DISTRIBUTION AND TAXATION

I’ve touched on this throughout this site but I want to elaborate on both Distribution and Taxation to provide you a basic understanding of what to expect.  The government wants people to save money for retirement for their own good.  As a result, they have included some rules to discourage people from taking constructive receipt of their money prior to retirement.

So let’s look at what you can expect when you terminate, retire or die while employed.  By the way, DB heretofore will be used to represent Defined Benefit and DC will be used to represent Defined Contribution.

Normal or Late Retirement

Regardless of when you were hired, when you reach Normal Retirement you are 100% vested.  Some plans allow you to defer your monthly benefit if you continue to work or if you do not need to start receiving it right away

DB Plan:

  • At that point, if you can begin receiving your monthly benefit and have Federal and State Income Tax withheld.
  • In January of the following year, and thereafter every January, you will receive a 1099-R form detailing the total amount of the monthly benefits you received for the preceeding calendar and the taxes that were withheld.
  • That information is to be entered in your Federal and State Tax returns (unless you live in a state with no income tax)
  • If you decide to take the lump sum value of your benefit, you have the option of rolling it over to an IRA and not be taxed on it until you take a partial or full distribution from the IRA.

DC Plan:

  • When you retire from a DC plan, it’s similar to taking a lump- sum from a DB plan.
  • You have the option of rolling it over to an IRA and not be taxed on it until you take a distribution from the IRA.
  • Your 401(k) contributions are taxable because they were made with pre-tax dollars.
  • Any after-tax contributions you made to the plan are not taxable.
  • Any contributions made to the plan by the employer are taxable.

Premature Distribution Withdrawals

If you take a distribution of the lump sum value of your monthly benefit from a DB plan or you take a distribution of your account balance prior to age 59 1/2, you will be hit with an extra 10% tax penalty.  The IRS instituted this to encourage people to keep their retirement funds intact until they reach retirement age.

There are certain conditions in which you will not be penalized the 10% penalty:

  • The distribution was made to your estate or beneficiary after your death.
  • The distribution was made because you are totally and permanently disabled.
  • The withdrawal was made to cover qualified post-secondary education expenses.
  • The withdrawal was made to cover deductible medical expenses.
  • The distribution was made to pay for an IRS tax lien.
  • The withdrawal was a Qualified Reservist Distribution (generally, one made after being called to active duty for 180 days).
  • The distribution was made as an installment in a series of equal and periodic payments over your life expectancy, or over the life expectancy of you and your beneficiary or beneficiaries and those payments will have had to start after you the employment of the employer.

Qualified Domestic Relation Order (QDRO)

If you get divorced, your alternate payee (which could be your spouse, ex-spouse, child, or dependent) may receive all or a portion of your retirement benefits.  The judge makes this ruling during the property settlement phase and determines the formula under which the amount is determined.  These distributions are also made pursuant to a State domestic relations law (including a community property law).

The QDRO (pronounced “Qua-dro”) has to comply with the require,emts of the plan, the domestic relations law of the applicable state, the requirements of ERISA and the requirements of the IRS Tax Code.,

Only plans covered by ERISA are subject to this rule.

Required Minimum Distributions

Whether you are still working or not, you are required to received a Required Minimum Distribution by April 1 of the following year in which you turn 70 1/2.  There are actuarial tables based on each gender’s life span and that of his/her spouse.  Last time I looked, The first required distribution was around 5% of your account balance.

If you had terminated or retired and rolled over your money into an IRA, it would be a Required Minimum IRA Distribution, which works in the same fashion.

The portion of your account balance that consists of your after-tax contributions to the plan are not held to this rule.

Conclusion

Most DB plans have a Normal Retirement Age of 65 with Early Retirement Age starting at age 55.  Some are a little different but let’s use this.  If you start taking your monthly retirement benefits during this period or later, they are taxed as ordinary income like your regular paycheck.

Under a DC plan, there are no early reduction rates to be applied because you’re taking a monthly benefit early, you have an account balance sitting and you have options:

  1. Leave it in your former employer’s plan, which makes it subject to the plan’s rules, costs, investment choices, and withdrawal options.
  2. You can move it into your new employer’s plan if he has one.
  3. You can roll it over into an IRA.  Make sure that you research any administrative fees and/or expenses before choosing the sponsor of the IRA into which you plan on moving your money.
  4. You can take it as a cash payment but but the Federal Income Withholding tax will automatically be 20% of your account balance that is taxable.(Any after-tax contributions made by you are not taxable.)

These are options that you want to think about when the time comes.  You age, your financial situation and whether you retire or terminate prior to retirement all matters in determining what you conclude what will be the best move.

As stated earlier, if your account is less than $5,000, the employer can opt to just pay you out instead of having to keep track of your whereabouts when you do eventually retire.

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