Income and Assets · Retirement income

Distributions from qualified and nonqualified plans

Any amount actually distributed by an employees’ trust described in § 401(a) and exempt under § 501(a) is taxable to the distributee in the year distributed, under § 72 (IRC § 402(a)). That single sentence carries the topic: everything else is about which part of the distribution is a return of after-tax money, and whether the taxpayer can defer the rest by moving it somewhere else.

The rule

Not every distribution can be rolled over. An eligible rollover distribution means any distribution of all or any portion of the balance to the employee’s credit, except a distribution that is one of a series of substantially equal periodic payments made at least annually over a life or joint lives or for a specified period of ten years or more; any amount required under § 401(a)(9); and any hardship distribution (IRC § 402(c)(4)(A)–(C)). Those three exclusions decide most rollover questions before any arithmetic starts.

Sixty days, with a safety valve. The rollover treatment does not apply to a transfer made after the 60th day following the day the distributee received the property (IRC § 402(c)(3)(A)) — but the Secretary may waive that requirement where enforcing it would be against equity or good conscience, including in cases of casualty or disaster (IRC § 402(c)(3)(B)).

Twenty percent leaves the plan unless the transfer is direct. For a designated distribution that is an eligible rollover distribution, the ordinary elective withholding rules do not apply and the payor must withhold twenty percent (IRC § 3405(c)(1)(A), (B)) — unless the distributee elects under § 401(a)(31)(A) to have it paid directly to an eligible retirement plan (IRC § 3405(c)(2)). This is the single most expensive trap in the topic, because a taxpayer who takes the cheque and intends to roll it over must replace the withheld amount from other funds within the sixty days or be taxed on it.

After-tax money comes out last on a rollover. Where a distribution is transferred under § 402(c), the amount transferred is treated as consisting first of the portion includible in gross income (IRC § 402(c)(2), closing sentence). So a partial rollover moves the taxable money and leaves the after-tax basis behind, which is usually what the taxpayer wants.

Annuity payments use a table, not a ratio. For an amount received as an annuity under a qualified employer retirement plan, § 72(b) does not apply; instead the investment in the contract is recovered by dividing it, as of the annuity starting date, by a number of anticipated payments taken from a statutory table keyed to the annuitant’s age at that date (IRC § 72(d)(1)(A), (B)(i), (iii)). A commercial annuity outside a qualified plan still uses the general exclusion ratio.

Nonqualified plans are a different regime. A nonqualified deferred compensation arrangement is governed by § 409A rather than by § 402, and the consequence of failure falls on the participant. There is no rollover, and no § 3405(c) withholding question, because there is nowhere for the money to go.

Two IRA-side rules travel with this topic. A qualified charitable distribution is excluded up to an annual limit, reduced by post-70½ § 219 deductions (IRC § 408(d)(8)(A)); and the spousal IRA in § 219(c) gives a non-earning spouse their own limit computed from the couple’s combined compensation — not a joint limit on a shared account.

Current figures

How it works in practice

Ask how the money is moving before anything else. A direct trustee-to-trustee transfer avoids the twenty percent withholding entirely and removes the sixty-day risk; a distribution paid to the taxpayer does neither. The difference costs nothing to arrange and is often not explained to the client by the plan, so it is worth raising the moment a rollover is mentioned rather than after the cheque arrives.

Where a cheque has already been issued, do the arithmetic out loud. To roll over the full balance the taxpayer must deposit the net amount received plus the withheld twenty percent, found from other resources, within sixty days. Rolling over only the net leaves the withheld portion treated as distributed — taxable, and exposed to the § 72(t) additional tax if no exception applies. The withheld money is not lost; it appears as a payment on the return, but that is a refund next April rather than funds in the account.

Establish whether the plan holds after-tax contributions. Older plans frequently do, and the ordering rule in § 402(c)(2) means a partial rollover carries the taxable money first — so basis can be isolated deliberately rather than diluted. The plan’s own records are the only source for that figure and are worth requesting before the distribution rather than after.

For a client already receiving annuity payments, check which method applies. The § 72(d) simplified method is mandatory for a qualified employer plan, and the divisor comes from the taxpayer’s age at the annuity starting date — a fact fixed years ago that has to be carried forward on every return thereafter.

How this has changed

The architecture here is settled, and the movement is in figures announced annually — the § 219(b)(5) contribution limit, the § 219(g) phase-out ranges, and the qualified charitable distribution limit.

That last one is worth stating carefully because the statute misleads. IRC § 408(d)(8)(A) still prints its original unindexed figure, and § 408(d)(8)(G) indexes it for taxable years beginning after 2023 — so the amount in the subparagraph has been wrong as a statement of the current limit every year since. Anyone reading the subparagraph without the adjustment will understate the exclusion.

The twenty percent withholding rule and the sixty-day period are statutory and have not moved, which makes older material reliable on the mechanics even where its figures are stale. The one thing that has changed around them is practice rather than law: direct trustee-to-trustee transfers are now routine where they once were not, so the population of taxpayers who receive a cheque and face the withholding problem has shrunk — but the consequence for those who still do is unchanged.

For nonqualified arrangements the change of substance was the arrival of § 409A, which is covered on the constructive receipt page. Material written before it understates the consequences of a failed deferral badly, and this topic attracts such material because § 402 itself is unchanged.

Exam focus

Know the three exclusions from the definition of an eligible rollover distribution, and that they do double duty — they take a distribution outside the rollover rules and outside the mandatory withholding.

Know that the withholding is twenty percent, that it is mandatory, and that the only way to avoid it is a direct payment to an eligible retirement plan under § 401(a)(31)(A). Expect a computation asking what must be deposited to defer the whole balance.

Know the § 402(c)(2) ordering rule — taxable money moves first — and be able to say why that helps a taxpayer with after-tax basis.

Know that the § 72(d) simplified method applies to qualified employer plans and uses a table of anticipated payments keyed to age at the annuity starting date.

Check yourself

1. A taxpayer receives a $50,000 eligible rollover distribution paid directly to them. What must they deposit to defer tax on the whole amount, and by when?

Answer: $50,000, within 60 days of receipt. IRC § 3405(c)(1)(B) requires the payor to withhold 20 percent, so the taxpayer receives $40,000 and must make up the $10,000 from other funds. IRC § 402(c)(3)(A) sets the 60-day limit, running from the day the distributee received the property, with a possible waiver under § 402(c)(3)(B).

2. Is a required minimum distribution subject to the 20 percent mandatory withholding?

Answer: no. IRC § 3405(c) applies only to an eligible rollover distribution, and IRC § 402(c)(4)(B) excludes from that term any distribution to the extent required under § 401(a)(9). The elective withholding rules in § 3405(a) and (b) apply instead, so the taxpayer may choose the amount withheld or elect out.

3. A plan balance of $300,000 includes $40,000 of after-tax contributions. The taxpayer rolls $260,000 to an IRA and takes $40,000 in cash. What is includible?

Answer: nothing from the cash. Where a distribution is transferred under IRC § 402(c), the amount transferred is treated as consisting first of the portion includible in gross income — so the $260,000 rollover absorbs all of the taxable money, and the $40,000 retained is the after-tax basis, received tax-free.

4. Which method recovers investment in the contract for annuity payments from a qualified employer plan?

Answer: the simplified method. IRC § 72(d)(1)(A) disapplies § 72(b) for an amount received as an annuity under a qualified employer retirement plan, and § 72(d)(1)(B)(i) recovers the investment by dividing it, as of the annuity starting date, by the number of anticipated payments from the table in clause (iii), which is keyed to the annuitant’s age at that date. The general exclusion ratio still governs a commercial annuity outside such a plan.