Op-Ed: Retirement plans and their taxation under the new Internal Revenue Code
Author CPA Rubén M. Rodríguez-Vega is former president Puerto Rico Society of CPAs.
Law 1 of January 31, 2011, also known as the Internal Revenue Code for a New Puerto Rico (herein the “New Code”), replaces the Internal Revenue Code of 1994, as amended. This New Code amends and adds new provisions to the previously known Section 1165, related to Puerto Rico Pensions Plans (now Section 1081.01). This article specifically refers to Chapter 8 — Trust and Successions, Subchapter A — Employees Trusts.
The New Code does not significantly change the taxation rules of pension plans in Puerto Rico, except for annual contributions to the plan, partial distributions due to separation of service and with respect to distributions before separation of service, for example, distributions for what is commonly known as financial emergency or “Hardship Withdrawals.”
Trusts corresponding to an employer pension plan and that are also qualified by the Puerto Rico Treasury Department, will not be taxable if it complies with certain requirements provided by previously mentioned Subchapter A. Nonetheless, we know that there will always be some questions and doubts. Let’s take a look:
If the Trust is tax exempt, what happens with the contributions made?
Contributions made by the employer and the participant in a defined contribution plan (commonly known as Keogh or Profit Sharing Plans), will not be taxable as long as the sum of these contributions does not exceed the lesser of: $49,000, or 100 percent of the participant’s compensation
Contributions made by a participant in a cash, or deferred contribution plan (most commonly known as 401k) will not be taxable as long as the sum of these contributions does not exceed the lesser of: $15,000, or 100 percent of the participant’s compensation
Funds contributed by the participant and those contributed by the employer to the participant’s account in the pension plan, as well as the increase in value of the account, will not be taxable (the payment is deferred from income taxes) until participant requests for the distribution of these funds.
Then the question is: When are funds contributed to a defined contribution plan taxable?
Funds contributed to a retirement plan are taxable at the time when the participant receives these funds. The income tax is determined by the way funds are received: either in a lump sum or partial payments.
Funds received in a lump sum might be taxed at a special capital gain tax rate, whereas the funds received in partial payments are taxed as ordinary income.
Distributions received in a lump sum:
Funds received in a lump sum due to separation of service, will be taxed as a long-term capital gain subject to a special rate of 20 percent. This special tax rate might be reduced by half and would only pay 10 percent if the following requirements are met:
- The trust for the pension plan is organized under the laws of the Government of Puerto Rico or has a trustee domiciled in Puerto Rico and uses this trustee as paying agent; and
- At least 10 percent of the total assets of the trust have been invested in property located in Puerto Rico as defined by the New Code. This 10 percent investment requirement will be computed based on the average daily balance of the trust’s investments during the plan year for which the distribution is made and each one of preceding two plan years for which the distribution is made. Assets in the participant’s account may be used, in case of defined contributions plans, to compute the 10 percent investment in assets within Puerto Rico.
Distributions received periodically (partial distributions):
In case of partial distributions from a pensions Plan, the New Code requires a 10 percent withholding, unless this partial distribution is made with respect to a loan. This withholding is also required in the case of distributions made for qualified emergencies (“hardship distributions.”)
However, this 10 percent withholding will not be required if a partial distribution is made to a participant due to separation of service and said partial distribution does not exceed the amount of $21,000 annually during taxable year 2012. This withholding limit will increase to $25,000 for retired taxpayers who have reached 60 years of age on the last day of the taxable year.
It is important to remember that Section 1031.02 (a) (13) exempts from income tax contribution the amounts received from Pensions Plan if funds are received in the form of annuities or periodic payments, due to separation of service, up to $11,000 annually. The exempt amount increases to $15,000 for retired taxpayers who have reached 60 years of age on the last day of the taxable year.
In summary and speaking clearly, the manner in which pension plan funds are distributed to participant determines the way they will be taxable for tax purposes. Partial distribution will be taxed as ordinary income (except the first $21,000 annually received and $25,000 in the case of retired tax payers who have reached 60 years of age on the last day of the taxable year) during taxable year 2012. These amounts increase to $23,500 and $27,500, respectively for taxable year 2013.
In case of lump sum distributions due to separation of service, funds are taxed as long-term capital gain, in which case it requires a withholding at source of 20 percent or 10 percent if it complies with the investment requirement of property located in Puerto Rico.
Therefore, it is extremely important to plan and consider these taxable events before asking the employer for a distribution of funds to determine the best and more convenient way to receive the funds. We recommended that you consult your Certified Public Accountant or Financial Advisor before making a decision.
