Sept. 22, 2017
By Heather R. McNabb, QKA, and Peter J. Shuler
When an employee dies, companies have several issues to contend with, including the grieving process within the company, replacing the deceased employee so that work can continue, and paying certain benefits to beneficiaries. Guidance within the Internal Revenue Code (IRC) governs when retirement plans, including employee stock ownership plans (ESOPs) and 401(k) plans, must begin to pay a deceased participant’s vested balance to his or her beneficiary or beneficiaries.
The timing and amount of a distribution to a beneficiary are dependent on two factors: how the beneficiary is related to the participant and when the participant died.
Getting Started: Determining the “Who” and the “When”
The first step to correctly process a deceased participant’s distribution is to determine the identity of the beneficiary and that person’s relationship to the deceased. If the deceased participant was married at the time of death, the surviving spouse is the beneficiary unless there is a valid election naming another beneficiary or beneficiaries. If the participant was not married and did not designate a beneficiary, the document governing the retirement plan generally will have an ordering provision that names surviving children, parents, and siblings as beneficiaries. If the participant didn't name a beneficiary, there are no surviving relatives, or the plan terms do not stipulate who should be the beneficiary, the participant’s estate is the beneficiary.
The second step when processing a deceased participant’s distribution is to determine whether the participant died before or after the required beginning date (RBD), which is April 1 of the year following the later of the participant turning 70 1/2 or the date the participant retires. If the deceased individual owns 5 percent or more of the company’s stock, the RBD is simply April 1 of the year after the participant turns 70 1/2.
If a participant dies before the RBD and the surviving spouse is the sole designated beneficiary, the plan may delay distributions to the surviving spouse until the year the participant would have turned 70 1/2. However, the plan does not have to delay distributions and may have a provision requiring balances to be paid sooner.
If the surviving spouse is not the sole designated beneficiary, distributions to the beneficiary must begin under one of two rules: the life expectancy rule or the five-year rule. Under the life expectancy rule, distributions must begin by the end of the calendar year following the year in which the participant died. Under the five-year rule, the entire balance must be distributed by the end of the calendar year in which the fifth anniversary of the participant’s death will occur. The plan document may have a provision stating whether the life expectancy or five-year rule applies, or it may allow the beneficiary to choose. In the event that there is no provision in the plan document, the life expectancy rule applies by default.
If the participant passes away after the RBD, distributions to the beneficiary or beneficiaries must be made by the end of the calendar year following the participant’s death regardless of whether the surviving spouse is the sole designated beneficiary. The required minimum distribution that would be payable to the participant also still must be made in the year of the participant’s death, but it instead is paid to the beneficiary or beneficiaries.
Moving Forward: Determining the “How Much”
Once the timing of distributions is determined, the next step is to determine the amount to be distributed. To calculate the minimum amount to be paid when the life expectancy rule applies, a plan first must determine the beneficiary’s life expectancy factor, which can be found in tables the IRS publishes. After the life expectancy factor is determined, the deceased participant’s account balance is divided by that number to determine the amount to be paid that year.
If a spouse is the sole beneficiary and the plan uses the life expectancy rule, the life expectancy factor is based on the spouse’s single-life expectancy, using the spouse’s age each year. When the beneficiary is not the spouse, the life expectancy factor used is the beneficiary’s single-life expectancy factor, based on the beneficiary’s age in the year following the year in which the participant died. But, for each subsequent year, the life expectancy factor is reduced by one and no longer is based on the beneficiary’s age. In the case of multiple beneficiaries, the age of the oldest beneficiary is used to determine the life expectancy factor in the first distribution year, and then the factor is reduced by one each subsequent year. This rule is used even if the spouse is the oldest beneficiary. If the participant’s balance already has been split into separate accounts for each beneficiary, then the distribution amount can be determined separately for each account based on the beneficiary of each account. The account balance for each account at the end of the calendar year preceding the year for which the distribution is made is used to determine subsequent distributions.
If even one of the beneficiaries is not a person for whom a life expectancy factor can be determined, such as an estate or certain trusts, then the deceased participant is considered to have no designated beneficiary and the five-year rule must be applied instead of the life expectancy rule. Under the five-year rule there is no specific amount that must be distributed in years one through four, but the entire amount must be distributed by the end of the calendar year in which the fifth anniversary of the participant’s death will occur.
Being Prepared: Determining What Comes Next
Upon learning the news of a participant’s death, sponsored plans need to determine the beneficiary or beneficiaries entitled to receive the participant’s balance. It also is necessary to obtain the beneficiary’s Social Security number, address, and date of birth in order to calculate the amount of the required distribution and the amount from IRS Form 1099-R, “Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.,” for tax reporting purposes.
In most cases, distributions to a beneficiary or beneficiaries comply with the rules. The beneficiary is readily determined and provides the plan with the information needed to calculate and pay the benefit. In cases where the distributions are not timely made, a penalty of 50 percent of the amount that should have been distributed is assessed and payable by the beneficiary. However, the penalty can be waived if the plan can demonstrate that the delay was due to reasonable cause.