Life and Death Planning for Retirement Benefits

Chapter 2: Income Tax Issues

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Step 1: How much basis does the participant have? To determine the participant’s basis in a QRP, see ¶ 2.2.03 . To determine the participant’s basis in his traditional IRAs, see ¶ 2.2.06 . To determine a beneficiary’s basis in inherited IRAs, see ¶ 2.2.07 . Step 2: How much of a particular distribution is basis? See ¶ 2.2.04 to determine how much of any particular distribution from a QRP is deemed to be after-tax money. See ¶ 2.2.08 to determine what portion of any particular distribution from a traditional IRA is deemed to be after- tax money. Step 3: How much of a partial rollover or Roth conversion is after-tax money? If a particular distribution is only partly rolled over, or only partly converted to a Roth IRA, how is after-tax money allocated between the rolled and nonrolled (or converted and nonconverted) portions? If a distribution is rolled over to multiple plans or IRAs, how is the after-tax money allocated among the various “destination” plans? See ¶ 2.2.05 to answer these questions with respect to QRP distributions, ¶ 2.2.08 – ¶ 2.2.10 for traditional IRA distributions. 2.2.02 General rule: The “cream-in-the-coffee rule” of § 72 Any distribution from a traditional retirement plan (or IRA) is deemed to carry out proportionate amounts of the pre- and after-tax money in all of the participant’s account(s) in that plan (or all of the participant’s traditional IRAs), unless an exception applies. Here is how we arrive at that general rule: § 402(a) provides that QRP distributions are taxable under the rules provided in § 72 . § 408(d)(1) provides similarly for distributions from IRAs, as § 403(b)(1) does for 403(b) plans. § 72 provides that any distribution from a retirement plan is deemed to carry out proportionate amounts of the pre- and after-tax money in the plan. See § 72(e)(8)(A) , (B) , (5)(D) . Ed Slott, CPA, one of America’s leading IRA experts, the author of several books on retirement distribution planning and publisher of Ed Slott’s IRA Advisor newsletter (see Appendix C ), calls § 72 the “ cream-in-the-coffee rule .” Once after-tax money (cream) has been combined with the pretax money (coffee) in your retirement plan, every “sip” (distribution) taken from the plan will contain some cream and some coffee. Of course, like everything else, the cream-in-the-coffee rule applies differently to IRAs and nonIRA plans, and has several exceptions (different exceptions for IRAs and nonIRA plans). So, the task of figuring how much of a particular distribution or rollover contribution consists of after- tax money will always start with the general “cream” rule, but then follow different tracks for IRAs and nonIRA plans. And remember, a totally different track applies for Roth IRAs—see ¶ 5.2.06 . Because § 72 was originally written to deal with distributions from annuity contracts, it often refers to the “contract,” which can be confusing when dealing with a retirement plan. 2.2.03 Participant’s basis in a QRP or 403(b) plan This ¶ 2.2.03 explains how a participant can get “basis” in his QRP, and how to determine what the participant’s basis is with respect to such a plan. Once you have determined what the participant’s basis is, ¶ 2.2.04 explains how to tell how much of that basis is included in any particular distribution.