The 20% Withholding Rules

Administrative Retirement Services, Inc. 2 S. 545 IL Route 53 Glen Ellyn, IL 60137-7175 Phone: (630) 942-0010, Fax: (630) 942-0020 The 20% Withholding Rules Administrative Retirement Services, Inc. On July 3, 1992, Congress passed the Unemployment Compensation Act of 1992 ("the Act"). One of the surprise measures in the Act was the inclusion of a 20% withholding provision on distributions made from qualified plans. This new withholding provision ("the new rule") applies to all distributions from qualified plans, which are not immediately rolled into an Individual Retirement Account ("an IRA") or another qualified plan. The new rule is effective for distributions made after December 31, 1992. The justification for the withholding provision is to provide funding for unemployment benefits provided under the Act. This new rule will simplify some of the currently complex rules regarding rollovers. However, plan sponsors must make sure participants clearly understand its implications. The Internal Revenue Service ("the IRS") released temporary regulations on October 21, 1992. In addition, the IRS also released a Notice containing a model notice for plan sponsors to provide to participants which explains the new rule as well as other information also required by the IRS. Hopefully, the following discussion will help to clarify the new rule and answer any questions you may have. How does the new rule differ from the prior treatment of rollovers? Under the former rule, a distribution could only be rolled over if it was a qualified total distribution (the balance to the credit of the participant's account paid within one taxable year due to death, disability, attainment of age 59 1/2, separation from service or plan termination) or if the distribution was 50% or more of the participant's account balance. (The remaining portion of the account balance could not be rolled over at a later time.) The participant was required to rollover the distribution within 60 days of receipt to an IRA or another qualified plan. Under the new rule, all distributions, other than a few exceptions discussed below, may be rolled over within 60 days of receipt or may be directly transferred to an IRA or another qualified plan. The difference is that, if a participant chooses to receive his distribution and then roll it over within the 60-day period, he or she will be subject to the 20% withholding. As with the former rule, after-tax employee contributions cannot be rolled into an IRA or a qualified plan. How does the new rule work? The new rule requires any "distributee" of an eligible rollover distribution to directly transfer his or her account balance to an IRA or to the trustee of another qualified plan. A "distributee" includes a spouse or former spouse who is receiving a distribution under a Qualified Domestic Relations Order ("QDRO"), as well as a participant or beneficiary. These rollovers are considered to be a "direct rollover" and not a "trustee-totrustee transfer." If a distributee chooses not to have a direct rollover, the payor (i.e., the trustee or plan sponsor) must withhold 20% of the taxable amount of the distribution. There is a de minimis exception for distributions of $200 or less. In addition, employers may decide not to allow the direct rollover option for those participants with distributions under $500. Unlike current law, a participant may not waive the withholding requirement. Page 1 of 5

Are there any exceptions to the new law? Yes. The following types of distributions are not subject to the 20% withholding requirements: Payments over the life expectancy of the participant or joint life expectancies of the participant and his or her spouse. Payments made in substantially equal amounts in a period exceeding ten years. Minimum distribution requirements under Section 401(a)(9) of the Internal Revenue Code. Return of excess contributions, excess deferrals and excess aggregate contributions. PS 58 costs. Dividends paid on employer securities pursuant to Section 404(k). Deemed distributions on the default of plan loans. How is a direct rollover actually accomplished? A direct rollover can be accomplished in the following manner: 1. Direct rollover to an IRA a. Participant may receive a check provided the payee line of the check is made out in a manner that will ensure the check is negotiable solely by the trustee/custodian of the IRA. For example, "ABC Bank as Trustee of the IRA account of Joe Participant." b. Direct rollover made by means of an electronic transfer from the distributing trustee bank to a receiving trustee bank or by mailing a check from the distributing trustee bank to a receiving bank. 2. Direct rollover to another qualified plan a. Participant may receive a check provided the payee line of the check is made out in a manner that will ensure the check is negotiable solely by the trustee of the successor plan. For example, "Trustee of the XYZ Savings Plan for the benefit of John Doe." b. Direct rollover may be made by means of an electronic transfer from the distributing trustee bank to a receiving trustee bank or by mailing a check from the distributing trustee bank to a receiving trustee bank. Must the plan sponsor allow the distributee to take a portion of the distribution in cash and to directly rollover the remaining portion? Yes, the plan sponsor must allow the participant to take a portion of the distribution in cash and to directly rollover the remainder. However, the plan sponsor can prohibit a direct rollover if the amount is less than $500. Must retirement plans accept direct rollovers by participants? No! There is no requirement that a plan accept a rollover or direct transfer. Plan participants must check with their new employer before authorizing a direct transfer. Must the plan sponsor allow a participant to divide an eligible rollover distribution into two or more rollovers to two or more eligible plans? No. The plan sponsor may limit the distributee to a single direct rollover. If a participant does not directly rollover his eligible distribution, can he or she still rollover the entire amount of the distribution within sixty (60) days? Yes. If a participant does not directly rollover his or her distribution, it will be subject to the 20% withholding requirement. The participant may add his own dollars to the distribution and rollover the entire amount if done in a timely fashion. For example, Susie Participant receives a distribution of $100,000. If Susie does not choose to directly rollover the distribution, $20,000 will be withheld and Susie will receive $80,000. Susie may add $20,000 of her own money and rollover $100,000 if done within 60 days. Page 2 of 5

What about plan loans? Defaulted loans that are deemed to be a distribution are exempt from the 20% withholding requirement. Therefore, if a participant is still employed and defaults on his loan, the deemed distribution is exempt from withholding. If the participant does not directly roll over the cash, you must base the amount of Federal income tax withholding on the total taxable portion of the payment, which includes the outstanding loan balance. The taxes are to be withheld from the available cash. If the tax withholding is equal to or greater than the amount of cash available, the participant will not receive a check from the plan. All the cash will be sent to the Internal Revenue Service for Federal taxes. What about hardship distributions? Hardship distributions are subject to mandatory 20% income tax withholding. Example 1. John Doe separates from service and is entitled to a distribution of $100,000; however, he has not repaid any of his $5,000 loan. John decides to default on the loan and to directly rollover the remaining $95,000 to an IRA. The loan amount of $5,000 will be deemed to be a distribution and must be included in ordinary income. It is subject to the 20% withholding. Example 2. John Doe separates from service but decides to repay his participant loan and to directly rollover the entire amount of the distribution. John may directly rollover $100,000. No taxable event will occur. Example 3. John Doe separates from service and decides to default on his participant loan and not to rollover the remainder of his distribution. The amount of $100,000 will be included in ordinary income, and $20,000 must be withheld. What about employer stock? A distributee may rollover employer securities provided the successor qualified plan or IRA will accept these securities. In order to directly rollover the securities, the security must be titled in a manner similar to the way in which checks are drafted. For example, "XYZ Bank as Trustee of the IRA of John Participant." A payor will not be forced to dispose of employer securities in order to satisfy the 20% withholding requirement. Any cash in a distribution (which is not directly rolled over) will still be subject to the 20% withholding requirement. If a participant takes a lump-sum distribution of employer stock which includes net unrealized appreciation and does not rollover the distribution, the participant will be taxed on the lower of the cost or market value of the stock in the year the distribution is received. The net unrealized appreciation, if any, will not be recognized until the year in which the stock is sold by the participant. If, however, the participant rolls over the stock (either by a direct rollover or otherwise) the cost basis of the stock will be $0 and no taxable event will have occurred in the year of distribution. If the participant does not directly rollover the cash and the employer stock, you must base the amount of Federal income tax withholding on the total taxable portion of the payment, excluding net unrealized appreciation. Taxes will be withheld from the available cash. If the tax withholding is equal to or greater than the amount of cash available, the participant will receive a payment of the employer stock and will not receive any cash. All the cash will be sent to the Internal Revenue Service for Federal taxes. If the participant directly rolls over the cash and takes the employer stock as an in-kind payment, no taxes will be withheld. Page 3 of 5

If the participant directly rolls over the employer stock and takes the cash as a payment, withholding will be based only on the taxable portion of the cash payment. What effect does the new rule have on 5/10 year forward averaging? The new rule does not change the 5/10 year forward averaging rules. If a participant is receiving a lump-sum distribution and meets the other requirements necessary to elect 5-year or 10-year forward averaging, the participant may elect once in his or her lifetime to forward average the distribution. The new rule clearly states that if a participant receives distributions in one taxable year, he must aggregate the distribution and he may choose either to elect forward averaging or roll over the distributions. A participant may not elect forward averaging on one distribution and choose to rollover the second distribution. Does the 10% early distribution penalty still apply if a distribution is made to a participant who has not reached age 59 1/2? Yes, the 10% early distribution penalty still applies to individuals who take a distribution prior to age 59 1/2 and do not roll it over to an IRA or another qualified plan. The 10% penalty tax does not apply if the participant 1) separates from service during or after age 55, 2) receives the payment in the form of equal periodic payments over the participant's lifetime, 3) the payment is made due to disability, or 4) the payment is used to pay (directly or otherwise) certain medical expenses. Can surviving spouses or alternate payees under a QDRO use the direct rollover option? Yes, both a surviving spouse and an alternate payee under a QDRO can directly rollover a distribution to an IRA. However, a surviving spouse can only rollover the distribution to an IRA and not to another qualified plan. A former spouse can directly rollover the distribution to a qualified plan or an IRA. An alternate payee who is neither a surviving spouse or a former spouse cannot rollover the distribution (directly or otherwise). Can Participant Elections be revoked? Participants have the right to make or revoke a payment election until the time the payment is made. If a participant elects a direct rollover or elects to have the payment made directly to him/herself, he/she can change that election until the time of the payment. Once the check is delivered to the participant, an IRA, or another plan, the transaction is not reversible. We suggest you notify your plan participants that the election is irrevocable. Can withheld taxes be refunded? When a participant elects to have a check made payable to him\herself, the law requires us as the payor to withhold 20% of the taxable portion of the payment for Federal income taxes. If, after receiving the check, the participant decides to roll over all or part of the taxable portion of the payment, the withheld taxes to the participant cannot be refunded. The participant reports the rollover to the Internal Revenue Service on the Form 1040 he/she files for the year in which the payment took place. The Internal Revenue Service may refund the withheld taxes if the participant does not owe taxes on other types of income. What are the Reporting Requirements? The law requires you to report direct rollover to the Internal Revenue Service using Form 1099R. What happens to money contributed after employees terminate and take a payment of their benefit? Additional contribution within three months after date of last payment. You may distribute the money based upon the participants prior election. You must have a new benefit reporting form completed by the participant if you would like to distribute the money in another way. This situation can occur if you pay the participant before the contributions have been determined for the year. Additional contribution three or more months after date of last payment. You must have completed by the participant a new benefit reporting form. Page 4 of 5

Must the plan be amended to comply with the new rule? Yes, a plan must be amended before the last day of the first plan year beginning on or after January 1, 1994 to allow participants to take direct rollovers. However, the plan must operate in compliance with the new rule effective January 1, 1993. A plan does not have to be amended to accept direct rollover distributions. What type of notice must the plan sponsor give to the participant prior to the distribution? The plan administrator is required to provide the distributee with a written explanation describing the rules under which the distributee may have the distribution paid in a direct rollover, the rules that require tax withholding on the distribution if it is not paid in a direct rollover, the rules under which the distributee will not be subject to tax if the distribution is rolled over within 60 days of receipt, and other applicable rules. A plan administrator will be deemed to have complied with this notice requirement if it uses the model notice published by the Internal Revenue Service. The notice must be provided within a "reasonable time" which means no earlier than 90 days prior to the distribution and no later than 30 days prior to the distribution. However, if after receiving the notice from the plan sponsor, a distributee affirmatively elects to make or not to make a direct rollover, the distribution can be made without violating the "reasonable time" requirement. The participant may waive the 30-day period by certifying that he has been given this period for making the decision about a direct rollover. A waiver cannot be made if the distribution is over $3,500 and a spousal consent is required. There are exceptions to the 30-day notice requirement. The plan can distribute the funds immediately when the participant or beneficiary affirmatively elects a direct rollover or payment to him/herself if: The participant's vested account balance has never exceeded $3,500, The participant has reached the plan's normal retirement age (but no earlier than age 62), The participant has died, or The payment is from a government or church plan, or certain tax-sheltered annuity plans. Does a direct rollover require the consent of the participant's spouse? A direct rollover is subject to the same spousal consent requirements that apply to a regular distribution. (1-ARS 20% Withholding Rules.wpd) Page 5 of 5