IRA PLANNING

TAKING TAX-FREE REQUIRED DISTRIBUTIONS

By Edward A. Slott

The IRS has ruled that certain 401(k) plan participants can totally avoid the tax on up to the first two years of required distributions, which would otherwise be taxable, by using after-tax contributions to satisfy the required amounts (PLR 9840041, published October 1998). For many, the first and second year tax savings will exceed $10,000.

New IRS Ruling

An employee with a 401(k) turned 70 years old on September 28, 1996. His 70 wQ year was 1997 and his required beginning date (RBD) was April 1, 1998. The balance of his 401(k) plan was $412,824, consisting of $350,040 taxable accumulations and $62,784 after-tax contributions. Before his RBD of April 1, 1998, he took a full distribution of the entire plan balance and rolled the taxable portion into an IRA. The $62,784 of after-tax contributions (not includable in income) was paid in a separate check to him but not rolled over. His after-tax money may not be rolled over into an IRA; there is no motivation to do so, because it is tax-free.

The distribution rules that apply to IRAs and qualified plans state that the first RBD must be made by April 1 of the year following the year during which the taxpayer turns 70 wQ , and the second required distribution must be taken by December 31 of that same year. In this case, the 401(k) owner's RBD was April 1, 1998. He determined that his first required distribution was $17,642 for the 1997 year and his second required distribution was $20,444 for the 1998 year, a total $38,086. The IRS ruled that since the $62,784 after-tax money withdrawn tax-free in early 1998 exceeded the total of the two required distributions, the tax-free withdrawal satisfied not only the first required distribution, but the second as well. Therefore, the first two required distributions were received totally tax-free.

The remaining funds rolled over to the IRA, and any other IRA balances that may exist are still subject to the regular taxable withdrawal rules. The bottom line is that, for the first two years, the IRS will give taxpayers a free ride by letting them apply after-tax money first to required distributions. This only works when the after-tax distributions are taken in a required distribution year, and only applies to the first two distributions. The remaining excess of the after-tax money cannot be used against the third year's required distribution. For example, in this case the excess of the $62,784 of after-tax money over the total of the first two years' required distributions of $38,086 cannot be credited against the third year's required distribution. The 1999 required distribution must be taken from the IRA and will be taxable.

Companies Must Be Informed

Some companies give participants three different checks for distributions from 401(k) plans in the first distribution year. The first check is the after-tax money. The second check is the amount of the first required distribution and would normally be taxable if not rolled over. The third check is the balance to be rolled over to an IRA. Using the amounts in the above IRS ruling, the $38,086 would have been taxed. Even at a modest 28% tax rate, that's $10,664. Many participants will save even more. Administrators of 401(k) plans must be alerted to issue two checks instead of three and let participants use after-tax money to satisfy required distributions. In order for this tax strategy to work, the first check should be for the after-tax money and the second the balance of the plan to be rolled over to an IRA.

Timing Is Everything

The key to getting a free ride for both the first and second required distribution years is to avoid taking a distribution until after the 70 wQ year, but before April 1 of the following year. *

Edward A. Slott, CPA, of E. Slott & Company, is the editor of Ed Slott's IRA Advisor , from which this article was adapted.

Editor:
Edward A. Slott, CPA
E. Slott & Company