Life and Death Planning for Retirement Benefits

Chapter 2: Income Tax Issues

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¶ 2.5 (employer stock). For how to determine the FMV of a life insurance contract, see Notice 89- 25, 1989-1 CB 662, A-10. If the distribution occurs after the participant’s death, it is also subject to the rules of § 691 , governing “income in respect of a decedent” (IRD); see ¶ 4.6 . § 72 is one of the most complicated sections of the Code. It has lengthy rules dealing with: taxation of distributions (and deemed distributions) from annuity contracts, employer plans, life insurance contracts, and modified endowment contracts; how the owner’s “investment in the contract” (basis) is apportioned among distributions; and various penalties. This ¶ 2.1 covers only nonannuity distributions from QRPs, IRAs, and 403(b) plans, so there is no need to tackle most of the intricacies of § 72 . The only parts of § 72 covered in depth in this book are: how to compute the participant’s “investment in the contract” (basis) that may be distributed tax-free (¶ 2.2) ; and the penalty for certain distributions before age 59½ ( Chapter 9 ). Taxpayers have litigated with the IRS over the years claiming for one reason or another that their retirement plan distributions should not be includible in their gross income. The IRS always wins these cases. See, e.g. , Toombs , T.C. Summary Opinion 2013-51, in which a divorcing husband argued he should not be taxable on a pension distribution that he used (pursuant to court order) to buy his wife’s share of their residence. He asserted the distribution was nontaxable under § 1041 as a divorce-related asset sale. He lost. § 1411 (effective for years after 2012) imposes a 3.8 percent additional tax on the “net investment income” of individuals, estates, and trusts whose modified adjusted gross income (MAGI) exceeds a certain threshold amount. Investment income includes “interest, dividends, annuities, royalties, and rents” and “net gain” attributable to the disposition of property. The threshold amount for individuals is $250,000 for “A taxpayer making a joint return…or a surviving spouse….” The threshold is half that amount for a married taxpayer filing separately; and $200,000 “in any other case.” These thresholds are not adjusted for inflation. Distributions from IRAs, Roth IRAs, qualified plans, 403(a) and 403(b) arrangements, and 457(b) plans are not subject to this net investment income tax (NIIT) (§ 1411(c)(5)) but are included in MAGI, so the effect will be the same in many cases as if such distributions were subject to the tax: Chris Example: Chris and his wife have MAGI of $200,000 in 2016, including $50,000 of interest and dividends, before taking any IRA distributions. At this point they are not subject to the surtax because their MAGI is below the $250,000 threshold. Then Chris takes $100,000 from his IRA (all pretax money). This increases their MAGI to $300,000, putting them above the threshold by $50,000. Their entire $50,000 of interest and dividends are now subject to the NIIT, incurring NIIT of $1,900. Trusts and estates have a much lower threshold than individuals, but (unlike the individual thresholds) it is indexed for inflation. The dollar level at which the trust or estate enters the highest regular income tax bracket becomes the trust’s or estate’s threshold amount for purposes of the NIIT. § 1411(a)(2) . Under § 1(e) , that level is $7,500 indexed for inflation. As of 2017, the $7,500 increases to $12,500. Rev. Proc. 2016-55, 2016-45 IRB, § 3.01 (Table 5). This means that trusts 3.8% additional tax on net investment income