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Qualified Retirement Plans


Retirement is sometimes referred to as the "golden years." However, retirement is not very golden for those without enough money to retire comfortably. Longer life spans and growing concern over the future of Social Security retirement benefits are just two of the reasons why your clients may be interested in sound retirement planning. For many Americans, qualified retirement plans are the keystone of retirement planning.

Click here to see a chart that summarizes the contribution and benefit limits for qualified retirement plans.

Beyond Social Security

The Social Security system provides significant retirement benefits for the vast majority of American workers. However, this program was never intended to be an individual's sole means of support after the working years have ended. Recognizing the importance of retirement planning, the U.S. government has provided tax incentives for the creation of employer-sponsored retirement plans that qualify for favorable federal income tax treatment—hence the name qualified retirement plans.

Before a plan can qualify for tax-favored treatment, the employer must:

  • establish the plan in writing
  • communicate it to the employees
  • establish it for the exclusive benefit of employees and their beneficiaries
  • make it permanent
  • prohibit the assignment or alienation of benefits
  • meet certain minimum participation (for defined benefit plans only as of January 1, 1997), coverage, vesting and funding standards
  • not discriminate in favor of highly compensated employees
  • adhere to rules regarding contribution and benefit limits.

Certain qualified retirement plans also must provide for a qualified joint-and-survivor annuity as a benefit option for married plan participants.

Let's examine a few of these areas in more detail.

Minimum Participation Requirements

Defined benefit pension plans must meet minimum requirements regarding employee participation. Generally, the plan must cover at least—

  • 50 employees, or, if less,
  • the greater of (1) 40% of all employees, or (2) two employees.

However, if a company has only one employee, then only that employee need be covered.

The plan may exclude certain employees. When applying the minimum participation requirements, the employer may omit employees who do not meet the plan's minimum age and service requirements, nonresident aliens who receive no U.S.-source income, and union members whose retirement benefits have been the subject of good-faith bargaining with the employer.

Minimum Vesting Requirements

To qualify, an employer-sponsored retirement plan must meet minimum vesting standards, which means that the participant's accrued benefits or accrued allocations in the plan must become nonforfeitable within the time frames prescribed by federal income tax law:

  • The participant must be fully vested in his or her normal retirement benefit upon attainment of normal retirement age. (Normal retirement age is either the retirement age stated in the plan, or the later of age 65 or the fifth anniversary of the date plan participation began.)
  • The employee must be 100% vested at all times in his or her own contributions.
  • The plan may not discontinue benefit or allocation accruals due to the participant's attainment of a specified age.
  • A participant in a defined contribution plan that is not a top-heavy plan must acquire nonforfeitable rights to all employer contributions no later than provided under either of the following schedules:
  • a participant who has completed three years of service must be 100% vested (the "three-year cliff" vesting schedule), or
  • graduated vesting under a schedule in which the employee is at least 20% vested after two years of service; 40% vested after three years; 60% vested after four years; 80% vested after five years; and 100% vested after six years (the "six-year graded" vesting schedule).
  • A participant in a defined benefit plan that is not top-heavy must acquire nonforfeitable rights to all employer contributions no later than provided under either of the following schedules:
  • 100% “cliff” vesting after the employee completes five years of service (the “five-year cliff” vesting schedule), or
  • graduated vesting under a schedule in which the employee is at least 20% vested after three years of service; 40% vested after four years; 60% after five years; 80% after six years; and 100% after seven years of service (the "seven-year graded" vesting schedule).

The defined contribution and defined benefit vesting schedules listed above represent a change enacted by the PPA beginning in 2007 (with special rules for collectively-bargained plans). Prior to this change, employer contributions vested under the five-year cliff or seven-year graded vesting schedules, and only employer matching contributions vested more rapidly under the three-year cliff or six-year graded vesting schedules.

An employer must take an employee's prior service into account when complying with the special vesting requirement for employer matching contributions. A plan’s vesting schedule may be quicker than what is required by law.

Section 415 Limits

Section 415 of the Internal Revenue Code prescribes ceilings on:

  • the annual additions that may be made to a participant's account in a defined contribution plan (such as a 401(k) plan, 403(b) plan, profit-sharing plan, or money-purchase pension plan), and
  • the annual benefit that may be provided by a defined benefit pension plan, including a 412(e)(3) plan [formerly known as a 412(i) plan].

The Section 415 ceiling dollar amounts are indexed to inflation and are periodically changed by statute. The following table shows the recent history of these ceilings:

Ceiling on annual
additions to a
defined contribution
plan account
Ceiling on annual
benefit payable
by a defined benefit
2011 $49,000 $195,000
2012 $50,000 $200,000
2013 $51,000 $205,000
2014 $52,000 $210,000

Note: the 415 ceiling amount for a defined contribution plan is the lesser of the dollar amount stated above or 100% of the participant's compensation, and the 415 ceiling amount for a defined benefit plan is the lesser of the dollar amount stated above or 100% of the participant's average highest three consecutive years of compensation. The 415 limit for defined benefit plans is also reduced for years of participation in the plan fewer than 10.

Nondiscrimination Requirements

An employer retirement plan must pass nondiscrimination tests to qualify for federal income tax benefits. In broad terms these are:

  • contributions and benefits may not discriminate in favor of "highly compensated employees," as defined below (although integration with Social Security, which is now called "permitted disparity," allows contributions and benefits to be weighted in favor of highly compensated employees in accordance with applicable Federal law);
  • the rights, benefits and features provided under the plan must be available to employees in a nondiscriminatory manner; and
  • past service credits, plan amendments, and plan terminations must be nondiscriminatory.

The nondiscrimination requirements are very technical, and vary with the type of retirement plan. A detailed discussion is beyond the scope of this service.


Highly Compensated Employee


A highly compensated employee (in whose favor a qualified retirement plan may not discriminate) is defined as someone who—

  • owns more than 5% of the employer's business, or
  • received compensation of more than $115,000 (indexed amount for 2014) in the preceding year and, if the employer so elects, is a member of the top-paid 20% group of employees.

Top-Heavy Plans

A retirement plan is considered "top-heavy" if more than 60% of the present value of the accrued benefits under the plan are for "key employees."

Whether an individual is a key employee for top-heavy testing purposes is based on the employee's status in the previous plan year only (not in the five prior years, as was formerly the case). A key employee is defined as:

  • an officer of the employer whose compensation exceeded $170,000 (indexed amount for 2014);
  • an employee who owned (directly or through attribution) more than 5% of the employer, regardless of compensation; or
  • an employee who owned (directly or through attribution) more than 1% of the employer if the employee's annual compensation exceeded $150,000.

Top-heavy defined contribution plans must make a minimum annual contribution on behalf of all non-key employees of the lesser of (1) 3% of compensation, or (2) the percentage of compensation at which contributions were made for key employees, including employer matching contributions and employee elective deferrals that are treated as employer contributions.

Top-heavy defined benefit plans must provide a minimum annual benefit to all non-key employees of the lesser of (1) 20% of compensation, or (2) 2% of compensation multiplied by the employee's years of service.

All top-heavy plans—both defined benefit and defined contribution—must either vest 100% all at once after three years of service (three-year cliff vesting), or must gradually phase in to 100% over not more than six years (20% after two years of service, 20% additional for each of the following four years) (six-year graded vesting).

Minimum Funding Requirements

Defined benefit pension plans, money purchase pension plans, and target benefit plans must satisfy minimum funding requirements. Employers must set up defined benefit plans on an actuarially sound basis that assures the funding of past-service liabilities. The employer must factor in any gains and losses experienced and any changes in actuarial assumptions when determining employer contributions.

In an effort to eliminate the funding deficits prevalent in many defined benefit plans, the PPA introduced major changes to the funding rules. The PPA provides for a funding target in terms of plan assets on hand to fund the benefit liabilities. (A plan's funding target is equal to 100% of the present value of all benefit liabilities accrued to date.) If the plan's assets are less than the funding target for any year, the minimum required contribution for that year will be the plan's normal cost for the year, plus an additional contribution to amortize the funding shortfall. (The funding shortfall is the excess of the plan's funding target over the plan's assets.) The PPA also provides rules on the use of interest rates in the determination of the actuarial liabilities and in the valuation of the plan's assets. These changes were phased in for existing plans, but generally became effective for plan years beginning after December 31, 2007.

Some employers that sponsor defined benefit plans also sponsor a nonqualified deferred compensation plan for certain key executives. The PPA prevents a publicly-traded employer from accumulating a reserve to fund nonqualified deferred compensation benefits for certain executives if the employer or a member of its controlled group is bankrupt, has an at-risk plan (generally less than 80% funded) or has a plan that terminated without sufficient assets to pay all benefits. If an affected employer funds a nonqualified deferred compensation plan, then the CEO and the other top four executives (if that is the group benefiting) must be treated as incurring immediate income (to the extent vested at the time of funding), interest, and a 20% penalty. If the employer grosses up the affected executives' compensation for the tax and penalty, the gross-up amounts also become subject to immediate taxation.

A money purchase pension plan may satisfy the minimum funding requirements simply by making the contributions required by the plan's contribution formula. A target benefit plan must take into account the participant's age and compensation and the plan's assumed interest rate in calculating the employer's minimum periodic contribution to the plan.

An excise tax is imposed if the employer fails to meet the minimum funding requirements.

Qualified Plans Can Have IRA Feature

Effective for plan years beginning on and after January 1, 2003, certain employer retirement plans that permit voluntary employee contributions may elect to set up traditional or Roth Individual Retirement Accounts or Annuities to which employees may contribute under the plan. Eligible employer plans include not only qualified plans but also 403(b) and governmental 457(b) plans. Contribution-tracking and separate accounting requirements are imposed on employers and Third Party Administrators (TPAs), which will increase the administrative responsibilities of creating plans with an IRA feature.

Supreme Court Decision in United States v. Windsor—Effects on Retirement Planning

An individual's marital status is of key importance in the administration of numerous employment-related plans and programs. The 1996 Defense of Marriage Act (DOMA) denied federal benefits to married couples of the same sex. However, with the advent of the Supreme Court's decision in United States v. Windsor, 133 S. Ct. 2675 (June 26, 2013), employers are now required to recognize legally married same-sex couples when determining how they provide benefits under most employer-sponsored benefit programs.

In fact, the Windsor ruling specifies that same-sex couples who are legally married will be treated as married for all federal tax purposes. As a result of this far-reaching decision, all employers, public and private, are required to adjust their employment practices to meet the new standard as outlined by the Court.

Both the Internal Revenue Service and the Department of Labor have begun publishing guidance as a result of the Windsor decision, including the following:

  • Revenue Ruling 2013-17 clarifies the "state of celebration rule"—namely, that same sex marriages in states where such marriages are legal will be recognized for all federal tax purposes where marriage is a factor, including filing status, personal and dependency exemptions, the standard deduction, employee benefits, IRA contributions and income tax credits. This recognition applies regardless of the state of domicile. Any same-sex marriage legally entered into in one of the 50 states, the District of Columbia, a U.S. territory or a foreign country is covered; however, the ruling does not apply to registered domestic partnerships, civil unions or similar formal relationships that may be recognized under state law.
  • DOL Technical Release No. 2013-04 contains guidance similar to Rev. Rul. 2013-17 respecting employee benefit arrangements subject to ERISA.
  • Notice 2014-19 provides important current and retroactive guidance on applying Windsor to plans qualified under IRC §401(a). This Notice, which also covers IRC §403(b) tax deferred annuities, addresses:
  • Qualified Domestic Relations Orders (QDROs)
  • spousal death protections
  • rollovers
  • Required Minimum Distributions (RMDs)
  • hardship distributions
  • Employee Stock Ownership Plan (ESOP) ownership issues
  • plan amendment issues (amendment generally required by December 31, 2014 for qualified plans—postponed dates apply to IRC §403(b) tax deferred annuities and plans maintained by governmental entities)
    According to Notice 2014-19, qualified plans were required to apply Windsor principles as of June 26, 2013; however, a qualified plan will not be treated as noncompliant if, prior to the date Rev. Rul. 2013-17 was issued (September 16, 2013), a plan sponsor recognized a plan participant's same-sex marriage only if the participant was domiciled in a state that recognized same-sex marriages. After September 16, 2013, a plan sponsor must recognize a participant's legal same-sex marriage regardless of where the participant is domiciled. Plan sponsors may choose to administer some provisions retroactively, although this complicates plan oversight and should only be undertaken after careful review of the administrative ramifications.
  • Notice 2014-37 provides further guidance on amendments to certain "safe harbor" 401(k) plans to reflect the Windsor decision. The Notice allows plan sponsors to amend safe harbor plans (plans designed to automatically satisfy IRS nondiscrimination requirements) during the plan year without jeopardizing the safe harbor status of the plan. Such "mid-year" alterations ordinarily cause a plan to lose its safe harbor status.
  • Notice 2014-1 addresses health savings accounts (HSAs), flexible spending arrangements (FSAs) and cafeteria plans for same-sex spouses. In essence, the Notice clarifies that legally married same sex spouses are to be treated the same as any other legally married spouses. For HSAs, that means they are subject to the same HSA rules and limitations and permitted reimbursements from an HSA for covered expenses incurred by a same sex spouse. As for cafeteria plans, the Notice allows a cafeteria plan to treat same sex spouses that were legally married on June 26, 2013 (the date of the Windsor decision) as though they experienced a "change in status" for plan purposes. The change in status rules permit a participant to revoke a previous election and make a new election consistent with the change.

Note that same sex couples remain subject to state law, and IRS and DOL guidance does not resolve tax and employment issues that exist under state law.

For employers, reasons for implementing a qualified retirement plan go far beyond securing federal income tax benefits for the business and its employees. Qualified retirement plans can help businesses:

  • recruit high-quality employees,
  • retain their services, and
  • enhance good employer-employee relationships.

When it comes to attracting and keeping good employees, firms without qualified retirement plans may be at a competitive disadvantage to those with these plans in place.

Federal Income Tax Benefits of Qualified Retirement Plans

Let's take a closer look at the specific federal income tax benefits of qualified retirement plans to see why these plans are so popular among employers and employees in all types of businesses.



Employer contributions to a qualified retirement plan are generally immediately tax-deductible by the employer within prescribed limits. If a plan is nonqualified, employers do not receive current deductions for contributions made to the plan (unless taxed immediately to the employee). Thus, an employer that wants immediate federal income tax deductions for contributions made should consider establishing a qualified retirement plan.

Employer contributions are not currently taxable to the employee. If an employer makes a contribution to a qualified plan on behalf of an employee, that contribution is not subject to current federal income tax until the money is distributed.

Tax-Deferred Growth

Participants do not pay tax on interest earnings and investment returns until they take the money out as plan distributions. That means more money is left to accumulate, thus potentially accelerating the growth of these funds when compared to a currently taxable funding vehicle. Qualified retirement plans provide the best of both worlds for the participant—no current taxes on contributions (up to specified limits), and no current taxes on earnings. If the qualified retirement plan includes life insurance, the participant must report the taxable economic benefit as income each year.


A defined benefit plan promises either a stated benefit at retirement or a benefit determined according to a fixed formula.

How Defined Benefit Plans Work

As the name implies, a defined benefit plan focuses on providing a specified benefit at retirement. The employer bears the responsibility of providing an adequate retirement income based on the benefit promised or the benefit formula utilized.

As you might imagine, the administration of a defined benefit plan can be quite complex. Investment performance must be closely monitored and projections made so the employer knows how much to contribute to provide the retirement income promised under the plan. Typically, an actuary or other financial specialist tells the employer how much to contribute annually, and a separate plan administrator is in charge of the administration details of the plan.

The employer can specify the benefit amount in a number of ways:

Flat Amount Benefit

Each employee receives a flat amount at retirement, without regard to earnings or years of service. This method is most appropriate for groups of employees who have relatively uniform compensation. Everyone who qualifies would receive the same pension benefit at retirement.

Flat Percentage Benefit

Each employee receives a fixed percentage of his or her compensation as a pension benefit, usually without regard to years of service. For example, the flat percentage may be 25% of the participant's average compensation for the three consecutive years for which he or she was most highly compensated. Average compensation of $60,000 would yield a yearly pension benefit of $15,000.

Unit Benefit

Each employee receives a fixed benefit amount per month for each year of completed service. This formula (and the flat amount formula) is most commonly found in union-negotiated or collectively bargained plans. If the formula provides for $30 of monthly pension benefit for each year of service and the employee has worked for the business 10 years, the monthly pension is $300.

Unit Benefit Percentage Formula

Each employee receives a fixed percentage of compensation for each year of service or participation. This method is popular with employers who want to reward years of service. For example, assume the benefit formula is 2% of monthly compensation for each year of service. An employee with 20 years of service who earns $2,000/month would have a pension benefit of $800 per month. An employee with 30 years of service who earns $2,000/month would have a monthly pension benefit of $1,200.

Who Uses Defined Benefit Plans

While some larger employers still use defined benefit plans, they often appeal to smaller firms with older, higher paid employees who are owners or shareholders. The reason defined benefit plans appeal to these firms is because the benefit formula can be based on recent compensation levels, largely ignoring time of service requirements for accumulating a sizeable pension benefit, subject to IRS limits. If there is not much time to build a substantial retirement fund for key employees (including owners) and the company has the financial ability to fund the plan, a defined benefit plan is often a good choice.


The benefits in most traditional defined benefit plans are protected, within certain limitations, by federal insurance provided through the Pension Benefit Guaranty Corporation (PBGC).

Benefit Limits

There are limits to the benefit amounts that an employer can provide under a defined benefit plan. The highest annual benefit that can be paid for any limitation year ending in 2014 is the lesser of:

  • 100% of the participant's average compensation for the three highest consecutive calendar years during which the employee plan had the greatest aggregate compensation from the employer, or$210,000.

The dollar limitation is indexed to inflation in $5,000 increments, rounded down to the next lowest multiple of $5,000.

In order to obtain the full maximum benefit, 10 years of participation is required. Only the first $260,000 for 2014 of an employee's annual compensation may be taken into account in determining benefits.

  Defined benefit plans are benefit-driven in their design; the employer bears the risk that the plan earnings may be insufficient to pay the promised benefits; administration is fairly complex; and these plans can use a final pay formula, which means that the benefit can be higher than if pay were averaged over the entire working career.

A cash-balance pension plan is a special type of defined benefit plan that has features of both a defined benefit plan and a defined contribution plan.

Both younger workers and employers may have concerns regarding traditional defined benefit plans that promise to pay a specific benefit at retirement. Benefit accruals under traditional defined benefit plans are usually backloaded (i.e., faster accruals in later years of service), and thus tend to favor older workers with more years of service. Also, many traditional defined benefit plans do not permit lump-sum payments, so benefits are not portable. Employers (especially public companies) may not like the unpredictable funding obligations of traditional defined benefit plans, and the resulting fluctuations in corporate earnings. Cash-balance pension plans were designed to address these concerns.

A cash-balance pension plan generally credits participants with a percentage of their pay each year, along with interest on these amounts. When participants become entitled to receive benefits under the plan, benefits are normally paid as an annuity. However, cash-balance plans typically also permit lump-sum payments. This permits benefit portability and faster accruals for certain employees, while also resolving some employers' funding concerns.

Employer contributions are determined actuarially to assure sufficient funds to provide the benefits promised by the plan. The employer bears the risks and rewards of the plan investments. Thus, increases and decreases in the value of the plan's investments will not affect the benefit amounts promised to the participants. The benefits in most cash-balance plans are protected, within certain limitations, by federal insurance provided through the Pension Benefit Guaranty Corporation (PBGC).

There has been a significant amount of litigation involving the conversion of traditional defined benefit plans into cash balance plans, with the focus of the litigation being on age discrimination issues because, in some cases, older participants did not fare as well under the cash balance plan as they would have if the defined benefit plan had continued in effect.

The PPA provides that a plan is not treated as violating the prohibition on age discrimination under ERISA, the Internal Revenue Code ("Code"), or the Age Discrimination in Employment Act ("ADEA") if a participant's accrued benefit, as determined as of any date under the terms of the plan, would be equal to or greater than that of any similarly situated, younger individual who is or could be a participant. For this purpose, an individual is similarly situated to a participant if the individual and the participant are (and have always been) identical in every respect (including period of service, compensation, position, date of hire, work history, etc.) except for age.

In addition, the PPA clarifies that cash balance plans are not inherently age discriminatory as long as the benefits are fully vested after three years of service and the interest credits under the plan's formula do not exceed a market rate of return. The PPA provisions for cash balance plans were effective for periods beginning on and after June 29, 2005; however, for a plan that was in existence on June 29, 2005, the interest credit and vesting requirements generally apply to years beginning after December 31, 2007.

A defined contribution plan provides that the employer as well as the participant can make contributions to the plan. The amount of each employee's retirement benefit ultimately depends on the amount of contributions and the investment performance of that particular employee's account, rather than the employer's promise (as in the defined benefit plan).

The employer's contributions are frequently based on a percentage of compensation. The employer's only obligation is to make these contributions if required; the employee generally bears the risk of investment performance. (With a defined benefit plan, the employer bears this risk.) In fact, defined contribution plans often permit participants to direct the investment of their plan accounts.

Defined contribution plans are popular today for several reasons, including little investment risk for the employer, often easier administration, and more easily determined employer costs. These plans also are often easier for participants to understand.

Under this type of defined contribution plan, employer contributions are based on a set percentage of each employee's compensation. The employer is required to make annual contributions, and an employee's ultimate pension benefit is equal to the total employer contributions plus the earnings (or minus any investment losses) on those contributions, and minus any administrative expenses. Under a money purchase plan, an employer is obligated to make annual contributions.

Money purchase pension plans are relatively easy to set up, administer, and explain to employees. Employers favor the predictable costs and the fact that they do not bear the plan's investment risk. However, money purchase pension plans are no longer as popular as they once were. Prior to EGTRRA, money purchase pension plans enjoyed an advantage over profit-sharing plans in terms of deductibility (up to 25% of employee compensation, versus up to 15% for profit-sharing plans). Because EGTRRA increased the profit sharing contribution limit to 25%, most employers prefer the flexibility of a profit-sharing plan over a money purchase plan.

These defined contribution plans, sometimes also called discretionary plans, are similar to money purchase pension plans in that the amount of an employee's retirement benefit depends on the amount in an individual employee's account at retirement. The distinguishing feature of this plan, however, is that the employer is not obligated to make contributions each year, but there must be recurring and substantial contributions.

When designing a profit-sharing plan, the employer has great flexibility in determining how and when it will make contributions. For example, contribution amounts could be (1) based on profits which exceed a certain amount, or (2) a percentage of net income, or (3) determined by a board of directors each year. Not-for-profit organizations can also adopt a "profit-sharing" plan by indicating that profits will not be considered in determining the contribution level.

In addition to identifying a method for determining contribution amounts, the plan must also have a method for allocating funds. Allocations could be based on total compensation, integration with Social Security, weighted average, comparability, or a point system which considers both compensation and years of service. Employer contributions to a profit-sharing plan are deductible but limited to no more than 25% of the total compensation of participating employees.

Many employers like profit-sharing plans for the following reasons:

  • Employers can manage the cost through a contribution formula that is based on profitability or the discretion of the board of directors.
  • Employees are often motivated when they share in company profits.

Profit sharing plans are often implemented by:

  • companies with relatively young owners or shareholders,
  • those with widely fluctuating profits, and
  • those that want to utilize the concept of defined contributions without being obligated to a specific contribution in lean income years.

Employee savings or thrift plans are a form of defined contribution plan that may require mandatory employee contributions as a condition of plan participation. The employer matches such employee contributions under a formula specified in the plan. For example, the employer may contribute 50 cents for each dollar contributed by the employee up to a stated cap (e.g.,3% of compensation). The employee may be permitted to make contributions over the maximum that the employer will match (i.e., over 6% of compensation in our example).

Savings or thrift plans are typically set up by employers who want to provide a retirement plan for employees but at a modest cost to the employer. Such plans can be set up as a money purchase pension plan or a profit-sharing plan. Sometimes a thrift plan supplements another retirement plan of the employer.

Employee contributions to a thrift plan are not deductible, but employer contributions are not taxed currently to the employee, and all funds in the plan accumulate on a tax-deferred basis. Because the employee contributions are made with after-tax dollars, thrift plans have largely been supplanted in recent years by 401(k) plans, which allow employees to make before-tax contributions.

An employee stock ownership plan (ESOP) is a special type of defined contribution plan in which the plan assets are invested primarily in employer securities. The employer's contribution deduction is generally limited to 25% of covered annual compensation.

A basic advantage of the ESOP is that the employer makes its contributions in cash or employer securities. In other words, an employer that is strapped for cash in a particular year can make its contribution in the form of securities and still enjoy the tax deduction. As in the case of a profit-sharing plan, the employer is not required to make a plan contribution every year unless the ESOP has borrowed to acquire employer securities. If the employer does borrow to purchase the securities, the interest paid on the loan is deductible.

Dividends paid on employer securities held by an ESOP are deductible by the employer. Cash dividends received by participants are taxable distributions.

When an employee leaves the company, he or she receives the vested interest in the ESOP. Depending on the plan terms, the distribution may be made in cash or the employee may demand employer securities. If the securities are not readily tradable in an established market, the employee has a right to sell the securities to the company at fair market value.

An ESOP, by definition, is limited to corporations. Prior to 1998, S corporations could not establish ESOPs. The Taxpayer Relief Act of 1997 opened the door to the establishment of ESOPs by S corporations. However, certain of the special tax benefits that are available in the case of ESOPs established by C corporations are not available in the case of an S corporation ESOP. The interest paid on an ESOP loan is included in the overall deduction limitation of 25% of compensation, resulting in less of a deduction. There is no deduction for dividends paid on employer securities held in the ESOP. And finally, the special rule that allows sellers of shares of stock to defer recognition of the gain on such sale if certain requirements are met does not apply to ESOPs maintained by an S corporation.

One appeal of the ESOP is that its contributions are to be invested primarily in employer securities, without the need of ERISA diversification requirements and without violating the "prudent man rule" under ERISA with respect to investments. However, any "qualified participant," which is one who has 10 years of participation in the ESOP and who has reached age 55, must be allowed to diversify up to 25% of his or her account in the 6-plan year period beginning on the date the individual first became a qualified participant. In the last year of the 6-plan year period, the qualified participant must be allowed to diversify up to 50% of his or her account out of employer securities.

The PPA added certain additional investment diversification requirements to ESOPs that hold publicly traded employer securities. As of 2006, participants are allowed to diversify pre-tax elective deferrals and any associated matching employer contributions out of publicly traded employer securities and into other investments which have materially different risk and return characteristics. Participants with more than three years of service (and their beneficiaries) are allowed to diversify other employer contributions out of employer securities as well.

A special effective date applies with respect to employer matching and nonelective contributions (and earnings thereon) that are invested in employer securities that, as of September 17, 2003, (1) consist of preferred stock, and (2) are held within an ESOP, under the terms of which the value of the preferred stock is subject to a guaranteed minimum. Under the special rule, the diversification requirements apply to such preferred stock for plan years beginning after the earlier of (1) December 31, 2007, or (2) the first date as of which the actual value of the preferred stock equals or exceeds the guaranteed minimum.

While it is classified as a defined contribution plan for federal income tax purposes, a target benefit plan is really a hybrid between a defined benefit plan and a money purchase pension plan. It is similar to a defined benefit plan because the annual employer contribution is based on the amount required to accumulate a fund that will pay a target benefit at the employee's normal retirement age utilizing an assumed interest rate.

Like a defined benefit plan, actuarial assumptions are used when the plan is adopted to determine the contributions an employer must make to provide the "targeted benefit" amount. After this calculation is done, the cost of the targeted benefit is compared to a money purchase pension plan contribution limit, and whichever is smaller is the required contribution. In later years, employer contributions are adjusted for increases or decreases in compensation.

After each contribution is determined, the target benefit plan is similar to a money purchase pension plan. As with all defined contribution plans, the employee bears the investment risk and the success of the plan is based on investment performance. There is no guarantee the target benefit will be attained. Conversely, the retirement benefit provided could exceed the target benefit if actual earnings exceed the interest rate assumed in determining contributions.

Target benefit plans are popular among many types of companies, but they are especially attractive when a company has not had a plan in place and wants to provide retirement benefits for older, well-paid employees. The structure of the target benefit plan allows the employer to make higher contributions for these employees in order to provide the desired retirement benefit in a relatively short period of time, subject to IRS limits.

Contribution Limits for Defined Contribution Plans

The three defined contribution plans—money purchase pension, profit sharing, and target benefit—have the same general limitations regarding annual additions on behalf of individual employees. The annual additions may not exceed, for the limitation year beginning in 2014, the lesser of $52,000 or 100% of compensation.

The dollar limitation is indexed for inflation in $1,000 increments, rounded down to the next lowest multiple of $1,000.

Defined contribution plans are contribution-driven in their design; the employee bears the investment risk; they are relatively easy to administer; and the benefits will be based on the amount accumulated.

Since both defined benefit and defined contribution plans fall under the umbrella of qualified retirement plans, they have the same ultimate objective: providing retirement funds for employees. Defined benefit plans are often more costly to the employer, since they require regular administrative attention and the employer bears the investment risk. If investments do not perform well, the employer is obligated to increase contributions in order to reach the defined benefit objective.

Defined contribution plans are often simpler and more economical. One of the employer's obligations is to make the annual contribution under the terms specified in the plan. The employer also has other obligations in its role as plan fiduciary. The employee bears the investment risk and generally has control over the investment account. Defined contribution plans do not require actuarial attention on a regular basis.

While there are no hard and fast rules for determining which type of plan is best for a business, you should be aware of these distinctions. In addition, keep in mind that a defined benefit plan is usually the best tool for developing a substantial retirement benefit in a short period of time.

Finally, you should be aware that employers providing defined benefit plans must be insured by the Pension Benefit Guaranty Corporation (PBGC), a wholly owned government corporation which oversees pension funds. Thus, most defined benefit plans have insurance to protect or guarantee certain employee benefits. Defined contribution plans are not insured by PBGC.

Note: A Section 412(e)(3) plan is a type of defined benefit, qualified retirement plan that takes its name from Section 412(e)(3) of the Code. Because of the plan's recent popularity, we have chosen to cover it separately here. As part of the PPA reorganization of the funding requirements for qualified plans, the entire Code Section 412 has been modified. Effective for plan years beginning after 2007, the Code Section 412(i) provisions have been recodified as Code Section 412(e)(3); however, the content is the same as the previous Code Section 412(i).

A combination of statutory changes and regulatory/ compliance burdens made defined benefit plans increasingly less popular in the 1980s and 1990s. The net effect of these changes was to—

  • allow smaller deductions for contributions to defined benefit plans,
  • increase the likelihood of penalties for compliance failures, and
  • increase the risk that plan actuarial assumptions would be attacked.

Some of these problems related to the intricacies of the minimum funding standards of IRC Sec. 412. For example, the "full funding limitation" restricted the amount that could be contributed and deducted. If the funding rules were the problem, then a plan that was exempt from the minimum funding standards could be the answer. A defined benefit plan that meets the requirements of IRC Sec. 412(e)(3) is such a plan.

Section 412(e)(3) Defined Benefit Plans

A Section 412(e)(3) plan is generally a defined benefit plan in which—

  • plan benefits are funded entirely by individual annuity contracts or a combination of annuity and life insurance contracts issued by an insurance company (i.e., a fully insured plan);
  • the contracts must provide for level annual premiums that begin when an employee becomes a plan participant and end no later than the employee's retirement age under the plan;
  • the plan benefits must be equal to the benefits provided under each contract at the plan's normal retirement age, and must be guaranteed by an insurance company to the extent premiums have been paid;
  • all premiums due on these contracts are paid for the current plan year and for all prior plan years;
  • rights under these contracts are not subject to a security interest at any time during the plan year; and
  • no policy loans against these contracts are outstanding at any time during the plan year.

The Appeal of Section 412(e)(3) Plans

The following are some of the reasons Section 412(e)(3) plans are attractive:

  • there is no full funding limitation or current liability test to limit the employer's deduction, thus making larger contribution deductions possible;
  • due to the insurer's rates used in 412(e)(3) plans, the contributions (and, therefore, tax deductions) available for older owner-employees can be significantly higher;
  • with increased funding, larger benefit payouts are likely at retirement, subject to IRS limits;
  • if death occurs before retirement, a portion of the beneficiaries' death benefit is income tax free rather than fully taxable (as is the account value typical in other retirement plans);
  • plan assumptions are not subject to attack, since they coincide with the guarantees in the insurance contracts; and
  • these plans are exempt from the minimum funding standards.


Section 412(e)(3) plans also have disadvantages:

  • less investment flexibility than other qualified plans;
  • the plan cannot allow loans;
  • if a sustained bull market returns, 412(e)(3) plans will not participate in the growth, and defined contribution plans may regain favor; and
  • they probably have limited appeal outside small and/or family corporations, where large allocations can be made to the accrued benefits of the owner(s).

IRS Responds to "Abuses" in Fully Insured Plans

In February 2004, the IRS released proposed regulations, revenue rulings and one revenue procedure to deal with what it characterized as "abuses" in 412(e)(3) plans (formerly 412(i) plans). The IRS issued the regulations in final form in August 2005.

One of the "abuses" identified by the IRS was the claim by some promoters that a 412(e)(3) plan could be used to generate high tax deductions for employer contributions, with little taxation of employees on retirement distributions or death benefits. This was supposedly accomplished by the use of "springing cash value" policies in which the cash values are artificially depressed at the time a policy is distributed out of the plan to a participant. After the policy distribution, the cash value increases to a more normal amount. The result was that participants recognized little income even though employers had taken large tax deductions while the policy was held inside the plan.

The IRS regulations are intended to prevent artificial depression of contract values [Reg. §§1.402(a)-1(a)(1)(iii); 1.402(a)-1(a)(2)]. One way they do that is by clarifying that a policy’s fair market value (not just the contract’s cash value) must be included in the income of the participant taking the distribution of a life insurance contract, retirement income contract, endowment contract, or other contract providing life insurance protection. In determining fair market value, the IRS specifies that all rights under the contract (including any supplemental agreements and whether or not guaranteed) must be included.

In addition, the IRS wanted to address the issue of qualified plan transfers of property to a plan participant or beneficiary in exchange for consideration that is less than the fair market value of the property. In such cases, the difference between the fair market value and the value of the consideration is now treated as a distribution to the plan participant. (For such transfers before August 29, 2005, the difference between the fair market value and the value of the consideration was includible in the gross income of the participant or beneficiary under Code section 61.)

In order to assist taxpayers in determining fair market value of a life insurance contract, the IRS issued Rev. Proc. 2004-16 in order to provide safe harbor guidelines. These safe harbors were replaced in Rev. Proc. 2005-25 for distributions, sales, and other transfers made on or after February 13, 2004.

Under the safe harbor rules found in Rev. Proc. 2005-25, the fair market value of a non-variable life insurance contract is the greater of (1) the sum of the interpolated terminal reserve and any unearned premiums plus a pro rata portion of a reasonable estimate of dividends expected to be paid for that policy year based on company experience, and (2) the product of the PERC amount and the applicable Average Surrender Factor. In general terms, the PERC amount consists of premiums and earnings less “reasonable charges.” In technical terms, it is the aggregate of:

(1) the premiums paid from the date of issue through the valuation date without reduction for dividends that offset those premiums,

(2) PLUS…dividends applied to purchase paid-up insurance prior to the valuation date,

(3) PLUS…any amounts credited (or otherwise made available) to the policyholder with respect to premiums, including interest and similar income items (whether credited or made available under the contract or to some other account), but not including dividends used to offset premiums and dividends used to purchase paid-up insurance,

(4) MINUS…explicit or implicit reasonable mortality charges and reasonable charges (other than mortality charges), but only if those charges are not expected to be refunded, rebated, or otherwise reversed at a later date, and

(5) MINUS…any distributions (including distributions of dividends and dividends held on account), withdrawals, or partial surrenders taken prior to the valuation date.

If the contract being distributed provides for explicit surrender charges, the Average Surrender Factor is the unweighted average of the applicable surrender factors over the 10 years beginning with the policy year of the distribution or sale.

The safe harbor for variable contracts found in Rev. Proc. 2005-25 provides the same measurement for fair market value, and the variable PERC amount includes the same factors as listed above, except the following differences in numbers 2 and 3:

(2) PLUS…dividends applied to increase the value of the contract (including dividends used to purchase paid-up insurance) prior to the valuation date,

(3) PLUS OR MINUS…all adjustments (whether credited or otherwise made available under the contract or to some other account) that reflect the investment return and the market value of segregated asset accounts.

Another perceived abuse was that some 412(e)(3) plans operated in a manner that violated the anti-discrimination rules of IRC §401(a)(4). The IRS has ruled that participants who are not "highly compensated employees" must be provided the same rights as highly compensated employees with respect to life insurance policies under a qualified plan. Otherwise, the plan will violate the anti-discrimination rules [Rev. Rul. 2004-21, 2004-10 IRB].

Finally, the IRS believed that some 412(e)(3) plans were providing "excessive" life insurance benefits. Death benefits payable under the policy exceed those payable to the participant's beneficiaries; the excess reverts to the plan as a return on investment. On and after February 13, 2004, such a policy may be a "listed transaction" for tax-shelter reporting purposes [Rev. Rul. 2004-20, 2004-10 IRB]. The label generally applies if the excess coverage is $100,000 or more.

A plan will not qualify as a 412(e)(3) plan if it holds life insurance and/or annuity contracts that provide benefits in excess of the benefits payable under the plan at normal retirement age. Employer contributions to provide such excess benefits will not be deductible when contributed, but must be carried over to future years, subject to the maximum amount deductible in those years under IRC §404.

Note: A Section 401(k) plan is a special type of defined contribution, qualified retirement plan. Because of the plan's popularity, we cover it separately here.

Section 401(k) Plan Defined

A 401(k) plan is a retirement plan under which a participant is allowed to defer compensation, and the employer contributes this elective deferral to the employee's account within the employer-sponsored 401(k) plan. Sole proprietors and partners with employees may also sponsor and participate in 401(k) plans.

The Appeal of 401(k) Plans

Here are some of the reasons for the popularity of 401(k) plans:

  • Elective deferrals (except Roth deferrals) are not included in the employee's taxable income, which means contributions are made with before-tax dollars.
  • Funds accumulate income tax deferred.
  • Distributions from the plan may be income-taxed under the annuity rules or as a lump-sum distribution.
  • Employer contributions (if any) are tax deductible up to the prescribed limits.

Elective Salary Deferral Limits

The annual limits on elective salary deferrals into a 401(k) plan, and the additional "catch-up" contributions permitted for participants age 50 and over, phase-in in accordance with the following table:

Deferral Limit
Under Age 50
Deferral Limit
Age 50 and Over
2012 $17,000 $22,500
2013 $17,500 $23,000
2014 $17,500 $23,000

The annual limit applies to participation in all cash or deferred arrangements and may be reduced by elective deferrals to a 403(b) plan, SIMPLE IRA, or SIMPLE 401(k).

Technically, a plan may not permit additional catch-up contributions (elective deferrals) by persons age 50 and over for a particular year that are greater than the lesser of—

  • the maximum incremental dollar amount allowable ($5,500 for 2014), or
  • the excess of the individual's compensation for the year over other elective deferrals made for the year, ignoring the additional catch-up amount.

The limit is subject to cost-of-living increases.

A plan is not required to allow additional catch-up contributions by participants age 50 and over; it is merely permitted to do so. A participant is deemed to be age 50 for a particular year if the participant turns 50 during that year.

Many employers elect to match all or a portion of the amount deferred by each employee. Thus, the amount actually deposited on behalf of an employee can exceed the dollar limit mentioned above. However, the combination of elective deferrals, employer matching contributions, additional employer profit-sharing contributions, and forfeitures for any employee cannot exceed the Section 415 limit ($52,000 for 2014) for defined contribution plans.

Employers cannot compel 401(k) participants to put more than 10% of their elective salary deferrals into stock of the employer. The participants can, however, exceed the 10% limit voluntarily. The 10% limit applies to elective salary deferrals for plan years beginning in 1999 and after.

Matching contributions to 401(k) plans made on behalf of self-employed individuals are not treated as elective contributions.

Roth Deferrals (2006 and after)

For plan years beginning in 2006, employer 401(k) plans may (but are not required to) include a provision that allows participants to designate all or part of their elective salary deferrals as Roth contributions.

Roth deferrals will be taxed immediately to the participant, but the deferral amounts and the earnings on them generally may be distributed federal income tax free, provided the distribution:

  • occurs at least five years after the participant began making Roth deferrals to the plan, and
  • is made after the participant reaches age 59½, or following the participant's death or disability.

Roth deferrals to 401(k) plans must satisfy several requirements:

  • The employer's 401(k) plan must specifically authorize Roth deferrals, but cannot offer only Roth deferrals.
  • The participant must irrevocably designate the deferral as a Roth contribution on the election form.
  • The employer must report the Roth contribution as W-2 wages, just as if the employee had received the amount in cash.
  • The plan must separately account for Roth contributions and earnings thereon.
  • No contributions other than designated Roth deferrals and rollover Roth contributions may be allocated to a Roth account (e.g., matching contributions may not be allocated to a Roth account).

Roth deferrals are counted with traditional (excludable) deferrals in applying 401(k) nondiscrimination testing. They are also aggregated with traditional deferrals in applying the annual elective deferral limits. Participants can designate part of their overall deferral as a Roth contribution and the balance as a traditional deferral.

Roth deferrals are available to all participants regardless of income level (unlike Roth IRAs). Following the American Taxpayer Relief Act, an employer may amend a 401(k), 403(b), or 457(b) governmental plan to allow in-service employees to roll over amounts from their traditional accounts to their designated employer Roth accounts in taxable transfers, even if the employees are under age 59½.

There are several differences between Roth deferrals and Roth IRAs:

  • A 401(k) participant can designate deferrals as Roth deferrals regardless of AGI, whereas individuals cannot make Roth IRA contributions at higher levels of AGI.
  • Lifetime distributions from Roth deferral accounts are subject to the required minimum distribution (RMD or age 70½) rules, whereas lifetime distributions from Roth IRAs are not.
  • Distributions from Roth deferral accounts are taxed under the Section 72 annuity rules, whereas Roth IRA distributions are subject to special statutory ordering rules [IRC §408A(d)(4)].

How 401(k) Plans Work

When a 401(k) plan is in place, the employee elects the compensation amount he or she would like to contribute to the plan (subject to the limitations already discussed). The employer also makes a contribution (if the employer provides matching funds). In effect, three significant things happen:

  • By deferring income, the employee is investing with before-tax dollars. For someone in the 28% income tax bracket, every $1,000 of deferred income represents $280 in current federal income tax savings, and that $280 can be put to work in a retirement account.
  • The employer receives a tax deduction for contributions made to the plan—both the deferred amount and any matching contributions, within prescribed limits.
  • Funds accumulate income tax deferred, often allowing a potentially greater accumulation than would be possible under currently taxable investments.

Nondiscrimination Rules

A 401(k) plan must meet the requirements of all qualified plans along with certain other nondiscrimination requirements:

  • Distributions cannot be made based on the completion of a stated period of plan participation or a fixed period of time.
  • The employee's rights to elective deferrals must be fully vested at all times.
  • Contributions on behalf of highly compensated employees may not exceed specified limitations based on the contributions made on behalf of non-highly compensated employees. Deferrals by highly compensated employees are limited by the average deferrals of non-highly compensated employees, and employer matching contribution rules must apply uniformly to all employees.

Note: The PPA affected the distribution rules otherwise applicable to 401(k) plans in the following respects:

  • Older workers. Code Section 401(a)(36), effective for distributions in plan years beginning after December 31, 2006, permits distributions to employees who have reached age 62 but who have not yet separated from employment at the time of the distribution. In order for an employee to take advantage of this provision, the plan document would have to allow for such distributions.
  • Military. The PPA also allows distributions for participants who are reservists and who are called to active duty after September 11, 2001, for a period in excess of 179 days (or for an indefinite period). These "qualified reservist distributions" must consist of amounts in the participant's account that are attributable to his or her elective deferrals. Distributions must be made during the period beginning on the date of the call to duty and ending at the close of the active duty period. The qualified reservist distribution is not subject to the 10% penalty tax on premature distributions from qualified plans.

As originally enacted in the PPA, these special rules for qualified reservist distributions applied to individuals ordered or called to active duty after September 11, 2001 and before December 31, 2007. The HEART Act deleted the reference to December 31, 2007 so that the special rules for qualified reservist distributions no longer have an expiration date. See also Notice 2010-15.

Individual 401(k) Plan

An individual 401(k) plan permits a business owner without eligible employees to create and operate a 401(k) plan solely for his or her own benefit (or for a spouse). If the business has employees who are excludable from the plan (i.e., seasonal or temporary workers, employees under age 21, union employees or nonresident aliens), the owner may still have an individual 401(k) plan.

What Are the Advantages?

An individual 401(k) plan gives the owner of an owner-only business the opportunity to:

  • save for retirement at higher contribution levels than other defined contribution plans currently available.
  • save up to 25% of their annual compensation as a discretionary, tax-deductible, employer contribution.
  • make pre-tax salary deferral contributions as an employee of the business of up to $17,500 in 2014 (individuals age 50 or older may be eligible to make an additional catch-up contribution of up to $5,500 in 2014, for a total of $23,000). Total contributions in 2014, including employer and deferral contributions, are limited to the lesser of $52,000 or 100% of compensation.
  • typically pay less in administrative expenses (since an individual 401(k) is designed for owner-only businesses, there is not the same level of complexity compared to a traditional 401(k) covering employees).
  • access a broad array of investment options (depending on the restrictions imposed by the plan document or investment provider).
  • roll over existing 401(k), traditional IRA, SEP-IRA, SIMPLE IRA, qualified plans or Keoghs, 403(b) and governmental 457 assets into an individual 401(k)—the management of retirement savings may be easier and distributions less complicated when all assets are under one plan.
  • complete less paperwork than is required for a traditional 401(k) and avoid the hassle of discrimination tests.
  • borrow against the 401(k) account (unlike a SEP or SIMPLE IRA plan).

How Does a Self-Employed Individual Establish an Individual 401(k)?

An individual 401(k) plan requires a plan document, recordkeeping, and administration. In addition, the plan must remain compliant with law changes. A self-employed business owner may decide to take on some of the tasks of maintaining the plan. However, most business owners seek the help of various financial services professionals—attorneys, CPAs, third party administrators and investment providers.

In addition to ongoing plan administration, the plan must annually file an IRS Form 5500 to account for contributions and activity. IRS Form 5500 must be filed for individual 401(k) plans once the plan's asset balance is greater than $100,000.

What Are the Drawbacks of an Individual 401(k)?

Business owners should consider the appropriateness of this plan if they anticipate hiring eligible employees in the near term. If the business adds an employee who is not the spouse and is eligible to participate in the plan, the individual 401(k) plan must convert to a traditional 401(k) plan. Upon conversion, the 401(k) plan will be subject to anti-discrimination tests and other rules and restrictions that may effectively reduce the contribution limits of the self-employed business owner.

A qualified retirement plan maintained by a sole proprietor or partnership is often referred to as a Keogh or H.R. 10 plan. In the case of partnerships, the partnership entity, not the individual partners, must establish the Keogh plan.


In general, Keogh plans are subject to the same requirements and limitations as any other qualified retirement plan, and they also receive the same favorable federal income tax treatment. However, self-employed individuals who are "owner-employees" cannot participate in a Keogh plan unless they provide coverage for essentially all full-time employees. An owner-employee is defined as either:

  •  a sole proprietor, or
  • a partner who owns more than a 10% capital or profits interest in a partnership.

Contribution or Benefit Limits

A Keogh plan must be either a defined benefit plan or a defined contribution plan. The applicable contribution or benefit limits generally applicable to such plans apply also to the Keogh version.

However, contributions or benefits for a self-employed plan participant are based on net earnings (including a reduction for qualified retirement plan contributions). An employer choosing a defined benefit plan will probably need an actuary to determine the amount of the allowable contributions and benefits for owner-employees.

For comparison and review purposes, here's a brief summary of qualified plans.

Defined Benefit Plan

The purpose is to provide a specified retirement benefit. Employers bear the investment risk. Annual employer contributions can sometimes fluctuate widely and generally must be determined by an actuary or other financial administrator.

Defined Contribution Plan

The purpose is to set aside funds to the individual accounts of participants based on an established contribution formula. Employers are generally committed only to making annual contributions. Plans are often easier to administer than defined benefit plans, and the employees bear all investment risk.

Money Purchase Pension Plan

A defined contribution plan under which employers make annual contributions based on a set percentage of the employee's compensation.

Profit Sharing Plan

A defined contribution plan under which employers base contributions on profits or income, or a determination by the board of directors. The employer is not necessarily obligated to make annual contributions, but contributions must be recurring and substantial.

Employee Stock Ownership Plan (ESOP)

A defined contribution plan in which plan assets are invested primarily in securities of the employer corporation.

Target Benefit Plan

A cross between a defined benefit and a money purchase pension plan. Employers base contributions on a target benefit formula established at the plan's inception, which includes an assumed earnings rate. Because the contribution formula is not adjusted in subsequent years to reflect actual plan earnings, the employee bears all investment risk. Contributions are allocated to separate accounts maintained for each participant.

Fully Insured Plans – Section 412(e)(3) Plan – Formerly Section 412(i) Plans

A defined benefit pension plan funded entirely by annuity contracts or a combination of annuity and life insurance contracts.

Section 401(k) Plan

A defined contribution plan under which employees or self-employed individuals can make elective deferrals to the plan. Employers may make matching contributions.

Individual 401(k) Plan

A defined contribution plan under which a business owner without eligible employees can make elective deferrals to the plan, as described above, but solely for his or her own benefit (or for a spouse).

Keogh Plan

Any qualified retirement plan maintained by a self-employed person or partnership. Keogh plans may be defined benefit or defined contribution plans.

In this "inventory" of plans, we should also mention two types of plans that are technically not qualified retirement plans, but alternatives to qualified retirement plans:

Simplified Employee Pension (SEP) Plan

A special type of employer retirement plan under which the employer makes contributions to each participant’s separate individual retirement account (IRA), reducing plan administration, recordkeeping, and reporting (covered in a separate section of this service).

SIMPLE Retirement Plan

A plan for employers with 100 or fewer employees. This plan is eligible for simplified nondiscrimination rules (covered in a separate section of this service).

Where Life Insurance Fits

Life insurance fits into the qualified retirement planning picture in one of two ways:

(1) Fully insured plans (i.e., 412(e)(3) defined benefit plans) use plan contributions to purchase annuity contracts only or a combination of life insurance policies and annuity contracts for the express purpose of accumulating retirement funds.

(2) Split-funded plans use life insurance to fund part of the retirement benefits, and a trustee-managed investment account to fund the rest.

Split-funded plans are more common than fully insured plans because they provide two distinct benefits: life insurance protection and a flexible investment fund. However, it is worth noting that a fully insured 412(e)(3) defined benefit plan may be exempt from funding standards and regulations applicable to other qualified plans; these plans are attractive to some employers for this very reason.

Split-funded plans are more common than fully insured plans because they provide two distinct benefits: life insurance protection and a flexible investment fund. However, it is worth noting that a fully insured 412(e)(3) defined benefit plan may be exempt from funding standards and regulations applicable to other qualified plans; these plans are attractive to some employers for this very reason.

The Incidental Tests

There are limits to the amount of life insurance a qualified retirement plan can purchase on behalf of a participant. Under a defined benefit plan, the face amount of insurance generally cannot exceed 100 times the participant's projected monthly retirement benefit. Under a defined contribution plan (including 401(k) and Keogh plans), life insurance coverage can be purchased if less than 50% of the employer's contribution on behalf of the participant is used to purchase whole life insurance, or no more than 25% of the employer contribution is used to purchase term or universal life insurance.

When insurance is purchased inside a qualified plan, the covered participant must report as income the taxable cost of the coverage. The participant must generally value the current life insurance protection provided under a qualified plan using Table 2001. If the insurance company's published one-year term insurance rates are lower than Table 2001 rates, the participant can use the company's own rates to determine the taxable income amount each year, provided the insurer makes the availability of such rates known, and regularly sells term insurance policies at such rates.

Transfers of Policies from Qualified Plans

ERISA generally prohibits the sale of qualified plan assets to a "party-in-interest." Any employee of the sponsoring employer, not just an owner-employee, is a party-in-interest. In the absence of a special exemption, any sale of a life insurance policy by the plan to an employee would trigger the prohibited transaction penalty.

Prohibited Transaction Exemption (PTE) 92-6 specifically permits sales of life insurance and annuity contracts between ERISA-covered plans and (1) plan participants, (2) certain relatives, (3) employers, and (4) other plans, provided certain conditions are met. The Department of Labor has expanded this exemption to include sales to life insurance trusts and certain other personal trusts of participating employees.

Although PTE 92-6 refers to "individual life" policies, DOL has indicated that sales of second-to-die policies that cover a spouse of the participant are covered by PTE 92-6 [DOL Advisory Opinion 98-07A]. The status of second-to-die policies covering a non-spouse is unclear.

As a general rule, distributions from a qualified plan are included in the recipient’s gross income and taxed under the annuity rules. If the participant has a basis in the distribution (which usually means the participant made after-tax contributions to the plan) the portion of any distribution which is attributable to that basis is not taxed. Any costs paid by a common-law employee toward the economic benefit of life insurance coverage provided by the plan can be recovered tax-free from benefits paid under the plan [Reg. Sec. 1.72-16(b)(4)]. Self-employed individuals with life insurance in their plan cannot use the taxable economic benefit to add to their basis.

Annuity Payments

Qualified retirement plans stipulate the normal form of benefit under the plan. Subject to certain exceptions, a married participant generally must have his or her spouse's written consent to elect a form of benefit other than a qualified joint-and-survivor annuity.

All distributions under the qualified retirement plan must meet minimum distribution requirements established under IRS and DOL (Department of Labor) regulations. Generally, the plan must provide for annual or more frequent payments over:

  • the life of the participant,
  • the lives of the participant and designated beneficiary,
  • a period certain which does not extend beyond the life expectancy of the participant or the joint life expectancies of the participant and his or her beneficiary.

Payments under a plan may increase if they are directly tied to a designated cost of living index. A variable annuity can also be used as a distribution mechanism, which means payment amounts may fluctuate.

The concept behind minimum distribution rules is this: since qualified plans are designed specifically to provide retirement income, the government wants to assure federal income taxation of these funds during the expected lifetime of the participant. The government wants to discourage an unlimited delay of the taxation of these funds.

The Pension Protection Act modified the qualified joint-and-survivor annuity rules for plan years beginning after December 31, 2007 (except collectively bargained plans, which have special effective dates). Now, at the election of the participant (and with appropriate spousal consent), the plan may pay benefits in the form of a "qualified optional survivor annuity"—an annuity for the life of the participant with a survivor annuity for the life of the spouse. The survivor annuity must be equal to the applicable percentage of the amount of the annuity that is (1) payable during the joint lives of the participant and spouse, and (2) the actuarial equivalent of a single annuity for the life of the participant. If the survivor annuity provided by the qualified joint and survivor annuity under the plan is less than 75% of the annuity payable during the joint lives of the participant and the spouse, the applicable percentage is 75%; if it’s greater than or equal to 75%, the applicable percentage is 50%.

The Section 72 annuity taxation rules generally provide for a tax-free recovery of the cost basis on a pro-rata basis over the expected payout period. Once basis has been fully recovered (i.e., upon the attainment of the life expectancy), remaining payments are fully taxable as ordinary income.

Lump-Sum Distributions

A lump-sum distribution is also taxed under the annuity rules. Historically, however, there were special averaging rules. For years prior to 2000, some recipients of lump-sum distributions could opt for a 5-year or 10-year averaging method to determine tax on the distribution. The 10-year method is only available to individuals born before 1936 and the 5-year averaging method expired after 1999.

Employer Securities

An employer that maintains a qualified retirement plan may contribute its own securities to the plan, which are then allocated to employees' accounts. If such employer securities are included as part of a lump-sum distribution, the "net unrealized appreciation" (NUA) in the securities is excluded from the participant's (or beneficiary's) gross income, unless the employee elects out of this treatment. The remaining value of the stock is taxable in accordance with the general rules applicable to lump-sum distributions.

For the purpose of determining the NUA on a distributed employer security, the basis of such security is computed in accordance with the rules in Reg. §1.402(a)-1(b)(2)(ii).

The exclusion is also available if the plan acquired employer securities with nondeductible employee contributions rather than employer contributions [IRC §402(e)(4)(B)]. If employer securities are distributed in a manner other than a lump-sum distribution, the net unrealized appreciation is excludable only to the extent acquired with nondeductible employee contributions [IRC §402(e)(4)(A)].

The NUA excluded at the time of the plan distribution is subject to tax when the recipient sells the securities. Gain (or loss) is determined by the difference between the amount realized upon the sale of the securities and the amount taxable at the time of the plan distribution related to those securities.

Any gain attributable to NUA is taxed as long-term capital gain, regardless of how long the employee held the securities. Any gain after distribution (in excess of the value at time of distribution) is long-term or short-term, depending on how long the employee held the securities.

A qualified plan participant who has appreciated employer securities in his/her qualified plan should consult with tax advisers before taking a distribution from the plan. Failure to take a lump-sum distribution is fatal to the NUA exclusion. Remember also, if employer securities are rolled over into an IRA, distributions from IRAs are generally taxed as ordinary income, so the individual would stand to forfeit the special tax treatment of NUA on the employer securities. Participants should make conscious choices before taking distributions.

10% Federal Income Tax on Early Distributions

Distributions from a qualified retirement plan are not only subject to the regular federal income tax, but also to a premature distribution tax if made before the employee reaches age 59½, unless an IRC Sec. 72(t) exception applies. The tax is a flat 10% of the taxable amount distributed. In addition to the age-59½ safe harbor, the 10% tax does not apply to distributions that—

  • are made to a beneficiary (or to the estate of the employee) following the death of the employee;
  • occur following the disability of the participant (but not a spouse's or child's disability), disability defined for this purpose as the owner's inability to "engage in any substantial gainful activity by reason of a medically determined physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration" [IRC Sec. 72(m)(7)];
  • are part of a series of substantially equal periodic payments made not less frequently than annually, for the life (or life expectancy) of the employee or for the joint lives (or joint life expectancies) of the employee and his/her designated beneficiary;
  • are transferred directly or properly rolled over within the 60-day rollover period, so that the distribution is not subject to the regular income tax;
  • represent a nontaxable return of the employee's nondeductible contributions;
  • are made following the employee's separation from the service of the employer maintaining the plan after reaching age 55 (qualified plans only; does not apply to IRAs);
  • are taken to pay deductible medical expenses of the participant or a family member and do not exceed the amount deductible under IRC Sec. 213 (i.e., only those medical expenses paid out-of-pocket and not covered by insurance that exceed 10% of adjusted gross income, or 7.5% for taxpayers 65 and over during 2013-2016));
  • are made pursuant to a qualified domestic relations order from the employer retirement plan of one divorcing or separating spouse to the other spouse.
  • individuals who receive a "qualified reservist distribution," which is a distribution from an individual retirement plan or from amounts attributable to pre-tax salary deferrals from a qualified plan or 403(b) annuity if the individual receiving the distributions was called to active duty after September 11, 2001, for a period in excess of 179 days.

Remember that if a participant satisfies one of these exceptions, he or she avoids only the 10% penalty on premature distributions, not the regular income tax on the distribution.

Caution: The preceding list of exceptions to the 10% premature distribution penalty applies only to qualified retirement plans. A similar but somewhat different list of exceptions applies to IRAs. Click here to jump to the exceptions for IRAs.

Phased Retirement Distributions

Under IRS regulations, a pension plan must exist primarily to pay benefits after retirement [Reg. §1.401-1(b)]. However, some employers allow employees to phase into retirement with a reduced work week. When the employer maintains a defined benefit pension plan or a money purchase pension plan, the question arises whether the plan can begin to pay a portion of the retirement benefit to supplement the reduced wages of such employees.

The IRS has issued proposed regulations that permit pension plans to pay a pro rata portion of a partially retired employee's accrued benefit under the plan when certain requirements are met [Prop. Reg. §§1.401(a)-1(b)(1); 1.401(a)-3]. Some of the key requirements in the proposed regs are:

  • The employer must have a written program offering the phased retirement option to employees, but not before they reach age 59½;
  • Employee participation must be voluntary;
  • The employee must reduce employment hours by 20% or more;
  • The maximum payment from the plan must be no more than a portion of the accrued benefit proportionate to the reduction in work; and
  • The employee must continue to accrue benefits under the plan during the phased retirement proportionate to the employee's hours of work.

The proposed regs apply to defined benefit pension plans and money purchase pension plans, but not to 401(k) plans or other types of defined contribution plans.

The PPA added new Code Section 401(a)(36) and amended ERISA Section 3(2), which provides that a trust forming part of a pension plan shall not be treated as failing to constitute a qualified trust solely because the plan provides that a distribution may be made from such trust to an employee who has attained age 62 and who is not separated from employment at the time of such distribution. The provision is effective for distributions in plan years beginning after December 31, 2006.

These Required Minimum Distribution (RMD) rules apply to traditional IRAs and qualified defined contribution plans including profit sharing, money purchase, 401(k), and 403(b) plans. For convenience, we will use "account owner" or simply "owner" to refer to both individual account owners in qualified defined contribution plans and owners of traditional IRAs. 

The Age 70½ Requirement

Participants in qualified retirement plans, SEP-IRAs, SIMPLE IRAs, and traditional IRAs (but not Roth IRAs) may not accumulate tax-deferred earnings indefinitely. Eventually, they must begin to take required minimum distributions (RMDs) or suffer a heavy penalty tax. RMDs are included in the recipient’s gross income (with tax-free recovery of basis, if any) as paid out.

Required Beginning Date

The “required beginning date” (RBD) is April 1 of the year following the year in which the account owner attains age 70½. This is the latest date on which the owner can take the first RMD from the account without a penalty tax. For example, if the owner reaches age 70½ on August 20, 2013, the latest date for the 2013 distribution is April 1, 2014.

By waiting until the RBD, the owner has two distributions in 2014 because he or she must take the 2014 distribution by December 31, 2014. Depending on the situation, it may be better tax planning to take the 2013 distribution by December 31, 2013. The owner will need to take future RMDs by December 31 of each new tax year to avoid the excise tax.

However, an account owner may delay the RBD until April 1 of the year following the year they actually retire (if later than age 70½) provided that (1) the distribution is from a qualified retirement plan and not an IRA (including SEP IRAs and SIMPLE IRAs), and (2) the account owner owns 5% or less of the company that maintains the plan. 

50% Excise Tax

The penalty tax for taxpayers who fail to comply with the RMD rules is severe: a 50% excise tax is levied on the difference between the RMD (the amount that should have been distributed) and the amount that was actually distributed. For example, if an owner should have taken a $50,000 RMD but only took a $30,000 distribution, the penalty would be $10,000 (50% of the $20,000 the owner failed to take). This penalty tax is in addition to the ordinary income tax due on the distribution (assuming zero basis). 

Uniform Lifetime Table-Reg. Sec. 1.409(a)(9)-9

This table is used to calculate lifetime required minimum distributions from qualified defined contribution plans (including 401(k) and 403(b) plans) and IRAs unless the employee's beneficiary is his/her spouse who is more than 10 years younger, or unless the spouse is not the sole beneficiary.

Click here to display the Joint and Last Survivior Table.

If the employee's sole beneficiary is his/her spouse, and that spouse is more than 10 years younger than the employee, the appropriate life expectancy from the Joint and Last Survivor Table should be used.

For every "distribution calendar year" (a calendar year for which a minimum distribution is required), find (1) the account balance on the last valuation date of the preceding year, (2) the account owner's age on his or her birthday in the distribution calendar year, and (3) the divisor that corresponds to that age in the Uniform Lifetime Table. The required minimum distribution for the distribution calendar year is (1) divided by (3). 

First Year Distribution

Required Minimum Distributions must begin when the account owner attains age 70½. However, the owner may delay the first RMD until April 1 of the following year.

Sarah, a retired account owner, was born on November 20, 1943. On November 20, 2013 she turned 70. Sarah turns 70½ on May 20, 2014. Her first distribution is due by December 31, 2014. However, as we said, she could choose to delay the first distribution until April 1 of the year following the year she turns 70½ (which, in our example, would be April 1, 2015). Any deferral beyond April 1, 2015, will result in the 50% excise tax penalty.

Sarah’s first distribution calendar year is the year she attains age 70½ (2014). Valuation of her account is based on the account value on December 31 of the preceding year (December 31, 2013).

The account value is divided by the applicable distribution period taken from the Uniform Lifetime Table and based on the owner’s age on the owner’s birthday in the relevant distribution calendar year. Continuing with our example, Sarah is 71 in 2014 and the factor for age 71 is 26.5. So, assuming an account value of $1,000,000, the RMD is $37,736 ($1,000,000 divided by 26.5). 

Second Year Distribution

The RMD for the first distribution calendar year is the only one that can be distributed after December 31 without penalty. For any subsequent distribution calendar year, the required minimum distribution must be distributed by December 31 of that year.

Continuing with our example, Sarah’s second RMD will be due by December 31, 2015, regardless of whether she took her first RMD in 2014 or delayed until April 1, 2015.

The 2015 RMD is calculated based on the account value on December 31, 2014 and the owner’s age at the end of 2015.

A strategy to defer taxation as long as possible by taking only required minimum distributions is fairly easy. For example, at age 80 the RMD is only about 5.35%. Account earnings greater than 5.35% would cause the account to continue to grow even while the owner meets the RMD rule and avoids the 50% excise tax penalty.

Until now, we have discussed the RMD rules as they applied to distributions made during the owner’s life. The rules that follow apply to beneficiaries of the owner after the owner's death. These rules apply to traditional IRAs, qualified defined contribution plans, and 403(b) plans. We will continue to use “account owner” and “owner” to refer to both qualified plan account owners and owners of traditional IRAs.

Determining the 'Designated Beneficiary'

The importance of being a “designated beneficiary” is that this beneficiary can use the Single Life Table below to calculate the required minimum distribution.

The designated beneficiary for tax purposes is the beneficiary of record as of September 30 of the year following the year of the owner's death. Thus, qualified disclaimers and lump-sum distributions can be used after the owner's death (and before the September 30 deadline) to narrow down the designated beneficiary, but only from among the group of beneficiaries named by the owner. For example, the owner's surviving spouse could disclaim his or her interest in order to permit an account to pass to a child named by the owner. But an executor or trustee cannot add a beneficiary after the owner's death.

Only an individual can be a designated beneficiary. If a non-individual (such as a charity) is named as a beneficiary of a plan account, the account will be treated as having no designated beneficiary, unless the non-individual is no longer a beneficiary on September 30 of the year following the year of death. This applies even if there are individuals designated as beneficiaries along with the non-individual.

The deceased owner’s estate cannot be a designated beneficiary and there are no provisions that allow for a “look through” to the individual beneficiaries of the estate.

However, where the owner names a trust as beneficiary of his plan or IRA account, the beneficiaries of the trust can qualify as designated beneficiaries if all of the following are true:

1) The trust is a valid trust under state law, or would be but for the fact that there is no corpus.

2) The trust is irrevocable or will, by its terms, become irrevocable upon the death of the owner.

3) The trust instrument identifies the beneficiaries of the trust who are beneficiaries with respect to the trust’s interest in the owner’s benefit.

4) The trustee must be provided a copy of the trust with an agreement that if the trust is amended, the plan administrator will be provided a copy of the amendment.

Trusts can provide numerous advantages including creditor protection, divorce protection, special needs, and investment management. There can be other advantages to using trusts as beneficiaries where, for example, you have young beneficiaries and large dollar amounts. Using trusts can be complicated. Advise clients to seek legal counsel before making such decisions.

If the beneficiary dies during the period between the owner's date of death and the September 30 deadline, the life expectancy of the deceased beneficiary may still be used to calculate RMDs. In the absence of this rule, the deceased beneficiary's estate could have been deemed the distributee with the result that there would be no designated beneficiary (and no stretch-out) for RMD purposes.

Single Life Table

Designated beneficiaries must use the Single Life Table to calculate RMDs on inherited IRAs and plan accounts. The Uniform Lifetime Table is only used for distributions during the owner’s lifetime.

The designated beneficiary uses his or her age as of his or her birthday in the calendar year following the account owner’s death, which is the year that distributions must begin. After the first distribution year, the beneficiary reduces life expectancy by one for each subsequent year.

EXAMPLE: You are the owner’s designated beneficiary figuring your first required minimum distribution. The owner died in 2011. In 2012, you turned 57 years old. The Single Life Table life expectancy factor for age 57 is 27.9. The account value on December 31, 2011, was $1,000,000 and your RMD was $35,843 ($1,000,000/27.9). In 2013, the factor is 27.9-1=26.9 so you would divide the December 31, 2012, account balance by 26.9 to determine the 2013 RMD. In 2014 the factor is 24.9 (27.9-3).

If the owner’s sole designated beneficiary is his or her surviving spouse, the first distribution year is the year in which the owner would have reached age 70½. After the first distribution year, the spouse will use their own age as of their birthday in each subsequent year.

EXAMPLE: The owner died in 2009. You are the owner’s surviving spouse and the sole designated beneficiary. The owner would have turned age 70½ in 2010 so distributions must begin in 2010. You, as the surviving spouse, become 69 in 2010 and your life expectancy from the Single Life Table for age 69 is 17.8. If the account balance on December 31, 2009, was $1,000,000, your RMD is $56,180 ($1,000,000/17.8).

As illustrated above, a designated beneficiary uses the life expectancy factor that corresponds to his or her age in the year after the owner’s death. The factor is then reduced by one for each succeeding distribution year.

Beneficiaries who are spouses, and who do not elect to roll over the account or treat it as their own, also use the Single Life Table, but they can recalculate the RMD each year using the factor for their then-current age.

When the owner dies BEFORE reaching the required beginning date—

If the owner dies before reaching the required beginning date, there are two options for distributing the owner’s account. The first option is the life expectancy method, which requires that any portion of the owner’s account payable to a designated beneficiary must be paid at least annually starting on or before the end of the calendar year following the calendar year in which the employee died.

The second method is called the five-year rule. It requires that the account owner’s entire interest must be paid out by the end of the calendar year which contains the fifth anniversary of the owner's death.

For example, if an owner died on January 1, 2009, the entire account must be paid out no later than December 31, 2014. Nothing need be paid out before that date, but the entire account must be paid out by December 31, 2014.

Absent a plan provision to the contrary, distributions must be made as follows:

1) If the employee has a designated beneficiary, distributions are to be made in accordance with the life expectancy rule.

2) If there is no designated beneficiary, distributions are to be made in accordance with the five-year rule.

Since the owner did not reach age 70½, the age at which required minimum distributions must begin, no distribution is required in the year of death.

However, if the sole designated beneficiary is the decedent's surviving spouse, distributions must commence on or before the later of the calendar year following the calendar year in which the participant died or the end of the calendar year in which the participant would have attained age 70½.

When the owner dies AFTER reaching the required beginning date—

Minimum distributions after the owner's death (for all years after the year in which death occurs) are available based on the remaining life expectancy of the designated beneficiary. The beneficiary's remaining life expectancy is calculated using the age of the beneficiary in the year following the year of the owner's death reduced by one for each subsequent year. However, the distribution period will never be shorter than the owner's life expectancy in the year of death.

A required minimum distribution must also be taken for the year of the owner's death using the owner's age/life expectancy from the Uniform Lifetime Table. If not withdrawn prior to the owner's death, this payment would generally be paid to the beneficiary as income in respect of a decedent.

If the account owner died after the required beginning date, the designated beneficiary can use his or her own life expectancy or the deceased owner's remaining life expectancy at death, whichever is longer, to calculate RMDs.

Election by Surviving Spouse

If the deceased owner designated the surviving spouse as beneficiary of the account, the spouse may elect to treat the account as her own IRA (we'll assume the surviving spouse is female). The spouse accomplishes this by having herself designated as the new account owner.

To roll an account over into the spouse's name, the surviving spouse must be the sole beneficiary of the account and must have an unlimited right of withdrawal. Before the IRA can be rolled, the RMD for the year of death must be distributed. If the spouse has reached her own required beginning date, RMDs for the years following the year of death are determined by entering the Uniform Lifetime Table with the surviving spouse's age.

When a spouse is the sole designated beneficiary and decides not to roll over the IRA into his or her own name, and the owner dies before reaching his/her required beginning date, then the spouse may defer payments until the year the deceased owner would have reached age 70½. Thereafter, required minimum distributions are calculated based upon the spouse's life expectancy as measured by the Single Life Table. For each succeeding year this process is repeated. If the owner dies after age 70½, the spouse must take the owner's required minimum distribution for the year of death if the owner dies before taking the distribution. Beginning in the year after the owner's year of death, the surviving spouse takes required minimum distributions based on the spouse's life expectancy as calculated using the Single Life Table.

Tom died in 2010 at age 77, before taking his RMD for the year. Tom’s wife Debbie is his sole beneficiary. Tom’s account balance at the end of 2009 was $1,000,000, so his final RMD amounts to $47,170 ($1,000,000/21.2, which is the divisor from the Uniform Lifetime Table). This distribution is paid to Debbie. The following year, Debbie is 71. With a December 31, 2010, account balance of $1,050,000, Debbie takes the factor for age 71 from the Single Life Table (16.3) and calculates an RMD of $64,418 ($1,050,000/16.3).

When no designated beneficiary is named

If the owner dies before the required beginning date, and if there is no designated beneficiary as of the date of death, the entire account balance must be distributed no later than December 31st of the fifth anniversary year of the owner's death. If there is a named beneficiary but no "designated beneficiary" (e.g., a charity is named as beneficiary), the account balance is distributed to the named beneficiary. If no beneficiary is named under the plan, state law will govern to whom the account balance will ultimately be paid. Generally, the recipients would be the beneficiaries named in the participant's will or identified under state intestacy laws.

If the owner dies after reaching the required beginning date and if there is no designated beneficiary, the distribution period available is the owner's life expectancy based on the age in the year of death, reduced by one for each year thereafter. Note that the life expectancy of the estate beneficiary may not be used in this situation. It is no longer required that the entire amount be distributed in the year after the owner's death. A required minimum distribution must be taken for the year of death based on the owner's age in the year of death using the Uniform Lifetime Table.

When multiple beneficiaries are named

The general rule when the account owner named multiple beneficiaries for post-death distributions (e.g., "I designate my spouse and child as beneficiaries of my IRA in equal shares") is that RMDs have to be based on the life expectancy of the oldest beneficiary. However, if the owner's account is split into separate accounts for each beneficiary, then each beneficiary can use his or her own life expectancy to compute RMDs. Some important points to remember:

  • The beneficiaries must have separate interests as of the owner's death, even if the separate accounts are not established until later. A person cannot be a "designated beneficiary" unless named as a beneficiary by the decedent. Single trusts must be divided into separate sub-trusts before the participant's death if the beneficiaries wish to use their own individual life expectancies; otherwise, the age of the oldest beneficiary will apply. However, for individual (non-trust) beneficiaries, as long as the separate shares are created by December 31 of the year following the participant's death, each beneficiary may use his or her own age [Ltr. Ruls. 200306008, 200306009, 200307095, 200308046].
  • In settling the identity of the designated beneficiary, the separate accounts have to be established by September 30 of the year following the year of the owner's death. For example, if the owner's niece and a charity were named as equal beneficiaries of an IRA, separate accounts would have to be set up by September 30 of the year following the year of death. Otherwise, the result for RMD purposes would be that no beneficiary would be deemed to have been "designated" because of the charity's presence in the "beneficiary pool", an entity without a life expectancy.
  • To determine the applicable distribution period, the separate accounts have to be established by December 31 of the year following the year of the owner's death. If separate accounts are not set up by then, the oldest beneficiary's life expectancy would have to be used to determine RMDs for all of the beneficiaries.

Section 72(t) payments

Persons who are using the "minimum distribution method" to calculate their "substantially equal periodic payments" under IRC Section 72(t) can switch to the new tables to calculate their payments. The IRS will not consider this change an impermissible "modification" that disqualifies the payments for Section 72(t) treatment.

Roth IRA beneficiaries

The RMD rules do not apply to lifetime distributions from Roth IRAs, but do apply after the owner's death. However, the tax code inadvertently failed to extend the 50% excise tax to Roth IRA beneficiaries. The final regs indicate that Roth IRA beneficiaries must pay the 50% excise tax for failure to comply with the RMD rules, but the tax code itself still needs to be amended by a technical correction.

When RMD exceeds account balance

Suppose this year's RMD, based on last year's account balance, exceeds the current value of the account due to a precipitous decline in value of the underlying investments. How can the owner or beneficiary withdraw more than the account's current value? The final regs allow the owner or beneficiary to avoid the 50% excise tax in this situation by withdrawing the entire account balance.

Reporting Requirements

IRA issuers, custodians, and trustees must notify IRA owners, but not the IRS, that a distribution is required under the RMD rules, and either report the amount of the required distribution or offer to compute the amount for them. For the time being, IRA issuers, custodians, and trustees do not have to report to beneficiaries of deceased owners.

IRA issuers, custodians and trustees must identify (using IRS Form 5498) each IRA for which a minimum distribution is required, but are not required to report the amount of the required minimum distribution [Notice 2002-27, 2002-18 I.R.B. 814].

Annuity-Type Required Minimum Distributions

At the same time the Treasury finalized the regs on RMDs from defined contribution plans and individual retirement accounts in April 2002, it issued new proposed and temporary regs on RMDs in the form of annuities. These regs were finalized in 2004. They affect defined benefit pension plans and annuity contracts purchased to make RMDs from IRAs and defined contribution plans.

Annuities Paid for a Period Certain. RMDs during the lifetime of a defined benefit plan participant generally can be made in the form of annuity payments for (1) the life of the participant, (2) the joint lives of the participant and a beneficiary, or (3) a period certain that ends on or before the life expectancy of the participant or the joint life expectancy of the participant and a beneficiary. The regs allow the period certain to be as long as the life expectancy period in the Uniform Lifetime Table that corresponds to the participant's age in the year in which the annuity starting date occurs.

The only exception is for a spouse who is (1) the participant's sole beneficiary and (2) more than 10 years younger than the participant. Here, the period certain can be as long as the joint life and last survivor expectancy of the participant and spouse. Moreover, the required period is unchanged when the participant dies, even if the beneficiary's single life expectancy is shorter (or longer) than the remaining period certain.

Minimum Distribution Incidental Benefit (MDIB). Suppose an employee's (or IRA owner's) annuity starting date is before age 70. In this case, an adjustment is made to the age difference between the employee and beneficiary. For example, if the employee's annuity starting date is age 55, a joint and 100 percent annuity can be paid to a surviving beneficiary who is not more than 25 (the usual 10 plus 15 additional) years younger than the employee.

Increasing Benefits. The regs contain rules specifying permissible increases in benefits. These include:

  • cost-of-living adjustments;
  • increases due to a plan amendment;
  • increases (so-called "pop-ups") due to the death of a designated beneficiary or the divorce of the employee;
  • a return of contributions upon the employee's death; and
  • increases under variable annuities.

Form of Distribution. The regs permit certain prospective changes in the form of distribution. These include:

  • a change to a qualified joint-and-survivor annuity upon the employee's marriage;
  • a change upon the employee's retirement or plan termination; and
  • a change to a life-contingency annuity from a period-certain annuity.

Payments to a Child. Payments to the employee's child may be treated as if the payments were made to a surviving spouse until the child reaches the age of majority. The age of majority may be extended through age 25 if the child is pursuing a course of education, or for so long as the child is disabled. The payments must be payable to the surviving spouse after payments to the child cease.

Separate Accounts. Separate accounts under a defined contribution plan can be used to determine RMDs if they are established by the end of the calendar year following the year of the employee's death.

Commercial Annuity Contracts. IRAs and defined contribution plans can meet the RMD requirements by purchasing a commercial annuity contract from an insurance company, and the regs contain a number of examples to show how this can be done.

What is a QDRO?

A divorce is a legal proceeding in state court (or through some other state instrumentality) that ultimately results in a judicial decree terminating a marriage. Within the context of the proceeding, a judge will often issue a domestic relations order to address issues of child support, alimony payments, or marital property rights.

If one of the spouses in a divorce has a pension plan or employee benefit plan subject to ERISA, any assignment of benefits from the plan required by the terms of the divorce must be done by a court-issued qualified domestic relations order or QDRO. The QDRO creates or recognizes the existence of an alternate payee’s right to, or assigns to an alternate payee the right to, receive all or a portion of the benefits payable with respect to a participant under a plan. A QDRO is “qualified” because it meets requirements set out in the Internal Revenue Code. In some states the state instrumentality charged with handling divorces may not be a court, but will still be authorized to issue a QDRO. A QDRO may be integrated within the final order of divorce, or issued as a separate order by the court. As always, consult legal counsel with any questions about a QDRO.

Elements of a QDRO

A QDRO is a very technical legal document and should be drafted by an attorney experienced in drafting QDROs. The Internal Revenue Code requires that a QDRO must state:

a) the name and last known mailing address (if any) of the participant and the name and mailing address of each alternate payee covered by the order;

b) the amount or percentage of the participant’s benefits to be paid by the plan to each alternate payee, or the manner in which the amount or percentage is to be determined;

c) the number of payments or period to which the order applies; and

d) each plan to which the order applies.

After determining that the QDRO meets these requirements, the plan administrator will follow the instructions in the QDRO to provide for payments to an individual who is to receive the portion of the plan participant's benefits. The actual payment of benefits will be done according to the rules of the plan, and may be a lump sum transfer or simply a percentage of the regular payments.

There are specific provisions a QDRO may not have, including:

  • providing an alternate payee or participant with any benefit or option not otherwise provided under the plan,
  • providing for increased benefits,
  • paying benefits from an alternate payee under a prior QDRO to new alternate payee under a new QDRO, and
  • paying benefits to an alternate payee in the form of a qualified joint and survivor annuity for the lives of the alternate payee and his or her subsequent spouse.