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Does Your Puerto Rico Qualified Retirement Plan Allow for
Installment Payments? It Should!
By Carlos Gonzalez-Padro,
Esq.
The Home Depot, Atlanta, GA
For a host of tax and administrative reasons, most of the U.S. and
international companies operating in Puerto Rico offer retirement
benefits to their Puerto Rico employees by including those employees
as participants in one or more retirement plans qualified only in
Puerto Rico (commonly referred to as “P.R.-only qualified
plans”), rather than as participants in the company's U.S.
retirement plans. These P.R.-only qualified plans are generally
designed as mirror plans of the equivalent U.S. plans. Except for
certain provisions that reflect the technical differences between the
U.S. and P.R. tax rules governing retirement plans (e.g., different
limits on elective deferrals, different definitions of highly and
non-highly compensated employee, and some qualification requirements
that apply in one jurisdiction but not the other), the equivalent P.R.
and U.S. plans are essentially alike. There is nothing inherently
wrong with such approach, as it facilitates plan administration and it
may even result in savings in recordkeeping and benefits communication
costs. There is one area, however, where oftentimes U.S. and
international companies simply replicate the U.S. plan terms when
designing their P.R.-only qualified plans without realizing that it
would be better to use different terms: the plan's alternatives for
distribution.
Except for some limited rules regarding distributions in the form
of employer stock and lump-sums to individuals born prior to 1936, the
U.S. tax code no longer awards favorable tax treatment to particular
forms of distribution. Whether a participant receives his or her
benefits through a lump-sum payment or installments, the tax treatment
is essentially the same; the taxable portion of the amount received is
ordinary income and is taxed at the regular tax rates. Since lump-sums
are easier and less expensive to administer than installments, and
from a tax standpoint both are treated alike, many U.S. retirement
plans, particularly 401(k) plans, have lump-sums as their only form of
distribution. Participants who want to spread out the distribution of
their retirement benefits over a series of years may do so by rolling
their benefits over to an IRA and then selecting some other form of
distribution within the IRA. Many U.S. and international companies
follow that same approach when designing their P.R. retirement plans.
The problem with that approach is that under the P.R. tax code the
taxation of lump-sums is quite different from the taxation of
installments, and in most cases participants of P.R.-only qualified
plans would be better off receiving their retirement benefits through
installments rather than lump-sums.
Under P.R. law there is one set of tax rules for lump-sums and
another for installments. Lump-sums are taxed at a flat rate of 20%,
or, if at least 10% of the participant's account (or for defined
benefit plans, the plan assets) have been invested in P.R. assets
during the two years prior to distribution, a flat rate of 12.5%. [It
should be noted that at present few P.R.-only qualified plans are
eligible to take advantage of the 12.5% rate, so in reality most
lump-sum distributions are taxed at a 20% tax rate.] Lump-sums are
likewise subject to an income tax withholding at source of 20% or
12.5%, as applicable (generally, 20%).
On the other hand, installments are taxed as ordinary income and
are not subject to any income tax withholding at source. The key
difference, however, is that installments are subject to an annual
income exclusion that does not apply to lump-sums. Specifically, if on
the last day of the taxable year of distribution the participant is
younger than age 60, the first $10,000 that he or she receives in the
form of installments from a P.R.-qualified plan is tax exempt, and if
the participant is age 60 or older, the annual income exclusion
increases to $14,000. For taxable years 2008 and beyond, this annual
income exclusion is set to increase to $11,000 for participants
younger than 60 and $15,000 for participants 60 or older. This annual
income exclusion also applies to distributions to beneficiaries.
It should be noted that this is not a once-in-a-lifetime income
exclusion, but an annual income exclusion. Participants get to exclude
the relevant amount of retirement income each taxable year. The tax
savings opportunity that this annual income exclusion offers is
considerable and should not be overlooked. For example, if a
participant has an account balance of $100,000, a lump-sum
distribution would result in a tax liability of $20,000. In contrast
if this participant were allowed to receive his or her benefits in the
form of equal annual installments over a 10 year period, he or she
will most likely not have to pay any taxes on the retirement benefits.
Not even a cent. That is a $20,000 tax savings, and it is entirely
legal. Since the average plan account for the majority of P.R.-only
qualified plans is well below $100,000, it is possible that most
participants will be able to shield their retirement benefits from
local taxation by taking advantage of the annual income exclusion on
installments. Only those participants with account balances above the
$150,000 to $200,000 range are likely to be better off with lump-sum
payments rather than 10-year installments. To accommodate both groups
of participants, a P.R.-only qualified plan may be designed to offer
both lump-sums and installments.
While installments are not subject to income tax withholding at
source, the payor still has to report them to the P.R. Treasury
Department (commonly known by its Spanish name as
“Hacienda”). Specifically, the payor needs to prepare
Hacienda Form 480.6A, officially known as “Informative Return
for Income Not Subject to Withholding,” and send a copy thereof
to Hacienda and the payee by February 28 of the year following the
year of distribution. The mechanics of incorporating installments into
a P.R.-only qualified plan are the same as for an equivalent U.S.
retirement plan, i.e., the plan is formally amended, the recordkeeping
system is setup for processing installments, the change is
communicated to participants via a SMM or SPD, etc.
In conclusion, offering installments to participants and
beneficiaries in P.R.-only qualified plans is a rather simple and
inexpensive proposition which should significantly enhance the
participants' retirement benefits, thus increase their level of
satisfaction with the plan. For those U.S. and international companies
whose P.R.-only qualified plans do not offer installments, this is a
text book example of an easy opportunity to improve employee benefits
at almost no cost or effort.
For more information, in the Tax Management Portfolios, see
Gonzalez-Padro, 324 T.M., International Pension Planning -- Puerto
Rico.
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