Tax Withholding on Qualified Plan Distributions
Rev. 04/13/06, E-mail Alert 2006-7

General Requirements, Tax Code §3405
In general, the payor of benefits from a qualified retirement plan is required to withhold income tax from the portion of such distribution that is includable in the participant's gross income. Unless the distribution is an "eligible rollover distribution", the participant has the option to waive or request a different amount of income tax withholding.

Eligible Rollover Distributions, Tax Code §401(a)(31)
Eligible rollover distributions not directly rolled over to an "eligible retirement plan" are subject to a mandatory 20% federal income tax withholding requirement. (Eligible rollover distributions are not subject to withholding as periodic or nonperiodic payments, both of which are discussed below.)

An eligible rollover distribution is defined as any distribution from a qualified plan, a governmental 457(b) or a 403(b) arrangement that is NOT:

• One of a series of substantially equal periodic payments made at least annually over:
       The life of the employee or the joint lives of the employee and the employee’sm      designated beneficiary,
       The life expectancy of employee or the joint lives of the employee and the employee’s      designated beneficiary, or
       A specified period of 10 years or longer.
  
• A required minimum distribution under tax code section 401(a)(9).
  
• A corrective distributions of excess deferrals, excess contributions, excess annual additions, or refunds to ineligible participants, plus earnings.
  
• Loans that are deemed distributed.
  
• The cost of current life insurance protection (PS 58 cost).
  
• Any hardship distribution.
  
• A distribution to a payee other than the participant, surviving spouse or spouse or ex-spouse as alternate payee of a Qualified Domestic Relations Order (QDRO).
  
• A payment of dividends passed through under an ESOP.
  
• A distribution of cash in an amount of less than $200 for the year.

As noted above, the participant has the option under Code §401(a)(31) to directly roll or transfer all or part of an eligible rollover distribution to an "eligible retirement plan" [a qualified plan, IRA, 403(b), or governmental 457(b)] and thus avoid the 20% mandatory withholding on the amount that is rolled over.

Periodic Payments

1. Periodic payments are defined as a series of payments which do not qualify as annuities and are not "eligible rollover distributions" under Code §402(c)(4). These payments include installments that are payable not less frequently than annually for a period based on the life expectancy of the participant and, if elected, the participant's beneficiary or for a specified period of not less than 10 years. These amounts would also include any minimum distribution required under Code §401(a)(9).
   
2. Withholding is calculated as if payment were wages. If no withholding instructions are received, the payor is required to withhold an amount determined as if the individual were married claiming three withholding exemptions.
   
3. An participant may file a withholding certificate (W-4P or substitute W-4P) in which the participant opts for either no withholding or the individual may specify the amount or percentage to be withheld. This election may remain in effect until a new election is filed.
   

Nonperiodic Distributions

1. A nonperiodic distribution is a distribution from a qualified plan, 457(b) or 403(b) plan that is neither an eligible rollover distribution nor a periodic distributions. Note: all IRA distributions are considered to be nonperiodic distributions.
   
2. The participant may specify the amount to be withheld by filing a withholding certificate with the employer. The participant can also specify no withholding is to be taken out of the payment.
   
3. If no withholding instructions are received, the payor is required to withhold 10% of the distribution.
   
   

Notices

Periodic Payments
A tax withholding notice and right to elect withholding explanation must be provided to the participant not earlier than 6 months before the first such payment but not later than date of the first payment.

At least once a year, a notice and right to elect withholding or revoke withholding (W-4P or substitute W-4P) is to be provided. Administratively, this can be included with the balance statement mailed to the participant.

Nonperiodic Payments
The notice to elect to withhold or to waive withholding must be provided no later than the time of the distribution.

Eligible Rollover Distributions
The 402(f) notice must be provided between 30 and 90 days prior to the distribution. The 30-day waiting period may be waived by the participant. If the plan is subject to the Qualified Joint and Survivor Annuity (QJSA) rules, payment can be made seven days after the 30-day waiver is executed. Only if the plan is not subject to QJSA, may distribution occur as soon as possible after the 30-day waiver is signed and returned.

Other Withholding Scenarios
Corrective Distributions
Corrective distributions are not eligible rollover distributions and are generally not subject to periodic or nonperiodic withholding, unless taxed in the year of distribution. In such a case, these would be nonperiodic distributions withheld at 10%.

Withholding on Distribution of Employer Securities

Distribution consists entirely of employer securities.
If the distribution consists entirely of employer securities, no withholding is to be done. Even if the distribution is an eligible rollover distribution, there is no withholding.

Distribution consists partly of employer securities and partly of cash.
Compute the withholding based on the entire balance, including the employer securities but only withhold on the cash (not to exceed the total cash amount).

Death Benefits

Spouse Subject to 20% Withholding
The spouse is eligible to roll the funds over to his or her own name. Therefore, the eligible rollover distribution 20% mandatory rules apply to funds not directly rolled over.

Non-spouse Beneficiary
Non-spouse beneficiaries are subject to the nonperiodic withholding rules.

Withholding on QDRO Distributions
The normal withholding rules apply to distributions to alternate payees. Specifically, if the distribution is eligible for rollover, the 20% mandatory withholding applies.

If the distribution is not an eligible rollover distribution, then the nonperiodic or periodic rules will be used as applicable, however, this withholding may be waived by the alternate payee.

Withholding for Eligible Rollover Distributions That Contain a Loan Offset
Calculate the 20% on the total distribution paid to the participant which includes the value of any current loan(s) being offset (that were not previously reported as a deemed distribution).

The amount of withholding is the lesser of:

• 20% withholding on the total distribution (including the loan offset amount), or
  
• the amount of the taxable distribution remaining after the loan is offset.
  

Withholding on Non-Resident Aliens
The withholding rate on non-resident aliens is generally 30%. However, this depends on the treaty rate with the non-resident alien’s particular country. The treaty rates and information on Non-resident Withholding may be found in IRS Publication 515.

Additional IRS Resources:
IRS Publication 505
Form 1099-R Instructions
Code Section 3405

Bill Grossman, QPA