Taxes on Lump-Sum Distributions
QUESTION: About five years ago, my employer began large layoffs for lack of new contracts. I survived the first round of cuts but was added to the list of unemployed in December, 1983. During my tenure of just under 10 years, I became 100% vested in the company’s employee stock option plan and 70% vested in a company savings plan. My first effort to get a lump-sum distribution from those plans was denied by the company on the grounds that it doesn’t make such distributions until the recipient is at least 62 years old. I am not yet 62. The second time, I argued successfully. But now the company says that, because I received a premature distribution from the plan, I don’t qualify for 10-year averaging on that lump sum. In other words, the $90,000 I received earlier this year will be taxed as ordinary income, and I will have to give half of the money to Uncle Sam. Is this legal?--F. B. B.
ANSWER: Either a pertinent fact is missing from your run-down of the circumstances surrounding the distribution or you have been misinformed. Based on the information you provide, there isn’t any reason to deny you 10-year forward averaging. The Frank B. Hall Consulting Co., which has been advising companies, including your former employer, on such matters as retirement plans for over 100 years, says anyone who completes at least five years of service with a company before his employment is terminated and who then receives all of his funds from the company’s qualified pension or profit-sharing plan is entitled to use 10-year averaging to reduce his tax bill.
As with most tax laws, there are some technicalities that could reverse that opinion. If, for example, this is your second lump-sum distribution since you turned age 59 1/2, you wouldn’t be entitled to the favorable tax treatment on this, your second, distribution. There also is a rule that a lump-sum distribution, to qualify for 10-year averaging, can be made in only four situations: death, disability, the participant’s having reached age 59 1/2 or separation from service. Again, you seem to meet that rule. So if, as you suggest, your former employer is citing an age policy as the reason for denying you 10-year averaging, you seem to have a legitimate case for challenging that decision. Ten-year averaging can make a big difference in a tax bill, and anyone counting on using it in the near future would be well advised to follow the tax-reform proceedings in Congress closely. Averaging is one of many tax breaks that President Reagan wants to eliminate.
Q: My husband is closing a Keogh plan this year, and he and two employees will be taking the money out. They hope to use 10-year averaging to reduce the tax bill on the payment, but you seemed to suggest in an earlier column that this break isn’t available to them. Can you elaborate?--S. F.
A: Tax specialists and pension-plan consultants are in agreement that if a retirement-plan participant takes his or her distribution from the plan while still employed by the plan sponsor, 10-year forward averaging isn’t available to him or her. In such cases, the recipient has to pay ordinary income tax on the distribution unless he or she rolls over the distribution into an IRA, thereby deferring the tax.
Keoghs fall under this rule.
Q: In a recent discussion of Ginnie Mae investments, you briefly mentioned Ginnie Mae funds and said they can be acquired for as little as $1,000. Where can I find them that cheap? Also, is it possible to buy them without a load charge? And what about their taxability?--R. E. E.
A: For a listing of funds that invest strictly or partly in Ginnie Maes, write to the Investment Company Institute, 1600 M St., N.W., Washington, D.C. 20036, or call (202) 293-7700. If you ask for the Ginnie Mae Mutual Fund List, the institute will give you the list at no charge. There are now about 20 funds investing in Ginnie Maes, and the list is growing rapidly. Many are load funds--that is, they charge sales commissions--and some require minimum investments of $3,000 or $5,000. But if you shop around, you can find some permitting an initial investment of $1,000 or less.
The Fidelity family of mutual funds in Boston, for example, offers a Mortgage Securities Fund for a minimum investment of $1,000 plus a sales charge equal to 1% of your investment. The fund invests in Ginnie Mae, Fannie Mae and Freddie Mac securities.
The Colonial group of mutual funds, also in Boston, will accept investments as small as $250 in its Colonial Government Securities Plus Trust, which invests in Treasury securities as well as Ginnie Maes. But it charges a sales commission of as much as 6 3/4% of the investment. If you’re looking for a Ginnie Mae fund with no sales commissions, you probably will have to invest more than $1,000. The Vanguard group’s Ginnie Mae fund, for example, charges no sales commissions and no fees for reinvesting the interest you earn, but it requires an initial investment of at least $3,000. Vanguard is in Valley Forge, Pa.
Most Ginnie Mae funds give investors a choice on handling the interest paid--which is, by the way, taxable. It can be automatically reinvested in the fund or paid out. If you opt for automatic reinvestment, be sure to ask whether there is a charge for that service. Some funds charge as much as 4% to reinvest dividends. Be sure, too, to compare sales commission charges if you decide to select a load fund. One reader wrote in to say that she paid a $910 sales commission on a $25,000 Ginnie Mae investment. And that is half the going rate of some funds.
Also, you should be aware that Ginnie Mae funds behave like bond funds, so they can be quite volatile. For every 1% change in interest rates, Ginnie Maes are estimated to move about 6% in the other direction.
One way to lessen the effect of interest-rate swings on your Ginnie Mae investment, and at the same time defer the taxes on the interest, is to put a Ginnie Mae fund into an IRA. Regular contributions over many years will lessen the effects of these funds’ volatility. Most mutual funds will substantially cut their minimum investment requirements, some to as low as $10, if you wrap the funds into an IRA.
For more information on these funds, call the funds directly or, if you are interested in a load fund, contact any stockbroker.
Debra Whitefield cannot answer mail individually but will respond in this column to financial questions of general interest. Do not telephone. Write to Money Talk, Business Section, The Times, Times Mirror Square, Los Angeles 90053.
