Lump-Sum Distributions

If you receive a lump-sum distribution from a qualified employee plan or qualified employee annuity and the plan participant was born before 1936, you may be able to elect optional methods of figuring the tax on the distribution. The part from active participation in the plan before 1974 may qualify as capital gain subject to a 20% tax rate. The part from participation after 1973 (and any part from participation before 1974 that you do not report as capital gain) is ordinary income. You may be able to use the 10-year tax option, discussed later, to figure tax on the ordinary income part.

Use Form 4972 to figure the separate tax on a lump-sum distribution using the optional methods. The tax figured on Form 4972 is added to the regular tax figured on your other income. This may result in a smaller tax than you would pay by including the taxable amount of the distribution as ordinary income in figuring your regular tax.

Lump-sum distribution defined.   A lump-sum distribution is the distribution or payment in 1 tax year of a plan participant's entire balance from all of the employer's qualified plans of one kind (for example, pension, profit-sharing, or stock bonus plans). A distribution from a nonqualified plan (such as a privately purchased commercial annuity or a section 457 deferred compensation plan of a state or local government or tax-exempt organization) cannot qualify as a lump-sum distribution.

The participant's entire balance from a plan does not include certain forfeited amounts. It also does not include any deductible voluntary employee contributions allowed by the plan after 1981 and before 1987. For more information about distributions that do not qualify as lump-sum distributions, see Distributions that do not qualify under Lump-Sum Distributions in Publication 575.

How to treat the distribution.   If you receive a lump-sum distribution, you may have the following options for how you treat the taxable part.

• Report the part of the distribution from participation before 1974 as a capital gain (if you qualify) and the part from participation after 1973 as ordinary income.
• Report the part of the distribution from participation before 1974 as a capital gain (if you qualify) and use the 10-year tax option to figure the tax on the part from participation after 1973 (if you qualify).
• Use the 10-year tax option to figure the tax on the total taxable amount (if you qualify).
• Roll over all or part of the distribution. See Rollovers, later. No tax is currently due on the part rolled over. Report any part not rolled over as ordinary income.
• Report the entire taxable part of the distribution as ordinary income on your tax return.

The first three options are explained in the following discussions.

Electing optional lump-sum treatment.   You can choose to use the 10-year tax option or capital gain treatment only once after 1986 for any plan participant. If you make this choice, you cannot use either of these optional treatments for any future distributions for the participant.

Taxable and tax-free parts of the distribution.   The taxable part of a lump-sum distribution is the employer's contributions and income earned on your account. You may recover your cost in the lump sum and any net unrealized appreciation (NUA) in employer securities tax free.

Cost.   In general, your cost is the total of:

1. The plan participant's nondeductible contributions to the plan,
2. The plan participant's taxable costs of any life insurance contract distributed,
3. Any employer contributions that were taxable to the plan participant, and
4. Repayments of any loans that were taxable to the plan participant.

You must reduce this cost by amounts previously distributed tax free.

NUA.   The NUA in employer securities (box 6 of Form 1099-R) received as part of a lump-sum distribution is generally tax free until you sell or exchange the securities. (For more information, see Distributions of employer securities under Taxation of Nonperiodic Payments, in Publication 575.)

Capital Gain Treatment

Capital gain treatment applies only to the taxable part of a lump-sum distribution resulting from participation in the plan before 1974. The amount treated as capital gain is taxed at a 20% rate. You can elect this treatment only once for any plan participant, and only if the plan participant was born before 1936.

Complete Part II of Form 4972 to choose the 20% capital gain election. For more information, see Capital Gain Treatment under Lump-Sum Distributions in Publication 575.

10-Year Tax Option

The 10-year tax option is a special formula used to figure a separate tax on the ordinary income part of a lump-sum distribution. You pay the tax only once, for the year in which you receive the distribution, not over the next 10 years. You can elect this treatment only once for any plan participant, and only if the plan participant was born before 1936.

The ordinary income part of the distribution is the amount shown in box 2a of the Form 1099-R given to you by the payer, minus the amount, if any, shown in box 3. You also can treat the capital gain part of the distribution (box 3 of Form 1099-R) as ordinary income for the 10-year tax option if you do not choose capital gain treatment for that part.

Complete Part III of Form 4972 to choose the 10-year tax option. You must use the special tax rates shown in the instructions for Part III to figure the tax. Publication 575 illustrates how to complete Form 4972 to figure the separate tax.

Rollovers

If you withdraw cash or other assets from a qualified retirement plan in an eligible rollover distribution, you can defer tax on the distribution by rolling it over to another qualified retirement plan or a traditional IRA.

For this purpose, the following plans are qualified retirement plans.

• A qualified employee plan.
• A qualified employee annuity.
• A tax sheltered annuity plan (403(b) plan).
• An eligible state or local government section 457 deferred compensation plan.

You generally must complete the rollover by the 60th day following the day on which you receive the distribution from your employer's plan. (This 60-day period is extended for the period during which the distribution is in a frozen deposit in a financial institution.) For all rollovers to an IRA, you must irrevocably elect rollover treatment by written notice to the trustee or issuer of the IRA.

The IRS may waive the 60-day requirement where the failure to do so would be against equity or good conscience, such as in the event of a casualty, disaster, or other event beyond your reasonable control.

Eligible rollover distributions.   Generally, you can roll over any part of most nonperiodic distributions from a qualified retirement plan.

Rollover of nontaxable amounts.   You may be able to roll over the nontaxable part of a distribution (such as your after-tax contributions) made to another qualified retirement plan or traditional IRA. The transfer must be made either through a direct rollover to a qualified plan that separately accounts for the taxable and nontaxable parts of the rollover or through a rollover to a traditional IRA.

If you roll over only part of a distribution that includes both taxable and nontaxable amounts, the amount you roll over is treated as coming first from the taxable part of the distribution.

Hardship distributions.   Hardship distributions are no longer treated as eligible rollover distributions.

Additional exceptions.   For more information about exceptions to eligible rollover distributions, see Publication 575.

Direct rollover option.   You can choose to have the administrator of your old plan transfer the distribution directly from your old plan to the new plan (if permitted) or traditional IRA. If you decide on a rollover, it is generally to your advantage to choose this direct rollover option. Under this option, the plan administrator would not withhold tax from your distribution.

Withholding tax.   If you choose to have the distribution paid to you, it is taxable in the year distributed unless you roll it over to a new plan or IRA within 60 days. The plan administrator must withhold income tax of 20% from the taxable distribution paid to you. (See Pensions and Annuities under Withholding in chapter 5.)

If you decide to roll over an amount equal to the distribution before withholding, your contribution to the new plan or IRA must include other money (for example, from savings or amounts borrowed) to replace the amount withheld.

The administrator must give you a written explanation of your distribution options within a reasonable period of time before making an eligible rollover distribution.

Rollover by surviving spouse.   You may be able to roll over tax free all or part of a distribution from a qualified retirement plan you receive as the surviving spouse of a deceased employee. The rollover rules apply to you as if you were the employee. You can roll over a distribution into a qualified retirement plan or a traditional IRA.

A beneficiary other than the employee's surviving spouse cannot roll over a distribution.

Alternate payee under qualified domestic relations order.   You may be able to roll over all or any part of a distribution from a qualified retirement plan that you receive under a qualified domestic relations order (QDRO). If you receive the distribution as an employee's spouse or former spouse (not as a nonspousal beneficiary), the rollover rules apply to you as if you were the employee. You can roll over the distribution from the plan into a traditional IRA or to another eligible retirement plan. See Publication 575 for more information on benefits received under a QDRO.

Retirement bonds.   If you redeem a retirement bond, you can defer the tax on the amount received by rolling it over to an IRA or qualified employer plan as discussed in Publication 590. For more information on the rules for rolling over distributions, see Publication 575.

Special Additional Taxes

To discourage the use of pension funds for purposes other than normal retirement, the law imposes additional taxes on early distributions of those funds and on failures to withdraw the funds timely. Ordinarily, you will not be subject to these taxes if you roll over all early distributions you receive, as explained earlier, and begin drawing out the funds at a normal retirement age, in reasonable amounts over your life expectancy. These special additional taxes are the taxes on:

• Early distributions, and
• Excess accumulation (not receiving minimum distributions).

These taxes are discussed in the following sections.

If you must pay either of these taxes, report them on Form 5329. However, you do not have to file Form 5329 if you owe only the tax on early distributions and your Form 1099-R shows a 1 in box 7. Instead, enter 10% of the taxable part of the distribution on line 58 of Form 1040 and write No on the dotted line next to line 58.

Even if you do not owe any of these taxes, you may have to complete Form 5329 and attach it to your Form 1040. This applies if you received an early distribution and your Form 1099-R does not show distribution code 2, 3, or 4 in box 7 (or the code shown is incorrect).

Tax on Early Distributions

Most distributions (both periodic and nonperiodic) from qualified retirement plans and nonqualified annuity contracts made to you before you reach age 59½ are subject to an additional tax of 10%. This tax applies to the part of the distribution that you must include in gross income.

For this purpose, a qualified retirement plan is:

• A qualified employee plan,
• A qualified employee annuity plan,
• A tax-sheltered annuity plan, or
• A state or local government section 457 deferred compensation plan (to the extent that any distribution is attributable to amounts the plan received in a direct transfer or rollover from one of the other plans listed here).

5% rate on certain early distributions from deferred annuity contracts.   If an early withdrawal from a deferred annuity is otherwise subject to the 10% additional tax, a 5% rate may apply instead. A 5% rate applies to distributions under a written election providing a specific schedule for the distribution of your interest in the contract if, as of March 1, 1986, you had begun receiving payments under the election. On line 4 of Form 5329, multiply by 5% instead of 10%. Attach an explanation to your return.

Exceptions to tax.   Certain early distributions are excepted from the early distribution tax. If the payer knows that an exception applies to your early distribution, distribution code 2, 3, or 4 should be shown in box 7 of your Form 1099-R and you do not have to report the distribution on Form 5329. If an exception applies but distribution code 1 (early distribution, no known exception) is shown in box 7, you must file Form 5329. Enter the taxable amount of the distribution shown in box 2a of your Form 1099-R on line 1 of Form 5329. On line 2, enter the amount that can be excluded and the exception number shown in the Form 5329 instructions.

If distribution code 1 is incorrectly shown on your Form 1099-R for a distribution received when you were age 59½ or older, include that distribution on Form 5329. Enter exception number 11 on line 2.

The early distribution tax does not apply to any distribution that meets one of the following exceptions.

General exceptions.   The tax does not apply to distributions that are:

• Made as part of a series of substantially equal periodic payments (made at least annually) for your life (or life expectancy) or the joint lives (or joint life expectancies) of you and your designated beneficiary (if from a qualified retirement plan, the payments must begin after your separation from service),
• Made because you are totally and permanently disabled, or
• Made on or after the death of the plan participant or contract holder.

Additional exceptions for qualified retirement plans.   The tax does not apply to distributions that are:

• From a qualified retirement plan after your separation from service in or after the year you reached age 55,
• From a qualified retirement plan to an alternate payee under a qualified domestic relations order,
• From a qualified retirement plan to the extent you have deductible medical expenses (medical expenses that exceed 7.5% of your adjusted gross income), whether or not you itemize your deductions for the year,
• From an employer plan under a written election that provides a specific schedule for distribution of your entire interest if, as of March 1, 1986, you had separated from service and had begun receiving payments under the election,
• From an employee stock ownership plan for dividends on employer securities held by the plan, or
• From a qualified retirement plan due to an IRS levy of the plan.

Additional exceptions for nonqualified annuity contracts.   The tax does not apply to distributions that are:

• From a deferred annuity contract to the extent allocable to investment in the contract before August 14, 1982,
• From a deferred annuity contract under a qualified personal injury settlement,
• From a deferred annuity contract purchased by your employer upon termination of a qualified employee plan or qualified employee annuity plan and held by your employer until your separation from service, or
• From an immediate annuity contract (a single premium contract providing substantially equal annuity payments that start within one year from the date of purchase and are paid at least annually).

Tax on Excess Accumulation

To make sure that most of your retirement benefits are paid to you during your lifetime, rather than to your beneficiaries after your death, the payments that you receive from qualified retirement plans must begin no later than on your required beginning date (defined next).

Unless the rule for 5% owners applies, you must begin to receive distributions from your qualified retirement plan by April 1 of the year that follows the later of:

1. The calendar year in which you reach age 70½, or
2. The calendar year in which you retire.

However, your plan may require you to begin to receive distributions by April 1 of the year that follows the year in which you reach age 701/, even if you have not retired.

For this purpose, a qualified retirement plan includes a:

1. Qualified employee plan,
2. Qualified employee annuity plan,
3. Section 457 deferred compensation plan, or
4. Tax-sheltered annuity plan (for benefits accruing after 1986).

Age 70½.   You reach age 70½ on the date that is 6 calendar months after the date of your 70th birthday.

For example, if you are retired and your 70th birthday was on June 30, 2001, you were age 70½ on December 31, 2001. If your 70th birthday was on July 1, 2001, you reached age 70½ on January 1, 2002.

5% owners.   If you are a 5% owner of the company maintaining your qualified retirement plan, you must begin to receive distributions by April 1 of the calendar year that follows the year in which you reach age 70½, regardless of when you retire.

Required distributions.   By the required beginning date, as explained above, you must either:

• Receive your entire interest in the plan (for a tax-sheltered annuity, your entire benefit accruing after 1986), or
• Begin receiving periodic distributions in annual amounts calculated to distribute your entire interest (for a tax-sheltered annuity, your entire benefit accruing after 1986) over your life or life expectancy or over the joint lives or joint life expectancies of you and a designated beneficiary (or over a shorter period).

Additional information.   For more information on this rule, see Tax on Excess Accumulation in Publication 575.

Required distributions not made.   If you do not receive required minimum distributions, you are subject to an additional excise tax. The tax equals 50% of the difference between the amount that must be distributed and the amount that was distributed during the tax year. You can get this excise tax waived if you establish that the shortfall in distributions was due to reasonable error and that you are taking reasonable steps to remedy the shortfall.

State insurer delinquency proceedings.   You might not receive the minimum distribution because of state insurer delinquency proceedings for an insurance company. If your payments are reduced below the minimum due to these proceedings, you should contact your plan administrator. Under certain conditions, you will not have to pay the excise tax.

Form 5329.   You must file a Form 5329 if you owe a tax because you did not receive a minimum required distribution from your qualified retirement plan.

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