The rules governing distributions from qualified plans and IRAs are exceedingly and unnecessarily complex. Please read IRC §§72, 401(a)(9), 402 and 408(d) (and the regulations thereunder) very quickly at this point in the outline if the reader has the least doubt on this score. Quite frankly, there is no need for this sort of nonsense in our system of taxation. There may be areas of the law where complexity is necessary and unavoidable, but here there is no excuse, other than that the drafters are incompetent, lazy and unconcerned.
As if to make clear to all who doubt the wisdom of Congress, and in order to once again reaffirm that the taxation committees are entirely lacking in judgment and common sense, Congress as part of its yearly ritual will next year almost certainly make numerous changes in the already prolix and overburdened language which sets forth the rules governing distributions from qualified plans and IRAs.
In the light of these most recent changes it is time for each of us to ask, and to perhaps ask loudly: Is all of this complexity really necessary in order to raise revenue, achieve fairness and implement social policy? Is it really necessary to the achievement of these purposes that the rules be abstruse, disjointed and continually changed? Is it really impossible to achieve the common objectives in this area by the use of rules that are lucid, succinct and of long duration?
In advising clients with regard to distributions and contributions it is important to bear in mind the various penalty taxes on distributions and contributions of the wrong amounts or at the wrong times. Such penalties include the following, at least:
1. The recipient is taxed if he gets a distribution too soon. IRC §72(t).
2. The payee is taxed if the distribution is made too late. IRC §§401(a)(9) and 4974.
3. The payee is taxed if the distribution is too small. IRC §§401(a)(9) and 4974.
4. The employer is taxed if it makes a contribution that is too small. IRC §4971.
5. The employer is taxed if it makes a contribution that is too large. IRC §4972.
6. The employer is taxed if the nonhighly compensated employees make a contribution that is too small. IRC §§402(g), 401(k)(8), 401(m) and 4979.
7. The employer is taxed if the highly compensated employees make a contribution that is too large. IRC §§402(g), 401(k)(8), 401(m) and 4979.
8. The employer may be subject to liability to the PBGC if there are insufficient assets at termination. ERISA Title IV.
9. The recipient is taxed if he makes a contribution to an IRA that is too large. IRC §4973.
Almost everyone is now subject to the 10% tax on premature distributions, not just key employees or 5% owners. The tax applies to distributions from qualified plans (§401(a)), IRAs, and §403(a) and (b) plans.[1] The tax does not apply to IRC §457 plans,[2] because it is outside of the definition of “qualified retirement plan.”[3]
For many years, only “owner-employees” were subject to the 10% premature distribution tax. [4]TEFRA, P.L. 97-248, dispensed with the term “owner-employee” and applied the tax to any person during such time as the person was a key employee in a top-heavy plan, effective for plan years beginning after 1983. The 1984 Tax Reform Act, repealed the reference to key employees, and imposed the tax for any distribution attributable to years after 1984 in which the person was a 5% owner. Various problems with the effective dates resulted in the passage of a technical correction to the 1984 TRA amending §72(m)(5)(A) to make the tax applicable for benefits accrued before 1985, in the case of 5% owners. But then the 1986 TRA simply made the tax apply to virtually everyone, for taxable years beginning after 1984, and eliminated 72(m)(5) for taxable years beginning after 1986.[5]
A premature distribution is generally a distribution from a "qualified retirement plan" that is includible in the gross income of a distributee and which is made prior to age 591/2. For this purpose a "qualified retirement plan" is a plan described in IRC §4974(c), i.e., a qualified plan, IRA, SEP, or a 403(a) or 403(b) annuity.
Even an involuntary distribution, such as a distribution to a trustee in bankruptcy, can invoke the tax.[6]
There are a number of important exceptions to the application of the §72(t) 10% penalty tax.
The penalty does not apply if the distribution is made after the employee has separated from service if the separation from service occurred during or after the calendar year in which the employee attained age 55.[7] The plan apparently need not contain any special language dealing with early retirement in order for the age 55 exception to apply.[8] Note that this exception is not available if the distribution is from an IRA (including a SEP-IRA).[9]
The penalty does not apply unless the distribution is includible in gross income. Therefore, the return of nondeductible employee contributions and amounts rolled over are exempt by definition from the tax.
§72(t)(2)(A)(ii) provides that the tax does not apply after death. This exception is important to note. A distribution on account of the death of the participant can be made without fear of incurring the premature distribution tax, no matter what the age of the beneficiary,[10] unless, perhaps, the distribution is to a spouse who has rolled over the IRA. See below.
Query, does the exception for distributions on account of death[11] continue to apply after a spousal rollover made pursuant to IRC §§402(c)(9), 403(b)(8)(B) or 408(d)(3)(C)? (As previously set forth, it is now the rule that a participant’s spouse is the only beneficiary eligible to rollover a death benefit distribution of the participant’s interest in a qualified plan or IRA.)
As previously indicated §72(t)(2)(A)(ii) provides that the tax does not apply after death, and thus, the tax clearly does not apply to an inherited IRA. IRC §408(d)(3)(C)(ii)(I) expressly describes an inherited IRA as one “acquired . . . by reason of the death of another individual.”[12] But what if a spouse is the beneficiary of an inherited IRA, and the spouse either makes a rollover or elects to treate the IRA as his or her own. The IRS definitely is of the opinion that the death exception does not survive a rollover.[13] However, I don’t think that the answer to this question is as clear as the IRS would have you believe.
It is very important to note that the tax does not apply if the distribution is part of a series of substantially equal periodic payments made for the life or life expectancy of the participant or the joint lives of the participant and his beneficiary.[14] However, in the case of a qualified plan, but not an IRA, this exception does not apply unless the participant has separated from service.[15]