Distributions:Tax on true gross, or tax on gross net of fees?

[ldr]

We are having a discussion in our office about how distributions are or should be processed.  Just for simplicity take a termination distribution.  Say that the participant has $10,000 and he's fully vested, to make it easy.  He doesn't want a rollover, he wants a taxable distribution.  The form he filled out calls for 20% federal withholding taxes and no state withholding taxes.  The recordkeeper charges $100 to process the distribution, and our office charges $70.

One of us thinks that the 20% federal withholding applies to the full $10,000.  The participant has $8,000 after taxes, out of which he pays the fees, and ends up with $7,830 in his pocket.  

Another of us thinks that the fees come off the top, and the taxable distribution is $9,830.  The participant ends up with 80% of $9,830, or $7,864.

It matters because we are trying to develop a consistent way of "grossing up" when requesting in-service or hardship distributions.  The amount we should request depends upon how the taxes are applied.

Thanks in advance for any help you can give!

 

[401king]

Net - otherwise I'm not sure how you would process a distribution for someone with a $200 balance? 

[Bird]

Those fees come off the top.  If the account is $170 are you going to send him a 1099-R for $170 when he received nothing?  I hope not.

[RatherBeGolfing]

Off the top.  I assume you report those as fees/expenses paid by the plan right?  If so, why would the participant get a 1099 for that amount?

[Luke Bailey]

I agree with all the answers, which are uniform, but will try to support with some legal theory. The issue is whether this is a plan expense, so "off the top," or a personal expense of the individual that is borne by him on the amount distributed when it has left the plan. Seems like it is the former on the facts you've described.

[austin3515]

100% off the top.  It does not make sense to tax someone on money they never got.  Doctrine of "Constructive receipt" applies in my opinion, which states that you should only be taxed if you receive the money.

Similarly, I personally cannot stand when a recordkeeper rolls up the loan fee into the loan balance.  $5,000 loan, person gets a check for $4,900.  You're making them pay interest on the loan fee, and taxes if they default?  That's not right.

[ldr]

Thank you to everyone who answered.  Luke Bailey hit the real question here.  The expenses are incurred by the participant, not the plan.  The participant could have chosen to leave his money in the plan indefinitely, as he has over $5,000.  So does the decision to take the taxable distribution mean that he incurred the fees by choice?  Is he perhaps liable for taxes on the full $10,000?

But then what about the hapless participant with under $5,000 whose money is forced out of the plan?  He doesn't get to pick, and indeed, it seems impossible that he would be taxed on the full gross instead of the net after fees are subtracted.

I feel like I have seen this done both ways in the past.  Just looking to see what you all are doing so we can come up with something consistent.

 

 

[Luke Bailey]

ldr, while the underlying issue seems clear, the outcome is not. I can see reasonable minds coming down either way. I don't think it's a "but for" test, but rather, a "whose expense is it" test. I think the way most people would look at this particular expense is, the guy or gal asked for his/her money, and then the plan incurred an expense to the recordkeeper to pay it to him or her, so it comes out of the plan, not the after-tax amount.

These issues of what is a plan expense vs. someone else's are tough and very facts and circumstances-based. The DOL has tackled this a number of times in the area of plan vs. employer ("settlor") expenses and has not been able to lay down a bright line test for deciding which is which, but has provided a number of examples. The DOL's thoughts are collected at https://www.dol.gov/agencies/ebsa/employers-and-advisers/guidance/advisory-opinions/guidance-on-settlor-v-plan-expenses.

[BG5150]

What if a person takes a partial distribution? 

 

Account balance: 40,000

Age 67

Takes a 10,000 distribution

Fee:  50

1099-R:  10,000 or 10,050?

[RatherBeGolfing]

2 hours ago, BG5150 said:

What if a person takes a partial distribution? 

 

Account balance: 40,000

Age 67

Takes a 10,000 distribution

Fee:  50

1099-R:  10,000 or 10,050?

If participant gets $10,000 cash and $50 is taken from the account as fees, the 1099 is $10,000.  It just isn't reasonable to treat a fee from plan assets ,even if it is an individually assessed fee, as distributed and therefore income to the participant.  

I can imagine some service providers trying to play this game if they want to hide what they collect in fees.  Very convenient to have it listed as a distribution rather than a fee...

[jpod]

I agree with the consensus.  So, if I need a 2018 MRD of $10,000, and I am going to be charged a distribution fee of $50, I better request a distribution of $10,050, right?

[Mike Preston]

Isn't that the opposite of what has been suggested?

[Luke Bailey]

I don't think it's the opposite. Either way, if you want $10,000 and the recordkeeper is going to withhold $50, you need to ask for $10,050. (Actually, I think in the original example the total charges on $10,000 distribution were $170.) The question is, does your 1099-R show a distribution of $10,000 or $10,050, and is the 20% withholding $2,000, or $2,010? The consensus seems to be $10,000 and $2,000, respectively.

[RatherBeGolfing]

Id say it is the opposite.   The 1099-R reflects the distribution, which is $10,000.  The fee is just that, a fee, not a distribution, so why would you need to gross up what you are asking for?

The fact that the fee is charged because of the distribution doesn't make it part of the distribution.

[Mike Preston]

What he said!

[jpod]

If you want the 1099-R to say "$10,000," and if a $50 fee will be a non-taxable payment of plan admin. expenses (in this case, the distribution fee), don't you need to ask for $10,050?  

[RatherBeGolfing]

55 minutes ago, jpod said:

If you want the 1099-R to say "$10,000," and if a $50 fee will be a non-taxable payment of plan admin. expenses (in this case, the distribution fee), don't you need to ask for $10,050?  

I think we agree that the distribution is what the participant gets, and the fee is a fee not included as income on the 1099 , right?

I'm fairly certain that most RKs will actually distribute the amount requested on an in-service and take the fee from the remaining assets. 

 

 

[austin3515]

RBG, yes yes yes. I go back to my original point, you cannot tax someone on money they NEVER got.  Period.  You just can't do that.  And no one does.

[jpod]

I am probably splitting hairs but the analysis is not based on the application of constructive receipt or tax accounting principles.  The reason only $10,000 is reported on the 1099-R and taxable is because the $50 in my example is a legitimate plan expense that can be paid with plan assets under both IRC 401(a)(2) and Title I of ERISA.  The fact that this expense is not borne by the plan as a whole but is charged to the participant's account is irrelevant. 

 

 

[K2retire]

Bottom line -- ask the record keeper if you need to request $10,000 or $10,050 to be sure the check you get is for $10,000. I'd bet money they don't all do it the same way!

[ldr]

Thanks again to all of you.  As a matter of office policy, it has been decided that fees are on top of, not part of, the taxable distribution.  For example, yesterday we processed a request for an in-service distribution designed to net the participant $25,000.  We filled out a request form for $31,250, so that when the 20% is withheld for the Feds (and nothing for the state of Texas), the lady will receive $25,000.  The record keeper is instructed on the form to also charge her account $70, which is our fee for processing.  Her 1099-R should reflect a withdrawal of $31,250 and taxes paid to the Feds of $6,250. 

[Luke Bailey]

So ldr, just to be clear, the $70 is charged against the remaining, nondistributed portion of her account, and reduces the balance immediately by $70,  but the $70 is not reported (ever) as a distribution on 1099-R.

[stephen]

This issue came up in our office today and searching led me here.  I wonder if the IRS knows about all of these fees leaving retirement plans that they are not collecting income tax on...

[austin3515]

They definitely do.  It is almost universally done that way.

[RatherBeGolfing]

2 minutes ago, stephen said:

This issue came up in our office today and searching led me here.  I wonder if the IRS knows about all of these fees leaving retirement plans that they are not collecting income tax on...

Of course they know.  What is the alternative, tax participants on the fees paid by money they never got?