FEDERAL TAXATION OF DISTRIBUTIONS

Plan distributions generally are taxed in accordance with the rules for taxing annuity payments found in Code Section 72. A lump sum distribution from a plan is generally taxed in full on receipt unless it is rolled over to an IRA, as discussed below. This section deals with federal income and estate taxation. Some states apply similar tax treatment, but there is considerable variation. Federal taxes are usually the dominant factor in the overall tax burden on plan distributions.

The initial step in determining the taxation of a qualified plan distribution is determining the taxable amount of the distribution. For a distribution upon retirement, disability, or termination of employment, the taxable amount consists of the total amount of the distribution less the following amounts, sometimes referred to as the employee's cost basis in the plan:

• The total nondeductible contributions made by the employee (in the case of a contributory plan)

• The total cost of life insurance reported as taxable income by the participant, assuming that the plan distribution is received under the same contract that provided the life insurance protection

• Any employer contributions previously taxed to the employee (for example, where a nonqualified plan later became qualified)

• Certain employer contributions attributable to foreign services performed before 1963

• Amounts paid by the employee in repayment of loans that were treated as distributions

• In the case of a stock bonus plan or other stock plan, the net unrealized appreciation.

The first two items in the list are the ones most frequently encountered. If the employee is self-employed or was self-employed in the past, the items excludable from the taxable amount are slightly different from the above list. The most important difference is that for a self-employed person who is an owner/employee (a more-than-10-percent owner of an unincorporated business), the insurance costs (the second item above) are not part of the cost basis.

The simplest way to describe the taxation of qualified plan distributions is to distinguish between those benefits that are paid out fully in a single taxable year of the participant and those that are spread out over more than one taxable year. The latter are discussed first.

Payment in One Taxable Year

If the qualified plan distribution is paid to the participant in a single taxable year, the taxable amount (the amount in excess of the participant's cost basis as described above) potentially is all taxable to the participant as ordinary income in the year received. Because this can increase the participant's effective tax rate by pushing up the marginal tax bracket in that year, a special one-time relief provision applies if the distribution qualifies as a lump-sum distribution and is received after age 59½. A lump-sum distribution must meet all of the following requirements:

• It is made in one taxable year of the recipient.

• It represents the entire amount of the employee's benefit in the plan.

• It is payable on account of the participant's death, attainment of age 59½ separation from service (non-self-employed person only), or disability (self-employed person only).

• It is from a qualified plan.

• Except for death benefits, the employee must have participated in the plan for at least five years prior to the distribution.

In determining whether the entire amount of the employee's benefit has been distributed, all pension plans maintained by the employer are treated as a single plan, all profit-sharing plans are treated as one plan, and all stock bonus plans are treated as one plan.

If the distribution qualifies as a lump-sum distribution, the taxable amount of the distribution (the amount remaining after the cost basis is subtracted) is eligible for special tax treatment in certain cases, owing to expiring tax provisions that are retained ("grandfathered") for long-term plan participants. For participants who attained age 50 before 1986, there is a "ten-year averaging" computation. For amounts accumulated before 1974, a special capital-gain treatment is available. All other distributions are treated as ordinary income, to the extent of the taxable amount.

Taxation of Death Benefits from Qualified Plans

The income tax treatment described above also applies in general to plan death benefits paid to beneficiaries of participants. That is, if the death benefit is paid as periodic payments, the annuity rules described above generally apply; if the death benefit qualifies as a lump-sum distribution, the special favorable tax treatment is available to the beneficiary. However, if the death benefit is payable under a life insurance contract held by the plan, the pure insurance amount paid—the difference between the policy's face amount and its cash value is excluded from tax.

Employee Haines dies before retirement and his beneficiary receives a lump-sum death benefit from the plan consisting of $100,000 of the proceeds of a cash-value life insurance contract, the cash value of which was $50,000. The plan was noncontributory, and Haines reported a total of $8,000 of insurance costs on his income tax return during his lifetime as a result of the plan's insurance coverage. The taxable amount of this distribution to the beneficiary is the total distribution of $100,000 less the following:

• The pure insurance amount ($100,000 minus the cash value of $50,000) and

• Haines's cost basis—in this case, only the $8,000 of insurance cost reported during his lifetime.

The taxable amount is therefore $42,000. This amount is taxable income to the beneficiary, subject to the special averaging provisions described above, if applicable.

Federal Estate Tax

The federal estate tax on qualified plan death benefits affects only highly compensated participants (those with a gross estate of at least $675,000) (2000 figure)