Life and Death Planning for Retirement Benefits

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Life and Death Planning for Retirement Benefits

A major difference between converting a traditional IRA to a Roth, and converting money from a nonIRA plan, has to do with the participant’s ability to obtain a distribution that he can convert. An IRA owner, regardless of age or employment status, is generally free (at least under the tax Code) at any time to withdraw money from his account. He will be taxable on the distribution, and will owe a penalty on the distribution if he is under age 59½ and doesn’t qualify for an exception, but nobody can stop him from taking the distribution if he wants to do so and is willing to pay the taxes. Not so with a qualified plan. Most qualified plans prohibit any distributions prior to attaining retirement age or severance of employment. 401(k) plans are generally forbidden to distribute the employee’s elective deferral account prior to age 59½ or termination of service. § 401(k)(2)(B)(i) . There is a hardship exception to that rule, but hardship distributions cannot be rolled over. § 402(c)(4)(C) . Plans that do permit “in-service distributions” often restrict such distributions to employees over age 62. § 401(a)(36) . So, realistically, the advisor is likely to encounter the opportunity for plan-to-Roth conversions mainly when the participant is leaving the service of the employer that sponsors the plan (but see ¶ 5.7.11 regarding “in-plan conversions”). 5.5 Roth Plans and the 10% Penalty For Pre-Age 59½ Distributions Generally, there is a 10 percent “additional tax” (penalty) on distributions from a retirement plan that occur while the participant is younger than age 59½. § 72(t) . For details on this “early distributions” penalty, and the more than one dozen exceptions to the penalty, see Chapter 9 . This ¶ 5.5 discusses the 10 percent penalty as it applies to Roth IRAs and DRACs (¶ 5.7) . The 10 percent penalty under § 72(t) applies to pre-age 59½ distributions from Roth IRAs the same as it applies to such distributions from traditional IRAs, under the rule that Roth IRAs are treated the same as traditional IRAs unless § 408A provides otherwise. Reg. § 1.408A-6 , A-5. Similarly, there is nothing in the Code that exempts distributions from DRACs (¶ 5.7) from the 10 percent penalty. If the distribution qualifies for any exception from the penalty, there is no penalty. See ¶ 9.2 – ¶ 9.4 for the exceptions to the 10 percent penalty. If no exception applies, then: A. Qualified distribution. A qualified distribution (from either a DRAC or Roth IRA) is excluded from gross income. See ¶ 5.2.03 (A), ¶ 5.7.04 . Since the 10 percent penalty applies only to amounts includible in gross income (with one exception; see ¶ 5.5.02 ), the penalty does not apply to any qualified distribution. See § 72(t)(1) ; Notice 87-16, 1987-1 CB 446, Question D9. B. Nonqualified distribution fromRoth IRA. In the case of a nonqualified distribution from a Roth IRA ( ¶ 5.2.06 ), the portion of the distribution allocable, under the Ordering Rules ( ¶ 5.2.07 ), to the earnings of the Roth IRA would be includible in the participant’s gross income and would accordingly be subject to the penalty. Reg. § 1.408A-6 , A-5(a). Penalty applies to certain Roth plan distributions

C. Nonqualified distribution from DRAC. In the case of a nonqualified distribution from a DRAC ( ¶ 5.7.05 ), the portion of the distribution allocable to the earnings of the account