A person who is about to retire or who otherwise becomes eligible to receive benefits from an employer's tax-qualified retirement plan may have several options concerning the form the benefits will take.

The most common options are: 1) to leave the benefits in the plan to be distributed either in the form of an annuity or other installment payments beginning at retirement; or 2) to take the benefits in the form of a lump sum.

Annuity Payments. If the benefits are taken as an annuity or installment payments, they will be paid over the recipient's (and, perhaps, a beneficiary's) lifetime or for a fixed term of years. In either event, the benefits are taxed under the tax law's annuity rules.

In general, those rules require the entire amount of each periodic payment to be taxed where no employee contributions were made. If the employee contributed to the plan, the portion of each payment attributable to after-tax employee contributions is not taxable. The remainder is taxed. Several special rules and exceptions apply.

Lump-sum Distribution. Many plans provide for a recipient to elect to receive a distribution consisting of his or her entire interest in the plan. If such a lump-sum distribution is received at retirement or other termination of employment, after reaching age 59 1/2, or due to the employee's disability or death, the taxable portion of the distribution may qualify for special tax treatment.

Prior to TRA 86, a recipient of a lump-sum distribution could elect to use a favorable 10-year forward averaging method to calculate the income tax on the distribution. Very generally, forward averaging involved calculating the tax as if the distribution were received over ten years and resulted in a lower current tax on the lump sum.

TRA 86 retained forward averaging, but made a number of modifications:

* A five-year averaging period was substituted for the ten-year period.

* A recipient may elect to use forward averaging only if age 59 1/2 or older.

* Forward averaging may only be elected for one lump-sum distribution.

Pre-TRA 86 law also provided that plan distributions attributable to pre-1974 contributions were entitled to favorable capital gains treatment. TRA 86 phases out capital gains treatment until, for 1992 and later, no capital gains treatment will be allowed. (Due to the fact that capital gains are now taxed as ordinary income, there would appear to be little reason to elect capital gains treatment under the phase-out rules unless the recipient has capital losses that may be used to offset the gain.)

TRA 86 also provided generous transition rules for certain recipients of lump-sum distributions. If a recipient of a lump sum was age 50 or older on January 1, 1986, the recipient may choose between the old ten- year forward averaging method (using 1986's tax rates) and the new five- year averaging (using tax reform's generally lower rates). But a recipient may still only elect forward averaging once.

Similarly, recipients who were age 50 or older on January 1, 1986, may elect capital gains treatment for the eligible pre-1974 portion of the distribution, taxed at a 20% rate, without regard to the phase-out provision.

IRA Rollover. Recipients of lump-sum distributions have one more taxrelated option. Rather than having the distribution taxed in the year of receipt, the recipient may roll over all or part of the taxable portion of the lump-sum distribution to an Individual Retirement Account.

If all tax requirements are met (i.e., the rollover is completed within 60 days after receiving the distribution), the recipient pays no immediate tax on the amount rolled over or on any IRA earnings generated by that amount. When distributions are made from the IRA, they are taxed as ordinary income--no forward averaging or capital gains treatment is allowed. If only part of the taxable portion of the lump sum is rolled over, the remainder is taxed immediately--again, without the benefit of forward averaging or capital gain treatment.

Planning Strategies

What form of distribution--annuity-type or lump-sum--is best depends largely on particular financial circumstances. For many people, an annuity-type payout offers the highest level of retirement security. Moreover, the tax on the benefits is spread over the term of the payout.

But an annuity that has no inflation adjustment can be adversely affected by inflation over the longer term. In addition, the ultimate amount of tax that will be paid with respect to an annuity is unknown, since tax rates in future years cannot be predicted with accuracy.

Other individuals appreciate the flexibility they can achieve with a lump-sum distribution--both with respect to the use of the money and the tax treatment.

For those individuals who were age 50 or older on January 1, 1986, and who have the option of taking a lump-sum distribution, the tax alternatives should be carefully weighed. For example, such an individual has a choice between ten- and five-year averaging. Figure 1 compares the tax effects of each choice on distributions of various sizes.

For 1988, ten-year averaging was more favorable than five-year averaging until the taxable distribution is $473,700. For larger distributions, the five-year averaging method was preferable.

Generally, IRA rollovers are more attractive after tax reform, especially if the recipient is under age 59 1/2 at the time of the lump- sum distribution. The reason: forward averaging is not available prior to age 59 1/2 (unless the recipient was age 50 or older at the beginning of 1986, thus qualifying for the transitional role). Also, the tax law generally imposes a 10% early distributions tax (in addition to income tax) on distributions from a plan prior to age 59 1/2, with certain exceptions (described later on). Early lump-sum distributions rolled over to an IRA avoid this penalty tax.

Excise Tax on Excess Benefits

TRA 86 also imposed a 15% excise tax on "excess distributions" from tax-qualified retirement plans, tax-sheltered annuities, and IRAs. The purpose of the tax is to discourage the accumulation of extraordinary large retirement benefits.

In determining what is an excess distribution, aggregate annual distributions from all pension, profit-sharing, stock-bonus, and annuity plans, IRAs, and tax-sheltered annuities are taken into account, no matter the form of distribution. All distributions received during a year--under a life annuity, a term certain, or other benefit form--are considered in applying the tax.

Certain distributions are excluded:

* Amounts representing a return of an individual's after-tax plan contributions;

* Amounts rolled over to an IRA; and

* Amounts excluded from a participant's income as payments under a qualified domestic relations order.

Excess distributions are defined as the total amount of distributions during the year to the extent such amounts exceed the greater of $112,500 as adjusted for inflation or $150,000 with no inflation adjustments. The 15% tax is imposed on this excess.

A special limit applies where the individual receives a lump-sum distribution. The limit is five times the regular ceiling. Thus, up to $750,000 in the form of a lump-sum distribution may be exempt from the excess distributions tax.

Distributions made after a participant's death are not subject to the general excess distributions tax. Rather, the decedent's estate will be subject to an additional estate tax equal to 15% of the decedent's "excess retirement accumulation." In general, this is the amount by which the value of the decedent's retirement plan accumulations as of the date of death exceed the present value of an annuity of the greater of $112,500 (as adjusted for inflation) or $150,000 payable over the decedent's life expectancy immediately before death. The tax may not be offset by any estate-tax credits (e.g., the unified credit that is essentially equivalent to a $600,000 estate-tax exemption).

There was, however, a "grandfather rule" under which certain individuals could elect to exempt pre-tax-reform benefits from the excess distributions tax and the estate tax on excess retirement accumulations. An individual who, as of August 1, 1986, had accrued benefits under qualified plans with a present value of at least $562,500 could elect this grandfather rule. In essence, the benefits accrued as of August 1, 1986, could have been exempt from the tax. However, if the election was made, the $150,000 annual ceiling on distributions is not available; rather, the $112,500 ceiling, as indexed for inflation, must be used in determining the amount subject to the tax.

The election to use the grandfather rule had to have been made with a tax return for a year beginning no later than January 1, 1988. That means that the election had to be made with a timely filed 1988 tax return.

Early Distributions Tax

Prior to TRA 86, restrictions were imposed on withdrawals from tax- qualified plans that had to be met for the plan to remain tax-qualified. However, no direct penalty was generally imposed on the plan participant if the restrictions on withdrawals were violated. In the case of IRAs, a 10% penalty tax was applied--in addition to regular income tax--on "early" withdrawals from an IRA (essentially, withdrawals prior to the IRA owner's attaining age 59 1/2, dying, or becoming disabled). A similar 10% penalty tax was imposed on early withdrawals from a qualified plan by a 5% owner of the sponsoring employer.

TRA 86 extended the 10% penalty tax to early plan distributions made to any participant. Thus, recipients of early distributions from all tax-qualified plans, tax-sheltered annuities, and IRAs are subject to the penalty tax.

Example: An employee receives an early distribution of $50,000 from a noncontributory retirement plan. In addition to regular income tax on the distribution, a $5,000 early distributions penalty tax is payable.

There are exceptions to the penalty tax for distributions that are:

* Made to an employee after separation from service under plan provisions allowing early retirement at age 55;

* Certain distributions made prior to 1990 with respect to an Employee Stock Ownership Plan;

* Made in the form of "substantially equal payments" over a participant's life or the joint lives of the participant and a beneficiary;

* Amounts used for medical expenses, but not exceeding the amount deductible as medical expenses for income-tax purposes;

* Certain payments under qualified domestic relations court orders;

* Qualifying lump-sum distributions and are properly rolled over to an Individual Retirement Account or another qualified plan; and

* Certain distributions of excess deferrals under a 401(k) case or deferred plan.

The first two exceptions listed above do not apply to IRA distributions.

Example: Employee X, age 45, leaves his job to take a position with another company. He is entitled to take his vested benefits from his former employer's qualified retirement plan in a lump sum. If X takes the distribution (and doesn't roll over his distribution), X is subject to the 10% penalty tax on early distributions.

Example: Employee Y, age 57, elects to take early retirement from her employer under the early retirement provisions of her employer's retirement plan. Y receives the benefits in a lump sum. Because Y is age 55 or older and has met the plan's early retirement requirements, Y is not subject to the early distributions tax under the first exception listed above.

The expanded penalty tax on early distributions applies to all early distributions made in tax years beginning after 1986. There is an exception, for individuals who, as of March 1, 1986, separated from service and began receiving benefits under a written election that set out a specific schedule of benefit payments or began receiving benefits under an automatic form of payments.

Planning Strategy

Due to the early distributions tax, withdrawing funds from a retirement plan (other than at age 59 1/2 or under another exception to the penalty tax) should be avoided, where possible. The 10% tax can, when combined with income taxes, take a substantial portion of your retirement fund. Where an early distribution cannot be avoided and the distribution qualifies as a lump-sum distribution, an IRA Rollover can be used to avoid the penalty tax. The lump sum may be rolled over to the IRA and, then, "substantially equal payments" may be made from the IRA.

Required Distributions from Retirement Plans and IRAs

Just as there are tax rules governing the earliest time an individual can take retirement plan distributions, there are rules that dictate the latest time that plan distributions must begin.

Again, the required distribution rules have their basis in the pre-tax reform requirements for Individual Retirement Accounts. TRA 86 expanded the required distribution rules so that all qualified plans and IRAs are affected.

In general, distributions from qualified plans and IRAs must begin no later than April 1 of the year following the year in which the employee attains age 70 1/2.

Example: Employee turns age 70 1/2 in 1988. Employee must begin receiving retirement plan distributions on or before April 1, 1989, even if Employee continues to work for the sponsoring employer.

An employee who became 70 1/2 before 1988, and who is not a 5% owner of the plan sponsor, may defer distributions until retirement. Certain key employees under a "top-heavy" retirement plan (one in which more than 60% of benefits have accrued for key employees) can also delay distributions beyond age 70 1/2, provided specific requirements are met.

After the first distribution, minimum annual distributions must generally be made by December 31 of each year. Thus, in the above example, Employee must receive another minimum distribution by December 31, 1990.

Minimum distributions must be determined based on the life expectancy of the employee or the employee and a designated beneficiary. IRS regulations provide tables from which the calculations are made. If the required distributions are not made, a nondeductible excise tax of 50% of the amount of the minimum required distribution that was not actually distributed is imposed--a stiff penalty on the individual employee.

Example: Employee is required to take a minimum distribution of $15,000 for 1989. However, Employee only receives $10,000. Employee is liable for an excise tax of $2,500 (50% of $5,000).

Planning Strategies

The required receipt of distributions from a qualified plan or IRA is a concern to individuals who do not need the benefits at age 70 1/2 and who would prefer to keep the benefits protected from income tax in the plan or IRA.

While such individuals cannot completely avoid the minimum distribution rules, there is a way the effect of those rules may be reduced. The tax law allows the payout schedule to be "stretched out" by, essentially, adjusting the life expectancy figures each year.

Stretching out the minimum payout schedule has two basic advantages. First, it allows more of your benefits to stay in the plan or IRA, thereby extending the tax-deferred build-up of the fund. Second, by adjusting the life expectancy figures, there is greater assurance that the payouts will last throughout one's lifetime.

The payout schedule may be extended in two ways:

Recalculated Life Expectancy. A participant in a plan or IRA may recompute his or her life expectancy in each year he or she receives distributions. The IRS tables are adjusted for the fact that, the longer a person lives, the longer that person is expected to live under the actuarial assumptions. For example, under the IRS tables, a person age 72 has a life expectancy of 14.6 years (i.e., is expected to live to age 86.6). A person age 74 has a life expectancy of 13.2 years (i.e., is expected to live to age 87.2). The result of recalculating life expectancy is a reduction in the amount of the minimum distribution required each year.

Using Joint Life Expectancies. By calculating minimum distributions over the joint lives of the employee and the employee's designated beneficiary (a spouse, for instance), the minimum distributions are reduced. Using the joint life expectancy of a recipient and a younger spouse, for example, can stretch out the minimum payout schedule significantly.

The minimum payout schedule may be further extended by adjusting the joint life expectancy each year. Figure 1 Omitted