Chapter 19: Applications in Planning for Retirement – Essentials of Personal Financial Planning



Hope and Jay Williams are both age 55. They married late in life and have no children. They also have very few major expenses because they own their home and both their cars outright, and they have no debt at all. Never much for travel, they are more than content to spend weekends at home watching sports on TV, taking only occasional trips to visit friends and relatives in other states. It’s fair to say they have a very modest standard of living, even though they both have good jobs that pay well.

Jay is project manager for Johansson, Morgan & James, a provider of management and technology consulting services to the U.S. government. Jay’s area of specialization is information technology for the IRS. Although all of his friends assume he must hate consulting for the IRS, Jay actually loves his job and looks forward to coming to work every day. He has no desire to retire anytime soon and plans to work until he turns 70.

Hope has a very different employment story. She spent the last 30 years working for a local defense contractor in the aerospace industry, x-raying the inside of aircraft wings using neutron radiography. But crawling through the fuselage of aircraft on the midnight shift has taken its toll on Hope. Arthritis has started to set in, the odd sleeping hours have wreaked havoc with her immune system, and she has gained 15 pounds that she just can’t get rid of. In short, Hope is miserable and is counting the days until she turns 62 and can retire.

Hope’s retirement benefits with the defense contractor are substantial. There is a defined benefit plan that, after 30 years of service to the company, provides 50 percent of the final year’s preretirement income (joint and survivor). Her employer also provides a profit-sharing plan with 401(k) provisions. Both Hope and Jay are maximum funding their qualified plans (elective deferrals and catch-up contributions). Additionally, the profit-sharing plan allows for the purchase of employer stock. The employer stock in Hope’s 401(k) accounts for 35 percent of its value.

Although retirement is still the furthest thing from Jay’s mind, Hope’s physical and work situation have the Williamses a bit worried, so they have come to you for some advice. They want to be in the best possible position at retirement. What should they be doing at this point to improve their position? What do they need to consider?


After completing this chapter, you should be able to do the following:

  Evaluate employer-sponsored retirement plan choices and options based on the employer’s goals and tax considerations.

  Identify the maximum contribution and benefit allowable under each type of plan.

  Identify appropriate use of advanced planning strategies in retirement planning (for example, withdrawal options and strategies, retirement risks, and so on).

  Determine the income tax planning concepts and applications within retirement planning.


We first discussed retirement planning in chapter 13, noting that it is effectively planning for financial independence—just at a specific, commonly accepted time. Retirement planning also allows for some additional tools, namely Social Security benefits and both employer-sponsored and individual retirement plans. As we have already seen, those tools are extremely useful and require serious thought and evaluation during the planning process. There are, however, some additional considerations regarding the various options available for retirement; in this chapter, we explore them.

Perhaps the most important consideration for any type of retirement plan is how the distributions will be managed. Given that these distributions are usually an individual’s primary source of income during retirement, the proper management of them can make the difference between a comfortable retirement at the desired standard of living and an anxious retirement at a notably lower standard of living. Of course, as with any financial plan, retirement plans need monitoring and management; this is especially so during the distribution phase. Investment-based retirement plans are subject to the same market fluctuations and risk as any other investment, but in the distribution phase those fluctuations can cause major interruptions to cash flows. As we will see in this chapter, investment management during the distribution phase is just one area in which retirement planning overlaps with other facets of personal financial planning.

Before we dive into these topics, we will revisit employer-sponsored plans. Our discussion in chapter 13 largely focused on these plans, mainly because there are so many different types, all with their own issues. We now return to this topic to take a look at employer-sponsored plans through a different lens; namely, that of the business owner.

The effective tax rate is the average rate at which income is taxed. It is calculated by dividing total tax liability by total income.

Employer Considerations

To this point, our discussion of employer-sponsored plans came from the viewpoint of employees and how they would benefit from the various types of plans. As we saw in chapter 16, owning a closely held business complicates estate planning. For owners of closely held businesses, retirement is a complex issue. Not only are they charged with making decisions to benefit their own business (and their own retirement), they are also charged with selecting an option that provides fair retirement solutions for their employees. In many cases, this will be through an employer-sponsored plan, but in some cases the best option involves individual plans.

A closely held business owner’s decision whether to establish an employer-sponsored retirement plan is contingent upon several of the following variables:

Goals of the business owner. Does the business owner need to reduce his or her own current income by contributions to an employer-sponsored retirement plan? Does the business owner need to establish a retirement plan in order to attract and retain employees? Should the plan design include an employer-matching contribution? What type of vesting schedule should be selected?

Cash flow of the business. The IRS requires employer-sponsored retirement plans to be permanent, as opposed to temporary arrangements used to capture tax benefits for the business owner. The business should have sufficient recurring cash flow to support the retirement plan contributions. The IRS regulations state that if the plan is terminated for any reason other than business necessity within a few years after it was established, the termination is evidence that the plan from its inception was not a bona fide retirement plan. If the IRS determines that the plan was not bona fide, then it will be disqualified retroactively, and penalties and interest are due on the disqualified contributions to the plan.

Plan design. Should the employer-sponsored retirement plan be qualified or nonqualified? If the plan is qualified, should it be a defined benefit plan or a defined contribution plan? Are the costs to establish and annually administer the plan a concern? A defined benefit plan requires annual actuarial analysis and has a higher cost than a defined contribution plan. However, defined benefit plans typically generate a higher tax-deductible contribution for the employer, which is beneficial for the business owner.

Funding. A variety of government agencies oversees the activity of retirement plans and, as a result, the administration of these plans is complex. One of the areas of complexity is related to employer contributions into a retirement plan. There are annual limits as to how much may be contributed to an employer-sponsored plan. The plans must specifically state that contributions or benefits cannot exceed certain limits. The limits differ depending on the type of plan and in most cases are subject to annual indexing. The IRC establishes limits on the dollar amount of contributions to retirement plans and IRAs, as well as the amount of benefits provided under a pension plan. Section 415 requires the limits to be adjusted annually for cost-of-living increases. This adjustment is referred to as annual indexing. The government applies these limits in order to keep an employer from potentially reducing his or her taxable income to the point where no tax is due.

Contribution Limits

Whether an employer-sponsored plan or an individual retirement plan, all retirement plans have IRS-imposed contribution limits. In the case of employer-sponsored plans, limitations can apply to both employer contributions and individual contributions. We’ll examine these limitations for employer-sponsored and individual plans. As we saw in chapter 13, the two main types of employer-sponsored plans are defined benefit plans and defined contribution plans, so we’ll organize our discussion by these two categories.


Defined benefit plans provide a fixed, guaranteed benefit for employees at retirement. The benefit is typically based on age, income, and years of service with an employer. Employer contributions to a defined benefit plan are a deductible business expense. Because of the guaranteed benefits, employer contributions to a defined benefit plan are typically greater than employer contributions to a defined contribution plan. Defined benefit plans are complex and, as a result, are more costly to establish and maintain than other types of employer-sponsored retirement plans.

The following case study shows how contribution limits affect defined benefit plans.


Mr. Jones, 57, owns Fire and Safety, Inc. His company has five employees, including himself, and has annual gross receipts of $2 million. Mr. Jones’s compensation from the company is $500,000 per year. He plans to retire at age 67.

Additional actuarial considerations needed to determine the amount of the defined benefit in this example include the following facts: Mr. Jones’s life expectancy is age 83; the projected benefit is 75 percent of preretirement earnings; and the defined benefit plan’s assumed rate of return is 5 percent. Tax-deductible contributions to a defined benefit plan are based on the present value of the amount needed to provide the definitely determinable benefit for the plan participants.

Based on these numbers, how much does the company need to pay into a defined benefit plan annually for Mr. Jones’s retirement?

As we have seen in earlier chapters, the first step in this calculation is to determine the present value of the money necessary to fund the benefit to Mr. Jones at age 67. Using the numbers provided in our description, we get the following inputs:

n=16 (83-67)
i=5 (assume rate of return of 5%)
PMT=$375,000 (75% x $500,000/yr. compensation)

We can then solve for a PV of $4,267,371.76.

Using this PV, we can then solve for the annual payment as follows:

n=10 (retirement age of 67 - current age of 57)
FV=$4,267, 371.76 (our calculated PV)

The annual payment is thus $339,275.58.

Our preceding example did not consider any contribution limits to defined benefit plans. In reality, there are two regulatory constraints that reduce the annual tax-deductible contributions to the Fire and Safety, Inc.’s defined benefit plan, as follows:

1. The amount of compensation that may be recognized for any qualified plan is limited to $265,000. In the previous example, Fire and Safety, Inc. recognized $500,000 of compensation to arrive at the defined benefit of $375,000.

2. The defined benefit that is being funded cannot exceed the lesser of 100 percent of the participant’s average compensation for his or her highest three consecutive calendar years or $210,000. In the preceding example, Mr. Jones was funding for $375,000 of defined benefit.

Using these new contribution limited numbers, let’s once again calculate how much the company needs to pay into a defined benefit plan annually for Mr. Jones’s retirement.

N=16 (83-67)
i=5 (assume rate of return of 5 percent)
PMT=$210,000 (due to the contribution limit)

We can then solve for a PV of $2,389,728.19.

Using this new PV, we can then solve for the annual payment as follows:

N=10 (retirement age of 67 – current age of 57)
FV=$2,389,728.19 (our calculated PV)

The annual payment is thus $189,994.31.

As a result of contribution limits, the annual tax-deductible contribution made by Fire and Safety, Inc. was reduced by $149,281.2694.

Note: Though greatly simplified, this case study broadly illustrates why regulatory limits, in the form of contribution limits, applied to employer-sponsored retirement plans is necessary—the potential for abuse by the employer is too great. Also important to note: Many of the qualified plan limitations are indexed and will change from year to year.


Defined contribution plans are also subject to regulatory funding limitations. Unlike a defined benefit plan, which only allows for employer contributions, the regulatory rules apply to both employer and employee contributions.

Annual Additions Limit

Section 415(c) limits the amount of annual contributions to a participant in a defined contribution plan. The total annual contributions to all accounts in plans maintained by one employer (and any related employer) are capped. The limit for tax year 2016 is the lesser of 100 percent of the participant’s compensation or $53,000. Contributions include the following:

Employee elective deferrals

Employer matching contributions

Employer nonelective contributions

Allocations of forfeitures

Elective Deferral Limit

Section 402(g) allows participants in qualified plans to make elective employee deferrals into their individual accounts. Elective deferrals for tax year 2016 are limited to $18,000 for 401 (k) and 403(b) plans. It is possible for an employee to work for multiple unrelated employers. If this is the case, the employees may aggregate their elective deferrals, but the combined amount cannot exceed $18,000. Additionally, elective deferrals are part of the overall 415(c) limit of $53,000.

Catch-up Contribution Limit

Section 414(v) allows plan participants who are age 50 or over by the end of the calendar year to make an additional elective deferral which exceeds the 402(g) limit ($18,000 in 2016). This additional amount is called a catch-up contribution. For tax year 2016, the catch-up contribution limit is $6,000. The following retirement plans allow for a catch-up contribution: 401 (k), 403(b), and governmental 457(b). A plan participant can make catch-up contributions up to the lesser of the following amounts: the catch-up contribution dollar limit ($6,000), or the excess of the participant’s compensation over the elective deferral contributions.


Alice and George Jones are married and are both age 55. Alice has decided to return to the work force in order to increase her and George’s retirement savings. George’s income is more than sufficient to meet their needs and desires. All of Alice’s income will be available for saving into a retirement plan.

Alice’s compensation is $20,000 per year. In 2016, she elects to defer $18,000 into her company’s 401(k) plan. She is also permitted to defer the remaining $2,000 as her catch-up contribution. This $2,000 is the lesser of the catch-up contribution ($6,000) or the excess of the participant’s compensation over the elective deferral contribution ($20,000–$18,000).

Elective Deferrals and Catch-up Contributions with SIMPLE IRA Plans

SIMPLE retirement plan contribution limits operate much the same way as traditional qualified plan limits, except the limits are lower. The limit for an elective deferral for a SIMPLE is $12,500 and the catch-up contribution limit is $3,000 (Section 414(v)). Both amounts are for tax year 2016.


Peter Jones, CPA, works for a local television station as CFO. Peter is 43 years old. The television station compensates Peter very well and provides a profit-sharing 401(k) plan for its employees. At night and during tax season, Peter supplements his television station income by providing tax compliance services as an independent contractor and has established a solo 401(k) plan through that job.

Peter contributes the maximum amount ($18,000) to the TV station’s profit-sharing 401(k) plan. He would also like to contribute the maximum amount to his solo 401(k) plan. He is not able to make additional elective deferrals to his solo 401(k) plan because he has already contributed his personal maximum of $18,000. However, he has enough earned income from his tax compliance business to contribute the overall maximum (Section 415(c)) for the year, $53,000.

Peter can make a nonelective employer contribution of $53,000 to his solo 401(k) plan. This limit is not reduced by his employee elective deferrals to the television station’s profit-sharing 401(k) plan. The television station and the tax compliance business are unrelated employers. This structure allows Greg to apply the annual additions limit separately to each employer.

IRA Contribution Limits

Like qualified plans, IRAs have contribution limits as well. Contributions to both a traditional and a Roth IRA cannot exceed the lesser of $5,500 or the total taxable compensation for the year. Additionally, contributions to a traditional IRA are not permitted once the taxpayer attains age 70½.

A catch-up contribution is available for both the traditional and Roth IRAs. In tax year 2016, the catch-up limitation is $1,000. Both regular and catch-up contributions to an IRA are due by the due date of the taxpayer’s tax return (not including extensions).

Retirement Distribution Optimization Planning (Income Management)

Contribution limits are an important factor to consider when calculating the eventual value of a retirement plan because they have a direct impact on just how much can be put into a given plan. But what about when it comes time to start taking money out of a retirement plan? Distributions from retirement plans can take many forms, and various laws dictate factors from the size of distributions to their timing. Many individuals simply think, “Oh, I’ll just collect my money,” but it’s not quite that simple.

Often overlooked in favor of the planning or saving phases, the retirement distribution phase is incredibly important. Planning and saving can amount to little if distributions are mismanaged. Given that these distributions are often the primary income source for retirees, there isn’t much margin for error. Personal financial planners must pay careful attention to distributions and should advise their clients accordingly. In this section, we examine the main distribution issues to consider.


When a plan participant receives a distribution from a retirement plan or an IRA before reaching age 59½, Section 72 mandates an additional 10 percent tax on the distribution. There are specific exceptions to this additional tax. For example, distributions made from a qualified plan or an IRA as part of a series of substantially equal periodic payments over the life expectancy of the taxpayer, or the life expectancies of both the taxpayer and their designated beneficiary, are not subject to the Section 72 tax. These equal payments are commonly referred to as a Section 72 distribution. If this type of distribution is from a qualified plan and not an IRA, the taxpayer must separate from service with the employer maintaining the plan before the payments begin.

There are three methods used to determine substantially equal periodic payments:

Required minimum distribution method. The required minimum distribution method divides the retirement account balance on December 31 of the previous year by the participant’s life expectancy based on attained age in the year of distribution. The annual payment is recalculated each year.

Amortization method. The fixed amortization method amortizes the retirement account balance over a specified number of years equal to life expectancy, utilizing an interest rate of not more than 120 percent of the federal midterm rate. Once an annual distribution amount is calculated, the same dollar amount must be distributed in subsequent years.

Annuitization method. The annuitization method applies an annuity factor to the retirement account balance to calculate the annual payment. The annuity factor is calculated based on IRS-provided mortality tables1 and an interest rate of not more than 120 percent of the federal midterm rate. Once an annual distribution amount is calculated under this method, the same dollar amount must be distributed in subsequent years.

Although the annuitization method specifically relies on an annuity factor calculated from IRS mortality tables, all three methods actually use these tables to determine life expectancy.

Because early withdrawals take place prior to retirement age but involve a retirement vehicle, they can provide an interesting overlap of retirement planning and overall planning for financial independence.

If the series of substantially equal periodic payments is subsequently modified (other than by reason of death or disability) within 5 years of the date of the first payment, or, if later, age 59½, the exception to the 10 percent tax does not apply. In this case, the tax for the modification year is increased by the amount that would have been imposed (but for the exception), plus interest for the entire deferral period.


Ken, age 50, feels that he has saved enough money to be financially independent. He has a traditional IRA from which he would like to start taking distributions. Ken wants to avoid the Section 72 additional 10 percent tax imposed on the early distributions by taking advantage of the exception for substantially equal periodic payments.

Ken’s traditional IRA account balance is $400,000 as of December 31, 20XX (the last valuation prior to the first distribution). 120 percent of the applicable federal mid-term rate is assumed to be 2.98 percent, and this will be the interest rate Ken uses under the amortization and annuitization methods. Ken is single and will determine distributions over his own life expectancy of 34 years.

Using the required minimum distribution method, the annual distribution amount is calculated by dividing the December 31, 20XX account balance ($400,000) by Ken’s life expectancy (34 years): $11,765. ($400,000/34). In subsequent years, the annual distribution amount will be calculated by dividing the account balance as of December 31 of the prior year by the single life expectancy at Ken’s attained age.

Using the amortization method, the annual distribution amount is calculated by amortizing the December 31, 20XX account balance ($400,000) by Ken’s life expectancy (34). The calculation is performed the same way we would calculate payments into a retirement plan:


We can thus calculate the annual distribution to be $18,329.

Using the annuitization method, the annual distribution amount is equal to the account balance ($400,000) divided by an annuity factor. The annuity factor for Ken based on the IRS table is 21. The annual distribution amount is then calculated as $400,000/21= $19,048.

For example, let’s say substantially equal periodic payments began for someone at age 52. If the payments are modified in any way, the 10 percent additional tax is applied retroactively to all payments received. An individual who began using a Section 72(t) distribution method at age 52 would have to continue receiving the same amount of payments up to age 59½. If the individual changed the payment amount at age 58, the 10 percent tax would be retroactively applied to all payments received since age 52. (It’s the later of 5 years or 59½).

The only exception is the one-time election a participant may make, which allows a change—without penalty—from the annuity or amortization method to the required minimum distribution method. The effect of this election will be to reduce the 72(t) payout amounts. Though this change could go a long way to preserve retirement funds, it also reduces payout levels.


The net unrealized appreciation (NUA) strategy should be considered if a plan participant is considering a lump-sum distribution from an employer’s qualified plan when some or all of the plan assets are employer stock. Net unrealized appreciation is the difference between the cost basis of the employer stock and the fair market value of the employer stock when it is distributed to the employee. The unrealized appreciation is not subject to income taxation until the employee sells the stock.

The cost basis of the employer stock is subject to ordinary income tax in the year of distribution. Taking an in-kind distribution of the employer stock allows the appreciation (NUA) above the cost basis to be taxed at the more favorable capital gains tax rate. For this reason, upon separation from service, it may be more tax advantageous to transfer the employer stock to a regular taxable investment account instead of rolling the employer stock into an IRA where future distributions will be taxed as ordinary income. (If the stock is rolled into an IRA, it loses NUA eligibility.) The net unrealized appreciation is always taxed at long-term capital gain rates, regardless of the holding period. Exhibit 19-1 shows the steps necessary to accomplish an NUA rollover.



Employer stock is contributed to a participant’s account in a profit-sharing 401(k) plan with a basis of $20,000. The employer stock is distributed at retirement as a lump-sum distribution with a fair market value of $200,000. The difference, $180,000, is not taxable until the employee sells the stock. The $20,000 employer stock basis is taxable as ordinary income at the time of the lump-sum distribution. If the stock is sold six months later for $250,000, then $180,000 is taxed at long-term capital gains rates. The $50,000 increase in FMV that occurred after the stock was distributed to the employee is taxed as a short-term capital gain.


The required beginning date (RBD) for distributions from IRAs, SEPs, and SIMPLE IRAs is April 1 of the year following the year in which the plan participant attained age 70½. Subsequent distributions must then be made by December 31 of each year thereafter.

The RBD for distributions from qualified plans, governmental Section 457 plans, and Section 403(b) plans is April 1 of the year following the year in which the plan participant attained age 70½ or when the plan participant retires, if later. Alternatively, a plan may require participants to begin receiving distributions by April 1 of the year after they reach age 70½, even if they have not retired. In all cases, a 5 percent or more owner of a business must begin taking distributions by April 1 of the year following the year in which the plan participant attained age 70½, even if he or she has not retired. The more-than-5 percent owner may continue to contribute to the qualified plan.

The required minimum distribution (RMD) is the account balance as of the end of the immediately preceding calendar year divided by a distribution period from the IRS’s “Uniform Lifetime Table.”2 A separate table is used if the sole beneficiary is the owner’s spouse who is 10 or more years younger than the participant.


Bob’s 70th birthday is on May 10, 2016. Age 70½ is, therefore, on November 10, 2016. The first RMD, for 2016, is no later than April 1, 2017. In addition, the 2017 RMD must be taken prior to December 31, 2017.

Sandra’s 70th birthday is on July 23, 2016. Age 70½ is on February 23, 2017. The first RMD, for 2017, is to be taken no later than April 1, 2018. The 2018 RMD must be taken prior to December 31, 2018.

If a taxpayer does not take an RMD, or if the RMD is not large enough, the taxpayer will have to pay a 50 percent excise tax on the amount not withdrawn. This is why it is recommended that RMDs be set on automated distributions, especially if the client has dementia or issues with incapacity.

For the year of the account owner’s death, the RMD is simply the amount the account owner would have normally received. For the year following the owner’s death, the RMD will depend on the identity of the designated beneficiary. Beneficiaries of retirement accounts and IRAs calculate the RMD using the single life table. The account balance is divided by their life expectancy to determine the first year’s RMD. The life expectancy is then reduced by one for each subsequent year.


Spouses who are the sole designated beneficiary can:

treat an IRA as their own;

base RMDs on their own current age;

base RMDs on the decedent’s age at death, reducing the distribution period by one, each year;

withdraw the entire account balance by the end of the 5th year following the account owner’s death, if the account owner died before the required beginning date.

wait until the owner would have turned 70½ to begin receiving RMDs, if the account owner died before the required beginning date.

Individual beneficiaries other than a spouse can:

withdraw the entire account balance by the end of the 5th year following the account owner’s death, if the account owner died before the required beginning date; or

calculate RMDs using the distribution period from the single life table based on when the owner died.

  If death occurred after RMDs began, the distribution period can be the longer of the:

beneficiary’s remaining life expectancy determined in the year following the year of the owner’s death reduced by one for each subsequent year; or

the owner’s remaining life expectancy at death, reduced by one for each subsequent year.

  If death occurred before RMDs began, the distribution period is the beneficiary’s age at year-end following the year of the owner’s death, reduced by one, for each subsequent year.


If your client is in a defined benefit or money purchase plan, the plan must offer a benefit in the form of a life annuity, which means that participants will receive equal, periodic payments, often as a monthly benefit, to continue for the rest of their life. Defined benefit and money purchase plans may also offer other payment options. If the participant is in a defined contribution plan (other than a money purchase plan), the plan may pay benefits in a single lump-sum payment as well as offer other options, including payments over a set period of time (such as five or 10 years) or an annuity with monthly lifetime payments.

In a defined benefit or money purchase plan, unless the employee and the employee’s spouse choose otherwise, the form of payment will include a survivor’s benefit. This survivor’s benefit, called a qualified joint and survivor annuity (QJSA), will provide payments over the employee’s lifetime, as well as the spouse’s lifetime. The benefit payment that the surviving spouse receives must be at least half of the benefit payment the employee received during their joint lives. If the employee chooses not to receive the survivor’s benefit, both the employee and spouse must receive a written explanation of the QJSA and, within certain time limits, must make a written waiver—and the spouse must sign a written consent to the alternative payment form without a survivor’s benefit. The spouse’s signature must be witnessed by a notary or plan representative.


In most 401 (k) plans and other defined contribution plans, the plan is written so that different protections apply for surviving spouses. In general, in most defined contribution plans, if the employee should die before beginning to receive benefits, the surviving spouse will automatically receive them. If the employee wishes to select a different beneficiary, the spouse must consent by signing a waiver, witnessed by a notary or plan representative.

If the employee was single at the time of enrollment and subsequently married, it is important that the employee notify the employer or plan administrator and change the beneficiary status under the plan. If the employee does not have a spouse, it is important to name a beneficiary.


A participant’s plan provides for a life-only annuity of $1,000 per month. The monthly benefit can be reduced by 15 percent to provide a 50 percent joint and survivor annuity benefit for the surviving spouse. Alternatively, the monthly benefit can be reduced by 25 percent to provide a 100 percent joint and survivor annuity benefit for the surviving spouse.

Joint and 50% Survivor $   850.00 $425.00 $   850.00
Joint and 100% Survivor $   750.00 $750.00 $   750.00
Life Only $1,000.00       -0- $1,000.00


Plan participants who receive a lump-sum distribution from a qualified retirement plan and were born before January 2, 1936, may be able to elect 10-year averaging. The 10-year income-averaging tax is figured separately from the regular income tax and the income is not added to adjusted gross income. The distribution will not cause a loss of tax deductions, credits, or other benefits. In addition, a lump-sum distribution that qualifies for 10-year income averaging will not trigger the alternative minimum tax as other retirement plan distributions might.

A lump-sum distribution from a qualified plan must meet the following conditions in order to qualify for favorable income tax treatment:

The distribution represents the entire amount of the employee’s benefit in the plan.

The distribution is made in a single tax year.

The employee participated in the qualified plan for at least 5 tax years prior to the tax year of the lump-sum distribution.

The distribution is payable due to the participant’s death, attainment of age 59½, separation from service, or disability.


In order for an employer-sponsored retirement plan to be considered a qualified plan, it must provide that the retirement benefits cannot be assigned, alienated, or subject to attachment or garnishment. This is called the anti-alienation or spendthrift provision of a qualified plan. There are four exceptions to this provision, as follows:

The collection of federal taxes

Limited assignment of benefit payments

Loans secured by the participant’s nonforfeitable benefits

A qualified domestic relations order (QDRO)

A QDRO is an order for a qualified retirement plan to pay alimony or marital property rights to a spouse, former spouse, child, or other dependent of a participant. A QDRO may also be used to provide child support. The QDRO must contain certain specific information, such as the plan participant and each alternate payee’s name and last known mailing address, and the amount or percentage of the participant’s benefits to be paid to each alternate payee. A court must issue the QDRO before it can be considered a domestic relations order under the Employee Retirement Income Security Act (ERISA). The mere fact that a property settlement is agreed to and signed by the parties will not, in and of itself, cause the agreement to be a domestic relations order.

Distributions as a Result of a QDRO

A spouse or former spouse who receives a QDRO benefit from a qualified retirement plan reports the payment received as if he or she were the plan participant. The spouse or former spouse is allocated a share of the participant’s cost (investment in the contract) equal to the cost times a ratio of the present value of the benefits payable to the spouse or former spouse divided by the present value of all benefits payable to the participant.

If, under the qualified plan, a participant has no right to an immediate benefit, a QDRO cannot require the trustees to make such a benefit payment. If a compensating benefit payment is not possible, the QDRO is used to segregate the qualified plan assets into a sub-trust for the benefit of the spouse making the claim, with the benefit distributions made at the earliest time permitted under the plan provisions. A QDRO may not award an amount or form of benefit that is not available under the plan.


If the qualified plan for XYZ, Inc. provides participant benefits beginning at age 55 (or later), then the QDRO distribution to a former spouse can be scheduled to begin at the former spouse’s age 55, whether or not the former spouse is retiring at that date.

Child Support

A QDRO distribution that is paid to a child or other dependent is taxed to the plan participant.


An individual may be able to roll over to an IRA all or part of a distribution from a qualified retirement plan that he or she received under a QDRO, tax-free. If the individual receiving the QDRO transfer is either the participant’s spouse or former spouse (not a non-spousal beneficiary), then he or she can roll the distribution over, just as if he or she were the participant receiving a distribution from the qualified plan.

Income Tax Issues

The income tax implications of retirement plans are usually fairly clear. Employer-sponsored retirement plans offer tax benefits both to the employer and the employee. Individual retirement accounts offer opportunities for individuals to save for retirement on a tax-favored basis when they do not have access to an employer-sponsored retirement plan. What is not clear to many individuals, however, is that income tax issues continue on into the distribution phase.

The retirement distribution phase is perhaps the most tax-sensitive area of personal financial planning. It is also an overlooked opportunity for adding value to a client’s personal financial plan. Understanding and analyzing the interplay of the income tax ramifications with the cash requirements of the client during retirement is imperative. Distributions from qualified plans have as many tax-related issues as contributions to qualified plans. Investment and risk management issues should also be taken into consideration. In this section, we explore some of the main income tax issues encountered during the distribution phase.


For many retirees, income tax is their largest expense during retirement. Proper planning, diversification, and utilization of multiple retirement savings vehicles during working years enable retirees to create greater tax efficiency.

In planning for retirement, tax rate diversification is achieved by purposefully investing in retirement savings vehicles with different income tax characteristics (that is, tax-deductible, tax-deferred, tax-free, and taxable). This strategy can reduce current taxable income and accelerate the growth of investment accounts as a result of potential compounding on the untaxed account balances. This also provides immunization from changes in tax law during retirement and financial independence.

Table 19-1 shows the different retirement savings vehicles and their tax characteristics.


Tax-loss harvesting is the sale of a security that has experienced a loss in value. The loss is “harvested” to offset long-term capital gains, short-term capital gains, and ordinary income in the client’s investment portfolio. Tax-loss harvesting is beneficial for both active traders and those who systematically rebalance their portfolio. Portfolio rebalancing is necessary to maintain a predetermined investment mix (stocks, bonds, and short-term investments) based on investment goals, time frame, financial needs, and risk tolerance.

The potential benefit from tax-loss harvesting is specific to each investor and is dependent on factors such as investor income, the amount of current year short- and long-term capital gains, current year losses, losses carried forward from previous years, and net investment income tax (NIIT). NIIT is imposed on the net investment income of individuals, estates, and trusts that have taxable income above a statutory threshold amount. The NIIT tax rate is 3.8 percent.

Annuities Annuities provide tax-deferred growth and a guaranteed source of income at retirement and financial independence. A nonqualified annuity is not subject to RMD and RBD. If income from an annuity is structured correctly, the tax on the gain in the contract can be amortized over the lifetime of the annuitant. Annuities have riders which can provide death benefits, annual guaranteed step-up in contract values, and guaranteed lifetime incomes.
Municipal Bonds Individual municipal bonds provide income that is free from federal income tax. Similar to corporate, Treasury, and other traditional types of bonds, municipal bonds provide a predictable stream of income. Depending on the taxpayer’s state of residence, the income may be free from state income tax as well. The sale of a municipal bond may create a taxable gain or loss. If a capital gain, then the capital gains tax rates will apply. The higher the taxpayer’s effective tax rate, the more beneficial municipal bonds may be for the taxpayer.
Cash-Value Life Insurance If there is a need for life insurance and there is surplus cash flow to fund the policy, cash-value life insurance is an excellent retirement savings vehicle. The values inside the contract grow tax-deferred and distributions are subject to first-in, first-out (FIFO) taxation. The FIFO accounting method allows the taxpayer to recover the cost basis from the tax-deferred account first. This action does not create an income taxable event. If structured properly, a cash-value life insurance policy allows the owner to access policy values through withdrawals and policy loans. One caveat to note: Even though the policy has guaranteed rates of return, cash-value life insurance should never be considered an investment.
Roth IRA Contributions to a Roth IRA are made with after-tax dollars. The account grows tax-deferred and distributions are received income-tax free, as long as certain conditions are met. Unlike a traditional IRA and other qualified plans, a Roth IRA has no required minimum distribution (RMD). Also, unlike a traditional IRA, contributions may be made to a Roth IRA beyond age 70½, as long as the taxpayer has earned income.
Taxable Accounts Taxable accounts are a key component in any plan for tax rate diversification. These accounts typically provide more flexibility in terms of liquidity to cover daily and short-term expenses. Instead of tapping into tax-deferred accounts, which could create additional taxes and penalties, assets in the taxable accounts could be used to cover unexpected and unanticipated expenses. The risk of penalties and additional taxes from the tax-deferred accounts is mitigated by the use of taxable accounts.

Determining the Taxable Gain or Loss

The IRS mandates an ordering to the application of long-term and short-term capital losses. When capital gains and losses are reported in the same tax year, the taxpayer must categorize all gains and losses between long- and short-term, and then aggregate the total amounts for each of the categories. Then the long-term gains and losses are netted against each other, and the same is done for short-term gains and losses. The net long-term gain or loss is then netted against the net short-term gain or loss.

Table 19-2 shows an example of a taxpayer’s gains and losses from investing in the current year.

Short-term gains $5,000 Long-term gains $1,000 Net short-term gain $1,000
Short-term losses $4,000 Long-term losses $5,000 Net long-term loss $4,000
Net short-term gain $1,000 Net long-term loss $4,000 Net loss $3,000

The tax code allows a taxpayer to deduct up to $3,000 of capital losses per year to reduce ordinary income, which is taxed at the same rate as short-term capital gains and nonqualified dividends. If, after the $3,000 deduction, a capital loss still remains, it is carried forward into future years until it is used up.

In order to be effective, planning for tax-loss harvesting must be a year-round activity. Additionally, the maintenance of detailed records is necessary to anticipate any capital gain (long- or short-term) tax liability prior to the end of the year. Tax-loss harvesting should not undermine a diversified investment portfolio; rather, it should complement the overall investment strategy. Securities that are candidates for tax-loss harvesting include investments that have lost value and are no longer in alignment with current investment strategy, have poor prospects for future growth, or that can be replaced by investments similar (but not exact matches) to the ones being considered for sale.

Investment Management During Retirement

The act of investing creates risk simply because securities go up and down in value. Individuals who are retired no longer earn income, but rather consume income from their accumulated savings. In order to preserve lifestyle during retirement, withdrawal rates as well as asset allocation need to be addressed. Both withdrawal rates and asset allocation are unique to each investor. Determining the correct asset allocation and withdrawal rate is as much an art as it is a science.

Note that these same issues apply to financial independence overall. We are looking at them in the context of retirement, but withdrawal rates and asset allocation play a role in financial independence at any age.


A withdrawal rate is a number that provides context for the amount that is withdrawn from a portfolio in a given year. The withdrawal rate is expressed as a percentage of the value of the portfolio. A simple way to determine the withdrawal rate is:


Juanita is 68 and retired from a career as a teacher. She is single, so to stay social and active she has moved into a rather nice senior living facility. Between the fees for the facility and her other minor expenses, Juanita has annual living expenses of $80,000. Between her Social Security benefits and a small pension, her annual income is $60,000. Given that her portfolio is worth $1 million, what is her withdrawal?

Juanita’s withdrawal rate is 2 percent.

The withdrawal rate is affected not just by the cash flow and income need, but also by income sources such as Social Security benefits for retirees that help offset the outflows. A safe withdrawal rate for an investment portfolio is between 3 percent and 4 percent. Studies have shown that withdrawal rates in this range will have a low risk of depleting the portfolio.


Asset allocation is the process of dividing an investment portfolio among different asset categories such as stocks, bonds, and cash equivalents. The mix of assets in a portfolio is unique to each investor. The asset allocation strategy that works best at any given point in time will depend on the investor’s time horizon and that person’s ability to tolerate risk.

With investing, risk and reward are interconnected. All investments involve some level of risk. An investor could lose all or some of their money in the purchase of a security. The reward for taking on that risk is the potential for greater investment returns. Investors with a longer time horizon are more likely to have greater returns by investing in asset categories with greater risk, like stocks or bonds, rather than restricting their investments to assets with less risk, like cash equivalents.

The time horizon for retirees is problematic because life expectancy is a significant factor. Should portfolio risk be reduced in anticipation of a short life expectancy? If a retiree lives longer than anticipated, then shorter portfolio duration will reduce returns and potentially affect lifestyle. A discussion of asset allocation and the potential for harm—living too long, or dying too quickly—is critical in planning for retirement and financial independence. As a bare minimum, the investment policy statement (IPS) should be updated to reflect that the investor is in the distribution phase of retirement planning.

Integration and Application of Retirement Planning in the PFP Process

Planning for retirement cannot take place in a vacuum. Recommendations made for retirement planning affect each of the other areas of personal financial planning. Beneficiary designations affect the estate plan. The purchase of long-term care insurance reduces the need for contingency funds for a long-term care event, and in turn, frees up more dollars to invest. The use of annuity contracts to supplement retirement income reduces overall risk to the investment portfolio, and the reduction in volatility increases returns over time. Each decision in the PFP process affects all of the areas; competent planning mandates integration and a holistic perspective of the client’s facts and circumstances.


Increased life expectancy is a significant factor in retirement planning and can affect all other areas of personal financial planning. In elder planning and estate planning, for instance, the amount of an inheritance available for children or a legacy can be affected. In addition, the hard questions may have to be asked regarding sufficient cash flow: Will the individual need to find work after retirement to make ends meet? Will the retiree’s children have to supplement cash flow? Will goals and plans have to be adjusted?

Life expectancy also affects investment planning with regard to withdrawal rates and asset allocation, as well as risk management planning relating to the analysis of long-term care and health and life insurance.


Assets in qualified retirement plans and IRAs total more than $20 trillion and represent 34 percent of U.S. household assets.3 Individuals, retirees, and personal financial planners want to make sure these assets are protected from creditor claims as much as possible.

Under ERISA, defined benefit plans and defined contribution plans are protected from all forms of creditor judgments. This protection does not apply to retirement plans that cover only the owner of the business or the owner and his or her spouse. In these instances, the protection is limited to bankruptcy.

Traditional and Roth IRAs are protected from bankruptcy claims up to a $1 million (indexed for inflation), so it is recommended when an individual rolls over qualified plan assets to an IRA, the assets be kept separate from regular IRA assets because rollovers into IRAs from qualified plans are not subject to the $1 million limit.

SEP’s, SIMPLE IRAs, Section 403(b) and governmental Section 457(b) plans are protected from bankruptcy claims without any limit.

With regard to state laws and non-bankruptcy creditors, traditional IRAs, Roth IRAs, SEP’S and SIMPLE IRAs are not offered much protection and the law is based on the owner’s state of residency.

Annuities and life-insurance policies and 529 plans are protected from creditors in some states.

An IRS tax lien can make all retirement vehicles vulnerable. When any plan’s assets are distributed, they can become available to creditors, again depending on state law.

Chapter Review

Planning for retirement is more than just saving money and withdrawing funds from an investment portfolio during an individual’s retirement. There are additional considerations. As you have seen, the government is intimately involved with the funding of retirement vehicles and is just as involved with the distribution of retirement assets from those vehicles. The personal financial planner plays a critical role in the management of distributions from retirement plans. The proper management of those distributions can make the difference between a comfortable and an uncomfortable retirement.


Hope and Jay Williams have come to you for advice. They want to be in the best position possible at retirement. What should they be doing at this point in the accumulation phase of the retirement planning process? What ideas come to mind in regards to their fact pattern?

1. Hope has 30 years of service with the defense contractor and is eligible to retire with the defined benefit plan. A benefit of 50 percent of the final year’s preretirement income is material.

2. Jay’s plan to continue working to age 70 is a significant factor.

3. Both Jay and Hope are maximum funding their qualified plans. The total of these contributions is $48,000 per year ($18,000 + $18,000 + $6,000 + $6,000). This amount, along with the employee’s portion of Social Security, when added to Hope’s defined benefit, may make up for the difference between the defined benefit check and her final year’s preretirement income.

4. Hope has a large position of employer stock in her profit-sharing 401(k) plan. Retiring now and utilizing an NUA strategy can significantly reduce both her and Jay’s income tax burden, especially since Jay wants to continue working until age 70.



1. Which of the following factors least affects a defined contribution plan participant’s account balance?

A. Investment return.

B. Inflation.

C. Employer contributions.

D. Life expectancy.

2. Alice Jones is a participant in Shield, Inc.’s ESOP. Over the years, Shield, Inc. has contributed stock with a cost basis of $100,000 to Alice’s account. Alice is planning to retire, and the stock has a fair market value of $300,000. She anticipates selling the stock at some point in the future. What are the income tax implications if Alice takes a lump-sum distribution at retirement?

A. $300,000 as ordinary income in the current tax year.

B. $100,000 as ordinary income in the current tax year, $200,000 as a long-term capital gain/loss when she sells the stock.

C. $200,000 as ordinary income in the current tax year, $100,000 as a long-term capital gain/loss when she sells the stock.

D. $300,000 as a long-term capital gain/loss when she sells the stock.

3. Pat’s 58-year-old husband Dennis recently died. He was employed by FastFood, Inc. at the time of his death. She brings Dennis’ retirement plan summary description to you for review. The employer-sponsored retirement plan is an ESOP. Pat is age 60. What advice might you give to her?

I. If she takes the employer securities as part of a lumpsum distribution, all of the net unrealized appreciation (NUA) will be nontaxable at the time of distribution.

II. The NUA constitutes income in respect of a decedent (IRD).

III. When she sells the stock after receiving it as part of a lump-sum distribution, the NUA portion of the proceeds will be taxed as long-term capital gain.

IV. If she takes the employer securities as part of a lump-sum distribution, all of the net unrealized appreciation (NUA) will be taxable at the time of distribution.

A. I, II, III.

B. I, II.

C. II.

D. I, III.

4. Which of the following retirement plans will qualify for NUA lump-sum treatment?

I. Profit-sharing 401(k) plan.


III. 403(b).


A. All of the above.

B. I, III, IV.

C. I, II, IV.

D. I, IV.

5. What is an exception to the tax penalty for the modification of a series of substantially and equal periodic payments within 5 years of the date of the first payment or, if later, age 59½?

A. Disability.

B. Illness.

C. Relocation.

D. Unemployment.

6. Herbert Johnson, age 55, participates in Miller Hospital’s 403(b) plan. His compensation for 2016 is $60,000. What is his maximum salary deferral for 2016?

A. He can defer $12,000.

B. He can defer $15,000.

C. He can defer $18,000.

D. He can defer $24,000.

7. Harmony Services, Inc. has 58 employees. The company would like to implement an employer-sponsored retirement plan with flexible contributions. The census indicates that integration with Social Security benefits would benefit the higher-wage earners. The director of human resources would like a plan that is simple to install. Which of the following plans best fits the company’s needs?

A. Profit-sharing.

B. Profit-sharing 401(k).



8. Richard Thomas, the owner of Green Scapes Lawn Services, Inc., is age 57. He began the company 30 years ago, and at times it was a real struggle. Richard would like to retire at age 67. Because the lawn services industry is physically demanding, most of his employees are younger and lower paid compared to his income of $230,000. Richard has no debts, personal or business, and he is willing to reduce his current income. Which of the following employer-sponsored retirement plans best fits the facts and circumstances?

A. Cash balance plan.

B. Defined benefit plan.

C. SIMPLE 401(k).

D. Target benefit plan.

9. Angie Walters retired from Hanson, Hanson and Roberts, LLLP on her 70th birthday on June 10. If Angie accomplishes a direct rollover to an IRA, when must she take her first RMD?

A. April 1 of the following year.

B. June 10 of the following year.

C. December 31 of the current year.

D. Within 60 days of the rollover.

10. Which of the following retirement plans is eligible for a QDRO?

I. 403(b).

II. 401(k).



A. I, II.

B. II.

C. I, III, IV.



1. The Internal Revenue Service has a website that provides an overview of the various types of retirement plans. Review the plan links and select the plan type that you would implement if you were a business owner.

2. In planning for retirement and financial independence, the Trinity Study is an informal name used to refer to a 1998 paper titled Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable. Find the paper and summarize its findings. Do you agree or disagree with the conclusions?

3. The National Association of Insurance Commissioners has created a model regulation for suitability in annuity transactions. Annuity contracts are a significant retirement savings vehicle for retirement and financial independence. Review the model act. What new information was discovered? What questions do you have as a result of your review?

4. In planning for retirement and financial independence, the IRS requires the use of a variety of actuarial tables. What actuarial tables are available over the Internet? Based on the tables, what is your life expectancy? Do different tables have different mortality assumptions?

5. Enron Corporation used employer stock in its employer-sponsored retirement plans. What types of qualified plans did the Enron Corporation have?

6. What resources are available from the Internet to assist with Section 72(t) calculations?

7. To which retirement savings vehicle does Section 72(q) apply?

8. Locate the following article from the January 1, 2014 issue of The Tax Adviser: “Protection from Creditors for Retirement Plan Assets,” by Richard A. Naegele, Mark P. Altieri, and Donald W. Mcfall Jr. Identify whether your state protects IRAs from all creditor claims.