Taxation Of Distributions

<div class="Section1"><br /> <br /> An employee normally will have no cost basis if a plan is noncontributory and does not provide life insurance protection.<br /> <br /> If life insurance protection has been provided under a cash value policy, the employee usually will have some cost basis, namely, the aggregate one year term costs that have been taxed to the employee, even though the plan is noncontributory.<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> A self-employed person who is an owner-employee cannot include in his or her cost basis the annual one year costs of life insurance protection under Table 2001 or previously under P.S. 58 ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3948">3948</a>), even though these costs were not deductible.<a href="#_ftn2" name="_ftnref2">²</a> No self-employed person, whether or not an owner-employee, can include in cost basis the cost of any health insurance features under the plan.<br /> <br /> A common law employee&rsquo;s cost basis consists of:<br /> <p style="padding-left: 40px;">(1)&nbsp; total nondeductible contributions made by the employee if the plan is contributory and amounts contributed by an S corporation for years beginning before January&nbsp;1, 1984, on behalf of a more-than-5-percent shareholder-employee in excess of the excludable amount;</p><br /> <p style="padding-left: 40px;">(2)&nbsp; the sum of the annual one year term costs of life insurance protection under Table 2001 or previously P.S. 58 ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3948">3948</a>) that have been includable as taxable income if payment is being received under the contract that provided the life insurance protection( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3952">3952</a>);</p><br /> <p style="padding-left: 40px;">(3)&nbsp; any other employer contributions other than excess deferrals ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3760">3760</a>) that already have been taxed to the employee, such as where a nonqualified plan was later qualified;</p><br /> <p style="padding-left: 40px;">(4)&nbsp; certain employer contributions attributable to foreign services performed before 1963; and</p><br /> <p style="padding-left: 40px;">(5)&nbsp; the amount of any loans included in income as taxable distributions ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3953">3953</a>).</p><br /> In addition, although amounts attributable to deductible employee contributions are not part of basis, it would seem they should be included in basis if benefits are received under the contract to the extent that they have been taxable to the employee because they were used to purchase a life insurance contract ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3952">3952</a>). This cost basis must be reduced by any amounts previously distributed to the employee that were excludable from gross income as a return of all or part of the employee&rsquo;s basis.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> A self-employed person&rsquo;s cost basis consists of (1) the nondeductible 50 percent of contributions made before 1968, after subtracting the cost of incidental benefits, if any, such as waiver of premium and health insurance benefits, and, in the case of an owner-employee, the costs of life insurance protection under Table 2001 or previously P.S. 58 ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3948">3948</a>), (2) contributions on behalf of owner-employees under the three year average rule for determining contributions to level premium insurance and annuity contracts in excess of the deductible limit, in effect for years beginning before 1984, and (3) nondeductible voluntary contributions, if any, to a contributory plan.<br /> <br /> In addition, any amounts taxed to an individual because they were attributable to deductible voluntary employee contributions used to purchase life insurance, if benefits are received under the contract, probably should be included.<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC &sect;&nbsp;61(a)(1); Treas. Reg. &sect;&nbsp;1.61-2(a)(1).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; IRC &sect;&nbsp;72(m)(2); Treas. Reg. &sect;&nbsp;1.72-16(b)(4).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp; IRC &sect;&nbsp;72(f); Treas. Reg. &sect;&sect;&nbsp;1.72-8, 1.72-16(b)(4), 1.402(a)-1(a)(6), 1.403(a)-2. <em><em>See also</em></em> Rev. Rul. 72-149, 1972-1 CB 218.<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> If a beneficiary has no cost basis for the payments, each payment will be fully taxable as ordinary income when received. The beneficiary&rsquo;s cost basis generally is the same as the employee&rsquo;s cost basis ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3973">3973</a>). In the case of decedents dying before August&nbsp;21, 1996, the $5,000 death benefit exclusion was included in the beneficiary&rsquo;s cost basis.<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> If the beneficiary does have a cost basis, payments are subject to the rules that follow, depending on whether the death benefits come from life insurance proceeds.<br /> <br /> If death benefit payments do not come from life insurance proceeds, the beneficiary is taxed as the employee would have been taxed had the employee lived and received the periodic payments ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3968">3968</a>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3969">3969</a>). The beneficiary&rsquo;s cost basis, rather than the employee&rsquo;s cost basis, is used. Depending on the annuity starting date, an exclusion ratio may have to be determined; if so, the beneficiary&rsquo;s cost basis is used as the investment in the contract (for an explanation of the basic annuity rule and its application to various types of payments <em><em>see</em> </em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="527">527</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="552">552</a>). For annuities with a starting date on or before November&nbsp;19, 1996, if a beneficiary elected the simplified safe harbor method for taxing annuity payments ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="613">613</a>) and increased the investment in the contract by any employee death benefit exclusion allowable, the beneficiary had to attach a signed statement to his or her income tax return stating that the beneficiary was entitled to such exclusion in applying the safe harbor method.<a href="#_ftn2" name="_ftnref2">²</a> After such date, if the annuitant is under age 75, the simplified method is required, rather than optional.<a href="#_ftn3" name="_ftnref3">³</a> When more than one beneficiary is to receive payments under a plan, the cost basis, including the $5,000 exclusion, if available, is apportioned among them according to each beneficiary&rsquo;s share of the total death benefit payments.<br /> <br /> If death benefit payments do come from life insurance proceeds, the proceeds are divided into two parts: the amount at risk, which are proceeds in excess of the cash surrender value immediately before death, and the cash surrender value.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> The portion of the payments attributable to the amount at risk is taxable under IRC Section&nbsp;101(d) as life insurance proceeds settled under a life income or installment option, as the case may be ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="71">71</a>). The amount at risk generally is prorated over the payment period, whether for a fixed number of years or for life, and the prorated amounts are excludable from the beneficiary&rsquo;s gross income as a return of principal.<br /> <br /> Where payments are for life, the beneficiary&rsquo;s life expectancy generally is taken from IRS unisex annuity tables V and VI.<a href="#_ftn5" name="_ftnref5">⁵</a><br /> <br /> The portion of the payments attributable to the cash surrender value is taxed in the same manner as any other periodic payments from a qualified plan.<br /> <br /> <em>Example:</em> The widow of an employee who died on June&nbsp;1, 2024 elects to receive $25,000 of life insurance proceeds in 10 annual installments of $3,000 each. The cash surrender value of the policy immediately before the insured&rsquo;s death was $11,000. The employee made no contributions to the plan and the aggregate one-year term costs of life insurance protection that were taxed to the employee amounted to $940. The widow must include $1,506 of each $3,000 installment, computed in the following manner.<br /> <table border="1" align="center"><br /> <tbody><br /> <tr><br /> <td width="359">Face amount of insurance contract</td><br /> <td style="text-align: center;" width="148">$25,000</td><br /> </tr><br /> <tr><br /> <td width="359">Cash value immediately before death</td><br /> <td style="text-align: center;" width="148">11,000</td><br /> </tr><br /> <tr><br /> <td width="359">Excludable as life insurance proceeds</td><br /> <td style="text-align: center;" width="148">$14,000</td><br /> </tr><br /> <tr><br /> <td width="359">Portion of each installment attributable to life insurance proceeds (14/25 of $3,000)</td><br /> <td style="text-align: center;" width="148">$ 1,680</td><br /> </tr><br /> <tr><br /> <td width="359">Excludable as return of principal ($14,000 &divide; 10)</td><br /> <td style="text-align: center;" width="148">1,400</td><br /> </tr><br /> <tr><br /> <td width="359">Includable in gross income</td><br /> <td style="text-align: center;" width="148">$ 280</td><br /> </tr><br /> <tr><br /> <td colspan="2" width="507"></td><br /> </tr><br /> <tr><br /> <td style="text-align: center;" colspan="2" width="507">(If the beneficiary is the surviving spouse of an employee who died before October&nbsp;23, 1986, the $280 would be excludable under the $1,000 annual interest exclusion)</td><br /> </tr><br /> <tr><br /> <td colspan="2" width="507"></td><br /> </tr><br /> <tr><br /> <td colspan="2" width="507">Portion of each installment attributable to cash surrender value</td><br /> </tr><br /> <tr><br /> <td width="359">of the contract (11/25 of $3,000)</td><br /> <td style="text-align: center;" width="148">$ 1,320</td><br /> </tr><br /> <tr><br /> <td width="359">Beneficiary&rsquo;s cost basis ($940)</td><br /> <td style="text-align: center;" width="148">$ 940</td><br /> </tr><br /> <tr><br /> <td width="359">Expected return (10 x $1,320)</td><br /> <td style="text-align: center;" width="148">$13,200</td><br /> </tr><br /> <tr><br /> <td width="359">Exclusion ratio ($940/$13,200)</td><br /> <td style="text-align: center;" width="148">7.12%</td><br /> </tr><br /> <tr><br /> <td width="359">Amount excludable each year (7.12% of $1,320)</td><br /> <td style="text-align: center;" width="148">$ 93.98</td><br /> </tr><br /> <tr><br /> <td width="359">Includable in gross income ($1,320 - $93.98)</td><br /> <td style="text-align: center;" width="148">$ 1,226.02</td><br /> </tr><br /> </tbody><br /> </table><br /> The beneficiary may be entitled to an income tax deduction for any estate tax attributable to the decedent&rsquo;s interest in the plan ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3993">3993</a>).<a href="#_ftn6" name="_ftnref6">⁶</a> It would seem that the deduction would be prorated over the beneficiary&rsquo;s life expectancy, in the case of life income payments, or over a fixed period, in the case of installment payments ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="544">544</a>).<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; Rev. Rul. 58-153, 1958-1 CB 43.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; Notice 88-118, 1988-2 CB 450, obsoleted by Notice 98-2, 1998-2 I.R.B. 22 below.<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp; Notice 98-2, 1998-1 C.B. 266.<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp; Treas. Reg. &sect;&nbsp;1.72-16(c).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.&nbsp; Treas. Reg. &sect;&nbsp;1.101-7.<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>.&nbsp; IRC &sect;&nbsp;691(c).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> The withholding rules that apply to a distribution depend on whether it constitutes an eligible rollover distribution ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3998">3998</a>). An eligible rollover distribution from a qualified retirement plan is subject to mandatory income tax withholding at the rate of 20 percent unless the distribution is directly rolled over to an eligible retirement plan ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="4000">4000</a>). An employee receiving an eligible rollover distribution may not otherwise elect out of this withholding requirement.<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> On the other hand, a recipient may elect out of withholding with respect to distributions that do not qualify as eligible rollover distributions.<a href="#_ftn2" name="_ftnref2">²</a> The amount to be withheld on periodic payments that are not eligible rollover distributions is determined at the rate applicable to wages.<a href="#_ftn3" name="_ftnref3">³</a> Non-periodic payments that are not eligible rollover distributions are subject to income tax withholding at the rate of 10 percent.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> Withholding applies to amounts paid to a beneficiary of a participant as well as to the participant. Withholding does not apply to amounts that it is reasonable to believe are not includable in income.<br /> <br /> <hr><br /> <br /> <strong>Planning Point:</strong> The IRS has released guidance providing that when a check for a fully taxable distribution from a qualified plan is mailed to a plan participant, but not cashed, it is considered to have been &ldquo;actually distributed&rdquo; from the plan and is taxable to the participant in the year of distribution. The fact that the participant failed to cash the check is irrelevant. Further, the failure to cash the check does not change the plan administrator&rsquo;s withholding obligations with respect to the distribution and does not change the obligation to report the distribution on Form&nbsp;1099-R (assuming the distribution exceeds the applicable reporting threshold). Despite these findings, the IRS was careful to note that it continues to consider the issue of uncashed distribution checks in situations involving missing participants.<a href="#_ftn5" name="_ftnref5">⁵</a><br /> <br /> <hr><br /> <br /> The maximum amount withheld cannot exceed the sum of the money plus the fair market value of property received other than employer securities.<a href="#_ftn6" name="_ftnref6">⁶</a> Thus, a payor will not need to dispose of employer securities to meet the withholding tax liability. Loans treated as distributions (i.e., deemed distributions) continue to be subject to withholding as non-periodic distributions at a rate of 10 percent. The IRS has stated that loans deemed to be distributions are not subject to the 20 percent mandatory withholding requirement because a deemed distribution cannot be an eligible rollover distribution. Where a participant&rsquo;s accrued benefit is reduced or offset to repay a plan loan, such as when employment is terminated, the offset amount may constitute an eligible rollover distribution.<a href="#_ftn7" name="_ftnref7">⁷</a> Withholding is not required on the costs of current life insurance protection taxable to plan participants under Table 2001 or previously P.S. 58 ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3948">3948</a>).<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC &sect;&nbsp;3405(c).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; IRC &sect;&sect;&nbsp;3405(a)(2), 3405(b)(2).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp; IRC &sect;&nbsp;3405(a)(1).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp; IRC &sect;&nbsp;3405(b)(1).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.&nbsp; Rev. Rul. 2019-19.<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>.&nbsp; IRC &sect;&nbsp;3405(e)(8).<br /> <br /> <a href="#_ftnref7" name="_ftn7">7</a>.&nbsp; Notice 93-3, 1993-1 CB 293.<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> The fair market value of any property reverting to an employer from a qualified plan is includable in the employer&rsquo;s gross income and generally is subject to a nondeductible excise tax.<a href="#_ftn1" name="_ftnref1">¹</a> The basic rule is that the excise tax is equal to 50 percent and is imposed on the amount of reversion that is subject to income taxes. The 50 percent tax rate can be reduced to 20 percent if the employer establishes or maintains a qualified replacement plan, provides for pro rata benefit increases for generally all participants and certain beneficiaries, or is in Chapter 7 bankruptcy liquidation as of the termination date of the qualified plan. Where the entire reversion is paid to a qualified replacement plan, there is no reversion to the employer, the employer pays no income taxes on the amount of the reversion, and as a result there is no excise tax.<br /> <br /> A qualified replacement plan is any qualified plan established or maintained by the employer in connection with a qualified plan termination in which:<br /> <p style="padding-left: 40px;">(1)&nbsp; at least 95 percent of the active participants in the terminated plan who remain employed by the employer are active participants;</p><br /> <p style="padding-left: 40px;">(2)&nbsp; a direct transfer of assets is made from the terminated plan to the replacement plan equal to 25 percent of the maximum reversion that could have been received under prior law, reduced, dollar-for-dollar, by the present value of certain increases in participants&rsquo; accrued benefits, if any, made pursuant to a plan amendment adopted during the 60 day period ending on the date of termination and taking effect on that date, before any reversion occurs; and</p><br /> <p style="padding-left: 40px;">(3)&nbsp; the portion of the reversion transferred to a defined contribution replacement plan is allocated to participants&rsquo; plan accounts in the plan year in which the transfer occurs or is credited to a suspense account and allocated to participants&rsquo; accounts no less rapidly than ratably over the seven year period beginning with the year of the transfer.</p><br /> If any amount credited to a suspense account cannot be allocated to a participant&rsquo;s account within the seven year period, such amount generally must be allocated to the accounts of other participants.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> The IRS has determined that where the above requirements were met, amounts transferred to a replacement plan could be used to make employer matching contributions.<a href="#_ftn3" name="_ftnref3">³</a> If the entire surplus is transferred to a 401(k) plan that meets the requirements of a qualified replacement plan, the employer&rsquo;s excise tax on the reversion will be eliminated.<a href="#_ftn4" name="_ftnref4">⁴</a> A profit sharing plan with a 401(k) feature also has been approved as a qualified replacement plan.<a href="#_ftn5" name="_ftnref5">⁵</a> None of the reversion, however, may be treated as employee salary deferrals.<br /> <br /> Any amount transferred to a qualified replacement plan is not includable in the employer&rsquo;s gross income and is not treated as a reversion. No deduction is allowed with respect to the transferred amount.<a href="#_ftn6" name="_ftnref6">⁶</a><br /> <br /> An employer is considered to provide for pro rata benefit increases for generally all plan participants and certain beneficiaries under the terminated plan if (1) a plan amendment is adopted in connection with the termination of the plan, (2) the pro rata benefit increases have an aggregate present value of not less than 20 percent of the maximum amount that the employer would otherwise have received as a reversion, and (3) the pro rata benefit increases take effect immediately on termination of the plan.<a href="#_ftn7" name="_ftnref7">⁷</a><br /> <br /> Where a plan is amended to increase benefits in an effort to reduce the reversion, the benefits may not be increased, and amounts may not be allocated in contravention of the qualification requirements of IRC Section&nbsp;401(a) or the IRC Section&nbsp;415 limits ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3719">3719</a>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3728">3728</a>, and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3868">3868</a>). Any such increases or allocations must be treated as annual benefits or annual additions under IRC Section&nbsp;415.<a href="#_ftn8" name="_ftnref8">⁸</a> The employer is determined on a controlled group basis and the Secretary of the Treasury may provide that two or more plans may be treated as one plan or that a plan of a successor may be considered.<a href="#_ftn9" name="_ftnref9">⁹</a><br /> <br /> The tax applies to both direct and indirect reversions. An indirect reversion occurs where plan assets are used to satisfy an obligation of the employer.<a href="#_ftn10" name="_ftnref10">¹⁰</a><br /> <br /> An employer maintaining a plan must pay the tax, which is due on the last day of the month following the month in which the reversion occurs.<a href="#_ftn11" name="_ftnref11">¹¹</a> Where money or property reverts to a sole proprietorship or partnership, the employer is the sole proprietor or the partners.<br /> <br /> A distribution to any employer by reason of a contribution made in error may be permitted if one of three criteria is met: a mistake of fact has occurred, the funds are being returned because of a failure of the plan to qualify initially, or the error arose from a failure of employer contributions to be deductible and the repayment is permitted by the terms of the plan document.<br /> <br /> A reversion from a multiemployer plan also will not be subject to the tax if made because of a mistake of law or the return of any withdrawal liability payment.<a href="#_ftn12" name="_ftnref12">¹²</a> ERISA exempts from the prohibited transaction rules the return of contributions or withdrawal liability payments if certain requirements are met.<a href="#_ftn13" name="_ftnref13">¹³</a><br /> <br /> A transfer of excess assets from a defined benefit plan to a defined contribution plan constitutes a reversion of assets to an employer if the assets were first transferred to the employer followed by a contribution to the defined contribution plan. Thus, excess assets are included in the employer&rsquo;s income and subject to the penalty tax.<a href="#_ftn14" name="_ftnref14">¹⁴</a><br /> <br /> Although a qualified transfer of excess pension assets ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3836">3836</a>) from a defined benefit plan to an IRC Section&nbsp;401(h) account of the plan is not treated as a reversion to the employer, any amount transferred and not used to pay for qualified current retiree health benefits must be returned to the transferor plan and generally is treated as a reversion subject to the 20 percent excise tax.<a href="#_ftn15" name="_ftnref15">¹⁵</a><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC &sect;&nbsp;4980.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; IRC &sect;&nbsp;4980(d)(2).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp; Let. Ruls. 200045031, 9834036, 9302027.<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp; Let. Rul. 9837036.<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.&nbsp; Let. Ruls. 9834036, 9252035.<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>.&nbsp; IRC &sect;&nbsp;4980(d)(2)(B)(iii).<br /> <br /> <a href="#_ftnref7" name="_ftn7">7</a>.&nbsp; IRC &sect;&nbsp;4980(d)(3).<br /> <br /> <a href="#_ftnref8" name="_ftn8">8</a>.&nbsp; IRC &sect;&nbsp;4980(d)(4).<br /> <br /> <a href="#_ftnref9" name="_ftn9">9</a>.&nbsp; IRC &sect;&sect;&nbsp;4980(d)(5)(D), 4980(d)(5)(E).<br /> <br /> <a href="#_ftnref10" name="_ftn10">10</a>.&nbsp; <em><em>See, e.g.,</em></em> Let. Rul. 9136017.<br /> <br /> <a href="#_ftnref11" name="_ftn11">11</a>.&nbsp; IRC &sect;&nbsp;4980(c)(4).<br /> <br /> <a href="#_ftnref12" name="_ftn12">12</a>.&nbsp; IRC &sect;&nbsp;4980(c)(2)(B). <em><em>See also</em></em> Treas. Reg. &sect;&nbsp;1.401(a)(2)-1; IRM 4.72.11.<br /> <br /> <a href="#_ftnref13" name="_ftn13">13</a>.&nbsp; ERISA &sect;&nbsp;403(c).<br /> <br /> <a href="#_ftnref14" name="_ftn14">14</a>.&nbsp; Notice 88-58, 1988-1 CB 546; GCM 39744 (7-14-88).<br /> <br /> <a href="#_ftnref15" name="_ftn15">15</a>.&nbsp; IRC &sect;&nbsp;420(c)(1)(B).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> Net unrealized appreciation (&ldquo;NUA&rdquo;) is the excess of the fair market value of employer securities at the time of a lump sum distribution over the cost or other basis of the securities to a qualified plan trust.<a href="#_ftn1" name="_ftnref1">¹</a> Employer securities for this purpose include shares of a parent or subsidiary corporation.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> If employer securities are distributed as part of a lump sum distribution ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3971">3971</a>) from a qualified plan, the net unrealized appreciation is excluded from the employee&rsquo;s income at the time of distribution to the extent that the securities are attributable to employer and nondeductible employee contributions. Taxation of NUA following a lump sum distribution is deferred until the securities are sold or disposed of, unless the employee elects out of NUA treatment.<a href="#_ftn3" name="_ftnref3">³</a> The election is made on the tax return for the year in which the distribution must be included in gross income and does not preclude an election for special income averaging.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> On a sale or other disposition of employer securities, the NUA amount is treated as long-term capital gain, regardless of the distributee&rsquo;s actual holding period. The taxpayer&rsquo;s basis in the stock is the same as the basis in the hands of the qualified plan trust; that is, it does not include the NUA amount.<a href="#_ftn5" name="_ftnref5">⁵</a> Gain accruing after distribution of the securities and before the later disposition of them is treated as long-term or short term capital gain, depending on the holding period after distribution.<a href="#_ftn6" name="_ftnref6">⁶</a> The distributee&rsquo;s holding period begins the day after the day the plan trustee delivers the stock to the transfer agent with instructions to reissue the stock in the distributee&rsquo;s name.<a href="#_ftn7" name="_ftnref7">⁷</a><br /> <br /> An employer&rsquo;s shares, if acquired and credited to an employee&rsquo;s account, still are considered employer stock, even if later transferred to the trust of an acquiring or subsidiary corporation.<a href="#_ftn8" name="_ftnref8">⁸</a> The basis does not change.<a href="#_ftn9" name="_ftnref9">⁹</a> The balance of the value of the stock is taxable to the recipient under the regular rules for taxing lump sum distributions ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3971">3971</a>).<a href="#_ftn10" name="_ftnref10">¹⁰</a><br /> <br /> Unrealized appreciation that is excluded from income is not includable in the recipient&rsquo;s basis in the stock for the purpose of computing gain or loss upon a later sale or other taxable disposition.<a href="#_ftn11" name="_ftnref11">¹¹</a> If part or all of the unrealized appreciation is excluded as something other than unrealized appreciation, only the part excluded as unrealized appreciation is not added to basis.<a href="#_ftn12" name="_ftnref12">¹²</a><br /> <br /> Unrealized appreciation realized on sale of the stock by the recipient of a distribution on account of the death of the employee or by a person inheriting the stock from the employee is income in respect of a decedent. It is taxed as long-term capital gain and a deduction may be taken for the estate tax attributable to the inclusion of any part of the appreciation prior to distribution in the deceased employee&rsquo;s estate.<a href="#_ftn13" name="_ftnref13">¹³</a><br /> <br /> <hr><br /> <br /> <strong><strong>Planning Point:</strong></strong> NUA treatment may not be the best option for a distribution of employer securities. Each situation should be analyzed based on factors including the amount of unrealized appreciation, the outlook for the employer&rsquo;s securities, and whether the participant can pay the tax on the basis without selling some of the employer securities.<br /> <br /> <hr><br /> <br /> NUA in employer securities distributed in other than a lump sum distribution is excludable only to the extent that the appreciation is attributable to nondeductible employee contributions.<a href="#_ftn14" name="_ftnref14">¹⁴</a> Thus, a rollover of employer securities to an IRA will preclude the taxpayer from receiving NUA treatment.<br /> <br /> A transfer to an IRA of less than all of a participant&rsquo;s account under an ESOP, with a distribution of the balance to the participant, does not bar treatment as a lump sum distribution, however. The IRS determined that a participant could exclude the net unrealized appreciation on the stock distributed outright to the participant until the participant disposes of it.<a href="#_ftn15" name="_ftnref15">¹⁵</a><br /> <br /> Similarly, a participant who had received a series of substantially equal periodic payments ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3679">3679</a>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3960">3960</a>) from his plan account prior to retirement was not precluded from treating a distribution of the remaining amounts, including stock, in his plan account as a lump sum distribution ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3968">3968</a>), nor from excluding net unrealized appreciation on the stock.<a href="#_ftn16" name="_ftnref16">¹⁶</a><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; Treas. Reg. &sect;&nbsp;1.402(a)-1(b)(2)(i).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; IRC &sect;&nbsp;402(e)(4)(E).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp; IRC &sect;&nbsp;402(e)(4)(B).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp; IRC &sect;&nbsp;402(e)(4).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.&nbsp; Treas. Reg. &sect;&nbsp;1.402(a)-1(b)(1)(i).<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>.&nbsp; <em><em>See</em></em> Treas. Reg. &sect;&nbsp;1.402(a)-1(b); Notice 98-24, 1998-1 CB 929; <em><em>see also</em></em> Rev. Rul. 81-122, 1981-1 CB 202.<br /> <br /> <a href="#_ftnref7" name="_ftn7">7</a>.&nbsp; Rev. Rul. 82-75, 1982-1 CB 116.<br /> <br /> <a href="#_ftnref8" name="_ftn8">8</a>.&nbsp; Rev. Rul. 73-29, 1973-1 CB 198; Let. Rul. 201242019.<br /> <br /> <a href="#_ftnref9" name="_ftn9">9</a>.&nbsp; Rev. Rul. 80-138, 1980-1 CB 87.<br /> <br /> <a href="#_ftnref10" name="_ftn10">10</a>.&nbsp; Rev. Rul. 57-514, 1957-2 CB 261.<br /> <br /> <a href="#_ftnref11" name="_ftn11">11</a>.&nbsp; Treas. Reg. &sect;&nbsp;1.402(a)-1(b).<br /> <br /> <a href="#_ftnref12" name="_ftn12">12</a>.&nbsp; Rev. Rul. 74-398, 1974-2 CB 136.<br /> <br /> <a href="#_ftnref13" name="_ftn13">13</a>.&nbsp; Rev. Rul. 69-297, 1969-1 CB 131; Rev. Rul. 75-125, 1975-1 CB 254.<br /> <br /> <a href="#_ftnref14" name="_ftn14">14</a>.&nbsp; IRC &sect;&nbsp;402(e)(4)(A).<br /> <br /> <a href="#_ftnref15" name="_ftn15">15</a>.&nbsp; Let. Ruls. 9721036, 200038057.<br /> <br /> <a href="#_ftnref16" name="_ftn16">16</a>.&nbsp; Let. Rul. 200315041.<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> If a death benefit is payable from the proceeds of a life insurance policy, the difference between the cash surrender value and the face amount is treated as death proceeds of life insurance, and is excluded from income under IRC Section&nbsp;101(a), but only if the insurance cost under Table 2001, the insurer&rsquo;s qualifying term rate, (or previously under P.S. 58 ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3948">3948</a>)) has been paid with nondeductible employee contributions or has been taxable to the employee.<a href="#_ftn1" name="_ftnref1">¹</a> The balance of the proceeds, representing the cash surrender value, is treated as a distribution from the plan.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> The following amounts may be subtracted from the cash surrender value and also excluded from gross income:<br /> <p style="padding-left: 40px;">(1)&nbsp; the sum of the annual term costs of life insurance protection previously taxed to the<br /> employee ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3952">3952</a>), but if the deceased was a self-employed owner-employee, the deceased&rsquo;s beneficiary cannot subtract these costs even though they were not deductible by the owner-employee;</p><br /> <p style="padding-left: 40px;">(2)&nbsp; if the plan is contributory, the employee&rsquo;s nondeductible contributions toward the cost of the insurance;</p><br /> <p style="padding-left: 40px;">(3)&nbsp; the amount of any loans included in the employee&rsquo;s income as taxable distributions ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3953">3953</a>); and</p><br /> <p style="padding-left: 40px;">(4)&nbsp; any employer contributions other than excess deferrals ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3760">3760</a>) that have been taxed to an employee, including contributions in pre-1984 years on behalf of a more-than-5-percent shareholder-employee in an S corporation in excess of excludable amounts.</p><br /> The balance, if any, of the cash surrender value is taxable according to the rules applicable to lump sum distributions ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3971">3971</a>).<br /> <br /> If an employer has purchased an existing policy from an employee for contribution to the trust, or if an employee has contributed it directly to the trust, the transfer for value rule<br /> ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="279">279</a>) does not apply so long as neither the employer nor the trustee has the right to change the beneficiary. The IRS determined that there was no significant change in the beneficial ownership of the policy.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> Similarly, if a trustee of one plan purchases a life insurance policy from the trustee of another plan, there is no transfer for value where the beneficiary is entitled to designate the beneficiary both before and after the transfer because there has been no change in beneficial<br /> ownership.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> If a contract is a retirement income contract, and the cash surrender value before death equals or exceeds the face amount, no portion of the proceeds is excludable as death proceeds of life insurance.<a href="#_ftn5" name="_ftnref5">⁵</a> The annual term costs of life insurance protection previously taxed to the employee would be excludable, except by the beneficiary of an owner-employee.<br /> <br /> If the contract was distributed to the employee before his or her death, the IRS has previously considered the proceeds entirely tax-exempt as life insurance proceeds, although the Tax Court has considered them taxable as proceeds payable under an annuity contract, because death occurs after the element of risk has disappeared.<a href="#_ftn6" name="_ftnref6">⁶</a><br /> <br /> If a contract distributed before death is subject to the definition of life insurance in IRC Section&nbsp;7702 or IRC Section&nbsp;101(f), the treatment of the death benefit would be as discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="65">65</a>.<br /> <br /> If a death benefit is not from life insurance proceeds, the beneficiary may subtract and receive tax-free any nondeductible employee contributions, the amount of any loans included in income, and any employer contributions other than excess deferrals ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3760">3760</a>) that have been taxed to the employee. The balance, if any, of the death benefit, other than amounts attributable to deductible employee contributions, is taxable according to the rules applicable to lump sum distributions ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3971">3971</a>).<br /> <br /> A distribution to an employee&rsquo;s beneficiary on account of plan termination, rather than on account of death, may not be treated as a lump sum distribution or as payment of an employee death benefit.<a href="#_ftn7" name="_ftnref7">⁷</a><br /> <br /> A beneficiary may be entitled to an income tax deduction for any estate tax attributable to the distribution ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3993">3993</a>).<a href="#_ftn8" name="_ftnref8">⁸</a><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; Treas. Reg. &sect;&nbsp;1.72-16(c)(4).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; IRC &sect;&nbsp;72(m)(3)(C); Treas. Reg. &sect;&nbsp;1.72-16(c).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp; Rev. Rul. 73-338, 1973-2 CB 20; Rev. Rul. 74-76, 1974-1 CB 30.<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp; Let. Rul. 7844032.<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.&nbsp; <em>Jeffrey v. U.S.</em>, 11 AFTR 2d 1401 (D. N.J. 1963).<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>.&nbsp; <em><em>See</em> Evans v. Comm.</em>, 56 TC 1142 (1971).<br /> <br /> <a href="#_ftnref7" name="_ftn7">7</a>.&nbsp; <em><em>Estate of Stefanowski v. Comm</em></em>., 63 TC 386 (1974).<br /> <br /> <a href="#_ftnref8" name="_ftn8">8</a>.&nbsp; IRC &sect;&nbsp;691(c).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> If an employee had no cost basis for his or her interest, or has recovered his or her cost basis from benefits received during the employee&rsquo;s life, all amounts received by the beneficiary will be fully taxable. The beneficiary may be entitled to an income tax deduction for any estate tax attributable to the employee&rsquo;s interest in the plan.<a href="#_ftn1" name="_ftnref1">¹</a><br /> <p style="text-align: center;"><strong>Joint and Survivor Annuity</strong></p><br /> The method of taxing survivor annuity payments to a beneficiary depends on how the employee was taxed ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a>).<br /> <br /> If the employee was taxed on everything, the survivor annuitant will be taxed on everything as well.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> If the employee was taxed under the three year cost recovery rule in existence with respect to annuities with starting dates prior to July&nbsp;1, 1986, and had not recovered his or her full cost basis, the survivor will receive the guaranteed payments tax-free until the total of the employee&rsquo;s and survivor&rsquo;s tax-free receipts equals the employee&rsquo;s cost basis; thereafter everything will be includable in gross income.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> If the employee was taxed under regular annuity rules or under the safe harbor method, the survivor will continue with the same exclusion ratio,<a href="#_ftn4" name="_ftnref4">⁴</a> but if the employee&rsquo;s annuity starting date was after December&nbsp;31, 1986, no amount is excludable by the employee or beneficiary after the investment in the contract has been recovered.<a href="#_ftn5" name="_ftnref5">⁵</a><br /> <p style="text-align: center;"><strong>Refund Beneficiary</strong></p><br /> If the employee had a cost basis for the employee&rsquo;s interest and had not recovered the full amount tax-free, a refund beneficiary under a life annuity with a refund or period-certain guarantee can exclude the balance of the cost basis from gross income ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a>). Otherwise, everything received by the beneficiary is taxable.<a href="#_ftn6" name="_ftnref6">⁶</a><br /> <br /> If the beneficiary receives the refund in a lump sum distribution, the lump sum distribution rules apply ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3971">3971</a>). If the beneficiary surrenders an annuity contract that has been previously distributed to the employee, the payment does not qualify for lump sum treatment because it is not viewed as a distribution from the trust but as a payment in settlement of the insurer&rsquo;s liability to make future payments.<a href="#_ftn7" name="_ftnref7">⁷</a><br /> <br /> If the beneficiary receives the refund in installments, the payments are taxable as ordinary income.<br /> <br /> If the refund beneficiary of a decedent whose annuity starting date was after July&nbsp;1, 1986, does not fully recover the cost basis unrecovered at the decedent&rsquo;s death, the refund beneficiary may take a deduction for the remaining unrecovered amount.<a href="#_ftn8" name="_ftnref8">⁸</a><br /> <p style="text-align: center;"><strong>Installment Payments</strong></p><br /> Where payments for a fixed period or of a fixed amount, not involving a life contingency, had commenced to the employee, tax consequences to the beneficiary can differ, depending on whether the installments are continued or are commuted and paid to the beneficiary in a lump sum.<br /> <br /> In addition, the balance, if any, of the lump sum payment is taxable under the lump sum distribution rules.<br /> <br /> If installments are continued, the method of taxing payments then will depend on how the employee was taxed ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a>). If the employee was taxed on everything, the beneficiary also will be.<a href="#_ftn9" name="_ftnref9">⁹</a> If the employee was taxed under the three year cost recovery rule in existence for annuities with starting dates prior to July&nbsp;1, 1986, and had not recovered his or her full cost basis tax-free, the beneficiary can exclude the balance from the first payments received. Thereafter, everything is taxable.<a href="#_ftn10" name="_ftnref10">¹⁰</a><br /> <br /> If the employee was taxed under regular annuity rules or under the safe harbor method, the beneficiary will continue to exclude the same portion of each payment from gross income.<a href="#_ftn11" name="_ftnref11">¹¹</a><br /> <br /> If the annuity starting date was after December&nbsp;31, 1986, the beneficiary can exclude amounts only until the investment in the contract has been fully recovered; thereafter, all amounts are included in income.<a href="#_ftn12" name="_ftnref12">¹²</a><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC &sect;&nbsp;691(c).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; Treas. Reg. &sect;&nbsp;1.72-4(d).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp; Treas. Reg. &sect;&nbsp;1.72-13.<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp; Treas. Reg. &sect;&sect;&nbsp;1.72-4, 1.72-5.<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.&nbsp; IRC &sect;&nbsp;72(b)(2).<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>.&nbsp; Treas. Reg. &sect;&nbsp;1.72-11; Treas. Reg. &sect;&nbsp;1.72-13.<br /> <br /> <a href="#_ftnref7" name="_ftn7">7</a>.&nbsp; Rev. Rul. 68-287, 1968-1 CB 174.<br /> <br /> <a href="#_ftnref8" name="_ftn8">8</a>.&nbsp; IRC &sect;&nbsp;72(b)(3).<br /> <br /> <a href="#_ftnref9" name="_ftn9">9</a>.&nbsp; Treas. Reg. &sect;&nbsp;1.72-4(d).<br /> <br /> <a href="#_ftnref10" name="_ftn10">10</a>.&nbsp; Treas. Reg. &sect;&nbsp;1.72-13.<br /> <br /> <a href="#_ftnref11" name="_ftn11">11</a>.&nbsp; Treas. Reg. &sect;&nbsp;1.72-4(a).<br /> <br /> <a href="#_ftnref12" name="_ftn12">12</a>.&nbsp; IRC &sect;&nbsp;72(b)(2).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> Normally, neither a participant nor a trust pays any tax on earnings on a trust because as long as the plan meets the requirements of IRC Section&nbsp;401(a), the trust is tax-exempt under IRC Section&nbsp;501(a). The tax exemption also applies to trusts of plans covering self-employed individuals.<br /> <br /> Trust income may be subject to income tax when it constitutes unrelated business income.<a href="#_ftn1" name="_ftnref1">¹</a> For example, a plan has unrelated business income from a trade or business regularly carried on by the trust.<a href="#_ftn2" name="_ftnref2">²</a> This could occur when an exempt trust is a limited partner that receives unrelated business income to the same extent as if it were a general partner.<a href="#_ftn3" name="_ftnref3">³</a> A specific deduction of up to $1,000 is allowed against unrelated business income.<a href="#_ftn4" name="_ftnref4">⁴</a> Thus, a trust generally will pay income taxes when its unrelated taxable income exceeds $1,000.<br /> <br /> Income from any type of property will be taxable as unrelated business income if the property has been acquired with borrowed funds, that is, debt-financed property. Thus, income from plan assets subject to debt, such as life insurance with policyholder loans, may give rise to unrelated business taxable income.<a href="#_ftn5" name="_ftnref5">⁵</a><br /> <br /> Where a pension fund, in an attempt to increase the rate of return on three certificates of deposit, borrowed funds from a savings and loan with the three old certificates as collateral and was issued a new certificate in an amount equal to the borrowed amount, the net interest earned on the new certificate was income from debt-financed property.<a href="#_ftn6" name="_ftnref6">⁶</a><br /> <br /> An exempt trust or 501(c)(3) organization may be a shareholder in an S corporation ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3818">3818</a>). Ordinarily, such an interest would be treated as an interest in an unrelated trade or business; thus, items of S corporation income allocable to a plan could result in unrelated business income.<br /> <br /> An employee stock ownership plan ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3817">3817</a>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3825">3825</a>) maintained by an S corporation is not treated as receiving unrelated business income on items of income or loss of the S corporation in which it holds an interest.<a href="#_ftn7" name="_ftnref7">⁷</a><br /> <br /> Employer securities purchased by an ESOP with borrowed funds do not give rise to unrelated business taxable income because the indebtedness that an ESOP incurs to purchase employer securities is inherent in the purpose of the trust&rsquo;s tax exemption.<a href="#_ftn8" name="_ftnref8">⁸</a> Securities purchased on margin by a profit sharing trust and by a pension trust have been held to be debt-financed property.<a href="#_ftn9" name="_ftnref9">⁹</a><br /> <br /> Where a trust is taxed because of its unrelated business income, the tax rate is the rate applicable to trusts.<a href="#_ftn10" name="_ftnref10">¹⁰</a><br /> <br /> A trust&rsquo;s earnings are not entirely tax-free, but are merely deferred until they are distributed or made available to participants or their beneficiaries.<a href="#_ftn11" name="_ftnref11">¹¹</a><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC &sect;&nbsp;511.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; IRC &sect;&nbsp;512.<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp; <em><em>Service Bolt &amp; Nut Co. Profit Sharing Trust v. Comm</em></em>., 724 F.2d 519 (6th Cir. 1983).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp; IRC &sect;&nbsp;512(b)(12).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.&nbsp; <em><em>See</em> Siskin Memorial Found., Inc. v. U.S.</em>, 790 F.2d 480 (6th Cir. 1986), <em>aff&rsquo;g,</em> 603 F. Supp.&nbsp;91 (E.D. Tenn. 1984); <em>Henry E. &amp; Nancy Horton Bartels Trust v. United States</em>, 617 F.3d 1357 (Fed. Cir. 2010). <em><em>See also</em></em> Let. Rul. 7918095.<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>.&nbsp; <em><em>Kern County Elec. Pension Fund v. Comm</em></em>., 96 TC 845 (1991).<br /> <br /> <a href="#_ftnref7" name="_ftn7">7</a>.&nbsp; IRC &sect;&nbsp;512(e)(3).<br /> <br /> <a href="#_ftnref8" name="_ftn8">8</a>.&nbsp; Rev. Rul. 79-122, 1979-1 CB 204.<br /> <br /> <a href="#_ftnref9" name="_ftn9">9</a>.&nbsp; <em><em>Elliot Knitwear Profit Sharing Plan v. Comm</em></em>., 614 F.2d 347 (3d Cir. 1980).<br /> <br /> <a href="#_ftnref10" name="_ftn10">10</a>.&nbsp; <em><em>See</em></em> IRC &sect;&nbsp;511(b); <em><em>Marprowear Profit Sharing Trust v. Comm</em></em>., 74 TC 1086 (1980), <em><em>aff&rsquo;d without opinion</em></em> (3d Cir. 1981).<br /> <br /> <a href="#_ftnref11" name="_ftn11">11</a>.&nbsp; IRC &sect;&sect;&nbsp;402(a), 403(a).<br /> <br /> </div></div><br />

<p>Except as noted below, amounts distributed from qualified retirement plans before the participant reaches age 59½ are early or premature distributions subject to an additional tax equal to 10 percent of the amount of the distribution includable in gross income.<a href="#_ftn1">¹</a></p><p>To the extent that they are attributable to rollovers from a qualified retirement plan or a Section 403(b) plan, amounts distributed from Section 457 plans ( Q <a href="javascript:void(0)">3584</a>) generally will be treated as distributed from a qualified plan, for purposes of the early distribution penalty.<a href="#_ftn2">²</a></p><p>The 10 percent penalty tax does not apply to distributions: </p><p>(1) made to a beneficiary, or the employee's estate, on or after the death of the employee;</p><p>(2) attributable to the employee's disability;<a href="#_ftn3">³</a></p><p>(3) that are part of a series of substantially equal periodic payments made at least annually for the life or life expectancy of the employee or the joint lives or joint life expectancies of the employee and his or her designated beneficiary, and beginning after the employee separates from the service of the employer ( Q <a href="javascript:void(0)">3679</a>);</p><p>(4) made to an employee after separation from service during or after the year in which the employee attained age 55, or age 50 for distributions to qualified public safety employees from a governmental plan as defined in IRC Section 414(d);<a href="#_ftn4">⁴</a></p><p>(5) made to an alternate payee under a qualified domestic relations order ( Q <a href="javascript:void(0)">3915</a>);</p><p>(6) made to an employee for medical care, but not in excess of the amount allowable as a deduction to the employee under IRC Section 213 for amounts paid during the year for medical care, determined without regard to whether the employee itemizes deductions for the year;</p><p>(7) made to reduce an excess contribution under a 401(k) plan ( Q <a href="javascript:void(0)">3808</a>);</p><p>(8) made to reduce an excess employee or matching employer contribution, that is, an excess aggregate contribution ( Q <a href="javascript:void(0)">3808</a>);<a href="#_ftn5">⁵</a></p><p>(9) made to reduce an excess elective deferral ( Q <a href="javascript:void(0)">3760</a>);<a href="#_ftn6">⁶</a></p><p>(10) that are dividends paid with respect to stock of a corporation described in IRC Section 404(k) (ESOPs) ( Q <a href="javascript:void(0)">3824</a>);</p><p>(11) made on account of certain levies against a qualified plan;<a href="#_ftn7">⁷</a> or</p><p>(12) that are qualified reservist distributions, which are distributions of elective deferrals made to reserve members of the U.S. military called to active duty for 180 days or more at any time after September 11, 2001. Reservists have the right to rollover the amount of any distributions to an individual retirement plan for two years following the end of active duty.<a href="#_ftn8">⁸</a></p><p>(13) made on account of qualified births or adoptions under the SECURE Act (<em><em>see</em></em> below for more details).</p><p>(14) beginning in 2024, qualifies as an emergency distribution under the rules discussed below.</p><p>(15) beginning in 2024, made on account of domestic violence if the participant certifies that they have been a victim of domestic violence by a spouse or domestic partner within the one-year period prior to the withdrawal (<em><em>see</em></em> below).</p><p>(16) beginning in 2025, made to cover the costs of long-term care insurance (<em><em>see</em></em> below).</p><p>(17) made on account of the taxpayer's being diagnosed with a terminal illness.</p><p><strong>Planning Point:</strong> Note that many clients mistakenly believe that the penalty does not apply to certain distributions used to fund the purchase of the taxpayer's home. This exception applies only with respect to IRA distributions—the 401(k) rules do not provide for a similar exception. </p><p><strong>Planning Point:</strong> Early distribution penalties are generally waived in the event of natural disasters, and were waived in response to COVID-19-related distributions for 2020. </p><p>The IRS has approved three methods for determining what constitutes a series of substantially equal periodic payments in the exception discussed in (3) above. If the series of payments is later modified, other than because of death or disability, before the employee reaches age 59½, or if after the employee reaches age 59½, within five years of the date of the first payment, the employee's tax for the year in which the modification occurs is increased by an amount equal to the tax that would have been imposed in the absence of the exception, plus interest for the deferral period. For an explanation of the calculation under each method, the definition of "modified," and related rulings, <em><em>see</em></em> Q <a href="javascript:void(0)">3679</a>. </p><p>The exception for distributions pursuant to a QDRO (<em><em>see</em></em> (5) above) was not applicable where a participant took a distribution from the plan following a trade of other marital property rights for his or her spouse's waiver of rights in his or her plan benefits.<a href="#_ftn9">⁹</a></p><p><strong>Planning Point:</strong> A participant who separates from service during or after the year he or she attains age 55 but is not yet age 59½ should generally leave plan accounts in the plan if permitted rather than transferring or rolling the accounts to an IRA or other qualified plan. This allows the participant to take distributions from the account as permitted by the plan without being subject to the 10 percent tax. A transfer to an IRA would subject the money transferred to the 10 percent tax while a transfer to another qualified plan would subject it to the new plan's restrictions on distributions and the 10 percent tax. </p><p>A court determined that a distribution originating from an arbitration award was subject to the 10 percent penalty because the amounts attributable to the award were thoroughly integrated with benefits provided under the state retirement plan.<a href="#_ftn10">¹⁰</a> The involuntary nature of a distribution does not preclude the application of the tax, provided that the participant had an opportunity, such as by a rollover, to avoid the tax.<a href="#_ftn11">¹¹</a></p><p>The IRS has stated that the garnishment of an individual's plan interest under the Federal Debt Collections Procedure Act to pay a judgment for restitution or fines as discussed in (11) above, will not trigger the application of the 10 percent penalty.<a href="#_ftn12">¹²</a></p><p>The cost of life insurance protection included in an employee's income ( Q <a href="javascript:void(0)">3948</a>) is not considered a distribution for purposes of applying the 10 percent penalty.<a href="#_ftn13">¹³</a> The Civil Service Retirement System is a qualified plan for purposes of the early distribution penalty.<a href="#_ftn14">¹⁴</a></p><p>A plan is not required to withhold the amount of the additional income tax on an early withdrawal.<a href="#_ftn15">¹⁵</a> Distributions that are rolled over ( Q <a href="javascript:void(0)">3996</a> to Q <a href="javascript:void(0)">4019</a>) generally are not includable in income, and, thus, the 10 percent penalty does not apply. In the case of a distribution subject to 20 percent mandatory withholding, the 20 percent withheld will be includable in income, however, to the extent required by IRC Section 402(a) or IRC Section 403(b)(1), even if the participant rolls over the remaining 80 percent of the distribution within the 60-day period ( Q <a href="javascript:void(0)">4016</a>). Thus, an employee who rolls over only 80 percent of a distribution may be subject to the 10 percent penalty on the 20 percent withheld.<a href="#_ftn16">¹⁶</a></p><p><strong>Qualified Birth and Adoption Distributions</strong></p><p>The SECURE Act amended the IRC to allow qualified plan participants to withdraw up to $5,000 for a qualified birth or adoption without becoming subject to the 10 percent penalty on early distributions. The distribution must be taken within the one-year period following the birth or adoption. </p><p>IRS guidance clarifies that an "eligible adoptee" does not include the child of the participant's spouse (in other words, step-parent adoptions do not count).<a href="#_ftn17">¹⁷</a> Notice 2020-68 also clarifies that each parent is entitled to take a distribution with respect to the same child. Parents are also eligible to take distributions more than once—i.e., for multiple children over time. Parents of twins are entitled to double the $5,000 limit. However, plans are not required to provide the option for qualified birth or adoption distributions. If the plan permits distributions for qualified birth or adoption, it must also permit recontribution of those amounts. </p><p><strong><strong>Planning Point:</strong></strong> The SECURE Act 2.0 clarified that taxpayers who take penalty-free withdrawals for qualifying birth or adoption expenses do not have an unlimited amount of time to repay those amounts. Instead, the repayment must be made within three years of the date of the withdrawal. For qualifying birth or adoption withdrawals that were taken before the new law was enacted, the repayment period ends December 31, 2025. </p><p>A qualified birth or adoption distribution is not treated as an eligible rollover distribution for purposes of the direct rollover rules of Section 401(a)(31), the notice requirement under Section 402(f), and the mandatory withholding rules under Section 3405. Thus, the plan is not required to offer an individual a direct rollover with respect to a qualified birth or adoption distribution. In addition, the plan administrator is not required to provide a Section 402(f) notice. Finally, the plan administrator or payor of the qualified birth or adoption distribution is not required to withhold an amount equal to 20 percent of the distribution, as generally is required in Section 3405(c)(1). </p><p>However, a qualified birth or adoption distribution is subject to the voluntary withholding requirements. If the plan does not permit qualified birth or adoption distributions and an individual receives an otherwise permissible in-service distribution that meets the requirements of a qualified birth or adoption distribution, the individual may treat the distribution as a qualified birth or adoption distribution on the individual's federal income tax return. The distribution, while includible in gross income, is not subject to the 10 percent additional tax. If the individual decides to recontribute the amount to an eligible retirement plan, the individual may recontribute the amount to an IRA. </p><p>In the case of a recontribution made with respect to a qualified birth or adoption distribution from an applicable eligible retirement plan other than an IRA, an individual is treated as having received the distribution as an eligible rollover distribution (as defined in Section 402(c)(4)) <br/> and as having transferred the amount to an applicable eligible retirement plan in a direct trustee-to-trustee transfer within 60 days of the distribution.<a href="#_ftn18">¹⁸</a></p><p><strong>Emergency Distributions</strong></p><p>Beginning in 2024, the SECURE Act 2.0 allows retirement plan participants to take emergency distributions from their retirement savings accounts without penalty (currently, a 10 percent penalty plus ordinary income tax applies if an early distribution does not qualify for an exception). </p><p>These emergency distributions will be limited to $1,000 each year. Also, taxpayers who take emergency distributions must repay the distribution within a three-year period or will be prohibited from taking another $1,000 distribution during the following three-year period. Non-highly compensated employees may be entitled to contribute the lesser of (1) 3 percent of compensation or (2) $2,500 to emergency savings accounts using after-tax dollars. </p><p><strong>Long-Term Care Insurance</strong></p><p>The SECURE Act 2.0 allows taxpayers to withdraw up to $2,500 each year to cover the costs of long-term care insurance without triggering the 10 percent early withdrawal penalty (these withdrawals will still be subject to ordinary income taxation). </p><p>The funds can be used to pay for standalone long-term care insurance or for certain life insurance or annuity contracts that also provide for meaningful financial assistance in the event that the insured person requires long-term care in a nursing home or home-based long-term care. </p><p>This new provision is effective for tax years beginning after December 31, 2024 (the $2,500 annual limit will also be adjusted for inflation, to $2,600 for the 2026 tax year). </p><p><strong>Domestic Violence</strong></p><p>Beginning in 2024, plan participants are entitled to take penalty-free withdrawals if the participant certifies that they have been a victim of domestic violence by a spouse or domestic partner within the one-year period prior to the withdrawal. The withdrawal will be limited to the lesser of $10,000 (the amount will be indexed for inflation) or 50 percent of the participant's vested account balance. Plan participants who take advantage of this withdrawal provision will be permitted to repay the amounts withdrawn within three years. </p><p><strong>Terminal Illness</strong></p><p>Taxpayers who have been certified by a physician as being terminally ill will also be permitted to take penalty-free withdrawals beginning immediately (the withdrawals can also be repaid within three years). The distribution is not exempt from income tax. </p><p>The IRS clarified that self-certification is not sufficient and the employee must provide evidence and documentation as required by the employer. That evidence must include the certifying physician's name and contact information, as well as a description of the evidence used to conclude that the individual suffers from a terminal illness. </p><p>The IRS also clarified that terminal illness means that the individual has been certified by a physician as having an illness or physical condition that can reasonably be expected to result in death in 84 months or less after the date of the certification. </p><p>While plans are not strictly required to offer the terminal illness exception, the employee may elect to treat an otherwise permissible in-service distribution as a distribution based on terminal illness via Form 5329, filed with their income tax return.<a href="#_ftn19">¹⁹</a></p><p><hr align="left" size="1" width="33%"></hr></p><p> <a href="#_ftnref1">1</a>. IRC § 72(t). </p><p> <a href="#_ftnref2">2</a>. IRC § 72(t)(9). </p><p> <a href="#_ftnref3">3</a>. As defined in IRC Section 72(m)(7). </p><p> <a href="#_ftnref4">4</a>. IRC § 72(t)(10) as modified by Pub. L. 114-26. </p><p> <a href="#_ftnref5">5</a>. IRC § 401(m)(7). </p><p> <a href="#_ftnref6">6</a>. IRC § 402(g)(2)(C). </p><p> <a href="#_ftnref7">7</a>. Under IRC § 6331. </p><p> <a href="#_ftnref8">8</a>. IRC § 72(t)(2)(G). </p><p> <a href="#_ftnref9">9</a>. <em>O'Brien v. Comm.</em>, TC Summary Opinion 2001-148. </p><p> <a href="#_ftnref10">10</a>. <em>Kute v. U.S.</em>, 191 F.3d 371 (3d Cir. 1999). </p><p> <a href="#_ftnref11">11</a>. <em>Swihart v. Comm.</em>, TC Memo 1998-407. </p><p> <a href="#_ftnref12">12</a>. Let. Rul. 200426027. </p><p> <a href="#_ftnref13">13</a>. Notice 89-25, 1989-1 CB 662, A-11. </p><p> <a href="#_ftnref14">14</a>. <em>Roundy v. Comm.</em>, 122 F.3d 835, 97-2 USTC ¶ 50,625, <em>aff'g</em> TC Memo 1995-298; <em>Shimota v. U.S.</em>, 21 Cl. Ct. 510, 90-2 USTC ¶ 50,489 (Cl. Ct. 1990). </p><p> <a href="#_ftnref15">15</a>. General Explanation—TRA '86, p. 716. </p><p> <a href="#_ftnref16">16</a>. Treas. Reg. §§ 1.402(c)-2 A-11, 1.403(b)-2. </p><p> <a href="#_ftnref17">17</a>. Notice 2020-68. </p><p> <a href="#_ftnref18">18</a>. IRC § 72(t)(2)(H)(v)(III). </p><p> <a href="#_ftnref19">19</a> Notice 2024-02. </p>

<div class="Section1"><br /> <br /> A refinancing transaction is any transaction in which one loan replaces another. For example, a refinancing may exist if the outstanding loan amount is increased or if the interest rate or the repayment term of the loan is renegotiated.<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> If the term of a replacement loan ends later than the term of the loan it replaces, both loans are treated as outstanding on the date of the refinancing transaction. This generally means that the loans must collectively satisfy the requirements of IRC Section 72(p).<a href="#_ftn2" name="_ftnref2">²</a> There is an exception where the replacement loan would satisfy IRC Section 72(p)(2) if it were treated as two separate loans. Under this exception, the amount of the replaced loan, amortized over a period ending no later than the end of the original term of the replaced loan or five years, if later, is treated as one loan. The other loan is for an amount equal to the difference between the amount of the replacement loan and the outstanding balance of the replaced loan.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> The IRS will not view the transaction as circumventing IRC Section 72(p) if a replacement loan effectively amortizes an amount equal to the replaced loan within the original term of the replaced loan or within five years, if later. For this reason, the outstanding balance of a replaced loan need not be taken into account in determining whether the limitations of IRC Section 72(p)(2) have been met; only the amount of the replacement loan plus any existing loans that are not being replaced is considered.<a href="#_ftn4" name="_ftnref4">⁴</a> If the term of a replacement loan does not end later than the term of the replaced loan, then only the amount of the replacement loan plus the outstanding balance of any existing loans that are not being replaced must be taken into account in determining whether IRC Section 72(p) has been satisfied.<a href="#_ftn5" name="_ftnref5">⁵</a><br /> <p style="text-align: center;"><strong>Multiple Loans</strong></p><br /> Where a participant receives multiple loans from a qualified retirement plan, each loan must separately satisfy IRC Section 72(p), taking into account the outstanding balance of each existing loan. The refinancing rules do not apply because the new loan is not used to replace any existing loan.<a href="#_ftn6" name="_ftnref6">⁶</a> Earlier proposed regulations set a limit of two loans per participant within a single year, but final regulations contain no such limit.<a href="#_ftn7" name="_ftnref7">⁷</a><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.  Treas. Reg. § 1.72(p)-1, A-20(a).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.  Treas. Reg. § 1.72(p)-1, A-20(a)(2).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.  Treas. Reg. § 1.72(p)-1, A-20(a)(2).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.  Treas. Reg. § 1.72(p)-1, A-20(a)(2).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.  Treas. Reg. § 1.72(p)-1, A-20(a)(1).<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>.  Treas. Reg. § 1.72(p)-1, A-20(a)(1).<br /> <br /> <a href="#_ftnref7" name="_ftn7">7</a>.  Treas. Reg. § 1.72(p)-1, A-20(a)(2).<br /> <br /> </div>