NEW FEDERAL LAW AFFORDS
ADDITIONAL EXCEPTION TO CODE 72(t)
EARLY DISTRIBUTION TAX
Defending Public Safety Employees’ Retirement Act (the “Act”), which was signed into law by President Obama earlier this year, includes some important changes to the “early distribution tax” under Section 72(t) of the Internal Revenue Code of 1986, as amended (the “Code”), which are relevant to public safety officers who are participating in governmental retirement plans.
Section 72(t) Tax and the Public Safety Officer Exception
Under Section 72(t) of the Code, all payments from a qualified retirement plan paid to a participant prior to the participant reaching age 59 ½ are subject to an additional 10% income tax, unless an exception is available. Nontaxable payments are not subject to the early distribution tax. For example, a payment rolled over to an IRA is not subject to the tax.
The Code provides several exceptions to the Section 72(t) tax. Under current law, there is an exception for distributions made to a participant after his separation from service, during or after the year in which the participant attains age 55. For public safety officers who are participants in a defined benefit pension plan, this age requirement decreases from 55 to 50. Therefore, public safety officers who separate from service in the year of or after reaching age 50, would not be subject to an early distribution tax, if their plan was a defined benefit plan. There is another exception to the Section 72(t) tax for distributions that are part of a series of substantially equal periodic payments, made over the life or life expectancy of the participant (or the participant and a designated beneficiary), and that begin after the participant separates from service at any age. Accordingly, if a participant in a plan separates from service and begins to receive monthly pension payments from a plan, those payments will be exempt from the Section 72(t) tax under the exception. Subject to certain exceptions, the modification of the periodic payments during the 5-year period beginning on the date of the first payment, so that they are not substantially equal, will result in all of the substantially equal payments becoming subject to the early distribution tax as if the exception never applied.
Recent Changes under the Act Effective as of January 1, 2016
The Act expanded the age 50 public safety officer exception. For distributions made after December 31, 2015, the exception will apply to all governmental plans, including defined contribution plans. Therefore, under this amendment, a public safety officer, who participates in a defined contribution plan and separates from service in the year of or after reaching age 50, will be able to take distributions from his account without paying the Section 72(t) tax.
In addition, the Act has modified the Section 72(t) exception for substantially equal payments. As described above, periodic payments that are modified will cause the participant to become subject to the early distribution tax as if the exception never applied. However, effective as of January 1, 2016, the modification of the substantially equal payments that results from a payment that qualifies for the age 50 public safety officer exception will not be considered a change to the substantially equal payments. For example, a participant in a defined contribution plan could start receiving monthly payments from the plan, then elect to receive a lump sum payment of his account balance in the plan and, if such lump sum payment qualified under the age 50 exception, the Section 72(t) tax will not be triggered by such modification.
Our thanks go out to attorneys Robert Friedman and Sepedeh Tofigh, both of Holland & Knight, for this very informative piece. And special kudos to retired Miami firefighter Dan Givens, who “discovered” the Act, which surprisingly received very little coverage in the media.