MEMORANDUM TO CLIENTS AND FRIENDS
Tax 2006-04
May 12, 2006
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Retirement Plans Update - Part III

Proposed Legislation Would Lower Tax Rates on Lump-Sum Distributions, Provide for Pre-Payment of Taxes and Allow Catch-up Contribution

In the middle of the current budgetary crisis and turmoil between the Puerto Rico Executive Branch and the Legislative Assembly (both controlled by different parties), two separate bills that would amend certain provisions related with qualified retirement plans in Puerto Rico are expected to be enacted into law during the days following the date of this memorandum. These bills would amend the Puerto Rico Internal Revenue Code of 1994, as amended (the "PR Code") to: (i) lower the tax rate for distributions from Puerto Rico individual retirement accounts ("IRAs") and lumpsum distributions from Puerto Rico qualified plans ("Plans") received during a six-month period; (ii) allow during the same time period the pre-payment of the applicable tax on accumulated and undistributed amounts in IRAs and Plans; and (iii) incorporate provisions for catch-up contributions. Although these bills have not been enacted into law, we understand at this time that it is very likely they will be signed by the Governor in the days following the preparation of this memorandum.

I. House of Representatives Bill No. 2596 ("H.R. 2596")¹

A. Retirement Plans

H.R. 2596 would amend the PR Code to lower the tax rate applicable to lump-sum distributions on account on separation from service received from May 16 to November 15, 2006 (the "Window Period") to a 5% tax rate, without regards as to the location of the trust funding the Plan.²

In addition, H.R. 2596 would allow a participant to elect to pre-pay a 5% tax on all or part of the amounts accumulated in a Plan which are not currently distributable. Based on its vague language, it appears that H.R. 2596 would provide that the 5% tax could be paid out from assets in the participant's Plan account. The amount distributed from the Plan for the pre-payment of the tax would be considered a distribution on account of separation from service and would not be subject to tax at the time of distribution. The participants's tax basis on his/her Plan account will be increased by the amount for which the participant elected to pre-pay the tax (i.e., amount would be re-characterized as an after-tax contribution), so that upon subsequent distribution only the earnings and accretions accumulated after the pre-payment of the 5% tax would be subject to taxation at the then applicable tax rate for Plan distributions.

We understand that Plans that do not provide for after-tax contributions would have to be amended to allow for the re-characterization of amounts for which the participant elects to pre-pay the 5% tax. In addition, it is possible that Plans may have to be amended to allow for the distribution of the amount required to pre-pay the 5% tax.³  It is currently unclear if and how the provisions of H.R. 2596 would be applicable to defined benefits plans. In addition, H.R. 2596 does not modify the tax withholding rules on Plan distributions which are currently 12.5% or 20% depending on the location of the trust that is funding the Plan.⁴

B. IRAs

H.R. 2596 would amend the PR Code to lower the tax rate applicable to distributions from IRAs not to exceed $20,000 per owner or beneficiary and received during the Window Period to a 5% tax rate in lieu of any other tax imposed by the PR Code. Said distribution will not be subject to the 10% penalty for withdrawals by individuals under 60 years of age and the 5% tax must be withheld by the financial institution. Any distribution in excess of the $20,000 cap will be taxed at the applicable tax rates

H.R. 2596 would also allow, during the Window Period, the pre-payment at a 5% tax rate of all or part of the accumulated and undistributed amounts in the IRAs. In such cases, the taxpayer's tax basis in the IRA would be increased by the amount for which the 5% tax was prepaid, so that upon the subsequent distribution only the earnings and accretions accumulated after the pre-payment would be subject to taxation at the then applicable tax rate for distributions from IRAs. 

II. House of Representative Bill No. 919 ("H. B. 919")⁵

If enacted into law, H.R. 919 would allow additional annual pre-tax contributions to Puerto Rico qualified plans by participants who have reached age 50 at the end of the calendar year ("catchup contributions"). Catch-up contributions would be limited to $1,000 per year,⁶  and may be matched by employer contributions. Further, catch-up contributions would have no impact on the actual deferral percentage ("ADP") test for the year in which they are made.  

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If you have any questions or comments, or wish additional information regarding these matters, please contact any of the attorneys listed below, members of our Employee Benefits Practice Group:

The content of this memorandum has been prepared by us for information purposes only. It is not intended as, and does not constitute, either legal advice or solicitation of any prospective client. An attorney-client relationship with McConnell Valdés cannot be formed by reading or responding to this memorandum. Such a relationship may be formed only by express agreement with McConnell Valdés.

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1. It is expected that H.R. 2596 will be approved by the Puerto Rico Senate and House of Representatives before the end of the week in which this memorandum was prepared. The Governor would have thirty days after receiving the approved bill to sign or veto the same. It is possible that H.R. 2596 may suffer additional modifications before enacted into law. We will keep our clients and friends informed of any major changes in the proposed legislation.

2. Act 49 of January 30, 2006 ("Act 49"), amended the PR Code to provide 12.5% or 20% tax rates for lump-sum distributions depending on certain requirements, including the location of the trust that is funding the Plan. See our Memorandum to Clients Tax 2006- for a description of the provisions of Act 49

3. "Dual-qualified"; plans (i.e., qualified both under the PR Code and the U.S. Code) may not be amended for such purposes since the pre-payment of Puerto Rico taxes is not a distributable event under the U.S. Code.

4. Further guidance with respect to these issues is expected from the Puerto Rico Department of the Treasury.

5. H.R. 919 was approved by the Puerto Rico Senate and House of Representatives on May 3, 2006. As of the date of this memorandum, it is unclear whether H.R. 919 has been sent for the Governor's signature. The Governor has thirty days after receiving the approved bill to sign or veto the same. It is possible that H.R. 919 may suffer additional modifications before enacted into law. We will keep our clients and friends informed of any major changes in the proposed legislation.

6. H.R. 919 provides that the maximum catch-up contributions for calendar year 2005 is $500. However, we understand that such language is not applicable since it is no longer possible to defer income for a year that already has finalized.