The recession has left many individuals saddled with debt and strapped for cash to pay for large purchases or obligations, or simply to cover daily expenditures. Obvious sources of funds for large purchases or obligations are the client's pension and/or individual retirement accounts (IRAs). Using these without first seeking competent professional advice, however, may be costly.

DISTRIBUTIONS FROM QUALIFIED PENSION PLANS

Funds may be distributed from qualified pension plans to participants at various times and for various reasons: retirement (including early retirement), separation from service, attainment of a specified age, plan termination, or execution of a loan agreement. Regardless of the reason for or the timing of the distribution, the recipient will face a regular tax and possibly penalty and excise taxes on the distributed funds.

Regular Tax

The amount of the distribution subject to regular tax is the total distribution less the portion that the recipient contributed with previously taxed dollars, i.e., via after-tax payroll deductions. This taxable distribution is generally added to the recipient's other income and taxed at the individual's marginal tax rate for the year. Thus, the regular tax on the taxable distribution depends on the rate in effect when the distribution is received-presumably higher if the distribution takes place while the recipient is still working.

The IRC contains several special elections to mitigate the regular tax liability on qualified plan distributions. These elections, however, apply only if the distribution is a lump-sum distribution, whereby:

* All of the pension funds are distributed within a single taxable year;

* rolled over into another retirement fund; and

* The distribution is received after an employee is separated from service (i.e., quits, retires, is laid-off, or is fired from his or her job), reaches age 59, or dies; or, if self-employed, the recipient reaches age 59, dies, or becomes disabled.

The special relief provisions afforded recipients of such distributions are of two types: capital gain and averaging. The capital gain election allows the recipient to treat the portion of the distribution attributable to his or her pre-1974 participation in the plan as long-term capital gain. The averaging elections allow the recipient to use one of two averaging techniques (five-year and 10-year) to separately compute, on Form 4972, the tax on the lump-sum distribution treated as ordinary income. The separate tax is then added to the recipient's regular tax liability for the year of distribution.

Capital Gain Election. TRA 86 generally repealed the capital gain election, but it remains available to taxpayers who were age 50 before January 1, 1986. For such taxpayers, the long-term capital gain portion of their distribution is taxed at a flat 20% rate. For other taxpayers, the pre-1974 portion of the lump-sum distribution afforded capital gain treatment is phased out according to the schedule in Exhibit I and taxed like any other long-term capital gain, i.e., not at the flat 20% rate. Generally, this latter relief provision only benefits employees with unused capital losses to offset the capital gain portion of the distribution.

Five-year Averaging. An employee may elect five-year averaging for the ordinary income portion of a distribution if the employee is at least age 59 at the time of distribution and has been in the plan for at least five years before the year of distribution. The amount of the tax under the five-year rule equals five times the amount of tax a single individual would pay on one-fifth of the taxable distribution in excess of a "minimum distribution allowance." The IRC defines this "minimum distribution allowance" as the lesser of 1) $10,O00 or 2) one-half of the taxable distribution, reduced (but not below zero) by 20% of the amount of the taxable distribution in excess of $20,000. Under this definition, the mini- mum distribution allowance cannot ex- reed $10,000 and will become zero when the taxable distribution reaches $70,000.

Columns (1) and (3) of Exhibit 2 illustrate the computations required under the five-year averaging election. The difference between the two columns, $2,400 ($33,110-$30,710), reflects the additional benefit of electing capital gain treatment for the portion of the distribution attributable to pre-1974 service. If Taxpayer K had not opted for either of the elections, his or her total tax liability on taxable income of $175,000 ($150,000 lump-sum distribution plus $25,000 other taxable income) would have been $49,612. Thus, the five-year averaging election saves Taxpayer K $16,502 ($49,612 -$33,110) without the capital gain election and $18,902 ($49,612-$30,710) with the capital gain election.

Ten-year Averaging. TRA 86 generally eliminated the ten-year averaging election, but made it available for individuals turning age 50 before January 1, 1986. These individuals also must meet the five year averaging criteria--age 59 in the year of distribution and a participant for five years--to qualify for 10-year averaging.

Under the 10-year averaging election, the tax is computed in the same manner as under the five-year election, except the portion of the distribution treated as ordinary income is averaged over 10 years, rather than five, and is taxed at the generally higher 1986 individual tax rates, adjusted for the elimination of the zero bracket amount of $2,480. Columns two and four of Exhibit 2 illustrate this computation, with and without the capital gain election. Compared to the tax liability without these elections ($49,612), 10-year averaging saves Taxpayer K $21,292 ($49,612 - $28,320) without the capital gain election and $21,682 ( $49,612 - $27,930) with the capital gain election. These amounts represent an added savings of $4,790 ($21,292-$16,502) and $2,780 ($21,682-$18,902), without and with the capital gain election, respectively, when compared to five-year averaging.

Elections Not Always Beneficial. While Taxpayer K in Exhibit 2 benefitted from both the averaging and capital gain elections, not all taxpayers will reduce their tax liabilities with these elections. Under both five-year and 10-year averaging, tax is applied to each dollar of lump-sum distribution treated as ordinary income, except for a distribution totalling less than $70,000, which is exempt from tax to the extent of the minimum distribution allowance. No deductions are allowed for personal and dependency exemptions, itemized items, or the alternative post-1986 standard deduction or pre- 1987 zero bracket amount. Thus, a taxpayer with little or no income other than a lump-sum distribution may pay more with the averaging election than without it.

In addition, a taxpayer receiving a very large distribution may find that the averaging elections are not beneficial. Under five-year averaging, the benefit of the lowest tax rate is phased out for very large distributions, and under 10-year averaging, the higher pre-TRA 86 rates eliminate the benefits of averaging for large distributions.

Neither the averaging nor the capital gain election will benefit a taxpayer who has ordinary. losses--e.g., from the operation of a partnership or sole proprietorship, or theft or casualty losses---that offset the lump- sum distribution treated as ordinary income. Similarly, because the elections are one-time elections, they will not benefit a taxpayer who receives a larger lump-sum distribution in the future or who is in a substantially higher tax bracket when the future distribution is received.

The taxpayer who does not need distributed amounts other than for investment purposes, may find it more advantageous to forego the elections and roll over all or part of the distribution into an IRA or other qualified plan. Rollover provides the advantage of continued tax deferral on the rolled over amounts and the related earnings. Later distributions of the rolled over amounts then can be planned and timed to minimize the tax bite, including any penalties that might have applied in the year the lump-sum distribution was received (see penalty discussion later). Electing to roll over a lump-sum distribution, however, is not without piffalls. For example, partial roll overs disqualify the taxpayer from electing averaging or capital gain treatment for the remaining distributed and undistributed amounts in the plan. Similarly, as discussed later, IRA distributions do not qualify for averaging and capital gain election, and thus will be taxed as ordinary income when received, unless the IRA distribution is rolled over into a qualified plan before the final distribution is made. Rolling the distribution over into an IRA also means that the taxpayer cannot borrow or pledge the IRA assets without triggering a tax on the entire amount.

Penalty Tax

Sec. 72(t) imposes a 10% penalty on premature withdrawals included in ordinary income unless the distribution:

* Occurs after the participant reaches age 59, dies, becomes disabled, or separates from service after age 55;

* Is part of a series of substantially equal periodic payments over the lifetime of the participant or his or her beneficiary;

* Is used to pay medical expenses that are deductible under Sec. 213; or

* Is from certain employee stock ownership plans (ESOPs).

Since both averaging methods require that the taxpayer be at least age 59, taxpayers electing averaging avoid the 10% penalty tax under the first of these exceptions. The second exception--equal lifetime payments--is the one most widely used by younger taxpayers, and it has precipitated several recent IRS interpretations. IRS Notice 89-25 clarifies the meaning of equal payments by identifying three options for determining payments that the IRS will consider satisfactory. However, in PLR 9008073, the IRS ruled that these three methods are only examples of ways to derive substantially equal periodic payments. Other distribution methods also may satisfy the equal payment requirements of Sec. 72(t).

The various acceptable distribution methods give the taxpayer wide latitude in deciding how much cash to receive and how much to leave within the shelter of the retirement plan account. Further flexibility is provided b.v the IRS's position in PLRs 8752061 and 8946045 that aggregation of all plans for purpose of the annuitization exception is not required. For example, consider Taxpayer Z's situation in Exhibit 3.

This flexibility generally does not extend to changes in the distribution pattern once it begins. Under Sec. 72(t)(4), changing the payout pattern triggers the 10% penalty tax on all previous withdrawals made before age 59, plus interest on the tax for the deferral period time elapsing from the tax year the distribution otherwise would have been included in income until the distribution pattern changes. The penalty tax is not imposed, however, if the payout change occurs 1) more than five years after payouts begin and 2) after the taxpayer reaches age 59. For example, a taxpayer who begins receiving substantially equal payments at age 56, and changes the payout pattern at age 60, subjects all pre-age 59 withdrawals to the 10% tax plus interest. By waiting until age 61 to change the payout pattern, the taxpayer can avoid the penalty tax.

PLR 9103046 indicates that the prohibition against a change in the payout pattern does not prohibit a taxpayer from moving the account to another institution or to another investment vehicle via an IRA rollover, provided that certain conditions are met. The method of computing substantially equal payments must remain the same, and the taxpayer must arrange for a catch-up payout to cover any gap in payments that occurs when the funds are transferred to the new financial institution.

Excise Tax

To further discourage withdrawals from qualified pension plans, Sec. 4980A(b) imposes a nondeductible 15% excise tax on any "excess distribution" received by an individual in any one year. An excess distribution is defined as the total taxable distribution in excess of $150,000, as indexed under Sec. 4980A. Any 10% premature withdrawal penalty tax assessed on the distribution may be used to reduce the excise tax imposed. Additionally, a taxpayer may escape the 15% excise tax if the excess distribution is 1) made after the participant's death, 2) rolled over into another qualifying plan within certain time limits, 3) attributable to contributions by the participant, or 4) made under a divorce decree to a nonparticipant who includes the amount in his or her income.

Unlike the 10% penalty tax, the 15% excise tax applies to lump-sum distributions under both averaging elections. The $150,000 threshold for imposing the tax, however, may be increased five-fold and applied separately to the lump-sum distribution--i.e. rather than to the aggregate distributions from all plans. For example, the excise tax on an $800,000 lump-sum distribution in 1991 is $7,500 .15 x ($800,000-(5 x $150,000 threshold)), regardless of whether the taxpayer receives other distributions within the year. The other distributions will be subject to the regular $150,000 excise tax threshold.

Borrowing from Qualified Plans

Under Sec. 72(p), a loan to a plan participant from a qualified pension plan generally is treated as a taxable distribution, and thus, subject to regular tax and possibly penalty and excise taxes. The term "loan" includes direct and indirect receipts of funds from the plan, as well as the use of the plan as collateral for another loan.

Sec. 72(p) also provides two exceptions to the treatment of loans as taxable distributions:

* Loans with a five-year repayment period; and

* Home loans, with extended repayment period. The legislative history of Sec. 72(p) indicates that Congress also did not intend investments by a plan in participant mortgage loans to be treated as distributions under Sec. 72(p) if the investment is made in the ordinary course of the plan's investment program. The IRS, however, had ruled (PLR 9110039) that it will not accept a mortgage loan investment program as an exempt investment program for Sec. 72(p).

Loans With Five-year Repayment Period A taxpayer who agrees to repay, and actualy, does repay, a loan from a qualified plan within five years max, avoid having some or all of the loan treated as a taxable distribution. The amount that escapes distribution treatment, and thus avoids regular tax and penalty and excise taxes, is the lesser of 1) $50,000 or 2) the greater of $10,000 or one-half of the taxpayer's present benefit under the plan. Since 1986, the $50,000 limit has been subject to a "lookback" provision that reduces the $50,000 limit if the taxpayer has an outstanding loan balance during the year ending the day before the date of a new loan. This reduction amount is the excess of the highest outstanding loan balance during the one-year lookback period over the outstanding loan balance on the date of the new loan. In addition, since 1986, the taxpayer has had to amortize the loan balance equally over the loan period, making at least four payments per year, instead of making a single balloon payment at the end of the five-year loan period. The combined effect of the lookback provision and level amortization is to prohibit a taxpayer from borrowing $50,000--assuming his or her vested benefit was large enough--paying periodic interest, making no principal payment until the end of the fifth year, and then after repaying the loan, immediately borrowing another $50'000'leaving a constant $50,000 loan balance. Under current law, the taxpayer would have to repay the original five-year loan of $50,000 at the rate of $10,000 per year, and because of the lookback provision, would not be able to borrow more until after more than one year's payments had been made on the first loan. For example, consider the illustration in Exhibit 4.

Home Loans. A loan used to acquire a dwelling unit that the taxpayer will use as a principal residence is not treated as a taxable distribution, regardless of the repayment term. However, a loan to purchase a second home, to make improvements to an existing residence, or to buy a home for other family members does not qualify for this extended, (i.e., greater than five years) repayment term. The amount of a home loan that will escape the distribution treatment and the related taxes is the same as a loan with a five-year repayment period, including the "lookback" provision reduction illustrated in Exhibit 4.

DISTRIBUTIONS FROM IRAS

Sec 408(d)(1) provides that withdrawals from IRAs are taxable in a manner similar to withdrawals from qualified pension plans under Sec. 72. Additionally, because they are defined as retirement plans under Sec. 4974(c), they may be subject to the 10% penalty tax and the 15% excise tax applicable to qualified pension plans.

Despite these similarities, important differences exist between the treatment of distributions from qualified pension plans and of distributions from IRA.s. First, an IRA distribution does not qualify for either the averaging or capital gain elections. Second, the IRA exceptions to the 10% premature withdrawal penalty tax do not include early retirement, medical expenses, and ESOP distributions. Third, if a participant borrows from his or her IRA or uses it as collateral for a loan, the IRA is "disqualified." For a borrowing, the entire value of the contract as of the first day of the taxable year of the disqualifying event, i.e., the borrowing, is included in the participant's gross income, and both the 10% penalty tax and the 15% excise tax may apply. If all or part of the IRA is pledged as security for a loan, only the portion used as security is treated as a distribution, subjecting it to regular tax and the premature withdrawal taxes. No exceptions comparable to the five-year and home loan exceptions applicable to loans from qualified retirement plans apply to IRA borrowings. However, once a year, IRA funds may be accessed for a 60-day period without triggering taxable income or penalty (TAM 9010007).

ASSISTING EMPLOYEES WITH LIQUIDITY NEEDS

The tax provisions governing distributions from qualified retirement plans suggest that employers could help employees with pressing liquidity needs by amending their plans to allow for early retirement and participant loans. Employers also could help by making employee relocation loans directly from general company assets.

An early retirement clause will provide employees an additional means of preventing the 10% premature withdrawal penalty. The effective cost of this option to the employer is largely a function of the effect of losing the services of employees before their scheduled retirement date.

The amendment authorizing employee loans may benefit more plan participants than the early retirement clause. The cost to the employer of administering this loan program, however, may be relatively high, especially at the outset.

Employee Relocation Loans

Interest-free or below-market loans may satisfy the liquidity needs of certain employees. These loans, however, must be carefully structured to take advantage of the tax laws. Sec. 7872 generally recharacterizes such loans as taxable compensation income to the employee and deductible compensation expense to the employer in an amount equal to the foregone interest.

The regulations under Sec. 7872 provide an exception to this recharacterization: mortgage and bridge loans that are "compensation- related" and secured by or used to buy a new principal residence acquired in connection with transfer of the employee to a new principal place of work. The terms, "new principal residence" and "new principal place of work," have the same meaning as they do under Sec. 217, which governs the deductibility of moving expenses. Thus, the employee must qualify, for the moving expense deduction under Sec. 217 to avoid recharacterization of the loan as compensation.

TAKING ADVANTAGE OF ESCAPE ROUTES

A liquidity--strained employee may be in that position for various reasons, but for illustrative purposes, consider the situation of Jim Jones, age 56, who in 1991 moves with his daughter, Kelly, from Phoenix, Arizona, to New York City because of an internal transfer with his company. Kelly applies and is accepted for admission as a freshman at Columbia University. Although Jim has not previously owned a principal residence, he finds an attractive apartment at a more than reasonable price of $650,000 that he wants to purchase.

Jim obviously has both immediate and long-term liquidity needs in trying to finance both Kelly's education and the apartment purchase. Jim has a vested balance of $325,000 in his employer's qualified pension plan and personal IRAs totaling $75,000. Although Jim is not an officer, director, or owner-employee of his company, top management has agreed to work with him in any reasonable way to utilize the pension funds and otherwise secure funding needed for Kelly's education and the apartment purchase.

Use of Pension Funds

Since Jim has not reached the age of 59, he will not qualify for the special lump-sum distribution election that could lower his tax liability--i.e., averaging and capital gain elections. The funds he withdrew in 1991 will be subject to regular tax, using 1991 rates, the 10% penalty tax, and the 15% excise tax. If Jim's income already is subject to the highest tax rate for 1991, 31%, the marginal tax rate on the amount of funds withdrawn will range from 41% to 46%, depending on the effect of the excise tax.

Early Retirement If the qualified plan provides special treatment for early retirement, Jim can avoid the 10% penalty tax by taking early retirement upon the transfer. However, the tax rate on the withdrawal of plan assets still will be between 31% and 46%, depending on Jim's regular tax bracket and the extent to which the 15% excise tax affects him. Moreover, early retirement is not an economically viable alternative, because Jim is sacrificing employment and the liquidity it will provide for future mortgage and tuition payments, solely for tax reasons.

Borrowing From Plan Under the loan rules, Jim can borrow up to $50,000 from his plan, assuming he has no other outstanding loans, without any resulting tax. An), funds borrowed in excess of the $50,000 limit will be taxed as discussed previously.

Assuming a fair rate of interest on the loan, Jim will be able to deduct the amount of interest paid if the loan is used to acquire the apartment, his principal residence. Since a qualified retirement plan is an exempt organization under Sec. 501(a), this interest will not be taxable income to the plan. Jim also will have an extended period of time to pay back the loan.

Use of IRA Funds

Any withdrawal from Jim's IRAs will result in a marginal tax ranging from 41% to 46%, depending on the effect of the excise tax and assuming he already is in a 31% tax bracket. If all funds are needed, he may either borrow or withdraw them, basing his decision on interest tradeoffs. If only a portion of the funds are needed, he may use one or more of the IRAs as collateral for loans from other conventional sources. This latter tactic mitigates the risk of disqualifying the IRKs and being taxed on the entire balance, $75,000.

If Jim can tap other sources for his immediate cash needs--apartment down payment, closing costs, and Kelly's tuition for the first term--he may want to use his IRKs to establish a future cash f1ow stream of substantially equal payments-thereby avoiding the 10% early withdrawal penalty tax. The funds received each year from the IRKs then can be used to satisfy periodic mortgage and tuition payments.

Assistance from Employer

Since Jim will qualify for a moving expense deduction under Sec. 217, a properly-structured employee relocation loan may be the most tax beneficial alternative for alleviating Jim's liquidity needs. As previously discussed, the loan must meet certain criteria to avoid having the interest break treated as taxable compensation.

YearDistributionDistributionTreated

ReceivedasCapitalGain(%)

1987100

198895

198975

199050

199125

19920

Ray A. Knight, JD, CPA, and Lee G. Knight, PhD, are Professors at Middle Tennessee State University. They have previously published articles in professional publications, including The CPA Journal.