Retiree tax planning for eligible retirement plans of tax-exempt entities.

• Author: Blankenship, Vorris J.

Tax-exempt entities may establish as many as three types of tax-favored retirement plans. They may, of course, establish qualified retirement plans. They may also establish Sec. 403(b) plans, generally known as tax-sheltered annuities. The tax law treats distributions from qualified plans and tax-sheltered annuities similarly, a treatment generally familiar to tax practitioners.

Less familiar, though, is the tax treatment of distributions from eligible deferred compensation plans (eligible exempt entity plans) that most types of tax-exempt entities can establish. (1) These are unfunded plans (2) designed for select groups of management or highly compensated individuals ("top-hat" plans). (3)

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Though unfunded, eligible exempt entity plans may involve related trusts or other vehicles that invest amounts deferred under the plans and may give plan participants the right to choose among selected investments. However, all property rights in the deferred funds and related income (whether or not segregated or invested) must belong exclusively to the eligible exempt entity and must be subject 1 to the claims of the entity's creditors. (4)

Note that traditional nonqualified retirement plans are not a feasible alternative for eligible exempt entities. Unlike unfunded deferred compensation payable by a taxable entity, deferred compensation payable by an exempt entity under an ineligible plan is generally taxable as soon as it vests. (5)

Taxation of Plan Benefits

A retiree or beneficiary must include in gross income the entire amount of a payment from an eligible exempt entity plan in the year received. In addition, he or she must generally include amounts the plan makes available, whether or not actually paid. (6) However, the tax law limits how soon the plan may make amounts available and how late the plan may commence payments.

Earliest Date Payments May Begin

An eligible plan may generally make payments available to a participant only after:

* The date the participant is no longer employed by the eligible entity;

* The calendar year in which the participant reaches age 70 1/2; or

* The date the participant is faced with an "unforeseeable emergency."

The plan may also make payments available to a beneficiary after the participant's death. (7)

The terms of the plan should specify the exact date that plan funds first become payable on or after the occurrence of one of the above events. For example, many plans provide a date of payment that is a specified number of days after a triggering event (e.g., 90 days after retirement). Available funds are generally includible in gross income at that time, even if not paid then. (8)

Example 1: C retires on June 15, 2012, when she is age 65. Her plan provides for payment of the entire benefit 90 days after retirement. C does not make an election to further defer payment, and the plan does not provide a default payment schedule in the absence of an election. The entire benefit becomes taxable on September 13, 2012 (90 days after retirement), even if payment is delayed. Unforeseeable Emergencies

A special rule applies to unforeseeable emergencies. A participant need not include any amount in gross income merely because he or she may elect to receive plan funds for an unforeseeable emergency, if the participant does not actually make the election. (9)

An unforeseeable emergency is a severe financial hardship suffered by the participant or beneficiary due to accident or illness of the participant or beneficiary or that person's spouse or dependent. It also includes hardship due to casualty or other similar circumstances beyond the participant's control. (10)

For example, medical expenses or funeral expenses incurred by the participant or foreclosure on the participant's residence may give rise to an unforeseeable emergency. (11) Significant damage to the participant's home from a water leak is an unforeseeable emergency, as are expenses incurred for the funeral of an adult child (even if the child was not a dependent). However, the need to pay accumulated credit card debt is not an unforeseeable emergency. (12)

Note that distributions are allowed for an unforeseeable emergency only if they are necessary after taking into account all other reasonably available financial resources of the participant. (13)

Elections to Further Delay Payments

An eligible exempt entity may allow a retiree to elect an additional deferral of plan payments if the retiree makes the election before any payments are available. (14) A plan may also allow a second election to further delay payments if the retiree makes the second election before any payments are available under the initial election. (15) In addition, a plan may allow a retiree to elect the form of payment (i.e., the number and amount of payments) at any time before the payments begin under the elections. (16)

If the retiree does not make an initial election or does not elect the form of payment, the plan may provide for a default payment schedule. (17) Imposition of such a default payment schedule will not prevent a retiree from making a second deferral election. (18)

Plan benefits will not be taxable until they are available under the elections (or under the plan terms in the absence of an election). (19) Nevertheless, a plan participant may not use the elections to accelerate payments. (20) On the other hand, a participant may cancel or revise an initial deferral election within the election period allowed by the plan. (21)

Example 2: E retires on June 15, 2012, when he is age 60. His plan provides for payment of the entire benefit 91 days after retirement unless, within the 90-day period following retirement, E elects a later or different form of payment. On July 1, 2012 (16 days after retirement), E elects to defer the payment of benefits until age 62. However, E later changes his mind, and on September 1, 2012 (78 days after retirement), he makes a revised initial election to receive installment payments beginning at age 65. E made both the initial election and the revised initial election within the 90-day period following retirement. Consequently, the revised initial election is valid and the installment payments will be taxable when due, commencing on E's 65th birthday. Then, if the plan allows, E may make a second election at any time before payment is due under the initial election. (22)

Example 3: The facts are the same as in Example 2, except that E's plan also permits him to make a second election to delay payments. One week before E's 65th birthday (i.e., before installment payments are to begin under the revised initial election), he elects to further delay the start of payments until the day he reaches age 68. Under this second election, the installment payments will be taxable when due, beginning on E's 68th birthday. In Example 3, the plan could also provide that at any time before payments commence under the elections, the retiree may change the form of payment (e.g., from installment payments to a lump sum payable at age 68). (23) Furthermore, a plan may provide for the acceleration of installment payments in the event of an unforeseeable emergency. (24) However, if a retiree has an unconditional right to accelerate installment payments, he or she must immediately include all unpaid installments in gross income. (25)

Latest Date Distributions May Begin

An eligible plan must begin making minimum distributions to a retiree by a specified date, regardless of the plan's terms or the retiree's wishes. Normally, the specified date is April 1 of the year following the calendar year the retiree reaches...