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Taxation of Distributions

  • 3940. What method is used to determine the cost of current life insurance protection provided in a qualified plan and taxed to common law employee participants?

    • The cost of life insurance protection provided under a qualified pension, annuity, or profit sharing plan must be included in an employee’s gross income for the year in which deductible employer contributions (whether deducted in the current year or a prior year) or trust income is applied to purchase life insurance protection.1 This rule applies whether the insurance is provided under group permanent or individual cash value life insurance policies or term insurance, and whether it is provided under a trusteed or non-trusteed plan.2 According to letter rulings, the rule applies as well to the protection under a life insurance policy on a third party if proceeds are allocable to an employee’s account, as can occur with the funding of a buy-sell arrangement.3

      An employee is taxed currently on the cost of life insurance protection if the proceeds either are (1) payable to the employee’s estate or beneficiary, or (2) payable to the plan’s trustee, if the plan requires the trustee to pay them to the employee’s estate or beneficiary.4

      On the other hand, an insured is not taxed on the insurance cost if the trustee has the right to retain any part of the death proceeds.5 Thus, an insured is not taxed on the cost of key person insurance purchased by the trustee as a trust investment. Likewise, participants are not taxed on the cost of a group indemnity policy purchased to indemnify the trust against excessive death benefit payments.6

      The insured does not avoid tax on the current cost of the insurance protection merely because, under the terms of the plan, his or her interest in the policy may be forfeited before his or her death and the trust may receive the cash surrender value of the contract.7


      1. IRC Sec. 72(m)(3)(B); Treas. Reg. §1.72-16(b).

      2. Treas. Reg. §§1.402(a)-1(a)(3), 1.403(a)-1(d).

      3. See Let. Ruls. 8426090, 8108110.

      4. Treas. Reg. §1.72-16(b)(1).

      5. Treas. Reg. §1.72-16(b)(6).

      6. Rev. Rul. 66-138, 1966-1 CB 25.

      7Funkhouser v. Comm., 58 TC 940 (1972).

  • 3941. How is the amount of taxable income determined when cash value insurance is provided under a qualified plan?

    • Only the cost of the pure amount at risk is treated as a currently taxable distribution. This cost, the amount of taxable income, is determined by applying the one year premium term rate at the insured’s age to the difference between the face amount of insurance and the cash surrender value at the end of the year.1 The applicable rate is the rate for the insured’s age on his or her birthday nearest the beginning of the policy year, although the insured’s age on his or her last birthday probably would be acceptable to the IRS, if used consistently.

      For many years, P.S. 58 rates were used to calculate the value of the protection.2 The IRS, however, revoked Revenue Ruling 55-747 for most purposes.3

      The manner in which the value of current life insurance provided under a qualified plan must be determined is not entirely clear. Guidance issued in 2001 and revised in 2002 provided Table 2001, which sets forth premium rates that replaced the earlier P.S. 58 Table.4 This table is reproduced in Appendix G – 01. Table 2001 will be used until additional guidance, which was authorized by final regulations in 2003, is published in the Internal Revenue Bulletin.5

      Until future guidance takes effect, taxpayers are permitted to use the insurer’s lower published premium rates that are available to all standard risks for initial issue one-year term insurance.6 The IRS does not consider an insurer’s published premium rates to be available to all standard risks who apply for term insurance unless (1) the insurer generally makes the availability of these rates known to persons who apply for term insurance coverage from the insurer, and (2) the insurer regularly sells term insurance at these rates to individuals who apply for term insurance coverage through the insurer’s normal distribution channels.7

      Earlier guidance stated that if an insurer published rates for individual, initial issue, and one-year term policies available to all standard risks, and these rates were lower than the then-applicable P.S. 58 (now Table 2001) rates, these insurer rates could be substituted to the extent provided by Revenue Ruling 66-110.8 The ability to use the insurer’s lower published rates was limited to arrangements entered into before the effective date of the final regulations (i.e., generally, September 17, 2003).9

      If a profit sharing plan permits a participant to direct a trustee to purchase term insurance riders on either the participant’s spouse or dependent children, the cost of the rider must be measured using the P.S. 58 rates (now Table 2001), not the actual cost of the rider.10

      The premium paid during an employee’s taxable year may cover a period extending into the following year. An employee will not be permitted to apportion the cost between the two years; the employee must include the entire P.S. 58 (now Table 2001) cost in his or her gross income for the taxable year during which the premium is paid.

      If only a portion of the premium is paid during the taxable year, the cost may be apportioned for that year.11

      An employee who leaves before the end of the year for which a premium has been paid must include in gross income the annual term cost reduced by the unearned premium credit reallocated to pay premiums for remaining employee-participants.12


      1. Treas. Reg. §§ 1.72-16(b), 1.402(a)-1(a)(3); 1.403(a)-1(d).

      2. Rev. Rul. 55-747, 1955-2 CB 228, amplified by Rev. Rul. 67-154, 1967-1 CB 11 and Rev. Rul. 78-420, 1978-2 C.B. 67.

      3. See Notice 2002-8, 2002-1 CB 398.

      4. See Notice 2002-8, 2002-1 CB 398.

      5. See Treas. Reg. §1.61-22(d)(3).

      6. See Notice 2002-8, 2002-1 CB 398.

      7. See Notice 2002-8, 2002-1 CB 398.

      8. 1966-1 CB 12, as amplified by Rev. Rul. 67-154, 1967-1 CB 11 and Rev. Rul. 78-420, 1978-2 C.B. 67.

      9. See Notice 2002-8, 2002-1 CB 398; Neff v. Comm., TC Memo 2012-244.

      10. See Let. Rul. 9023044.

      11. See Special Ruling, 1946, Pension Plan Guide (CCH), Pre-1986 IRS Tax Releases, ¶17,303.

      12. Rev. Rul. 69-490, 1969-2 CB 11.

  • 3942. How is the amount of taxable income determined when term insurance is provided under a qualified plan?

    • Where individual or group term life insurance is provided under a qualified plan, the cost of the entire amount of protection is taxable to employees. No part of the coverage of group term insurance is exempt under IRC Section 79 (Q 246).1 Moreover, the cost of the insurance protection cannot be determined by use of the special group term rates that are applicable to taxing excess group term life insurance purchased directly by an employer.2 It is not settled whether the taxable amount is the actual premium or the P.S. 58 (now Table 2001) cost.


      1. IRC Sec. 79(b)(3).

      2. Treas. Reg. §§1.79-1(a)(3), 1.79-3(d)(3).

  • 3943. How is the amount of taxable income determined when life insurance protection is purchased under a contributory plan?

    • Life insurance protection purchased under a contributory plan is considered to have been paid first from employer contributions and trust earnings, unless the plan provides otherwise. Thus, the P.S. 58 (currently Table 2001) costs are taxed to the employee unless the plan provides that employee contributions are to be applied to the insurance cost.1

      If amounts attributable to deductible employee contributions, including net earnings allocable to them, are used to purchase life insurance, the amount used, not the P.S. 58 (currently Table 2001) cost, is included in the employee’s gross income.2 It is unclear whether such amounts are subject to a premature distribution penalty; the IRS has specifically exempted P.S. 58 (currently Table 2001) costs of life insurance protection included in income from such a penalty (Q 3960). Although the deduction for any contribution used to purchase life insurance is not disallowed, it is, in effect, offset. Loans under the policy would be considered a distribution, including automatic premium loans on default of payment of a premium.


      1. Rev. Rul. 68-390, 1968-2 CB 175.

      2. IRC Sec. 72(o)(3)(B).

  • 3944. May the cost of life insurance protection provided under a qualified plan be recovered tax-free when benefits are paid?

    • If life insurance protection under a plan is provided by a cash value policy and the employee has reported the pure death benefit each year, then the total amount reported will be the basis in the contract (Q 3940, Q 3941). That basis may be recovered tax-free if it is paid as a death benefit directly to the beneficiary of the participant.

      If a contract is distributed to a participant as a benefit, then the basis in that contract is not taxable.1 It does not matter whether the contract is distributed or is cashed in and that amount is distributed. It would seem that deductible employee contributions that have been applied to purchase life insurance and taxed to the employee also would be recovered tax-free from benefits received under the policy.2 The amount recoverable is the total amount of income that has been reported, and not just the taxes paid on that income.3

      Regulations say that “each separate program of the employer consisting of interrelated contributions and benefits” is a single contract. Where retirement benefits and life insurance are separately provided (e.g., through retirement income contracts and a side fund), they generally are separate programs. Thus, if insurance is provided under a separate term policy, the taxable cost cannot be recovered from the retirement benefits.4

      Where a plan was amended to eliminate death benefits for employees dying prior to age sixty-five and its trustees redeemed the whole life insurance policies and invested the proceeds in various securities, the plan became a single program of interrelated contributions and benefits; the employees then could recover their taxable insurance cost from distributions from the plan.5

      Where, under a combination plan, the trustee surrendered the life insurance policy and used both the policy’s cash surrender value and the auxiliary fund to purchase an immediate annuity for a retiring employee, the employee could not recover the taxable insurance costs from the annuity payments; the result would have been different had the auxiliary fund been applied to a settlement under the life insurance policy.6

      Similarly, where life insurance policies were surrendered and the value used to provide a cash lump sum distribution, the costs taxed to the employee under Table 2001 or P.S. 58 (Q 3940) were not part of the employee’s cost recoverable from the distribution. Thus, they could be included in the amount rolled over (Q 3990).7

      Where nondeductible employee contributions have been earmarked under plan provisions for payment of the cost of life insurance protection, a letter ruling provided the following guidelines: (1) if the life insurance contracts are surrendered by the trustee and payment is made as a lump sum distribution or otherwise, the employee’s basis is the amount of the employee’s nondeductible contributions to the plan that were not applied to the cost of life insurance protection, and (2) if the life insurance contract is distributed as part of the distribution, the employee’s basis is (x) the amount of the employee’s nondeductible contributions to the plan, including those applied to the cost of life insurance protection, plus (y) any additional amounts taxed to the employee as the cost of life insurance protection under Table 2001 or P.S. 58 (Q 3945).8 For estate tax results, see Q 3983.

      Keogh Plans

      A self-employed individual does not include any costs the individual paid for life insurance protection  (Q 3940Q 3941) in the individual’s cost basis of benefits received under the contract.9 Rather, a self-employed individual loses the tax deduction for the part of the employer’s contribution that is allocable to the cost of pure insurance protection for himself or herself.

      In other words, the income tax deduction must be based on the balance of the premium after subtracting the one year term cost of the current life insurance protection.10

      The premium attributable to a waiver of premium provision may not be deducted.11 If any trust earnings are applied to purchase life insurance protection under a trusteed plan, however, a self-employed individual must include the cost, (Q 3940Q 3941) in gross income.12 The life insurance cost is determined in the same manner as for regular employees (Q 3940Q 3941). The cost of life insurance protection included in income may not be included in an owner-employee’s cost basis.13


      1. Treas. Reg. §1.72-16(b).

      2. See IRC Sec. 72(o)(3)(B).

      3. Treas. Reg. §1.72-16(b)(4). See Let. Rul. 8539066.

      4. Treas. Reg. §1.72-2(a)(3), Ex. 6.

      5. Let. Rul. 8721083.

      6. Rev. Rul. 67-336, 1967-2 CB 66.

      7. Let. Ruls. 7902083, 7830082.

      8. Let. Rul. 7922109.

      9. Treas. Reg. §1.72-16(b)(4).

      10. IRC Sec. 404(e); Treas. Reg. §1.404(e)-1(b)(1).

      11. Treas. Reg. §1.404(e)-1(b)(1).

      12. IRC Sec. 72(m)(3)(B); Treas. Reg. §1.72-16(b)(2).

      13. Treas. Reg. §1.72-16(b)(4).

  • 3945. What are the tax consequences and requirements for a loan from a qualified plan?

    • Qualified plans may permit participants to borrow from their accounts, but are not required to permit loans. A loan from a plan to a participant or to a beneficiary will be treated as a taxable distribution unless it meets certain requirements regarding:

      (1) the enforceability of the agreement,

      (2) the term of the loan,

      (3) repayment, and

      (4) a limitation on the maximum loan that may be made (Q 3946).1

      In certain situations, a violation of one of these requirements will not result in taxation to the participant if the violation is corrected under EPCRS. The IRS expanded the EPCRS program with respect to plan loans in Revenue Procedure 2019-19. Plans may now use the self-correction program to correct errors with respect to defaulted loans, failure to obtain spousal consent if necessary and situations where the plan issues more loans than are permitted under the plan. With respect to defaulted loans, the participant will generally be responsible for making a corrective payment, although the employer will be required to pay interest in certain circumstances. For corrections for failure to obtain spousal consent, the spouse must be notified so that he or she can provide consent. The revenue procedure also permits plans to be amended retroactively to allow for the number of plans loans that were actually permitted.2

      Repayment of a loan treated as a distribution will be considered a nondeductible employee contribution for tax purposes.3 When a recipient’s benefit is later distributed to the recipient, the amount already taxed will not be taxed again. Repayments constitute investment in the contract (i.e., basis)4 and are not considered annual additions subject to the IRC Section 415 limits.5

      Plan Qualification

      A qualified plan generally can provide for loans to participants if they are adequately secured, bear a reasonable rate of interest, have a reasonable repayment schedule, and are made available on a nondiscriminatory basis.6 If a plan is subject to automatic survivor benefit requirements, the loan may require spousal consent (Q 3875).

      Treatment of a loan as a distribution for tax purposes generally does not affect the plan’s tax qualification. A bona fide loan that is not a prohibited transaction (Q 3971) will not cause a pension plan to fail to satisfy the requirement that a pension plan primarily provide benefits for employees or their beneficiaries over a period of years or for life after retirement.7 When a plan loaned out almost all of its assets to the company president, without seeking adequate security, a fair return, or prompt repayment, the plan was held not to have been operated for the exclusive benefit of the employees and plan disqualification was justified.8

      A deemed distribution under IRC Section 72(p) will not be treated as an actual distribution for purposes of the qualification requirements of IRC Section 401; thus, plan qualification will not be affected by reason of a deemed distribution. If a participant’s accrued benefit is reduced or offset to repay a plan loan, an actual distribution occurs for purposes of IRC Section 401. This occurs generally when a participant with a loan terminates employment with the employer, if so specified in the loan agreement. An offset distribution from a 401(k) plan or a pension plan at a time when the plan is not otherwise permitted to make a distribution would result in plan disqualification.9


      Planning Point: Under prior law, if a loan from a qualified plan had not been repaid when the participant left employment or the plan was terminated (among other reasons), the outstanding loan balance would be offset against his or her account balance and would become taxable if not rolled over to another retirement account within 60 days.  Under the 2017 Tax Act, the 60-day deadline is extended to the participant’s tax filing deadline for the tax year in which the offset occurs if the amount is treated as distributed from the participant’s qualified plan because either: (1) the plan was terminated, or (2) the participant failed to meet the loan repayment terms because of a separation from employment (if the plan provides that the accrued unpaid loan amount must be offset at this time).


      A plan loan that is secured by a participant’s or a beneficiary’s interest in the plan but that is not a prohibited transaction generally will not be an assignment or alienation of plan benefits that would disqualify a plan.10 If there is a tacit understanding that collection of a loan is not intended, however, the loan may be treated as a disqualifying distribution if made at a time when the plan is not permitted to make distributions.11

      When an actual distribution follows a deemed distribution, a plan must treat the loan transition amount as an outstanding loan that is taxable on actual distribution. The loan transition amount is the amount by which the initial default amount, attributed as tax basis, exceeds the tax basis immediately preceding the transition date, plus any increase in tax basis thereafter. The plan may not attribute investment in the contract as a loan repayment (Q 3964). The tax basis in the distribution is determined based on the initial default amount and, to the extent that a tax basis has been attributed, it must be reduced by the initial default amount.

      Cash repayments made after a loan is deemed to have been distributed will increase the participant’s tax basis as if they were after-tax contributions, although they are not treated as after-tax contributions for other purposes.12

      Prohibited transactions. Plan loans that do not meet any of the requirements for a prohibited transaction exemption (Q 3971) could result in excise taxes and possible plan disqualification. The prohibited transaction rules apply to a loan that does not meet the exemption requirements, even if it is treated as (and taxed as) a distribution (Q 3971). Loans from a qualified plan to certain S corporation shareholders, partners, and sole proprietors also may qualify for the prohibited transaction exemption (Q 3971).13

      Investments in residential mortgages. Plan investments in residential mortgages of employees, other than officers, directors, or owners, or their beneficiaries, are permitted but are subject to limitations of IRC Section 72(p) unless they are made in the ordinary course of a plan investment program that is not limited to participants and their beneficiaries.14 A longer term than the five years allowed for other plan loans may be permitted (Q 3946).

      Mandatory Withholding

      Distributions that constitute eligible rollover distributions from a qualified plan generally are subject to mandatory income tax withholding at the rate of 20 percent, unless the participant elects a direct rollover.15 The IRS has stated that a deemed distribution attributable to a plan loan that does not meet the requirements of IRC Section 72(p) will not be subject to the 20 percent mandatory withholding requirement because such a distribution cannot be an eligible rollover distribution.

      Where a participant’s accrued benefit is reduced or offset to repay a plan loan, such as when employment is terminated, the offset amount may constitute an eligible rollover distribution.16 Mandatory withholding is required on a deemed distribution of a loan, or a loan repayment by benefit offset, to the extent that a transfer included cash or property other than employer securities at the same time.17


      1. IRC Sec. 72(p)(2); Treas. Reg. §1.72(p)-1, A-3.

      2. Rev. Proc. 2019-19.

      3. Sen. Rept. 97-494, 97th Cong. 2nd Sess.

      4. Let. Rul. 9122059.

      5. Notice 82-22, 1982-2 CB 751.

      6. IRC Sec. 4975(d)(1); Notice 82-22, 1982-2 CB 751; Rev. Rul. 71-437, 1971-2 CB 185; Rev. Rul. 67-288, 1967-2 CB 151.

      7. Notice 82-22, 1982-2 CB 751.

      8Winger’s Dept. Store, Inc. v. Comm., 82 TC 869 (1984).

      9. See Treas. Reg. §1.72(p)-1, A-12, A-13.

      10. Treas. Reg. §1.401(a)-13(d)(2). See Q 3904. See also Notice 82-22, 1982-2 CB 751.

      11. See Rev. Rul. 71-437, 1971-2 CB 185.

      12. Treas. Reg. §1.72(p)-1, A-19 through A-21. See also Treas. Reg. §1.72(p)-1, A-1 through A-18.

      13. IRC Sec. 4975(f)(6)(B)(iii).

      14. Treas. Reg. §1.72(p)-1, A-18.

      15. IRC Sec. 3405(c).

      16. See Notice 93-3, 1993-1 CB 293.

      17. Treas. Reg. §1.72(p)-1, A-15.

  • 3946. What requirements must a qualified plan loan meet to avoid taxation as a distribution?

    • To avoid being taxed as a distribution, a loan made from a plan to a participant or beneficiary must be made pursuant to an enforceable agreement (Q 3947) that meets certain requirements with respect to the term of the loan (Q 3948), its repayment (Q 3949), and the dollar amount loaned (Q 3950).1


      1. IRC Sec. 72(p)(2); Treas. Reg. §1.72(p)-1, A-3(a).

  • 3947. Must a qualified plan loan be evidenced by a loan agreement to avoid taxation as a distribution?

    • A plan loan must be evidenced by a legally enforceable agreement, which may consist of more than one document. The agreement must specify the date, amount, and term of the loan, as well as the repayment schedule. The agreement need not be signed if it is enforceable without a signature under applicable law.1 The date of the loan is the date the loan is funded (i.e., the date of delivery of the check to the participant).2

      An agreement must be set forth in a written paper document, an electronic medium, or any other form approved by the IRS.3 If a loan agreement is in the form of an electronic medium, the medium must be reasonably accessible to the participant or beneficiary and must be provided under a system that is reasonably designed to preclude any individual other than the participant or beneficiary from requesting a loan.4

      The system also must provide the participant or beneficiary with a reasonable opportunity to review the terms of the loan, and to confirm, modify, or rescind the terms of the loan before it is made.5 Finally, the system must provide a confirmation to the participant or beneficiary within a reasonable time after the loan is made. The confirmation may be made on a written paper document or through an electronic medium that meets the accessibility requirements above. The electronic confirmation must be no less understandable than a written paper document and must inform the participant or beneficiary of his or her right to receive confirmation via a written paper document at no charge.6


      1. Treas. Reg. §1.72(p)-1, A-3(b).

      2. ABA Joint Committee on Employee Benefits, Meeting with IRS and Department of Treasury Officials, May 7, 2004 (Q&A-4).

      3. Treas. Reg. §1.72(p)-1, A-3(b).

      4. Treas. Reg. §1.401(a)21(d).

      5. Treas. Reg. §1.401(a)21(f), Example 3.

      6. Treas. Reg. §1.401(a)21(D)(5), §1.401(a)-21(b)(3)(i).

  • 3948. How long can a qualified plan loan remain outstanding in order to avoid being taxed as a distribution?

    • The term of a loan must be no longer than five years. If a loan does not meet the term requirement, the entire loan is a distribution.1 A distribution is deemed to occur the first time the term requirement is not met in form or operation; thus, it may occur at the time the loan is made, or at a later date.2

      If a loan initially satisfies the term requirement but payments are not made under the terms of the loan, a deemed distribution occurs as a result of the failure to make the payments.3 Although such a failure will constitute an immediate violation of the loan provisions, the plan may allow for a cure period of up to three months beyond the calendar quarter in which the payment was due. A distribution in the amount of the entire outstanding balance of the loan will be deemed to have occurred on the last day of the cure period.4 Legislative history suggests that a loan treated as a distribution because its repayment period was not limited to five years cannot be corrected by renegotiation or repayment.5 If a loan is outstanding when a total distribution is made to a participant, the loan is treated as repaid (and the amount included in the distribution) on the date of distribution; thus, inclusion in income cannot be deferred until the end of the five year period.6

      The IRS has released guidance explaining situations in which a cure period may apply to prevent missed installment payments on a retirement plan loan from causing the loan to be treated as a deemed distribution.  Generally, a plan loan is treated as a taxable deemed distribution unless it is paid in installment payments over a five-year period.  A cure period that lasts up until the last day of the calendar quarter following the quarter when the missed installment payment was due may apply to prevent deemed distribution treatment.  Pursuant to the guidance, the IRS uses the example of payments missed on March 31, 2020 and April 30, 2020, followed by on-time payments on May 31, 2020 and June 30, 2020 where a cure period ending June 30 applies.  The May and June payments apply to “cure” the missed March and April payments, but then the normal May and June payments are treated as though they were missed because they were applied to cure the missed payments.  As a result, the borrower is required to make an installment payment equal to three normal payments to bring the account up to date.7

      An exception to the five year rule exists for residence loans used to acquire a dwelling unit that is to be, within a reasonable time, the principal residence of the participant (Q 3951).8


      1. IRC Sec. 72(p)(2)(b)(i).

      2. Treas. Reg. §1.72(p)-1, A-4.

      3. Treas. Reg. §1.72(p)-1, A-4.

      4. Treas. Reg. §1.72(p)-1, A-10.

      5. Sen. Rept. 97-760, 97th Cong. 2nd Sess.

      6. Let. Rul. 8433065.

      7. ILM 201736022.

      8. IRC Sec. 72(p)(2)(B)(ii).

  • 3949. What repayment requirements must apply to qualified plan loans?

    • Editor’s Note: The 2017 Tax Act modified the plan loan rules for tax years beginning after 2017 by permitting an extended period of time for repaying or rolling over “plan loan offset amounts”.  See below.

      The loan agreement must specify the amount and term of the loan and the repayment schedule.1 Failure to make a timely payment of a plan loan installment when due generally will result in a deemed distribution, but the agreement may provide for a cure period so long as the cure period does not extend beyond the end of the calendar quarter following the quarter in which the payment was due.2

      A loan that was not repayable in full within five years and that had a balloon payment at the end was held to be a premature distribution subject to the 10 percent penalty (Q 3960) because it violated both the term requirement and the level amortization requirement. The participant was not subject to the substantial understatement or negligence components of the accuracy-related penalty because the participant relied in good faith on the plan administrator’s representations that the plan loan was in compliance.3

      It should be noted that U.S. bankruptcy courts have held that a debtor’s repayment of a participant loan from a 401(k) plan is not necessary for support and thus is not exempt from the bankruptcy estate (Q 3904).4

      The 2017 Tax Act

      The 2017 Tax Act modified the plan loan rules for tax years beginning after 2017.  Under prior law, if a loan from a qualified plan (including 403(b) plans) had not been repaid when the participant left employment or the plan was terminated (among other reasons), the outstanding loan balance would be offset against his or her account balance and would become taxable if not rolled over to another retirement account within sixty days.

      Under the 2017 Tax Act, the 60-day deadline is extended to the participant’s tax filing deadline (including extensions) for the tax year in which the offset occurs if the amount is treated as distributed from the participant’s qualified plan 401(k) plan, 403(b) plan or 457(b) plan because either (1) the plan was terminated or (2) because the participant failed to meet the loan repayment terms because of a separation from employment (if the plan provides that the accrued unpaid loan amount must be offset at this time).5 The 2017 Tax Act does not extend the 60-day deadline for plan loan offset amounts that arise for other reasons.


      Planning Point: This provision applies to defaulted loans that are actually offset against the retirement account that provided security for the loan and treated as an actual distribution, rather than a deemed distribution. If an actual distribution does not occur by the end of the year in which
      the default occurs, the tax liability for the deemed distribution accrues in the year of the default. Plan sponsors and administrators should consider how to best meet their fiduciary obligations and achieve the purpose of the retirement plan if a plan loan goes into default.


      This extended time period does not apply to loans that have already been deemed taxable distributions (whether because the loan installment payment remained unpaid beyond the applicable cure period or because the loan’s terms did not comply with the IRC requirements).

      Repayment during Military Service

      A participant may suspend repayment of a loan during any period that he or she serves in the military.6 This rule applies regardless of whether the service performed is “qualified military service” under the Uniformed Services Employment and Reemployment Rights Act of 1994. The suspension of repayment under these circumstances may extend beyond one year, unlike the suspension rules for other leaves of absence.7

      A participant must resume loan repayment once the participant completes his or her service with the uniformed services, at which time payments must be made as frequently and in an amount no less than was made before the suspension. The latest permissible term of the loan is five years from the date of the original loan, plus any period during which repayment was suspended due to military service.8


      1. Treas. Reg. §1.72(p)-1, A-3(b).

      2. Treas. Reg. §1.72(p)-1, A-10.

      3Plotkin v. Comm., TC Memo 2001-71.

      4In re Darcy I. Estes, 254 BR 261 (2000); In re Cohen, 246 BR 658 (2000).

      5. IRC Sec. 402(c)(3)(C).

      6. IRC Sec. 414(u)(4).

      7. Treas. Reg. §1.72(p)-1, A-9(b).

      8. Treas. Reg. §1.72(p)-1, A-9.

  • 3950. Are there limits on the amount that can be borrowed under a qualified plan loan?

    • Editor’s Note: The CARES Act relaxed the rules to provide relief for qualified plan participants with existing plan loans.  See Q 3947.01.

      The amount of the loan, when added to the outstanding balance of all other loans, whenever made, from all plans of the employer, may not exceed the lesser of (1) $50,000 (reduced by the excess of the highest outstanding balance of plan loans during the one-year period ending on the day before the date when the loan is made over the outstanding balance of plan loans on the date when the loan is made), or (2) one-half of the present value of the employee’s non-forfeitable accrued benefit under the plans, determined without regard to any accumulated deductible employee contributions. A plan may provide that a minimum loan amount of up to $10,000 may be borrowed, even if it is more than one-half of the present value of the employee’s non-forfeitable accrued benefit.[1] For valuation purposes, a valuation within the prior twelve months may be used, if it is the latest available.[2]

      If a loan does not meet the dollar limitation, distribution of the amount in excess of the dollar limit is deemed to occur when the loan is made.[3] If the outstanding loan balance meets the dollar limitation immediately after the date when the loan is made, the loan will not be treated as a distribution merely because the present value of the employee’s non-forfeitable accrued benefit subsequently decreases.[4]

      In determining the outstanding balance and the present value of the non-forfeitable accrued benefit under a plan, an employer’s plans include plans of all members of a controlled group of employers, of trades and businesses under common control, and of members of an affiliated service group (Q 3922, Q 3924).[5] The plans include all qualified pension, profit sharing, and stock bonus plans, all Section 403(b) tax sheltered annuities, and all Section 457 deferred compensation plans of aggregated employers.[6]

      [1].    IRC Sec. 72(p)(2)(A).

      [2].    Notice 82-22, 1982-2 CB 751.

      [3].    Treas. Reg. §1.72(p)-1, A-4(a).

      [4].    General Explanation—TEFRA, p. 296.

      [5].    IRC Sec. 72(p)(2)(D)(i).

      [6].    IRC Sec. 72(p)(2)(D)(ii).

  • 3950.01. What relief did the CARES Act provide to expand the qualified plan loan rules post COVID-19?

    • The CARES Act relaxed the rules to provide relief for qualified plan participants with existing plan loans.  If a participant had an existing plan loan with a repayment obligation falling between March 27 and December 31, 2020, that repayment obligation was extended for one year.  Any subsequent repayment obligations are to be adjusted to reflect this extension.  For plan participants who are “qualifying individuals,” the plan loan limits were increased to the greater of $100,000 or 100 percent of the vested balance in the participant’s account.

      Qualifying individuals are those (1) diagnosed with COVID-19, (2) whose spouse or dependent are diagnosed with COVID-19 or (3) who experiences adverse financial consequences as a result of being quarantined, furloughed or laid off (or having work hours reduced) due to COVID-19, being unable to work due to lack of child care due to COVID-19, closing or reducing hours of a business owned or operated by the individual due to COVID-19, or other factors as determined by the Treasury.[1]

      Later IRS guidance expanded the list of qualifying individuals to include anyone whose pay was reduced due to COVID-19 (regardless of whether hours were reduced or whether the individual was laid off).  If a taxpayer was planning to start a new job and the start date was pushed back (or the offer was rescinded entirely) due to COVID-19, that taxpayer also qualifies for relief.  Further, if a spouse or member of the plan participant’s household has suffered one of the effects described above, the participant becomes eligible for the expanded retirement account access.[2]  “Members of the participant’s household” presumably include roommates or anyone who shares the participant’s primary residence.  For example, if the participant’s live-in partner owned a business that was shut down due to COVID-19, the participant would be eligible for the plan distribution relief.


      Planning Point: Despite the increased loan limits, plan sponsors need to remember the one-year lookback rule.  In reality, the $100,000 limit is reduced by (a) the excess of the employee’s highest outstanding plan loan balance during the one-year period ending on the day before the loan is made, over (b) the employee’s outstanding balance of any plan loan on the date the loan is made (this calculation also includes loans from any other plans maintained by the employer or member of a controlled group).  See below for more details.


      The IRS has also released the first Q&A in what is likely to be a series of guidance on the CARES Act retirement-related provisions.  One overarching issue is the IRS confirmation that plan sponsors can look to past guidance issued in response to Hurricane Katrina in 2005 and the RMD waiver in 2009 for help implementing the CARES Act provisions.

      IRS Q&A clarifies that increased loan limits are currently available between March 27, 2020 and September 22, 2020.  Further, the guidance confirms that the loan and distribution relief is optional for plan sponsors–and sponsors can elect to adopt one provision and not another (including the loan repayment option). Plan sponsors can rely on the participant’s certifications that they are eligible for the relief unless they have actual knowledge to the contrary.  COVID-19 related distributions are reported on Form 1099-R (even if the distribution is repaid in the same year).[3]

      The IRS has confirmed that the plan loan or hardship distribution amount does not have to directly correspond to the financial loss the participant has suffered.  As a result, plan sponsors will not have to obtain documentation to substantiate the amount of the financial hardship and plan participants will not have to prove the amount of their loss.[4]

      The expanded plan loan and hardship withdrawal options are completely optional for plan sponsors.  However, Notice 2020-50 clarifies that plan participants are eligible for the tax benefits regardless of whether the plan sponsor chooses to amend the plan in accordance with the CARES Act relief options.

      Plan administrators are also entitled to rely upon plan participants’ certifications that they are qualifying individuals absent actual knowledge to the contrary (there is no duty to investigate)—but the participant must be a qualifying individual to reap the tax benefits.

      If the plan permits a delayed repayment for outstanding loans as of March 27, 2020, the payments can be deferred until 2021 with the remaining amounts re-amortized beginning with the first payment date after January 1, 2021.  The re-amortization period will begin January 1, 2021 and run through the date that is one year after the loan was originally due.  The guidance also notes that there may be other reasonable methods to handle the loan repayment deferral.

       

      [1]      Pub. Law No. 116-36, CARES Act, Sec. 2202(b).

      [2]      Notice 2020-50.

      [3]     IRS FAQ, which are expected to be updated on a rolling basis, available at: https://www.irs.gov/newsroom/coronavirus-related-relief-for-retirement-plans-and-iras-questions-and-answers

      [4]      Notice 2020-50.

  • 3951. What special rules apply to residence loans from a qualified plan?

    • If a plan has a program to invest in residential mortgage loans, loans made in the ordinary course of the program are not subject to the rules that apply to plan loans. Loans that benefit an officer, director, or owner of the employer maintaining the plan or their beneficiaries are not treated as made under an investment program and are subject to the limitations of IRC Section 72(p) (Q 3946). An investment program exists if the plan has established that a certain percentage or amount of plan assets will be invested in residential mortgages available to persons who satisfy commercially customary financial criteria. 1

      If a loan is to acquire a dwelling unit that is to be, within a reasonable time, the principal residence of the participant, it will not be subject to the otherwise applicable 5-year term requirement (Q 3946).2 The determination of whether the unit is to be used, within a reasonable time, as the participant’s principal residence is made when the loan is made. Legislative history indicates that a dwelling unit includes a house, apartment, condominium, or mobile home not used on a transient basis. The determination of whether plan loan proceeds are used for the purchase or improvement of a principal residence is made using the tracing rules under IRC Section 163(h)(3)(B).3

      A principal residence loan can include a plan loan used to repay a third-party loan used to pay a portion of the purchase price if the plan loan would qualify as a principal residence loan without regard to the third-party loan.4 For example, on July 1, 2020, a participant requests a plan loan to acquire a principal residence to be paid in level monthly installments over fifteen years. On August 1, 2020, the participant acquires a principal residence, paying a portion of the purchase price with a bank loan. On September 1, 2020, the plan makes the loan and the participant uses it to repay the bank loan. The regulations state that the plan loan qualifies as a principal residence loan, considering the IRC Section 163(h)(3) tracing rules.5

      Interest paid on residence loans may be deductible if the general requirements for deducting mortgage interest are met and the deduction is not denied based on the participant’s status as a key employee or the loan is secured by amounts attributable to elective deferrals. (Q 3956)

      Planning Point: Although a mortgage is not required for this purpose,6 a participant may want to give the trustee a mortgage to qualify the interest as deductible interest. Treasury Department regulations require that for interest to be deductible as qualified residence interest the borrower must give the lender a mortgage and the lender actually must take the step of recording the mortgage. Martin Silfen, J.D., Brown Brothers Harriman Trust Co., LLC.

      Planning Point: If a participant wants to give the plan a mortgage to qualify for the mortgage interest deduction, the participant should verify with the plan that the plan will record the mortgage and that the mortgage in favor of the plan will not violate the terms of any other mortgage secured by the residence.

      Planning Point: Because the 2017 tax reform legislation increased the standard deduction and limited the state and local tax deduction to $10,000 through 2025, many people will no longer be able to deduct mortgage interest, even if the interest otherwise qualifies.

      No specific time limit is placed on residential loans, but the loans must provide for substantially level amortization, with payments to be made at least quarterly.7 This requirement does not preclude repayment or acceleration of the loan prior to the loan period, or the use of a variable interest rate.8 All loans, regardless of when made, must provide for a reasonable repayment schedule to qualify as a loan exempt from the prohibited transaction rules (Q 3971). A loan need not be secured by the residence to be considered a principal residence plan loan.9Assuming that a loan is otherwise a bona fide debt and the other requirements for deducting the plan loan interest as mortgage interest are met, a taxpayer may deduct interest paid on a mortgage loan from his or her qualified plan, even though the amount by which the loan exceeded the $50,000 limit of IRC Section 72(p) was deemed to be a taxable distribution. (Q 3956).10


      1. Treas. Reg. §1.72(p)-1, A-18.

      2. See IRC Sec. 72(p)(2)(B)(ii).

      3. Treas. Reg. §1.72(p)-1, A-7. 

      4. Treas. Reg. §1.72(p)-1, A-8(a).

      5. Treas. Reg. §1.72(p)-1, A-8(b).

      6. See Treas. Reg. §1.72(p)-1, A-6.

      7. See IRC Sec. 72(p)(2)(C).

      8. General Explanation — TRA ’86, p. 728.

      9. Treas. Reg. §1.72(p)-1, A-6.

      10. FSA 200047022.

  • 3952. How did the 2017 tax reform legislation change the rules governing loans from 401(k) plans and other types of qualified

    • Generally, If a qualified plan participant leaves his job (or is fired), the loan must be repaid within sixty days in order to avoid taxes and penalties (the 10 percent excise tax for early distributions will apply in addition to ordinary income taxes if the individual is under 59½). Typically, the participant would roll the required funds into another tax-preferred retirement account within the sixty-day period to avoid taxes and penalties.

      This is known as a “plan loan offset” (or the part of the taxpayer’s remaining 401(k) account balance that would have to be reduced in order to repay the loan). Prior to tax reform, the participant had only sixty days to come up with the funds necessary to satisfy this requirement, which could, in many cases, present a problem for an individual who may have recently lost his or her primary source of income. The otherwise applicable five-year time frame does not apply to plan participants in this situation. These rules applied for any qualified plan, including 403(b) and 457 plans as well as 401(k)s.

      Under the 2017 tax reform legislation, the sixty-day deadline is extended to the participant’s tax filing deadline for the tax year in which the offset occurs if the amount is treated as distributed from the participant’s qualified 401(k) plan because either: (1) the plan was terminated, or (2) the participant failed to meet the loan repayment terms because of a separation from employment (if the plan provides that the accrued unpaid loan amount must be offset at this time). This generally means that individuals will have until April 15 of the following tax year (or October 15 if they take advantage of the ability to extend the deadline) to gather the funds necessary to satisfy the offset.

      Planning Point: This extended time period does not apply to loans that have already been deemed taxable distributions (whether because the loan installment payment remained unpaid beyond the applicable cure period or because the loan’s terms did not comply with the IRC requirements). If the default occurred while the individual remained employed with the employer and continued to have the ability to participate in the plan, the sixty-day limit continues to apply.

  • 3953. How can a plan participant who has taken a loan from his or her 401(k) plan cure a default on repayments?

    • The IRS has recently released guidance explaining situations in which a cure period may apply to prevent missed installment payments on a 401(k) plan loan from causing the loan to be treated as a deemed distribution. Generally, a plan loan will be treated as a taxable deemed distribution unless it is paid in installment payments over the applicable five-year period.

      A cure period that lasts up until the last day of the calendar quarter following the quarter when the missed installment payment was due may apply to prevent deemed distribution treatment. Pursuant to the guidance, the IRS has allowed taxpayers to apply a later payment to an earlier missed payment in order to prevent deemed distribution treatment. The IRS uses the example of payments missed on March 31, 2020 and April 30, 2020, followed by on-time payments on May 31, 2020 and June 30, 2020 where a cure period ending June 30 applies. The May and June payments apply to “cure” the missed March and April payments, but then the normal May and June payments are treated as though they were missed because they were applied to cure the missed payments. As a result, the borrower is required to make an installment payment equal to three normal payments to bring the account up to date.1

      Further, a taxpayer who misses payments may also be permitted to refinance the plan loan in order to include the missed payments, but the refinancing must occur before the end of the applicable cure period.


      1. IRS CCA 201736022.

  • 3954. What miscellaneous rules apply to loans from a qualified plan?

    • Both direct and indirect loans are considered loans. A participant’s or beneficiary’s assignment, agreement to assign, pledge, or agreement to pledge any portion of his or her interest in the plan is considered to be a loan of that portion. If a participant’s interest in a plan is pledged or assigned as security for a loan, only the amount of the loan, not the amount assigned or pledged, is treated as a loan.1

      Any amount received as a loan under a contract purchased under a plan, and any assignment or pledge with respect to such a contract, is treated as a loan under the plan.2 This would appear to treat a policy loan by a trustee as a loan to the participant. If a premium that is otherwise in default is paid in the form of a loan against the contract, the loan is not considered made to the participant unless the contract has been distributed to the participant.3

      The IRS has stated, in a general information letter, that where plan participants received mortgage loans from a bank that were contingent on the plan making deposits equal to the loan amounts, the loans were indirect plan loans for purposes of IRC Section 72(p).4

      A loan received by a beneficiary is treated as received by the participant if he or she is alive at the time the loan is treated as a distribution.5


      1. Treas. Reg. §1.72(p)-1, A-1.

      2. Treas. Reg. §1.72(p)-1, A-1.

      3. General Explanation – TEFRA, p. 295.

      4. See IRS General Information Letter, 5 Pens. Pl. Guide (CCH) ¶17,383J (August 12, 1992).

      5. General Explanation – TEFRA, p. 295.

  • 3955. How do renegotiations, extensions, renewals, or revisions work in the context of qualified plan loans?

    • Any loan balance outstanding on August 13, 1982 (September 3, 1982, in the case of certain government plans) that is renegotiated, extended, renewed, or revised is treated as a loan made on the date it is renegotiated, extended, renewed, or revised.1

      A consolidation of two qualified plans is not a renegotiation, extension, renewal, or revision that would subject a loan to the provisions of IRC Section 72(p).2

      Similarly, the transfer of a participant’s account balance, including an outstanding loan, in a trustee-to-trustee transfer is not treated as such a renegotiation, extension, renewal, or revision.3

      A plan loan offset against the participant’s account balance when the plan terminated was treated as a constructive distribution, subject to income tax and penalties.

      Planning Point: A qualified plan may not allow modifications to an existing plan loan. A new plan loan can be used to pay off an existing plan loan if the total of all plan loans does not exceed the maximum loan permitted (generally, the lesser of $50,000 or 50 percent of the account balance. See Q 3950.) Refinancing of a plan loan used to acquire the participant’s principal residence will be subject to the five year term. Because the loan is not used to acquire the residence, it does not qualify for an extended term. However, a plan loan used to repay a loan from a third party
      can qualify as a principal residence loan. (See Q 3951.)

       


      1. TRA ’86, Sec. 1134(e). See e.g., TAM 9344001.

      2. Let. Rul. 8542081.

      3. Let. Rul. 8950008.

      4Caton v. Comm., TC Memo 1995-80.

  • 3956. How does the interest deduction apply to qualified plan loans?

    • An employee is not allowed an interest deduction with respect to a loan (otherwise meeting the requirements explained in Q 3946) made after 1986 during the period on or after the first day on which the borrower is a key employee (Q 3923) or in which the loan is secured by elective contributions made to a 401(k) plan or tax sheltered annuity.1 Loans from a qualified retirement plan do not qualify as a qualified education loan for which an interest deduction is available.2


      1. IRC Sec. 72(p)(3).

      2. Treas. Reg. §1.221-1(f)(3).

  • 3957. How do refinancing transactions work in the context of qualified plan loans?

    • A refinancing transaction is any transaction in which one loan replaces another. For example, a refinancing may exist if the outstanding loan amount is increased or if the interest rate or the repayment term of the loan is renegotiated.1

      If the term of a replacement loan ends later than the term of the loan it replaces, then both loans are treated as outstanding on the date of the refinancing transaction. This generally means that the loans must collectively satisfy the requirements of IRC Section 72(p).2 There is an exception where the replacement loan would satisfy IRC Section 72(p)(2) if it were treated as two separate loans. Under this exception, the amount of the replaced loan, amortized over a period ending no later than the end of the original term of the replaced loan or five years, if later, is treated as one loan. The other loan is for an amount equal to the difference between the amount of the replacement loan and the outstanding balance of the replaced loan.3

      The IRS will not view the transaction as circumventing IRC Section 72(p) if a replacement loan effectively amortizes an amount equal to the replaced loan within the original term of the replaced loan or within five years, if later. For this reason, the outstanding balance of a replaced loan need not be taken into account in determining whether the limitations of IRC Section 72(p)(2) have been met; only the amount of the replacement loan plus any existing loans that are not being replaced is considered.4 If the term of a replacement loan does not end later than the term of the replaced loan, then only the amount of the replacement loan plus the outstanding balance of any existing loans that are not being replaced must be taken into account in determining whether IRC Section 72(p) has been satisfied.5

      Multiple Loans

      Where a participant receives multiple loans from a qualified retirement plan, each loan must separately satisfy IRC Section 72(p), taking into account the outstanding balance of each existing loan. The refinancing rules do not apply because the new loan is not used to replace any existing loan.6 Earlier proposed regulations set a limit of two loans per participant within a single year, but final regulations contain no such limit.7


      1. Treas. Reg. §1.72(p)-1, A-20(a).

      2. Treas. Reg. §1.72(p)-1, A-20(a)(2).

      3. Treas. Reg. §1.72(p)-1, A-20(a)(2).

      4. Treas. Reg. §1.72(p)-1, A-20(a)(2).

      5. Treas. Reg. §1.72(p)-1, A-20(a)(1).

      6. Treas. Reg. §1.72(p)-1, A-20(a)(1).

      7. Treas. Reg. §1.72(p)-1, A-20(a)(2).

  • 3958. Are deemed distributions treated as outstanding loans?

    •  

      Yes. For purposes of the dollar limitation on loans under IRC Section 72(p) (Q 3946), a loan treated as a deemed distribution is considered an outstanding loan until it is repaid.1

      Regulations place two conditions on loans made while a deemed distribution loan remains unpaid.

      First, the subsequent loan must satisfy the rules for qualifying plan loans.

      Second, the loan must either be repayable under a payroll withholding arrangement enforceable under applicable law or the participant must provide the plan with adequate collateral for the loan in addition to the participant’s accrued benefit.

      The payroll withholding arrangement may be revocable, but should the participant revoke it, the outstanding loan balance is treated as a deemed distribution. If, for any reason, the additional collateral ceases to be in force before the subsequent loan is repaid, the outstanding balance of the subsequent loan is treated as a deemed distribution.

      If these conditions are not satisfied, the entire subsequent loan is treated as a deemed distribution under IRC Section 72(p).2


      1. Treas. Reg. §1.72(p)-1, A-19(b)(1).

      2. Treas. Reg. §1.72(p)-1, A-19.

  • 3959. How is an employee taxed on preretirement distributions from a qualified plan?

    • Preretirement distributions, meaning those received before the annuity starting date, that are made to an employee from a qualified plan are fully included in gross income except to the extent allocated to investment in the contract, as described below.1 Early or premature distributions generally are subject to an additional tax (Q 3960).

      A participant who has an investment or cost basis (Q 3964) in a contract under a pension, profit sharing, or stock bonus plan, or under an annuity contract purchased by any such plan, is taxed under a rule that provides for pro rata recovery of cost.2 The employee excludes the portion of the distribution that bears the same ratio to the total distribution as his or her investment in the contract bears to the total value of the employee’s accrued benefit on the date of the distribution. The IRS has recently released guidance providing that amounts received under a defined benefit plan during phased retirement are not taxed as annuity payments if (1) the employee who has begun to receive phased benefits will not receive a full benefit until he or she stops working and begins receiving full benefits at an indeterminate future time (i.e., if his or her date of full retirement could change), (2) the plan’s obligations to the employee are based in part on the employee’s continued part-time employment and (3) the employee does not have an election as to the form of phased retirement benefit, but elects a distribution option at full retirement that applies to his or her entire benefit (including the phased benefits).3

      The total value of an employee’s account balance generally is the fair market value of the total assets under the account, excluding any net unrealized appreciation attributable to employee contributions, whether or not all of such securities are distributed.4 The annuity starting date is the first day of the first period for which an amount is received as an annuity under the plan or contract (Q 540).5

      Employee contributions under a defined contribution plan may be treated as a separate contract for purposes of these rules.6 A defined benefit plan is treated as a defined contribution plan to the extent that employee contributions and earnings thereon are credited to a separate account to which actual earnings and losses are allocated.7

      Conversely, the IRS privately ruled that there was a single contract in the case of a defined benefit plan that did not credit earnings on employee after-tax contributions and allowed single sum withdrawal of such contributions at retirement, in exchange for actuarially reduced lifetime pension payments. The withdrawn amounts were taxed as preretirement distributions under IRC Section 72(e)(8)(B) and the investment in the contract with respect to the remaining benefit was reduced by the amount of such distribution.8

      A lump sum distribution received under the alternative form of the Civil Service Retirement System annuity did not qualify as a defined contribution plan or a hybrid plan under these rules; thus it was not subject to separate contract treatment.9

      Grandfather Rule

      If, on May 5, 1986, a plan permitted in-service withdrawal of employee contributions, the pro rata recovery rules do not apply to investment in the contract prior to 1987. Instead, investment in the contract prior to 1987 will be recovered first, and the pro rata recovery rules will apply only to the extent that amounts received before the annuity starting date, when added to all other amounts previously received under the contract after 1986, exceed the employee’s investment in the contract as of December 31, 1986.10 If employee contributions are transferred after May 5, 1986 from a plan that permitted in-service withdrawals to another plan permitting such withdrawals, the pre-1987 investment in the contract under both plans continues to qualify for this grandfather treatment. If the transferor plan did not permit such in-service withdrawals, only the pre-1987 investment in the contract under the transferee plan qualifies.11

      An employee who cashed out prior to 1986 and buys back after 1986 cannot use the grandfather rule because there is no pre-1987 investment in the contract. Even if the cash-out occurs after 1986 and there was investment in the contract as of December 31, 1986, the cash-out causes a permanent reduction in the grandfathered investment that may not be restored by a later buy-back.12

      Where an employer amended its plan to provide that employees could receive distributions at their request, but not less than the minimum amounts that must be distributed by the applicable distribution date under IRC Section 401(a)(9), distributions were not annuity payments and there was no annuity starting date, so distributions were treated as amounts received before the annuity starting date and were subject to the grandfather rule of IRC Section 72(e)(8)(D).13

      Where a state’s defined benefit plan allowed eligible participants to elect optional retirement with Partial Lump Sum Distributions (“PLSDs”) and PLSDs were received within the window of eligibility specified in TAMRA ’88, Section 1011A(b)(11), the PLSDs were taxable, on a pro-rata basis under IRC Section 72(e), to the extent that they exceeded the recipient’s investment in the plan.14


      1. IRC Secs. 72(e)(8), 72(e)(2)(B).

      2. See IRC Sec. 72(e)(8).

      3. Notice 2016-39.

      4. Notice 87-13, 1987-1 CB 432, A-11, as modified by Notice 2000-30, 2000-1 CB 1266; Rev. Rul. 2002-62, 2002-2 CB 710.

      5. IRC Sec. 72(c)(4).

      6. IRC Sec. 72(d)(2).

      7. IRC Sec. 414(k)(2); Notice 87-13, 1987-1 CB 432, A-14. See also, Let. Ruls. 9618028, 8916081.

      8. Let. Rul. 9847032.

      9George v. U.S., 96-2 USTC ¶50,389 (Fed. Cir. 1996); Logsdon v. Comm., TC Memo 1997-8.

      10. IRC Sec. 72(e)(8)(D); see also Let. Ruls. 9652031, 8747061.

      11. Notice 87-13, 1987-1 CB 432, A-13. See also, Let. Ruls. 8829017, 8829006.

      12. Notice 89-25, 1989-1 CB 662, A-5, modified by Notice 2002-62.

      13. Let. Ruls. 200117044, 200117045.

      14. Let. Rul. 200114040.

  • 3960. What is an early distribution from a qualified plan, and what penalties relate to it?

    • Except as noted below, amounts distributed from qualified retirement plans before the participant reaches age 59½ are early or premature distributions subject to an additional tax equal to 10 percent of the amount of the distribution includable in gross income.1

      To the extent that they are attributable to rollovers from a qualified retirement plan or a Section 403(b) plan, amounts distributed from Section 457 plans (Q 3582) generally will be treated as distributed from a qualified plan, for purposes of the early distribution penalty.2

      The 10 percent penalty tax does not apply to distributions:

      (1) made to a beneficiary, or the employee’s estate, on or after the death of the employee;

      (2) attributable to the employee’s disability;3

      (3) that are part of a series of substantially equal periodic payments made at least annually for the life or life expectancy of the employee or the joint lives or joint life expectancies of the employee and his or her designated beneficiary, and beginning after the employee separates from the service of the employer (Q 3677);

      (4) made to an employee after separation from service during or after the year in which the employee attained age fifty-five, or age fifty for distributions to qualified public safety employees from a governmental plan as defined in IRC Section 414(d);4

      (5) made to an alternate payee under a qualified domestic relations order (Q 3907);

      (6) made to an employee for medical care, but not in excess of the amount allowable as a deduction to the employee under IRC Section 213 for amounts paid during the year for medical care, determined without regard to whether the employee itemizes deductions for the year;

      (7) made to reduce an excess contribution under a 401(k) plan (Q 3801);

      (8) made to reduce an excess employee or matching employer contribution, that is, an excess aggregate contribution (Q 3801);5

      (9) made to reduce an excess elective deferral (Q 3757);6

      (10) that are dividends paid with respect to stock of a corporation described in IRC Section 404(k) (ESOPs) (Q 3817);

      (11) made on account of certain levies against a qualified plan;7 or

      (12) that are qualified reservist distributions, which are distributions of elective deferrals made to reserve members of the U.S. military called to active duty for 180 days or more at any time after September 11, 2001. Reservists have the right to rollover the amount of any distributions to an individual retirement plan for two years following the end of active duty.8


      Planning Point: Note that many clients mistakenly believe that the penalty does not apply to certain distributions used to fund the purchase of the taxpayer’s home.  This exception applies only with respect to IRA distributions—the 401(k) rules do not provide for a similar exception.


      The IRS has approved three methods for determining what constitutes a series of substantially equal periodic payments in the exception discussed in (3) above. If the series of payments is later modified, other than because of death or disability, before the employee reaches age 59½, or if after the employee reaches age 59½, within five years of the date of the first payment, the employee’s tax for the year in which the modification occurs is increased by an amount equal to the tax that would have been imposed in the absence of the exception, plus interest for the deferral period. For an explanation of the calculation under each method, the definition of “modified,” and related rulings, see Q 3677.

      The exception for distributions pursuant to a QDRO (see (5) above) was not applicable where a participant took a distribution from the plan following a trade of other marital property rights for his or her spouse’s waiver of rights in his or her plan benefits.9

      Planning Point: A participant who separates from service during or after the year he or she attains age fifty-five but is not yet age 59½ should generally leave plan accounts in the plan if permitted rather than transferring or rolling the accounts to an IRA or other qualified plan. This allows the participant to take distributions from the account as permitted by the plan without being subject to the 10 percent tax. A transfer to an IRA would subject the money transferred to the 10 percent tax while a transfer to another qualified plan would subject it to the new plan’s restrictions on distributions and the 10 percent tax.

      A court determined that a distribution originating from an arbitration award was subject to the 10 percent penalty because the amounts attributable to the award were thoroughly integrated with benefits provided under the state retirement plan.10 The involuntary nature of a distribution does not preclude the application of the tax, provided that the participant had an opportunity, such as by a rollover, to avoid the tax.11

      The IRS has stated that the garnishment of an individual’s plan interest under the Federal Debt Collections Procedure Act to pay a judgment for restitution or fines as discussed in (11) above, will not trigger the application of the 10 percent penalty.12

      Planning Point: An individual who is facing an IRS levy against his or her plan benefit and who is not yet age 59½ should allow the IRS to follow through on the levy rather than voluntarily taking a plan distribution and paying it to the IRS in satisfaction of the unpaid taxes. A “voluntary” distribution would be subject to the 10 percent tax, whereas any amount distributed directly to the IRS pursuant to the levy would not. Martin Silfen, J.D., Brown Brothers Harriman Trust Co., LLC.

      The cost of life insurance protection included in an employee’s income (Q 3940) is not considered a distribution for purposes of applying the 10 percent penalty.13 The Civil Service Retirement System is a qualified plan for purposes of the early distribution penalty.14

      A plan is not required to withhold the amount of the additional income tax on an early withdrawal.15 Distributions that are rolled over (Q 3986 to Q 4009) generally are not includable in income, and, thus, the 10 percent penalty does not apply. In the case of a distribution subject to 20 percent mandatory withholding, the 20 percent withheld will be includable in income, however, to the extent required by IRC Section 402(a) or IRC Section 403(b)(1), even if the participant rolls over the remaining 80 percent of the distribution within the sixty day period (Q 4006). Thus, an employee who rolls over only 80 percent of a distribution may be subject to the 10 percent penalty on the 20 percent withheld.16


      1. IRC Sec. 72(t).

      2. IRC Sec. 72(t)(9).

      3. As defined in IRC Sec. 72(m)(7).

      4. IRC Sec. 72(t)(10) as modified by Pub. L. 114-26.

      5. See IRC Sec. 401(m)(7).

      6. IRC Sec. 402(g)(2)(C).

      7. Under IRC Sec. 6331.

      8. IRC Sec. 72(t)(2)(G).

      9O’Brien v. Comm., TC Summary Opinion 2001-148.

      10Kute v. U.S., 191 F.3d 371 (3d Cir. 1999).

      11Swihart v. Comm., TC Memo 1998-407.

      12. See Let. Rul. 200426027.

      13. Notice 89-25, 1989-1 CB 662, A-11.

      14Roundy v. Comm., 122 F.3d 835, 97-2 USTC ¶50,625, aff’g TC Memo 1995-298; Shimota v. U.S., 21 Cl. Ct. 510, 90-2 USTC ¶50,489 (Cl. Ct. 1990).

      15. General Explanation—TRA ’86, p. 716.

      16. See Treas. Reg. §§1.402(c)-2, 1.403(b)-2.

  • 3961. How is an employee taxed on postretirement distributions from a qualified plan?

    • The tax treatment of distributions received at or after retirement depends on the time and manner of distribution.

      If a distribution is rolled over to an IRA or other eligible retirement plan, taxation of the amounts rolled over is deferred until it is distributed in the future (Q 3986).

      If a lump sum distribution is made, it is subject to the treatment explained in Q 3962 and, in the case of net unrealized appreciation on employer securities, as explained in Q 3963.

      If an employee receives annuity payments, the benefits are taxed as explained in Q 616 and Q 621. The employee’s cost basis, if any, is determined under the rules set forth in Q 3964.

      If a distribution is received prior to age 59½, it may trigger the 10 percent penalty on early or premature distributions unless one of the exceptions applies (Q 3960).

  • 3962. What is a lump sum distribution? What special tax treatment is available for a lump sum distribution from a qualified plan?

    • A distribution is a lump sum distribution if it:

      (1) is made in one taxable year;

      (2) consists of the balance to the credit of an employee;

      (3) is payable on account of the employee’s death, after the employee attained age 59½, disabled or on account of the employee’s separation from service; and

      (4) is made from a qualified pension, profit sharing, or stock bonus plan.1

      The classification will be relevant to certain distributions of employer securities that consist of net unrealized appreciations.

      The distinction between lump sum distributions has become less important as fewer participants are able to use the pre-ERISA grandfather provisions for capital gain treatment of pre-ERISA accounts under a plan and certain income averaging rules that were repealed in 1986 (Q 626). The following discussion applies to the grandfathered tax treatment of certain participant accounts that are conditioned on a distribution constituting a lump sum distribution.

      Planning Point: The IRS has released a ruling that impacts whether pension plan sponsors are permitted to provide lump-sum distribution options to plan participants who are already receiving plan benefits via regular annuity payments.  The issue was whether, under the IRS required minimum distribution (RMD) rules, a lump-sum payment would constitute an impermissible increase in the payment amounts these participants were receiving.  In 2015, the IRS reversed its previous position allowing these lump-sum payments to participants in pay status and stated its intent to amend the RMD rules to prohibit the lump-sum option for participants already receiving annuity payments.  Now, the IRS has once again changed course and announced that, for the time being anyway, it is no longer planning to amend the RMD rules to prohibit lump-sum payments to pension plan participants already receiving annuity payments under the plan.2

      The same requirements apply to distributions to self-employed individuals, except that full distributions made after a self-employed person has become disabled are considered lump sum distributions, and distributions made on account of “separation from service” are not.

      The balance to the credit includes all amounts in the participant’s account, including nondeductible employee contributions, as of the first distribution received after the triggering event.3

      Certain eligible employees may elect ten-year averaging of certain lump sum distributions and special treatment of certain capital gains. For this purpose, an eligible employee is an employee who attained age fifty before January 1, 1986. Earlier IRC provisions that allowed for five year averaging of lump sum distributions were repealed for tax years beginning after 1999.

      Ten-year averaging. An eligible employee makes a special averaging election by filing Form 4972 with his or her tax return; the election may be revoked by filing an amended return.4 An eligible employee can make this election only once and it must apply to all lump sum distributions the employee receives for that year.

      Under ten-year averaging, the tax on the ordinary income portion of the distribution is ten times the tax on 1/10 of the total taxable amount, reduced by the minimum distribution allowance. 1986 tax rates must be used, considering the prior law’s zero bracket amount.5 Generally speaking, the larger the distribution, the less likely that ten-year averaging will be advantageous.

      Long-term capital gain treatment. An eligible employee also may elect capital gain treatment for the portion of a lump sum distribution allocable to his or her pre-1974 plan participation.6 This portion is determined by multiplying the total taxable amount by a fraction, the numerator of which is the number of pre-January 1, 1974 calendar years of active plan participation and the denominator of which is the total number of calendar years of active plan participation.

      For these purposes, the minimum distribution allowance is the lesser of $10,000 or one-half of the total taxable amount. This must be reduced by 20 percent of the total taxable amount in excess of $20,000. Thus, if the total taxable amount is $70,000 or more, there is no minimum distribution allowance. The total taxable amount is the amount of the distribution that exceeds the employee’s cost basis (Q 3964). The employee’s cost basis is reduced by any previous distributions excludable from his or her gross income.


      Planning Point: It is particularly important to pay attention to the exact terms of a lump sum offer when considering whether to accept.  Many plans offer a lump sum “window”, during which the participant must make a decision and may have an opportunity to revoke that decision.  However, once the window is closed, courts generally will not allow the participant to change the final decision made during the window.



      1. IRC Sec. 402(e)(4)(D).

      2. Notice 2019-18.

      3. Let. Ruls. 9031028, 9013009.

      4. Treas. Reg. §11.402(e)(4)(B)-1 (prior to removal in 2019).

      5. TRA ’86, Sec. 1122(h)(5); TAMRA ’88, Sec. 1011A(b)(15)(B).

      6. TRA ’86, Sec. 1122(h)(3).

  • 3963. How is net unrealized appreciation taxed when employer securities are distributed from a qualified plan?

    • Net unrealized appreciation (“NUA”) is the excess of the fair market value of employer securities at the time of a lump sum distribution over the cost or other basis of the securities to a qualified plan trust.1 Employer securities for this purpose include shares of a parent or subsidiary corporation.2

      If employer securities are distributed as part of a lump sum distribution (Q 3962) from a qualified plan, the net unrealized appreciation is excluded from the employee’s income at the time of distribution to the extent that the securities are attributable to employer and nondeductible employee contributions. Taxation of NUA following a lump sum distribution is deferred until the securities are sold or disposed of, unless the employee elects out of NUA treatment.3 The election is made on the tax return for the year in which the distribution must be included in gross income and does not preclude an election for special income averaging.4

      On a sale or other disposition of employer securities, the NUA amount is treated as long-term capital gain, regardless of the distributee’s actual holding period. The taxpayer’s basis in the stock is the same as the basis in the hands of the qualified plan trust; that is, it does not include the NUA amount.5 Gain accruing after distribution of the securities and before the later disposition of them is treated as long-term or short term capital gain, depending on the holding period after distribution.6 The distributee’s holding period begins the day after the day the plan trustee delivers the stock to the transfer agent with instructions to reissue the stock in the distributee’s name.7

      Planning Point: The portion of the fair market value of the employer securities in excess of their net unrealized appreciation and the amount of the participant’s after-tax contributions to the plan, if any, is included in income and potentially subject to the 10 percent tax, so that tax should be taken into account in determining whether and how much of the distribution should be rolled over to an IRA if the participant has not yet attained age 59½ and has separated from service before age fifty-five. Martin Silfen, J.D., Brown Brothers Harriman Trust Co., LLC.

      An employer’s shares, if acquired and credited to an employee’s account, still are considered employer stock, even if later transferred to the trust of an acquiring or subsidiary corporation.8 The basis does not change.9 The balance of the value of the stock is taxable to the recipient under the regular rules for taxing lump sum distributions (Q 3962).10

      Unrealized appreciation that is excluded from income is not includable in the recipient’s basis in the stock for the purpose of computing gain or loss upon a later sale or other taxable disposition.11 If part or all of the unrealized appreciation is excluded as something other than unrealized appreciation, only the part excluded as unrealized appreciation is not added to basis.12

      Unrealized appreciation realized on sale of the stock by the recipient of a distribution on account of the death of the employee or by a person inheriting the stock from the employee is income in respect of a decedent. As such, it is taxed as long-term capital gain and a deduction may be taken for the estate tax attributable to the inclusion of any part of the appreciation prior to distribution in the deceased employee’s estate.13

      Planning Point: In the case of divorce, be sure that the non-participant spouse has the QDRO drafted to specifically provide for an alternate payee to receive a pro-rata share of employer securities with the same cost basis; otherwise the ability to utilize NUA tax treatment may be lost. Many plans do not preserve this benefit for alternate payees in their sample QDRO language, so customized language may be required. Helen Modly,CFP, ChFC, Focus Wealth Management, Ltd.

      Planning Point: NUA treatment may not be the best option for a distribution of employer securities.
      Each situation should be analyzed based on factors including the amount of unrealized appreciation, the outlook for the employer’s securities, and whether the participant can pay the tax on the basis without selling some of the employer securities.

      NUA in employer securities distributed in other than a lump sum distribution is excludable only to the extent that the appreciation is attributable to nondeductible employee contributions.14 Thus, a rollover of employer securities to an IRA will preclude the taxpayer from receiving NUA treatment.

      A transfer to an IRA of less than all of a participant’s account under an ESOP, with a distribution of the balance to the participant, does not bar treatment as a lump sum distribution, however. The IRS determined that a participant could exclude the net unrealized appreciation on the stock distributed outright to the participant until the participant disposes of it.15

      Similarly, a participant who had received a series of substantially equal periodic payments (Q 3677, Q 3951) from his plan account prior to retirement was not precluded from treating a distribution of the remaining amounts, including stock, in his plan account as a lump sum distribution (Q 3959), nor from excluding net unrealized appreciation on the stock.16


      1. See Treas. Reg. §1.402(a)-1(b)(2)(i).

      2. IRC Sec. 402(e)(4)(E).

      3. See IRC Sec. 402(e)(4)(B).

      4. IRC Sec. 402(e)(4).

      5. Treas. Reg. §1.402(a)-1(b)(1)(i).

      6. See Treas. Reg. §1.402(a)-1(b); Notice 98-24, 1998-1 CB 929; see also Rev. Rul. 81-122, 1981-1 CB 202.

      7. Rev. Rul. 82-75, 1982-1 CB 116.

      8. Rev. Rul. 73-29, 1973-1 CB 198; Let. Rul. 201242019.

      9. Rev. Rul. 80-138, 1980-1 CB 87.

      10. See Rev. Rul. 57-514, 1957-2 CB 261.

      11. Treas. Reg. §1.402(a)-1(b).

      12. Rev. Rul. 74-398, 1974-2 CB 136.

      13. Rev. Rul. 69-297, 1969-1 CB 131; Rev. Rul. 75-125, 1975-1 CB 254.

      14. IRC Sec. 402(e)(4)(A).

      15. Let. Ruls. 9721036, 200038057.

      16. See Let. Rul. 200315041.

  • 3964. How is an employee’s cost basis determined for an interest in a qualified plan?

    • An employee normally will have no cost basis if a plan is noncontributory and does not provide life insurance protection.

      If life insurance protection has been provided under a cash value policy, the employee usually will have some cost basis, namely, the aggregate one year term costs that have been taxed to the employee, even though the plan is noncontributory.1

      A self-employed person who is an owner-employee cannot include in his or her cost basis the annual one year costs of life insurance protection under Table 2001 or previously under P.S. 58 (Q 3940), even though these costs were not deductible.2 No self-employed person, whether or not an owner-employee, can include in cost basis the cost of any health insurance features under the plan.

      A common law employee’s cost basis consists of:

      (1) total nondeductible contributions made by the employee if the plan is contributory and amounts contributed by an S corporation for years beginning before January 1, 1984, on behalf of a more-than-5-percent shareholder-employee in excess of the excludable amount;

      (2) the sum of the annual one year term costs of life insurance protection under Table 2001 or previously P.S. 58 (Q 3940) that have been includable as taxable income if payment is being received under the contract that provided the life insurance protection(Q 3944);

      (3) any other employer contributions other than excess deferrals (Q 3757) that already have been taxed to the employee, such as where a nonqualified plan was later qualified;

      (4) certain employer contributions attributable to foreign services performed before 1963; and

      (5) the amount of any loans included in income as taxable distributions (Q 3945).

      In addition, although amounts attributable to deductible employee contributions are not part of basis, it would seem they should be included in basis if benefits are received under the contract to the extent that they have been taxable to the employee because they were used to purchase a life insurance contract (Q 3944). This cost basis must be reduced by any amounts previously distributed to the employee that were excludable from gross income as a return of all or part of the employee’s basis.3

      A self-employed person’s cost basis consists of (1) the nondeductible 50 percent of contributions made before 1968, after subtracting the cost of incidental benefits, if any, such as waiver of premium and health insurance benefits, and, in the case of an owner-employee, the costs of life insurance protection under Table 2001 or previously P.S. 58 (Q 3940), (2) contributions on behalf of owner-employees under the three year average rule for determining contributions to level premium insurance and annuity contracts in excess of the deductible limit, in effect for years beginning before 1984, and (3) nondeductible voluntary contributions, if any, to a contributory plan.

      In addition, any amounts taxed to an individual because they were attributable to deductible voluntary employee contributions used to purchase life insurance, if benefits are received under the contract, probably should be included.


      1. IRC Sec. 61(a)(1); Treas. Reg. §1.61-2(a)(1).

      2. IRC Sec. 72(m)(2); Treas. Reg. §1.72-16(b)(4).

      3. IRC Sec. 72(f); Treas. Reg. §§1.72-8, 1.72-16(b)(4), 1.402(a)-1(a)(6), 1.403(a)-2. See also Rev. Rul. 72-149, 1972-1 CB 218.

  • 3965. When an employee dies before retirement, how is the employee’s beneficiary taxed on a single sum cash payment of the death benefit payable under the employee’s qualified plan?

    • If a death benefit is payable from the proceeds of a life insurance policy, the difference between the cash surrender value and the face amount is treated as death proceeds of life insurance, and is excluded from income under IRC Section 101(a), but only if the insurance cost under Table 2001, the insurer’s qualifying term rate, (or previously under P.S. 58 (Q 3940)) has been paid with nondeductible employee contributions or has been taxable to the employee.1 The balance of the proceeds, representing the cash surrender value, is treated as a distribution from the plan.2

      The following amounts may be subtracted from the cash surrender value and also excluded from gross income:

      (1) the sum of the annual term costs of life insurance protection previously taxed to the employee (Q 3944), but if the deceased was a self-employed owner-employee, the deceased’s beneficiary cannot subtract these costs even though they were not deductible by the owner-employee;

      (2) if the plan is contributory, the employee’s nondeductible contributions toward the cost of the insurance;

      (3) the amount of any loans included in the employee’s income as taxable distributions (Q 3945); and

      (4) any employer contributions other than excess deferrals (Q 3757) that have been taxed to an employee, including contributions in pre-1984 years on behalf of a more-than-5-percent shareholder-employee in an S corporation in excess of excludable amounts.

      The balance, if any, of the cash surrender value is taxable according to the rules applicable to lump sum distributions (Q 3962).

      If an employer has purchased an existing policy from an employee for contribution to the trust, or if an employee has contributed it directly to the trust, the transfer for value rule (Q 279) does not apply so long as neither the employer nor the trustee has the right to change the beneficiary. The IRS determined that there was no significant change in the beneficial ownership of the policy.3

      Similarly, if a trustee of one plan purchases a life insurance policy from the trustee of another plan, there is no transfer for value where the beneficiary is entitled to designate the beneficiary both before and after the transfer because there has been no change in beneficial ownership.4

      If a contract is a retirement income contract, and the cash surrender value before death equals or exceeds the face amount, no portion of the proceeds is excludable as death proceeds of life insurance.5 The annual term costs of life insurance protection previously taxed to the employee would be excludable, except by the beneficiary of an owner-employee.

      If the contract has been distributed to the employee before his or her death, the IRS has previously considered the proceeds entirely tax-exempt as life insurance proceeds, although the Tax Court has considered them taxable as proceeds payable under an annuity contract, because death occurs after the element of risk has disappeared.6

      If a contract distributed before death is subject to the definition of life insurance in IRC Section 7702 or IRC Section 101(f), the treatment of the death benefit would be as discussed in Q 65.

      If a death benefit is not from life insurance proceeds, the beneficiary may subtract and receive tax-free any nondeductible employee contributions, the amount of any loans included in income, and any employer contributions other than excess deferrals (Q 3757) that have been taxed to the employee. The balance, if any, of the death benefit, other than amounts attributable to deductible employee contributions, is taxable according to the rules applicable to lump sum distributions (Q 3962).

      A distribution to an employee’s beneficiary on account of plan termination, rather than on account of death, may not be treated as a lump sum distribution or as payment of an employee death benefit.7

      A beneficiary may be entitled to an income tax deduction for any estate tax attributable to the distribution (Q 3983).8


      1. Treas. Reg. §1.72-16(c)(4).

      2. IRC Sec. 72(m)(3)(C); Treas. Reg. §1.72-16(c).

      3. Rev. Rul. 73-338, 1973-2 CB 20; Rev. Rul. 74-76, 1974-1 CB 30.

      4. Let. Rul. 7844032.

      5Jeffrey v. U.S., 11 AFTR 2d 1401 (D. N.J. 1963).

      6. See Evans v. Comm., 56 TC 1142 (1971).

      7Est. of Stefanowski v. Comm., 63 TC 386 (1974).

      8. IRC Sec. 691(c).

  • 3966. How is a beneficiary taxed on life income or installment payments of a death benefit under a qualified plan when an employee dies before retirement?

    • If a beneficiary has no cost basis for the payments, each payment will be fully taxable as ordinary income when received. The beneficiary’s cost basis generally is the same as the employee’s cost basis (Q 3964). In the case of decedents dying before August 21, 1996, the $5,000 death benefit exclusion was included in the beneficiary’s cost basis.1

      If the beneficiary does have a cost basis, payments are subject to the rules that follow, depending on whether the death benefits come from life insurance proceeds.

      If death benefit payments do not come from life insurance proceeds, the beneficiary is taxed as the employee would have been taxed had the employee lived and received the periodic payments (Q 3959, Q 3960). The beneficiary’s cost basis, rather than the employee’s cost basis, is used. Depending on the annuity starting date, an exclusion ratio may have to be determined; if so, the beneficiary’s cost basis is used as the investment in the contract (for an explanation of the basic annuity rule and its application to various types of payments see Q 531 to Q 556). For annuities with a starting date on or before November 19, 1996, if a beneficiary elected the simplified safe harbor method for taxing annuity payments (Q 616) and increased the investment in the contract by any employee death benefit exclusion allowable, the beneficiary had to attach a signed statement to his or her income tax return stating that the beneficiary was entitled to such exclusion in applying the safe harbor method.2 After such date, if the annuitant is under age seventy-five, the simplified method is required, rather than optional.3 When more than one beneficiary is to receive payments under a plan, the cost basis, including the $5,000 exclusion, if available, is apportioned among them according to each beneficiary’s share of the total death benefit payments.

      If death benefit payments do come from life insurance proceeds, the proceeds are divided into two parts: the amount at risk, which are proceeds in excess of the cash surrender value immediately before death, and the cash surrender value.4

      The portion of the payments attributable to the amount at risk is taxable under IRC Section 101(d) as life insurance proceeds settled under a life income or installment option, as the case may be (Q 71). The amount at risk generally is prorated over the payment period, whether for a fixed number of years or for life, and the prorated amounts are excludable from the beneficiary’s gross income as a return of principal.

      Where payments are for life, the beneficiary’s life expectancy generally is taken from IRS unisex annuity tables V and VI (Appendix A).5

      The portion of the payments attributable to the cash surrender value is taxed in the same manner as any other periodic payments from a qualified plan.

      Example: The widow of an employee who died on June 1, 2020 elects to receive $25,000 of life insurance proceeds in ten annual installments of $3,000 each. The cash surrender value of the policy immediately before the insured’s death was $11,000. The employee made no contributions to the plan and the aggregate one-year term costs of life insurance protection that were taxed to the employee amounted to $940. The widow must include $1,506 of each $3,000 installment, computed in the following manner. 

      $25,000
      Cash value immediately before death 11,000
      Excludable as life insurance proceeds $14,000
      Portion of each installment attributable to lifeinsurance proceeds (14/25 of $3,000) $ 1,680
      Excludable as return of principal ($14,000 ÷ 10) 1,400
      Includable in gross income $ 280
       
      (If beneficiary is the surviving spouse of an employee who died before October 23, 1986, the $280 would be excludable under the $1,000 annual interest exclusion)
      Portion of each installment attributable to cash surrender value
      of the contract (11/25 of $3,000) $ 1,320
      Beneficiary’s cost basis ($940) $ 940
      Expected return (10 x $1,320) $13,200
      Exclusion ratio ($940/$13,200) 7.12%
      Amount excludable each year (7.12% of $1,320) $ 93.98
      Includable in gross income ($1,320 – $93.98) $ 1,226.02

      The beneficiary may be entitled to an income tax deduction for any estate tax attributable to the decedent’s interest in the plan (Q 3983).6 It would seem that the deduction would be prorated over the beneficiary’s life expectancy, in the case of life income payments, or over a fixed period, in the case of installment payments (Q 548).


      1. Rev. Rul. 58-153, 1958-1 CB 43.

      2. Notice 88-118, 1988-2 CB 450, obsoleted by Notice 98-2, 1998-2 I.R.B. 22 below.

      3. Notice 98-2, 1998-1 C.B. 266.

      4. Treas. Reg. §1.72-16(c).

      5. Treas. Reg. §1.101-7.

      6. IRC Sec. 691(c).

  • 3967. How is an employee’s beneficiary taxed on death benefit payments from a qualified plan when the employee dies after retirement?

    • If an employee had no cost basis for his or her interest, or has recovered his or her cost basis from benefits received during the employee’s life, all amounts received by the beneficiary will be fully taxable. The beneficiary may be entitled to an income tax deduction for any estate tax attributable to the employee’s interest in the plan.1

      Joint and Survivor Annuity

      The method of taxing survivor annuity payments to a beneficiary depends on how the employee was taxed (Q 616).

      If the employee was taxed on everything, the survivor annuitant will be taxed on everything as well.2

      If the employee was taxed under the three year cost recovery rule in existence with respect to annuities with starting dates prior to July 1, 1986, and had not recovered his or her full cost basis, the survivor will receive the guaranteed payments tax-free until the total of the employee’s and survivor’s tax-free receipts equals the employee’s cost basis; thereafter everything will be includable in gross income.3

      If the employee was taxed under regular annuity rules or under the safe harbor method, the survivor will continue with the same exclusion ratio,4 but if the employee’s annuity starting date was after December 31, 1986, no amount is excludable by the employee or beneficiary after the investment in the contract has been recovered.5

      Refund Beneficiary

      If the employee had a cost basis for the employee’s interest and had not recovered the full amount tax-free, a refund beneficiary under a life annuity with a refund or period-certain guarantee can exclude the balance of the cost basis from gross income (Q 616). Otherwise, everything received by the beneficiary is taxable.6

      If the beneficiary receives the refund in a lump sum distribution, the lump sum distribution rules apply (Q 3962). If the beneficiary surrenders an annuity contract that has been previously distributed to the employee, the payment does not qualify for lump sum treatment because it is not viewed as a distribution from the trust but as a payment in settlement of the insurer’s liability to make future payments.7

      If the beneficiary receives the refund in installments, the payments are taxable as ordinary income.

      If the refund beneficiary of a decedent whose annuity starting date was after July 1, 1986, does not fully recover the cost basis unrecovered at the decedent’s death, the refund beneficiary may take a deduction for the remaining unrecovered amount.8

      Installment Payments

      Where payments for a fixed period or of a fixed amount, not involving a life contingency, had commenced to the employee, tax consequences to the beneficiary can differ, depending on whether the installments are continued or are commuted and paid to the beneficiary in a lump sum.

      In addition, the balance, if any, of the lump sum payment is taxable under the lump sum distribution rules.

      If installments are continued, the method of taxing payments then will depend on how the employee was taxed (Q 616). If the employee was taxed on everything, the beneficiary also will be.9 If the employee was taxed under the three year cost recovery rule in existence for annuities with starting dates prior to July 1, 1986, and had not recovered his or her full cost basis tax-free, the beneficiary can exclude the balance from the first payments received. Thereafter, everything is taxable.10

      If the employee was taxed under regular annuity rules or under the safe harbor method, the beneficiary will continue to exclude the same portion of each payment from gross income.11

      If the annuity starting date was after December 31, 1986, the beneficiary can exclude amounts only until the investment in the contract has been fully recovered; thereafter, all amounts are included in income.12


      1. IRC Sec. 691(c).

      2. Treas. Reg. §1.72-4(d).

      3. Treas. Reg. §1.72-13.

      4. Treas. Reg. §§1.72-4, 1.72-5.

      5. IRC Sec. 72(b)(2).

      6. Treas. Reg. §1.72-11; Treas. Reg. §1.72-13.

      7. Rev. Rul. 68-287, 1968-1 CB 174.

      8. IRC Sec. 72(b)(3).

      9. Treas. Reg. §1.72-4(d).

      10. Treas. Reg. §1.72-13.

      11. Treas. Reg. §1.72-4(a).

      12. IRC Sec. 72(b)(2).

  • 3968. What general rules apply to withholding of income tax from qualified retirement plan benefits?

    • The withholding rules that apply to a distribution depend on whether it constitutes an eligible rollover distribution (Q 3988). An eligible rollover distribution from a qualified retirement plan is subject to mandatory income tax withholding at the rate of 20 percent unless the distribution is directly rolled over to an eligible retirement plan (Q 3990). An employee receiving an eligible rollover distribution may not otherwise elect out of this withholding requirement.1

      On the other hand, a recipient may elect out of withholding with respect to distributions that do not qualify as eligible rollover distributions.2 The amount to be withheld on periodic payments that are not eligible rollover distributions is determined at the rate applicable to wages.3 Non-periodic payments that are not eligible rollover distributions are subject to income tax withholding at the rate of 10 percent.4

      Withholding applies to amounts paid to a beneficiary of a participant as well as to the participant. Withholding does not apply to amounts that it is reasonable to believe are not includable in income.


      Planning Point: The IRS has released guidance providing that when a check for a fully taxable distribution from a qualified plan is mailed to a plan participant, but not cashed, it is considered to have been “actually distributed” from the plan and is taxable to the participant in the year of distribution.  The fact that the participant failed to cash the check is irrelevant.  Further, the failure to cash the check does not change the plan administrator’s withholding obligations with respect to the distribution and does not change the obligation to report the distribution on Form 1099-R (assuming the distribution exceeds the applicable reporting threshold).  Despite these findings, the IRS was careful to note that it continues to consider the issue of uncashed distribution checks in situations involving missing participants.5


      The maximum amount withheld cannot exceed the sum of the money plus the fair market value of property received other than employer securities.6 Thus, a payor will not need to dispose of employer securities to meet the withholding tax liability. Loans treated as distributions (i.e., deemed distributions) continue to be subject to withholding as non-periodic distributions at a rate of 10 percent. The IRS has stated that loans deemed to be distributions are not subject to the 20 percent mandatory withholding requirement because a deemed distribution cannot be an eligible rollover distribution. Where a participant’s accrued benefit is reduced or offset to repay a plan loan, such as when employment is terminated, the offset amount may constitute an eligible rollover distribution.7 Withholding is not required on the costs of current life insurance protection taxable to plan participants under Table 2001 or previously P.S. 58 (Q 3940).


      1. IRC Sec. 3405(c).

      2. IRC Secs. 3405(a)(2), 3405(b)(2).

      3. IRC Sec. 3405(a)(1).

      4. IRC Sec. 3405(b)(1).

      5. Rev. Rul. 2019-19.

      6. IRC Sec. 3405(e)(8).

      7. See Notice 93-3, 1993-1 CB 293.

  • 3969. When are the earnings of a qualified pension or profit sharing trust taxable to the trust or to participants? When does trust income constitute unrelated business income?

    • Normally, neither a participant nor a trust pays any tax on earnings on a trust because as long as the plan meets the requirements of IRC Section 401(a), the trust is tax-exempt under IRC Section 501(a). The tax exemption also applies to trusts of plans covering self-employed individuals.

      Trust income may be subject to income tax when it constitutes unrelated business income.1 For example, a plan has unrelated business income from a trade or business regularly carried on by the trust.2 This could occur when an exempt trust is a limited partner that receives unrelated business income to the same extent as if it were a general partner.3 A specific deduction of up to $1,000 is allowed against unrelated business income.4 Thus, a trust generally will pay income taxes when its unrelated taxable income exceeds $1,000.

      Income from any type of property will be taxable as unrelated business income if the property has been acquired with borrowed funds, that is, debt-financed property. Thus, income from plan assets subject to debt, such as life insurance with policyholder loans, may give rise to unrelated business taxable income.5

      Where a pension fund, in an attempt to increase the rate of return on three certificates of deposit, borrowed funds from a savings and loan with the three old certificates as collateral and was issued a new certificate in an amount equal to the borrowed amount, the net interest earned on the new certificate was income from debt-financed property.6

      An exempt trust or 501(c)(3) organization may be a shareholder in an S corporation (Q 3811). Ordinarily, such an interest would be treated as an interest in an unrelated trade or business; thus, items of S corporation income allocable to a plan could result in unrelated business income.

      An employee stock ownership plan (Q 3810, Q 3818) maintained by an S corporation is not treated as receiving unrelated business income on items of income or loss of the S corporation in which it holds an interest.7

      Employer securities purchased by an ESOP with borrowed funds do not give rise to unrelated business taxable income because the indebtedness that an ESOP incurs to purchase employer securities is inherent in the purpose of the trust’s tax exemption.8 Securities purchased on margin by a profit sharing trust and by a pension trust have been held to be debt-financed property.9

      Where a trust is taxed because of its unrelated business income, the tax rate is the rate applicable to trusts.10

      A trust’s earnings are not entirely tax-free, but are merely deferred until they are distributed or made available to participants or their beneficiaries.11


      1. IRC Sec. 511.

      2. IRC Sec. 512.

      3Service Bolt & Nut Co. Profit Sharing Trust v. Comm., 724 F.2d 519 (6th Cir. 1983).

      4. IRC Sec. 512(b)(12).

      5. See Siskin Memorial Found., Inc. v. U.S., 790 F.2d 480 (6th Cir. 1986), aff’g 603 F. Supp. 91 (E.D. Tenn. 1984); Henry E. & Nancy Horton Bartels Trust v. United States, 617 F.3d 1357 (Fed. Cir. 2010). See also Let. Rul. 7918095.

      6Kern County Elec. Pension Fund v. Comm., 96 TC 845 (1991).

      7. IRC Sec. 512(e)(3).

      8. Rev. Rul. 79-122, 1979-1 CB 204.

      9Elliot Knitwear Profit Sharing Plan v. Comm., 614 F.2d 347 (3d Cir. 1980).

      10. See IRC Sec. 511(b); Marprowear Profit Sharing Trust v. Comm., 74 TC 1086 (1980), affirmed without opinion (3d Cir. 1981).

      11. IRC Secs. 402(a), 403(a).

  • 3970. What is the tax treatment of trust assets that revert to a plan sponsor?

    • The fair market value of any property reverting to an employer from a qualified plan is includable in the employer’s gross income and generally is subject to a nondeductible excise tax.1 The basic rule is that the excise tax is equal to 50 percent and is imposed on the amount of reversion that is subject to income taxes. The 50 percent tax rate can be reduced to 20 percent if the employer establishes or maintains a qualified replacement plan, provides for pro rata benefit increases for generally all participants and certain beneficiaries, or is in Chapter 7 bankruptcy liquidation as of the termination date of the qualified plan. Where the entire reversion is paid to a qualified replacement plan, there is no reversion to the employer, the employer pays no income taxes on the amount of the reversion, and as a result there is no excise tax.

      A qualified replacement plan is any qualified plan established or maintained by the employer in connection with a qualified plan termination in which:

      (1) at least 95 percent of the active participants in the terminated plan who remain employed by the employer are active participants;

      (2) a direct transfer of assets is made from the terminated plan to the replacement plan equal to 25 percent of the maximum reversion that could have been received under prior law, reduced, dollar-for-dollar, by the present value of certain increases in participants’ accrued benefits, if any, made pursuant to a plan amendment adopted during the sixty day period ending on the date of termination and taking effect on that date, before any reversion occurs; and

      (3) the portion of the reversion transferred to a defined contribution replacement plan is allocated to participants’ plan accounts in the plan year in which the transfer occurs or is credited to a suspense account and allocated to participants’ accounts no less rapidly than ratably over the seven year period beginning with the year of the transfer.

      If any amount credited to a suspense account cannot be allocated to a participant’s account within the seven year period, such amount generally must be allocated to the accounts of other participants.2

      The IRS has determined that where the above requirements were met, amounts transferred to a replacement plan could be used to make employer matching contributions.3 If the entire surplus is transferred to a 401(k) plan that meets the requirements of a qualified replacement plan, the employer’s excise tax on the reversion will be eliminated.4 A profit sharing plan with a 401(k) feature also has been approved as a qualified replacement plan.5 None of the reversion, however, may be treated as employee salary deferrals.

      Any amount transferred to a qualified replacement plan is not includable in the employer’s gross income and is not treated as a reversion. No deduction is allowed with respect to the transferred amount.6

      An employer is considered to provide for pro rata benefit increases for generally all plan participants and certain beneficiaries under the terminated plan if (1) a plan amendment is adopted in connection with the termination of the plan, (2) the pro rata benefit increases have an aggregate present value of not less than 20 percent of the maximum amount that the employer would otherwise have received as a reversion, and (3) the pro rata benefit increases take effect immediately on termination of the plan.7

      Where a plan is amended to increase benefits in an effort to reduce the reversion, the benefits may not be increased, and amounts may not be allocated in contravention of the qualification requirements of IRC Section 401(a) or the IRC Section 415 limits (Q 3716, Q 3725, and Q 3861). Any such increases or allocations must be treated as annual benefits or annual additions under IRC Section 415.8 The employer is determined on a controlled group basis and the Secretary of the Treasury may provide that two or more plans may be treated as one plan or that a plan of a successor may be taken into account.9

      The tax applies to both direct and indirect reversions. An indirect reversion occurs where plan assets are used to satisfy an obligation of the employer.10

      An employer maintaining a plan must pay the tax, which is due on the last day of the month following the month in which the reversion occurs.11 Where money or property reverts to a sole proprietorship or partnership, the employer is the sole proprietor or the partners.

      A distribution to any employer by reason of a contribution made in error may be permitted if one of three criteria is met: a mistake of fact has occurred, the funds are being returned because of a failure of the plan to qualify initially, or the error arose from a failure of employer contributions to be deductible and the repayment is permitted by the terms of the plan document.

      A reversion from a multiemployer plan also will not be subject to the tax if made because of a mistake of law or the return of any withdrawal liability payment.12 ERISA exempts from the prohibited transaction rules the return of contributions or withdrawal liability payments if certain requirements are met.13

      A transfer of excess assets from a defined benefit plan to a defined contribution plan constitutes a reversion of assets to an employer if the assets were first transferred to the employer followed by a contribution to the defined contribution plan. Thus, excess assets are included in the employer’s income and subject to the penalty tax.14

      Although a qualified transfer of excess pension assets (Q 3829) from a defined benefit plan to an IRC Section 401(h) account of the plan is not treated as a reversion to the employer, any amount transferred and not used to pay for qualified current retiree health benefits must be returned to the transferor plan and generally is treated as a reversion subject to the 20 percent excise tax.15


      1. IRC Sec. 4980.

      2. IRC Sec. 4980(d)(2).

      3. Let. Ruls. 200045031, 9834036, 9302027.

      4. Let. Rul. 9837036.

      5. Let. Ruls. 9834036, 9252035.

      6. IRC Sec. 4980(d)(2)(B)(iii).

      7. IRC Sec. 4980(d)(3).

      8. IRC Sec. 4980(d)(4).

      9. IRC Secs. 4980(d)(5)(D), 4980(d)(5)(E).

      10. See, e.g., Let. Rul. 9136017.

      11. IRC Sec. 4980(c)(4).

      12. IRC Sec. 4980(c)(2)(B). See also Treas. Reg. 1.401(a)(2)-1; IRM 4.72.11.

      13. ERISA Sec. 403(c).

      14. Notice 88-58, 1988-1 CB 546; GCM 39744 (7-14-88).

      15. IRC Sec. 420(c)(1)(B).