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The Taxman Cometh – Maybe

Lynn Knight

As Benjamin Franklin once said, “In this world nothing can be said to be certain, except death and taxes.” What if Ben was wrong about the taxes? What if there was a way to avoid paying taxes on amounts in a retirement plan? In fact, Mr. Franklin, there is a way to receive a tax-free distribution of amounts from a retirement plan through Designated Roth Contributions (DRCs) as long as certain conditions are met.

Let’s help Jane, a public school teacher at Elwood Middle School, determine how DRCs fit into her financial plan. In addition to her state retirement plan, Jane also participates in 403(b) and 457(b) retirement plans sponsored by her employer. Both plans have a DRC feature. As most of Jane’s retirement assets are contributed on a pre-tax basis, those amounts will be subject to federal income taxes (and potentially state income taxes) when distributed. By comparison, DRCs, which are made on an after-tax basis, could provide Jane with tax-free income in her retirement years.

So now that Jane has decided that tax-free income would fit into her financial plan, what does she need to know about DRCs? First, she must decide on the amount of her pay she wants to contribute to her 403(b) plan and/or 457(b) plan, both on a pre-tax basis and as DRCs on an after-tax basis. The total amount of annual pre-tax deferrals and DRCs she can make to each retirement plan is limited to $18,000 (in 2016) before any catch-up contributions.

Once Jane makes DRCs to her 403(b) plan and/or 457(b) plan, the next step is to ensure that she meets the criteria to receive a tax-free distribution of DRCs from her retirement plans. She must first keep the DRCs in the plans for at least five years. An important consideration for Jane is that the five-year holding period is determined separately for each retirement plan. So if she decides to make DRCs to both her 403(b) and 457(b) plans, she should start contributing DRCs to each plan as soon as possible in order to start the five-year holding period for each plan.

The second condition for Jane to receive tax-free distributions of DRCs is that the distribution can only be made:

1. to her after she reaches age 59½;
2. to her if she becomes disabled; or
3. to her beneficiaries after her death.

So, for example, if Jane retires at age 52, she would have to wait until she reaches age 59½ (assuming she has met the five-year holding period) in order to receive a tax-free distribution of DRCs.

What if Jane does not meet the five-year holding period or a distribution of DRCs is made before she reaches age 59½, becomes disabled or dies? First, any earnings on the DRCs are subject to federal (and potentially state) income taxes. In addition, the earnings on DRCs contributed to the 403(b) plan may be subject to the IRS 10% premature distribution penalty tax. Therefore, in order for Jane to take full advantage of the tax-free income provided by DRCs, she would need to pay special attention not only to the length of time that the DRCs are held in her retirement plans but also the reason for taking a distribution.

Utilizing DRCs could be a valuable part of an individual’s retirement income. However, as discussed in this article, the rules for qualified distributions for DRCs and the tax consequences for non-qualified distributions of DRCs are complex. Therefore, an individual who wishes to take advantage of DRCs available under their retirement plans should work with their tax advisor to ensure that s/he understands the requirements for a tax-free distribution and in the case of a distribution of DRCs that do not meet the criteria for a tax-free distribution (both the five-year holding period or reason for distribution), the potential tax consequences of a non-qualified distribution.

Lynn Knight is a member of Technical Services for Tax-Exempt Markets at Voya Financial. Lynn has worked extensively in the retirement plan field for a broad spectrum of defined contribution plans, including 403(b), 401(k) and 457(b) plans, both at law firms and with retirement service providers.

This material was created to provide accurate information on the subjects covered. It is not intended to provide specific legal, tax or other professional advice. The services of an appropriate professional should be sought regarding your individual situation. These materials are not intended to be used to avoid tax penalties, and were prepared to support the promotion or marketing of the matters addressed in this document. The taxpayer should seek advice from an independent tax advisor.

Opinions expressed are those of the author, and do not necessarily reflect the views of NTSA, or its members.