Life and Death Planning for Retirement Benefits

Chapter 2: Income Tax Issues

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A. Separate employee-employer contribution accounts may be distributed separately. In a defined contribution plan that accepts voluntary employee contributions, the employer typically maintains a separate accounting for the employ ee contribution account ( i.e., the employee’s after-tax contributions and the earnings thereon) and the employ er contribution account ( i.e., the employer’s contributions and the earnings thereon). § 72 is applied separately to these separate accounts. § 72(d)(2) . In the lingo of § 72 , the employee contribution account is treated as a “separate contract” for purposes of § 72 . This rule is favorable to the employee, because typically he has a higher proportion of after-tax money in the employee-contribution account, so a distribution from that account (or direct Roth conversion of that account; see ¶ 5.4.08 ) might be largely tax-free if it is treated separately from the rest of his plan benefits. Since issuance of Notice 2014-54, enabling pre- and after-tax money in a single plan account to be rolled or distributed to separate “destinations” (see “C”), this advantage has become less significant. Some employees are confused by this exception and think it means they can withdraw their after-tax contributions separately from any pretax money in the plan. That is not correct. The “employee contribution account” includes not only the employee’s own contributions (which are indeed after-tax money) but also the earnings that have accrued on those contributions. The earnings are pretax money. A distribution from the employee contribution account is subject to the same rules of § 72 (though applied only to that separate account) as usual, meaning that a partial distribution from the employee contribution account would carry out proportionate amounts of the pre- and after-tax money in that account (unless some other exception applies; see “B”). Under some plans that allow the employee to make after-tax contributions to purchase “past service credits,” the employee’s after-tax contributions are not kept in a “separate account.” Rather, the plan pays a single benefit based on both employer and employee contributions. A distribution from such a plan is generally treated as a pro rata distribution of pretax and after -tax money, based on the value of the employee’s entire account, rather than as a distribution from a separate employee contribution account. However, there are exceptions and grandfather rules, so § 72 must be carefully studied in these cases; see PLRs 2001-15040, 2004-11051, and 2004-19036. B. “Cream” rule exception for pre-1987 balances. Some pre-1987 balances are not subject to the general rule applicable to other balances. The Code provides that: “In the case of a plan which on May 5, 1986, permitted withdrawal of any employee contributions before separation from service, subparagraph (A) [of § 72(e)(8) ] shall apply only to the extent that amounts received before the annuity starting date (when increased by amounts previously received under the contract after December 31, 1986) exceed the investment in the contract as of December 31, 1986.” § 72(e)(8)(D) . In other words, to the extent the money in the employee’s account consists of the employee’s pre-1987 nondeductible contributions (and this can be documented in the plan’s accounting for such funds), the employee can withdraw that money separately from other money in the account. The employee can indeed say with respect to these funds, “Send me a check for an amount equal to my pre-1987 after-tax contributions, and keep all the earnings thereon (and other pretax money) inside the plan for now.”