When Are Retirement Plan Distributions Subject To Tax?

Prior to taking transferring or taking a distribution from a retirment plan contact us to discuss these provisions as well as how it will affect your tax situation. 

Distributions from an employer-sponsored retirement plan may or may not be subject to withholding depending on the nature of the payment. In some cases, withholding is mandatory, and in others the recipient can elect out. The Summer 2011 edition of IRS's Retirement News for Employers (http://www.irs.gov/pub/irs-tege/rne_sum11.pdf) sorts out the rules for payors and payees.

Withholding on eligible rollover distributions.In general, the payor of any designated distribution that is an eligible rollover distribution must withhold an amount equal to 20% of the distribution. A designated distribution is a distribution or payment from, or under: (1) an employer deferred compensation plan, (2) an individual retirement account (IRA) or individual retirement annuity, or (3) a commercial annuity. An eligible rollover distribution generally is a plan distribution from an eligible retirement plan (i.e., plan distributions other than periodic distributions, minimum required distributions, or hardship distributions). The recipient of a distribution subject to 20% withholding may not elect out of the withholding requirement.

IRS's Retirement News for Employers points out that eligible rollover distributions are not subject to withholding if expected distributions to an individual are less than $200 for the year. Also, 20% withholding generally only applies to any previously untaxed amount of an eligible rollover distribution. The most important exception by far is that no withholding is required if the plan directly rolls over (in a trustee-to-trustee transfer) the eligible rollover distribution amount to another qualified retirement plan or IRA.

Periodic payments.The payor of a periodic payment—namely, one made at regular intervals for more than one year, such as an annuity—that isn't an eligible rollover distribution must withhold from the payment as if it were a wage payment for the appropriate payroll period.

IRS's Retirement News for Employers points out that generally, the plan administrator must withhold at the rate for a married individual with 3 withholding exemptions. However, recipients have the right (and must be so informed by the plan administrator) to: (1) elect no withholding or elect to have a different amount withheld, by filing Form W-4P, Withholding Certificate for Pension or Annuity Payments, with the plan administrator; and (2) revoke the election at any time.

Nonperiodic payments.A nonperiodic payment is a distribution that usually isn't made at regular intervals and isn't an eligible rollover distribution. IRS's Retirement News for Employers says examples of nonperiodic payments are:

• distributions of excess annual additions;
• distributions of excess contributions and excess aggregate contributions from most plans if made within 2-½ months after the end of the plan year;
• hardship distributions; and
• loans treated as distributions.

Nonperiodic payments generally are subject to 10% withholding. However, the recipient may elect no withholding or have a different amount withheld by filing a Form W-4P with the plan administrator.

Special situations.IRS's Retirement News for Employers points out that plan administrators need to be aware that special rules apply to: distributions made because of recognized disasters; distributions delivered outside the U.S. or U.S. possessions; certain noncash distributions, including employer securities; and a participant's accrued benefit offset because of a defaulted loan. 

Finally, for distributions from designated Roth accounts in 401(k), 403(b), or 457(b) plans, payors and payees are reminded that there's no withholding for a qualified distribution from a designated Roth account because the distribution is not taxable. If a nonqualified distribution is made from such an account, withholding is required only from any distributed earnings that the recipient must include in gross income.