Life and Death Planning for Retirement Benefits

Chapter 2: Income Tax Issues

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The mandatory withholding on eligible rollover distributions does not pose a problem if someone simply wants to get the money out of the QRP without simultaneously paying any income tax on the distribution. All such person has to do is have his distribution transferred directly (a “direct rollover”) into an IRA, so the qualified plan does not have to withhold anything; and then take the money out of the IRA (electing out of withholding on the IRA distribution). The person for whom “mandatory withholding” is truly mandatory is the person who wants to take a lump sum distribution from a QRP in order to qualify for special averaging treatment ( ¶ 2.4.06 ). This person cannot roll over any part of the distribution, and so will be forced to pay 20 percent income tax on it through withholding. He can get a refund when he files his tax return for the year of the distribution, if his total tax payments (including this withholding) exceed his actual tax liability. D. Roth conversion of eligible rollover distribution. Under § 3405(c)(2) , as long as the recipient elects (under § 401(a)(31) ) to have the eligible rollover distribution sent directly to an “eligible retirement plan,” there is no required income tax withholding. “Eligible retirement plan” is not defined in § 3405(c) , but is defined in regulations: “ ...[A]n eligible retirement plan is a trust qualified under section 401(a), an annuity plan described in section 403(a), or an individual retirement plan (as described in Sec. 1.402(c)-2, Q&A-2 of this chapter).” Reg. § 31.3405(c)-1 , A-1(a). The referenced section states that eligible retirement plan includes an individual retirement account under § 408(a) . Notice 2008-30, 2008-12 IRB 638, A-1, A-6, makes clear that Roth IRAs are also eligible to receive direct rollovers, and that a direct rollover to a Roth IRA is not subject to the 20 percent mandatory income tax withholding: “ ...[A]n eligible rollover distribution that a distributee elects, under § 401(a)(31)(A) , to have paid directly to an eligible retirement plan (including a Roth IRA) is not subject to mandatory withholding, even if the distribution is includible in gross income.” Despite that clear statement, the IRS’s instructions to employers in Publication 15-A (2010), at page 22, after stating that eligible rollover distributions are subject to mandatory 20 percent withholding, states that “However, you should not withhold federal income tax if the entire distribution is transferred ...in a direct rollover to a traditional IRA , qualified pension plan [etc.],” making it sound as though mandatory withholding does apply to direct Roth rollovers. 2.3.03 Exceptions and special rules A retirement plan is not required to withhold taxes from an eligible rollover distribution to the extent it is “reasonable to believe” that the distribution is not includible in the payee’s income. § 3405(e)(1)(B)(ii) ; Temp. Reg. § 35.3405-1T , A-2. For example, a qualified distribution from a DRAC or Roth IRA, as a nontaxable distribution, would not be subject to withholding. If the entire distribution consists of securities of the employer corporation (as defined in § 402(e)(4)(E) ) (and up to $200 cash “in lieu of fractional shares”), there is no withholding. If the distribution consists of securities of the employer corporation plus cash and other property, the maximum amount the employer is required to withhold is the value of the cash and other property. § 3405(e)(8) . In connection with determining the amount required to be withheld from that sort of mixed distribution, “it is reasonable to believe that all net unrealized appreciation [NUA] from employer securities is not includible in gross income.” Temp. Reg. § 35.3405-1T , A-30; see ¶ 2.5