Distribution options for defined-contribution plans: this two-part article examines issues and strategies to enhance the value of defined-contribution plans. Part II discusses rollovers and the order in which distributions should be taken.

• Author: Maloney, David M.
• Position: Part 2

EXECUTIVE SUMMARY

* A rollover distribution from a qualified plan may be used as a short-term loan.

* The PPA '06 allows tax-free charitable contributions out of traditional IRAs of up to $100,000 in 2007.

* When liquidating assets, consideration should be given to the source of the funds and the other used.

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This two-part article examines common strategies to enhance the value of defined-contribution retirement plans and distributions. Part I, in the May 2007 issue, identified the various types of qualified defined--contribution plans and applicable withdrawal restrictions. Part II, below, discusses various issues and strategies to consider when an account owner wishes to access assets invested in a qualified retirement account.

Rollover Loans

The taxpayer may find that certain of his or her retirement accounts can be used as a ready source of funds to meet short-term cashflow needs. A rollover (in contrast to a conversion) can be used to gain up to 60 days' use of the funds.

A rollover occurs when a distribution is made from a qualified retirement plan to an employee and the amount received is reinvested in another retirement plan (frequently an IRA) within a statutory period. Normally, a rollover or conversion occurs when an account owner transfers retirement assets from one account to another (e.g., when changing jobs). A conversion (or a direct rollover) occurs when the entire amount in a taxpayer's qualified retirement plan is transferred directly from the old plan (i.e., the distributing plan) to the new plan (i.e., a trustee to-trustee transfer without the taxpayer receiving cash or other property).

A benefit of a conversion, when compared with a rollover, is that it is not subject to withholding, while a rollover is subject to mandatory 20% withholding. (25) A benefit of a rollover, however, is that the taxpayer can effectively use the cash distribution as a short-term loan; a conversion cannot be so used, because the account owner never actually receives the assets. In a qualified rollover, the amount distributed to the taxpayer must be reinvested within 60 days. If only part of the distribution is reinvested within this period (i.e., a partial rollover), only that amount is eligible for rollover treatment. A distribution can be in the form of money or property. If in the form of property, it must be recontributed to a qualified retirement plan or traditional IRA to be eligible for rollover treatment. (26)

In deciding whether a rollover or conversion should be used, the key is whether the taxpayer is in need of short-term cash. If so, a rollover (i.e., cash distribution in the taxpayer followed by qualified reinvestment within 60 days) should be used. If cash is not needed, a conversion should be used, to avoid 20% withholding.

A taxpayer receiving a distribution from a qualified retirement plan can effectively use a rollover to borrow from the plan. Distributions can be reinvested in the distributing retirement plan (if it so permits) or in a traditional IRA (enabling deferral to continue). However, because 20% of the distribution is subject to mandatory withholding, the taxpayer will experience a temporary shortfall (from the time of the distribution to receipt of a tax refund). To determine the required contribution, the amount actually received by the taxpayer in the distribution must be grossed up to the full amount of the distribution (i.e., amount before 20% withholding).

Nonrollover Loans

One of the biggest limits to the rollover loan described above is that the participant has use of the money for no more than 60 days. If the taxpayer needs access to the funds for a longer period, his or her employer plan (e.g., Sec. 401(k) or 403(b) plan) may allow loans for up to limited amounts (e.g., the lesser of $50,000 or 50% of account accumulations). Because the loan proceeds are not taxed as income, the Sec. 72(t) early withdrawal penalty does not apply. Generally, no restrictions limit the use of the loan proceeds; however, a definite and limited repayment schedule is required. In contrast to a bank loan, the interest for the use of the loan proceeds is paid to the retirement account, thus benefiting the participant.

Charitable Contributions

The Pension Protection Act of 2006 (PPA '06) provides another distribution option for traditional IRAs. This provision can benefit both deductible traditional IRAs (basis equals zero) and nondeductible traditional IRAs (basis equals contributions made). This legislation allows a taxpayer to make charitable contributions out of traditional IRAs of up to $100,000 annually; any excess contributed over the taxpayer's IRA basis is excluded from gross income. (27) This provision applies for 2006 and 2007. Thus, a taxpayer who makes such a contribution will receive the following tax benefits:

1. Exclusion of...