Loans Treated as Distributions
If you borrow money from an employer's qualified pension or annuity plan, tax-sheltered annuity program, or government plan, you may have to treat the loan as a nonperiodic distribution. This also applies if you borrow from a contract purchased under any of these plans. You must treat the loan as a deemed distribution unless the exception explained below applies. This means that you may have to include all or part of the amount borrowed in your income under the rules discussed earlier.
This treatment also applies to the value of any part of your interest in any of these plans that you pledge or assign (or agree to pledge or assign). Further, it may apply if you renegotiate, extend, renew, or revise a loan that qualifies for the exception explained below. If the altered loan no longer qualifies for the exception, you must treat the outstanding balance of the loan as a distribution on the date of the transaction.
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Exception for loans repayable in 5 years and home loans. If by the terms of the loan described above you must repay it within 5 years (and you do not extend it by renegotiation or other means), only part of the loan might be treated as a distribution. A loan you use to buy your main home does not have to be repaid within 5 years.
You treat the loan as a distribution only to the extent that the outstanding balances of all your loans from all plans of your employer and certain related employers exceed the lesser of:
- $50,000, or
- Half the present value (but not less than $10,000) of your nonforfeitable accrued benefit under the plan, determined without regard to any accumulated deductible employee contributions.
You must reduce the $50,000 amount above if you already had an outstanding loan from the plan during the 1-year period ending the day before you took out the loan. The amount of the reduction is your highest outstanding loan balance during that period minus the outstanding balance on the date you took out the new loan. If this amount is zero or less, ignore it.
Level payments required. This exception applies only if the loan terms require substantially level payments made at least quarterly over the life of the loan.
Related employers and related plans. Treat separate employers' plans as plans of a single employer if they are so treated under other qualified retirement plan rules because the employers are related. You must treat all plans of a single employer as one plan.
Employers are related if they are:
- Members of a controlled group of corporations,
- Businesses under common control, or
- Members of an affiliated service group.
An affiliated service group generally is two or more service organizations whose relationship involves an ownership connection. Their relationship also includes the regular or significant performance of services by one organization for or in association with another.
Denial of interest deduction. If the loan from a qualified plan is not treated as a distribution and the exception applies (as discussed earlier), you cannot deduct any of the interest on the loan during any period that:
- The loan is secured by amounts from elective deferrals under a qualified cash or deferred arrangement (section 401(k) plan) or a tax-sheltered annuity, or
- You are a key employee as defined in Internal Revenue Code section 416(i).
Loans from nonqualified plans. The following explanation applies to a loan from a retirement plan that is not a qualified pension or annuity plan, tax-sheltered annuity program, or government plan.
If you borrow money from an annuity, endowment, or life insurance contract before the annuity starting date, you must treat the loan as a nonperiodic distribution. This treatment also generally applies to any part of the contract's value that you pledge or assign (or agree to pledge or assign) before the annuity starting date.
To figure how much of the amount borrowed or pledged must be included in your income, use the rules explained earlier under Distribution Before Annuity Starting Date From a Nonqualified Plan and the Exceptions to allocation rules. Increase your investment in the contract by the amount you include in your income, unless one of the exceptions applies to the distribution. In that case, reduce your investment in the contract by the amount you do not include in your income.
Transfers of Annuity Contracts
If you transfer without full and adequate consideration an annuity contract issued after April 22, 1987, you are treated as receiving a nonperiodic distribution. The distribution equals the excess of:
- The cash surrender value of the contract at the time of transfer, over
- The cost of the contract at that time.
This rule does not apply to transfers between spouses or transfers incident to a divorce.
No gain or loss is recognized if you exchange an annuity contract for another if the insured or annuitant remains the same. However, the gain on the sale of an annuity contract is ordinary income if the gain is due to interest accumulated on the contract. Gain due to interest is also ordinary income if the contract is exchanged for a life insurance or endowment contract.
If you transfer a full or partial interest in a tax-sheltered annuity that is not subject to restrictions on early distributions to another tax-sheltered annuity, the transfer qualifies for nonrecognition of gain or loss.
If you exchange an annuity contract issued by a life insurance company that is subject to a rehabilitation, conservatorship, or similar state proceeding for an annuity contract issued by another life insurance company, the exchange qualifies for nonrecognition of gain or loss. The exchange is tax free even if the new contract is funded by two or more payments from the old annuity contract. This also applies to an exchange of a life insurance contract for a life insurance, endowment, or annuity contract.
In general, a transfer or exchange in which you receive cash proceeds from the surrender of one policy and invest the cash in another policy does not qualify for nonrecognition of gain or loss. However, no gain or loss is recognized if the cash distribution is from an insurance company that is subject to a rehabilitation, conservatorship, insolvency, or similar state proceeding. For the nontaxable transfer rules to apply, you must also reinvest the proceeds in a single policy or contract issued by another insurance company and the exchange of the policies or contracts must otherwise qualify for nonrecognition. You must withdraw all the cash you can and reinvest it within 60 days. If the cash distribution is less than required for full settlement, you must assign all rights to any future distributions to the new issuer.
If you want nonrecognition treatment for the cash distribution, you must give the new issuer the following information:
- The amount of cash distributed,
- The amount of the cash reinvested in the new policy or contract, and
- Your investment in the old policy or contract on the date of the initial distribution.
You must attach the following items to your timely filed income tax return for the year of the initial distribution.
- A copy of the statement you gave to the new issuer, and
- A statement that contains the words "ELECTION UNDER REV. PROC. 92-44," the new issuer's name, and the policy number or similar identifying information for the new policy or contract.
If you acquire an annuity contract in a tax-free exchange for another annuity contract, the date of purchase of the annuity you acquired in the exchange is the date you purchased the annuity you exchanged. This rule applies for determining if the annuity qualifies as an immediate annuity and for the tax on early distributions.
If you receive a lump-sum distribution from a qualified retirement plan, you may be able to elect optional methods of figuring the tax on the distribution. The part from active participation in the plan before 1974 may qualify for capital gain treatment. The part from participation after 1973 (and any part from participation before 1974 that you do not report as capital gain) is ordinary income. You may be able to use the 5- or 10-year tax option, discussed later, to figure tax on the ordinary income part.
You can use these tax options to figure your tax on a lump-sum distribution only if the plan participant was born before 1936.
You may be able to figure the tax on a lump-sum distribution under the 5-year tax option even if the plan participant was born after 1935. You can choose this option for tax years beginning before the year 2000 only if the distribution is made on or after the date the participant reached age 59 1/2 and the distribution otherwise qualifies.
For tax years beginning after 1999, the 5-year tax option for figuring the tax on lump-sum distributions from a qualified retirement plan is repealed. However, a plan participant can continue to choose the 10-year tax option or the capital gain treatment for a lump-sum distribution that qualifies for the special treatment.
Lump-sum distribution defined. A lump-sum distribution is the distribution or payment of a plan participant's entire balance (within a single tax year) from all of the employer's qualified plans of one kind (pension, profit-sharing, or stock bonus plans). The participant's entire balance does not include deductible voluntary employee contributions or certain forfeited amounts.
The distribution is paid:
- Because of the plan participant's death,
- After the participant reaches age 59 1/2,
- Because the participant, if an employee, separates from service, or
- After the participant, if a self-employed individual, becomes totally and permanently disabled.
Reemployment. A separated employee's vested percentage in his or her retirement benefit may increase if he or she is rehired by the employer. This possibility does not prevent the distribution from qualifying as a lump-sum distribution. However, if an employee's vested percentage in benefits previously subject to lump-sum treatment increases after reemployment, the employee must recapture the tax saved by applying lump-sum treatment as provided by Treasury regulations.
Alternate payee under qualified domestic relations order. If you receive a distribution as an alternate payee under a qualified domestic relations order (discussed earlier under General Information), you may be able to choose the optional tax computations for it. You can make this choice for a distribution that would be treated as a lump-sum distribution had it been received by your spouse or former spouse (the plan participant). However, for this purpose, the balance to your credit does not include any amount payable to the plan participant.
More than one recipient. One or all of the recipients of a lump-sum distribution can use the optional tax computations. See Multiple Recipients of a Lump-Sum Distribution in the instructions for Form 4972.
Distributions that do not qualify. The following distributions do not qualify as lump-sum distributions.
- A distribution of your deductible voluntary employee contributions and any net earnings on these contributions. A deductible voluntary employee contribution is a contribution that:
- Was made by the employee in a tax year beginning after 1981 and before 1987 to a qualified employer plan or a government plan that allows such contributions,
- Was not designated by the employee as nondeductible, and
- Was not mandatory.
- U.S. Retirement Plan Bonds distributed with a lump sum.
- Any distribution made during the first 5 tax years that the employee was a participant in the plan, unless it was made because the employee died.
- The current actuarial value of an annuity contract included in a lump-sum distribution. (However, this value is used to figure tax on the ordinary income part of the distribution under the 5- or 10-year tax option method.)
- A distribution to a 5% owner that is subject to a penalty because it exceeds the benefits provided under the plan formula.
- A distribution from an IRA.
- A distribution of the redemption proceeds of bonds rolled over tax free to the plan from a qualified bond purchase plan.
- A distribution from a qualified plan if the plan participant or his or her surviving spouse previously received an eligible rollover distribution from the same plan (or another plan of the employer that must be combined with that plan for the lump-sum distribution rules) and the previous distribution was rolled over tax free to another qualified plan or to an IRA.
- A corrective distribution of excess deferrals, excess contributions, excess aggregate contributions, or excess annual additions.
- A lump-sum credit or payment from the Federal Civil Service Retirement System (or the Federal Employees Retirement System).
- A distribution from a tax-sheltered annuity.
- A distribution from a qualified plan if any part of the distribution is rolled over tax free to another qualified plan or IRA.
- A distribution from a privately purchased commercial annuity.
- A distribution from a section 457 deferred compensation plan of a state or local government or a tax-exempt organization.
How to treat the distribution. If you receive a lump-sum distribution from a qualified retirement plan, you may have various options for how you treat the taxable part. You can:
- Roll over all or part of the distribution. No tax is currently due on the part rolled over. See Rollovers, later.
- Report the entire taxable part of the distribution as ordinary income on your tax return.
- Report the part of the distribution from participation before 1974 as a capital gain and the amount from participation after 1973 as ordinary income (if you qualify).
- Use the 5- or 10-year tax option, discussed later, to figure the tax on the ordinary income part of the distribution (from participation after 1973) if you qualify. Report the capital gain part (from participation before 1974) on Form 4972, Part II (if you qualify).
- Use the 5- or 10-year tax option to figure the tax on the total taxable amount (if you qualify).
These various options are explained in the following discussions.
Electing optional lump-sum treatment. You can choose to use the 5- or 10-year tax option or capital gain treatment only once after 1986 for any plan participant. If you make this choice, you cannot use any of these optional methods for any future distributions for the participant.
Complete Form 4972 and attach it to your Form 1040 income tax return if you want to use the tax options. If you received more than one lump-sum distribution for a plan participant during the year, you must add them together in your computation.
If you and your spouse are filing a joint return and you both have received a lump-sum distribution, each of you should complete a separate Form 4972. Then add the separate taxes from the Forms 4972 and enter the total on line 40, Form 1040.
Time for choosing. You must decide to use the tax options before the end of the time, including extensions, for making a claim for credit or refund of tax. This is usually 3 years after the date the return was filed or 2 years after the date the tax was paid, whichever is later. (Returns filed before April 15 are considered filed on April 15.)
Changing your mind. You can change your mind and decide not to use the tax options within the time period just discussed. If you change your mind, file Form 1040X, Amended U.S. Individual Income Tax Return, with a statement saying you do not want to use the optional lump-sum treatment. You must pay any additional taxes due to the change with the Form 1040X.
Taxable and tax-free parts of the distribution. You may recover your cost in the lump sum tax free. In general, your cost consists of:
- The plan participant's total nondeductible contributions to the plan,
- The total of the plan participant's taxable costs of any life insurance contract distributed,
- Any employer contributions that were taxable to the plan participant,
- Repayments of loans that were taxable to the plan participant,
- The net unrealized appreciation in employer's securities distributed, and
- The death benefit exclusion, only if you are the beneficiary of a deceased employee who died before August 21, 1996. See Death benefit exclusion under Investment in the Contract (Cost), earlier.
You must reduce this cost by amounts previously distributed tax free.
The total taxable amount of a lump-sum distribution is the part that is the employer's contribution and income earned on your account.
Losses. You may be able to take a loss on your return if you receive a lump-sum distribution that is less than the plan participant's cost in the lump-sum. You must receive the distribution entirely in cash.
To claim the loss, you must itemize deductions on Schedule A (Form 1040). Show the loss as a miscellaneous deduction (subject to the 2%-of-adjusted- gross-income limit). The amount that you may claim as a loss is the difference between the participant's cost and the amount of the distribution.
Distributions of employer securities. If your distribution includes securities in the employer's corporation, these securities may have increased in value while they were in the trust. "Securities" includes stocks, bonds, registered debentures, and debentures with interest coupons attached. This increase in value is called "net unrealized appreciation" (NUA).
If the distribution is a lump sum, you are not taxed on the NUA when you get the securities, unless you elect to include it in your gross income in the year received.
If the distribution is not a lump sum, this tax deferral applies only to the extent the NUA in employer securities results from employee contributions. This treatment does not apply to a distribution based on deductible voluntary employee contributions (defined earlier). The NUA on which tax is deferred should be shown in box 6 of the Form 1099-R you receive from the payer of the distribution.
You can choose to be taxed on the NUA before you sell the securities. Make this choice on the tax return on which you have to include the distribution. If you choose to be taxed on the NUA and there is an amount in box 3 of the Form 1099-R, part of the NUA will qualify for capital gain treatment. See the instructions for Form 4972.
When you sell or exchange employer securities with untaxed NUA, any gain is long-term capital gain up to the amount of the NUA. Any gain that is more than the NUA is a long-term or short-term capital gain, depending on how long you held the securities after the distribution.