Puerto Rico Government Plan-to-Private Plan Rollovers Allowed
On January 20, 2021, the Puerto Rico Department of the Treasury (Departamento de Hacienda, commonly known as “Hacienda”) issued Administrative Determination No. 21-01 (AD 21-01), which provides that lump-sum distributions from the retirement plan for Puerto Rico government employees are eligible for direct and indirect rollovers into Puerto Rico–qualified retirement plans maintained by private-sector employers. In practice, however, this determination is unlikely to have much of an impact on the operation of private-sector employer plans.
Since the 1940s, Puerto Rico government employees have been covered by contributory-defined benefit and hybrid pension plans. In 2017, the local government transferred all its employees to a new defined contribution savings plan comparable to the 401(k) plans sponsored by private-sector employers. Previously, distributions from local government plans were ineligible for tax-free rollovers into private-sector employer plans. Pursuant to AD 21-01, however, lump-sum distributions—but not other forms of payment—from the new government retirement plan are now eligible for tax-free rollovers into private-sector employer plans.
Government-to-Private Plan Rollovers Unlikely
Lump-sum distributions from the government retirement plan are generally taxed at a lower rate than lump-sum distributions from private-sector employer plans. Therefore, former government employees who subsequently work in the private sector are likely to be better off receiving taxable lump-sum distributions from the government retirement plan than rolling over their retirement money into private-sector employer plans and then receiving lump-sum distributions from those plans.
Pursuant to Sections 1023.09 and 1081.01(b)(1)(B) of the Puerto Rico Internal Revenue Code of 2011 (PRIRC), lump-sum distributions from retirement plans qualified with Hacienda pay local income taxes at the lower of (i) the individual’s ordinary income tax rate for the year of distribution (i.e., between 0 percent and 33 percent, depending on the individual’s taxable income) or (ii) 20 percent. Also, lump-sum distributions are subject to a mandatory 20 percent tax withholding at source. If at least 10 percent of a participant’s plan account is invested over a 2-year period in certain property located within Puerto Rico, however, the maximum local income tax rate and the mandatory withholding rate on lump sums are reduced from 20 percent to 10 percent.
Neither Puerto Rico income tax liability nor mandatory withholding at source applies to the portion of a lump-sum distribution completed after a participant’s separation from service that is directly rolled over into another Puerto Rico–qualified plan. A subsequent lump-sum distribution from the rollover transferee plan will be subject to the local tax rules described in the previous paragraph. For these purposes, the nature of the investments within the rollover transferor plan is disregarded. Lump-sum distributions from the transferee plan are eligible for the 10 percent income tax and withholding rates only if the participant’s account within the transferee plan met Puerto Rico’s property investment requirements.
While the government retirement plan is exempt from the Employee Retirement Income Security Act of 1974 (ERISA) and designed to invest at least 10 percent of the balance of its accounts in eligible Puerto Rico property, due to a host of ERISA fiduciary compliance and liability concerns, most private-sector employer plans do not include investment options that invest in eligible Puerto Rico property. Consequently, lump-sum distributions from the government retirement plan are subject to a maximum income tax rate and a mandatory withholding rate of 10 percent, whereas lump-sum distributions from private-sector employer plans are subject to a maximum income tax rate and a mandatory withholding rate of 20 percent.
By completing government plan-to-private sector plan rollovers, former local government employees would be doubling their Puerto Rico income tax liability on subsequent lump-sum distributions. It is therefore unlikely that many of these employees would elect this option.
Neither ERISA nor the PRIRC require plan sponsors to provide tax-planning materials or information to participants or newly hired employees. If a former government employee now working in the private sector wants to roll his or her government retirement plan money to the new employer’s 401(k) plan, and, in the process, potentially double his or her Puerto Rico income tax liability, that is up to the participant.
2021 Annual Limits for Puerto Rico–Qualified Plans
On January 20, 2021, Hacienda also issued Circular Letter of Internal Revenue No. 2021-01, which establishes the various annual limits that apply to retirement plans qualified in Puerto Rico during 2021. The local 2021 annual limits are generally similar to the 2021 annual limits under the U.S. Internal Revenue Code of 1986 (Code) and included by the Internal Revenue Service (IRS) in Notice 2020-79.
Specifically, the 2021 annual limits applicable to retirement plans qualified in Puerto Rico are the following:
Defined benefit plan limit on annual benefits: $230,000. (See PRIRC § 1081.01(a)(11)(A)(i), which is based on and intended to operate similarly to Code § 415(b).)
Defined contribution plan annual additions limit: $58,000. (See PRIRC § 1081.01(a)(11)(B)(i), which is based on and intended to operate similarly to Code § 415(c).)
Retirement plan annual compensation limit: $290,000. (See PRIRC § 1081.01(a)(12), which is based on and intended to operate similarly to Code § 401(a)(17).)
Highly paid employee compensation limit: $130,000. (See PRIRC §1081.01(d)(3)(E)(iii)(III), which is based on and intended to operate similarly to Code § 414(q)(1)(B)(i).)
Regular before-tax elective deferrals to 401(k) plans qualified in both the United States and Puerto Rico (commonly known as “dual-qualified plans”): $19,500. (See PRIRC § 1081.01(d)(7)(A)(ii), which is based on and intended to operate similarly to Code § 402(g)(1)(B).)
The annual limit on regular before-tax elective deferrals to 401(k) plans qualified only in Puerto Rico (commonly known as “P.R.-only plans”) remains fixed at $15,000. For participants who are age 50 or older, annual before-tax catch-up contributions to P.R.-only plans and dual-qualified plans remain fixed at $1,500 per year. Plan documents do not have to be formally amended to incorporate the 2021 updated limits, and these changes do not require any sort of Hacienda filings.