On January 20, 2021, the Department of Treasury of Puerto Rico (Departamento de Hacienda, commonly known as the “Hacienda”) issued Administrative Order No. 21-01 (AD 21-01), which provides the flat rate retirement payouts for the plan Government employees in Puerto Rico can be transferred, directly and indirectly, to Puerto Rico qualified pension plans that are maintained by private employers. In practice, however, this finding is unlikely to have a major impact on the implementation of private sector employer plans.
background
Since the 1940s, government employees in Puerto Rico have been covered by defined contribution and hybrid pension plans. In 2017, the local government moved all of its employees to a new defined contribution savings plan, similar to the 401 (k) plans sponsored by private sector employers. Previously, distributions from municipal plans were not permitted for tax-free transfers to private employer plans. According to 21-01 AD, however, lump-sum distributions – but no other payment types – from the new state pension plan can now be transferred tax-free into private employer plans.
Government-to-private plan rollover unlikely
Flat-rate distributions from the state pension plan are usually taxed at a lower tax rate than flat-rate distributions from private employer plans. Therefore, for former government employees who later work in the private sector, it is likely better to receive taxable lump-sum distributions from the state pension plan than to convert their retirement funds into private employer plans and then receive lump-sum distributions from those plans.
Pursuant to Sections 1023.09 and 1081.01 (b) (1) (B) of the 2011 Internal Revenue Code of Puerto Rico (PRIRC), flat-rate distributions from Hacienda Eligible Pension Plans pay local income tax at the lesser of (i) the individual’s Ordinary Income Tax Rate for the year the distribution (ie between 0 percent and 33 percent, depending on the taxable income of the person) or (ii) 20 percent. A mandatory withholding tax of 20 percent at source also applies to flat-rate distributions. However, if at least 10 percent of a participant’s Plan Account is invested in certain Puerto Rico real estate over a two-year period, the maximum local income tax rate and the mandatory withholding tax rate for lump sums will be reduced from 20 percent to 10 percent.
Neither Puerto Rico income tax liability nor mandatory withholding tax will apply to the portion of a lump sum distribution that is received after a participant is removed from service and transferred directly to another Puerto Rico qualifying plan. A subsequent lump sum distribution from the Rollover Transfer Plan is subject to the local tax regulations described in the previous paragraph. For these purposes, the nature of the investments under the rollover transfer plan is not taken into account. Lump sum distributions from the Acquirer Plan are only eligible for 10 percent income tax and withholding tax if the entrant’s account in the Acquirer Plan meets the requirements for real estate investment in Puerto Rico.
While the state retirement plan is exempt from the Employee Retirement Income Security Act of 1974 (ERISA) and is intended to invest at least 10 percent of the balance in eligible Puerto Rico real estate due to a variety of compliance and liability concerns of ERISA trustees, most private employer plans include most private employer plans no investment options investing in eligible Puerto Rico real estate. As a result, flat-rate distributions from the state pension plan are subject to a maximum income tax rate and a mandatory withholding tax rate of 10 percent, while flat-rate distributions from private employer plans are subject to a maximum income tax rate and a mandatory tax rate of 20 percent.
By completing plan-to-private sector plan rollovers, former local government employees would double their Puerto Rico income tax liability on subsequent flat-rate distributions. It is therefore unlikely that many of these employees will choose this option.
Neither ERISA nor PRIRC require plan sponsors to provide tax planning materials or information to participants or newly hired employees. If a former government employee who now works in the private sector wants to put his state pension money into the new employer’s 401 (k) plan, potentially doubling his Puerto Rico income tax liability in the process; H. up to the participant.
2021 annual limits on qualifying plans in Puerto Rico
On January 20, 2021, the Hacienda also issued Internal Revenue Circular # 2021-01, which sets the various annual limits for retirement plans qualified in Puerto Rico in 2021. The local annual limits for 2021 are generally similar to the annual limits for 2021 limits under the U.S. Internal Revenue Code of 1986 (Code) and contained by the Internal Revenue Service (IRS) in Notice 2020-79.
In particular, for Puerto Rico qualified retirement plans, the annual limits for 2021 apply:
-
Annual benefit limit: $ 230,000. (See PRIRC § 1081.01 (a) (11) (A) (i), which is based on Code § 415 (b) and is intended to function similarly.)
-
Annual Addition Limit for Defined Contribution Plans: $ 58,000. (See PRIRC § 1081.01 (a) (11) (B) (i), which is based on Code § 415 (c) and is intended to function similarly.)
-
Annual Compensation Limit for the Retirement Plan: $ 290,000. (See PRIRC § 1081.01 (a) (12), which is based on Code § 401 (a) (17) and is intended to function similarly.)
-
High Paid Employee Compensation Limit: $ 130,000. (See PRIRC § 1081.01 (d) (3) (E) (iii) (III), which is based on Code § 414 (q) (1) (B) (i) and is intended to function similarly.)
-
Periodic pre-tax deferrals for 401 (k) plans that qualify in both the US and Puerto Rico (commonly known as “Double Qualified Plans”): $ 19,500. (See PRIRC § 1081.01 (d) (7) (A) (ii), which is based on Code § 402 (g) (1) (B) and is intended to function similarly.)
The annual pre-tax election moratorium limit on 401 (k) plans that qualify in Puerto Rico (commonly known as “PR-only plans”) remains fixed at $ 15,000. For participants 50 years of age or older, the pre-tax annual pre-tax pre-tax fees for PR-only plans and dual-qualifying plans remain fixed at $ 1,500 per year. Planning documents do not need to be formally changed to include the updated 2021 limit values, and no hacienda filings are required for these changes.
© 2020, Ogletree, Deakins, Nash, Smoak and Stewart, PC, All rights reserved.National Law Review, Volume XI, Number 32