CRS REPORT DESCRIBES PROBLEMS WITH PENSION WITHHOLDING RULES.

SUMMARY

The extension of emergency unemployment benefits signed into law on July 3, 1992, included several provisions designed to raise revenue to offset the cost of these extra benefits. One provision mandates 20-percent income tax withholding on all lump-sum distributions from employer pension plans except those that are transferred directly from one plan to another or to an individual retirement account (IRA) without passing through the plan participant's hands. All pension plans are now required to offer direct transfers that bypass the participant and, hence, are not subject to withholding. Participants are now permitted to roll over any portion of their pension assets when received as a lump sum. (Prior policy permitted rollovers only when a distribution amounted to at least half of a participant's assets in the plan.) The major goal of these changes is to encourage plan participants to preserve retirement savings for later use and to discourage the immediate consumption of savings. Critics argue that the changes burden plan sponsors, may trap unwary participants, and fail to address the major reasons why workers often lose much of the value of future pension benefits when changing jobs. Legislation has been introduced in the 103d Congress to repeal mandatory withholding, but no action has occurred.

THE LEGISLATIVE CONTEXT

Under the Budget Enforcement Act, legislation to create new Federal entitlements must be offset by reductions in entitlements and/or increases in Federal revenue. The July 3, 1992, extension of the temporary emergency unemployment compensation program constituted such legislation, and the enacted bill (P.L. 102-318) included several revenue-raising provisions. One of these provisions imposes a mandatory 20-percent Federal income tax withholding rate on certain distributions from employer pension plans. This provision does not change the taxability of these distributions, nor does it impose a new tax. It simply requires that 20 percent of distributions be sent to the Internal Revenue Service as tax withholding. The actual tax status of a distribution and the recipient's tax liability is still determined as before when the annual tax return is filed.

The offsetting of new spending by revenue increases is a budget procedure intended to maintain a limit on the annual deficit in the Federal cash budget. The revenue actually raised by a particular law flows into the U.S. Treasury and is used to meet any current obligation of the Federal Government. The funds are not held in reserve to pay the specific benefits provided in the law (in this case, emergency unemployment benefits). Thus, reports that pensions are being taxed to pay unemployment benefits are not literally true. Any revenue raised by mandatory tax withholding from pension distributions is used for the general purposes of the Government.

WHAT THE NEW LAW PROVIDES

Since most contributions to employer-sponsored pension plans are not subject to the Federal income tax, and these funds earn interest tax-free while invested in the plans, distributions of these untaxed funds from pension plans are taxable as ordinary income. However, the recipient of a distribution can defer taxation by transferring the distributed assets to another employer pension plan or to an IRA within 60 days, or by having the plan execute such a transfer directly. Such tax-deferred transfers are termed "rollovers." ¹ Under the law prior to P.L. 102-318, distributions eligible for rollover were limited to distributions that included at least half of the assets to which a participant was entitled from the plan. Plan trustees were not obligated to make rollovers directly to other plans ("trustee-to-trustee" rollovers).

Under previous law, income tax withholding from taxable distributions was not required but could have been chosen by the participant. If the participant elected withholding, withholding tables were used to determine the rate in the case of a total distribution. Otherwise, a 10-percent rate was used.

These provisions changed as a result of P.L. 102-318, effective for distributions from employer pension plans after December 31, 1992. ² This law made several important changes:

o Plan trustees are now required to offer participants the option of trustee-to-trustee rollovers.

o Plan administrators are required to inform participants of their distribution options.

o A lump-sum pension distribution received directly by a participant is subject to mandatory income tax withholding at a 20-percent rate, regardless of whether the distribution is rolled over by the participant within the allowable 60-day period.

o A rollover of a partial distribution is now allowed, even if the distribution is less than half of the participant's assets in the plan.

IT SHOULD BE NOTED THAT MANDATORY WITHHOLDING APPLIES ONLY TO LUMP- SUM DISTRIBUTIONS FROM EMPLOYER PLANS. IT DOES NOT APPLY TO PERIODIC DISTRIBUTIONS, NOR DOES IT APPLY TO IRA WITHDRAWALS.

Sponsors characterized this law as a revenue-raiser primarily because the mandatory withholding speeds up collection of taxes on distributions that are not rolled over, thereby moving some revenue collection into an earlier fiscal year. ³ It also permits the Government to earn interest on taxes withheld from distributions that are rolled over by participants until they obtain their tax refunds. Additional revenue also may be realized if mandatory withholding results in rollover amounts being smaller than under prior law, which could happen if participants whose distributions are reduced by mandatory withholding do not have other funds they can use to replace the amounts withheld when they execute their rollovers. However, in the longer term, as plan participants learn about this new law, taxable distributions may be reduced because of the encouragement of trustee-to-trustee rollovers, thereby delaying the collection of taxes on pension distributions compared to prior law.

HOW THE NEW LAW WORKS

To understand the new law, consider the example of a person eligible to withdraw pension funds who elects to withdraw $100,000 as a lump sum. This amount need not include all the plan's assets to which the participant is entitled. The plan administrator informs the participant of the option to have the distribution transferred directly by the trustee to another employer plan or to an IRA. Employer plans are not required to accept trustee-to-trustee transfers, but an individual faced with this situation can have the money sent to a rollover IRA instead.

If the participant elects a trustee-to-trustee rollover (Case A), the amount rolled over will remain tax-deferred. However, suppose the participant elects to receive the distribution directly (Case B). The plan will send the participant $80,000, the full distribution amount less the mandatory 20-percent tax withholding. The participant can still roll over a sum equal to the full distribution of $100,000 or any part thereof within 60 days of its receipt. However, a full rollover will require the participant to come up with the withheld amount ($20,000) from other assets. Doing so will keep the full distribution tax-deferred.

Suppose the participant has no liquid assets available with which to make the full $100,000 rollover (Case C). In that case, $80,000 could be kept tax-deferred by means of a rollover, but the remaining $20,000 would be considered a taxable distribution. The $20,000 distribution would also be subject to a 10-percent tax penalty if it occurs before age 59-1/2 and does not qualify for any of the exemptions ⁴ from the tax penalty for early withdrawals.

When a participant files a tax return for the year that includes this $100,000 distribution, a variety of situations could occur:

o If the full distribution were rolled over trustee-to-trustee, there would be no tax withholding and no tax liability, and the transaction would not affect the tax owed for that year (Case A);

o If the full distribution were first received by the participant and then rolled over, there would be no tax liability and the amount of tax withheld would be received as a refund unless needed to make up for underwithholding from other sources of income (Case B);

o If the distribution were received by the participant, but only $80,000 were rolled over, tax would be owed on the other $20,000, plus a $2,000 penalty tax if it were an early withdrawal. A part of the withholding would be refunded unless needed to cover underwithholding from other income sources (Case C);

o If no part of the distribution were rolled over, the full $100,000 distribution would be taxed as ordinary income (plus a $10,000 penalty if it were an early distribution), and the tax liability would be offset by the amount withheld, with any difference between liability and withholding adding to or subtracting from the participant's taxes owed or refund due.

ISSUES RAISED BY THE NEW LAW

Aside from the immediate purpose of moving revenue forward into fiscal year 1993 to offset the cost of the unemployment benefit extension, the primary objective of mandatory withholding and the accompanying changes in law is to encourage the preservation of retirement assets. Many policymakers have been concerned that too high a proportion of lump-sum pension distributions is spent quickly and too little is rolled over to other retirement plans. A consequence of this behavior is that retirees will have fewer assets to use for income in old age.

The new law attempts to increase asset preservation in three ways. First, mandatory withholding will lead some participants to use trustee-to-trustee rollovers, a process that makes it impossible to spend a distribution immediately. Currently, only about 1 in 10 lump- sum pension distributions is rolled over into another retirement plan. About one-third of lump-sum distributions is spent for goods and services. Second, plan trustees are required to offer trustee-to- trustee rollovers and inform participants of their options, which will presumably increase the number of such rollovers. Third, liberalizing the rules for rollovers of partial distributions expands the opportunities for rollovers.

The law could present problems for the uninformed, however. Someone who intends to roll over a distribution but is unaware of the advantage of trustee-to-trustee transfers might accept a distribution directly and then be unable to make up the withheld amount with other funds. The individual would then have less in retirement assets than under prior law and would incur a tax liability (the loss of tax deferment) for the amount not rolled over plus the penalty tax that might apply for an early distribution.

Another problem has to do with hardship withdrawals from section 401(k) retirement plans. ⁵ These withdrawals are allowed for active employees who have immediate financial need and lack other financial resources. Hardship withdrawals are subject to mandatory withholding, which partially undermines the purpose of such withdrawals.

A technical problem is presented by employees who have outstanding loans from their pension plans. Application of mandatory withholding in this circumstance raises the question of what source the employer can tap for the withholding, because the cash balance in the plan account could be less than 20 percent of the full distribution since the outstanding loan is considered to be a part of the distributed amount that is subject to withholding.

Some pension professionals have criticized the new law as overly burdensome for plan sponsors. Consulting actuary David Langer estimated that the cost of plan amendments and added administrative expenses will total $4.55 billion for pension plans over the next 5 years.

Advocates for participants point out that the changes do not deal with the main problems of pension portability. That is, the law does not improve the treatment of separating employees. Pension plans are not required to allow lump-sum distributions to separating employees, nor does the law provide inflation protection for deferred benefits when separating employees leave plans which tie benefits to final salary. Currently, about 60 percent of defined benefit pension plans do not offer lump-sum distributions, and none provides inflation adjustments for deferred benefits paid to participants who leave their jobs before retirement age.

In response to these criticisms, bills have been introduced in the 103d Congress calling for repeal of mandatory withholding and the associated changes in pension rules (H.R. 94, H.R. 503, S. 190, S. 195, S. 501). However, no action has occurred on these proposals.

² Section 403(b) annuity plans maintained by State and local governments were given up to an additional year to make changes in law needed to allow trustee-to-trustee rollovers. Section 403(b) plans are tax-deferred annuity plans for nonprofit institutions of higher education and certain research, cultural, and scientific organizations.

³ The Joint Committee on Taxation estimated that $2.1 billion in revenue would be collected in fiscal year 1993 rather than in later years. However, this change in law could lead pension plan participants to alter their behavior to avoid mandatory withholding to a greater degree than anticipated in the revenue estimate, which would negate the expected speedup in revenue collection.

⁴ Exemptions from the early retirement tax penalty are available for the disabled, survivor beneficiaries, and retirees who elect withdrawals in the form of lifetime annuities.

⁵ Section 401(k) plans allow employees to elect salary deferrals into retirement plan accounts. Employers often match these deferrals.