Life and Death Planning for Retirement Benefits

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Life and Death Planning for Retirement Benefits

money; the IRS calls this the “earnings”). Hopefully, the “earnings” will NEVER be taxed, because they will come out eventually in the form of a tax-free qualified distribution ( ¶ 5.7.04 ). But if there is a nonqualified distribution, the earnings cannot come out tax-free. Accordingly, we need to determine how much of any nonqualified distribution represents a return of the participant’s basis (tax-free) and how much is considered earnings (taxable), and here’s where we find the difference between Roth IRAs and DRACs. With a Roth IRA, the participant’s own contributions ( i.e., the after-tax money) come out first. ¶ 5.2.06 , ¶ 5.2.07 . Accordingly, even nonqualified Roth IRA distributions are income tax-free until the entire basis has been distributed. With DRACs, in contrast, there is no special rule allowing the participant’s basis to come out first. So, the regular rule of § 72(e)(8) will apply—the “cream-in-the-coffee rule,” under which any distribution carries out proportionate amounts of the participant’s basis (after-tax money) and earnings (pretax money). Reg. § 1.402A-1 , A-3; see ¶ 2.2.02 . Thus, every nonqualified distribution from a DRAC will be partly taxable unless either (1) there has been no appreciation in the account since the original contributions or (2) the earnings portion is rolled over ( ¶ 5.7.06 ). The participant’s DRAC is treated as a separate account from the participant’s traditional accounts in the plan for purposes of applying § 72 . § 402A(d)(4) . Thus, distributions can be taken from each category (traditional or Roth) separately, without their being aggregated for purposes of the “cream-in-the-coffee rule.” However, if the participant has more than one DRAC inside a single 401(k) plan (for example, an elective deferral account and a rollover account), these are treated as a single account for purposes of § 72 . Reg. § 1.402A-1 , A-9(a). The only exceptions to this are: If an account is divided between the participant and his spouse pursuant to a QDRO, each spouse’s share of the employee’s DRAC is treated as a separate account (or “separate contract,” in the lingo of § 72 ; see ¶ 2.2.04 (C)); and, the plan can split the DRAC into multiple separate accounts for the participant’s multiple beneficiaries after the participant’s death, and each such account will be treated as a separate “contract” under § 72 . Reg. § 1.402A-1 , A-9(b). A distribution from a DRAC may be rolled over only to another DRAC or to a Roth IRA. § 402A(c)(3) ; Reg. § 1.402A-1 , A-5(a). See ¶ 5.7.07 for the rules for DRAC-to-DRAC rollovers, ¶ 5.7.08 for DRAC-to-Roth IRA rollovers. Though both direct rollovers and indirect (60-day) rollovers are permitted (see ¶ 2.6.01 for the difference), different rules apply to these two types of rollovers:  If a DRAC pays a distribution from the participant’s account directly to another DRAC (trustee-to-trustee transfer or direct rollover), that is treated as a separate distribution from “any amount paid directly to the employee,” for purposes of determining how much of each of these “separate distributions” is after-tax money and how much is pretax money. Reg. § 1.402A-1 , A-5(a), third sentence; A-6(a). Although this regulation addresses only direct rollovers from one DRAC to another, Notice 2009-68, 2009-39 IRB 423, at p. 429, provides the same rule for rollovers from any QRP to any other eligible retirement plan; see ¶ 2.2.04 (A).  If a distribution is paid to the participant (rather than being rolled directly to another plan or IRA), and the participant rolls over only part of the distribution (using a 60-day rollover), Rollovers of DRAC distributions: General rules