issue, will identify other issues and strategies that may help enhance the value of distributions to account owners.