How Are DB Plan Benefits Taxed?
By Ian Berger, JD
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Most of us have a pretty good understanding of how IRA and 401(k) plan benefits are taxed. But the taxation rules for defined benefit (DB) plans are less familiar, probably because there are fewer DB plans out there these days.
DB plans usually offer several types of annuity distribution options, but most do not offer a lump sum distribution option. Under the tax code, only “eligible rollover distributions” can be rolled over to an IRA or another company plan. Annuity payments do not qualify (unless payments are scheduled over a period of fewer than ten years). So, benefits payable from DB plans are typically fully taxable in the year received and cannot be rolled over.
The good news is that DB plan annuity payments are not subject to mandatory 20% federal income tax withholding. Rather, you would complete IRS Form W-4P to elect the amount of withholding you want.
Some DB plans, especially those in the governmental sector, require employee contributions. In that case, each payment is treated as consisting of a portion attributable to employer contributions and a portion attributable to employee contributions. This is another situation where the tax code’s “pro-rata rule” comes into play.
Employee contributions are sometimes considered pre-tax contributions and other times considered to be made after-tax. If considered pre-tax, each DB benefit payment is fully taxable.
If considered after-tax, a portion of each payment comes out tax-free as a recovery of your employee contributions (i.e., your basis). The tax-free portion of each annuity payment is calculated from IRS tables. The tables assume you will receive a certain number of payments based on your age (or the combined ages of you and your beneficiary if you elect a joint life annuity). The total amount of employee contributions is divided by that assumed number of payments, and the resulting amount is the tax-free portion of each payment.
Example: Mia participates in a DB plan that requires employee contributions that are made after-tax. Mia retires at age 60 after having made $62,000 of employee contributions to the plan. She elects to receive an annuity in the form of a single life annuity. That annuity pays a monthly benefit of $1,500.
Based on Mia’s age and the IRS tables, the plan can assume that she will receive 310 monthly payments. Therefore, $200 ($62,000/310) of each of her monthly payments is tax-free, and the remaining $1,300 is taxable.
If you “outlive” the life expectancy tables and receive more than the assumed number of payments, all remaining payments are fully taxable. If you die before receiving the number of assumed payments, your unrecovered basis is allowed as an itemized deduction on your final income tax return.
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