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Tax Impacts of Early Withdrawals from Your IRA

early withdrawalsA common situation that we run across is when someone would like to make early withdrawals from an IRA or 401k plan. As you might expect, there is taxation of the money withdrawn in most cases. There can be other taxes, and certain early withdrawals can be tax-free. The nature of the taxation depends on the circumstances around your early withdrawals.

The IRS recently published Tax Tip 2017-09, which lists some important facts about early withdrawals from retirement plans. The complete text of the Tip follows below.

Early Withdrawals from Retirement Plans

Many people find it necessary to take out money early from their IRA or retirement plan. Doing so, however, can trigger an additional tax on top of income tax taxpayers may have to pay. Here are a few key points to know about taking an early distribution:

  1. Early Withdrawals. An early withdrawal normally is taking cash out of a retirement plan before the taxpayer is 59½ years old.
  2. Additional Tax. If a taxpayer took an early withdrawal from a plan last year, they must report it to the IRS. They may have to pay income tax on the amount taken out. If it was an early withdrawal, they may have to pay an additional 10 percent tax.
  3. Nontaxable Withdrawals. The additional 10 percent tax does not apply to nontaxable withdrawals. These include withdrawals of contributions that taxpayers paid tax on before they put them into the plan. A rollover is a form of nontaxable withdrawal. A rollover occurs when people take cash or other assets from one plan and put the money in another plan. They normally have 60 days to complete a rollover to make it tax-free.
  4. Check Exceptions. There are many exceptions to the additional 10 percent tax. Some of the rules for retirement plans are different from the rules for IRAs.
  5. File Form 5329. If someone took an early withdrawal last year, they may have to file Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts, with their federal tax return. Form 5329 has more details.
  6. Use IRS e-file. Early withdrawal rules can be complex. IRS e-file is the easiest and most accurate way to file a tax return. The tax software that taxpayers use to e-file will pick the right tax forms, do the math and help get the tax benefits they are due. Seven out of 10 taxpayers qualify to use IRS Free File tax software. Free File is only available through the IRS website at IRS.gov/freefile.

More information on this topic is available on IRS.gov.

Taxpayers should keep a copy of their tax return. Beginning in 2017, taxpayers using a software product for the first time may need their Adjusted Gross Income (AGI) amount from their prior-year tax return to verify their identity. Taxpayers can learn more about how to verify their identity and electronically sign tax returns at Validating Your Electronically Filed Tax Return.

Additional IRS Resources:

Answers to Common DIY Income Tax Questions

DIY income tax questionsDo-It-Yourself or DIY Income tax filing software is very common, pervasive and easy-to-use these days. Many folks are taking advantage of this option for filing their taxes each year – but it’s not infallible. There is only so much that can be automated with the software. Certain things you’ll need to know for yourself. If you don’t know these things ahead of time you’ll need to know how to fix them later.

Over the course of many years of questions from DIY income tax preparers, we’ve noticed a few patterns of common questions. Below are listed some of the most common questions and answers to those questions.

Answers to the Most Common DIY Income Tax Questions

1. Question: I’ve already filed my income tax return and I just received another W2 (or 1099, or whatever additional form). Should I file an amendment right now?

Answer: You should wait until your original return has completely processed before you file your amendment. You should then file your amended return (see the article at this link for more information about filing an amended tax return) as soon as possible. Delays in filing your amended tax return can result in penalties and interest charges.

2. Question: I’ve already filed my income tax return and I just received another W2 – but it’s only for a small amount. When I completed the amendment return there was no (or only a very small) difference in my tax owed or refunded. Will the IRS just adjust my return, or should I file the amendment?

Answer: Under-reporting of income can result in penalties and interest to you. You should file an amendment to ensure that all of your income has been properly reported, even though the result is no (or a very small) change to your tax. This way the IRS has record that you have reported all of your income.

Properly reporting all income when you are aware of it can be helpful to your case when you have mistakenly under-reported. If you disregard the additional income reported to you, it can be misconstrued as income tax evasion (strong word, I know). The IRS views minor infractions like this in a more positive light if you self-report your overlooked income as soon as possible.

3. Question: How can I find out if my tax return has been completely processed?

Answer: You can use the Where’s My Refund? tool on the IRS website to check the status of your return.

4. Question: I mistakenly claimed my child on my tax return as a dependent and I’ve already filed my return. The child’s father was supposed to claim the child. How can I fix this so that the father can file and claim the child as a dependent? A variation on this question is where a child has claimed him or herself as a dependent on his or her own tax return and it’s preferred to have the parent claim the child as a dependent.

Answer: In order for someone else to claim a dependent that someone else has already claimed, the original return must be amended, removing the dependent from the return. This amendment must be completely processed before the dependent can be claimed on another return.

5. Question: I have filed an amended return to remove a dependent from the return (we’ll call this Return #1) so that someone else can claim the dependent on their return (we’ll call this Return #2). The amendment has not processed completely yet, and the filing date is very near. How do we handle this situation?

Answer: There are a couple of different ways to handle this situation:

a) You can file an original return (Return #2) without claiming the dependent. Then, once the amendment (Return #1) has processed completely, an amendment can be filed on Return #2 to include the dependent. This has the benefit of providing some refund (if a refund is due) while waiting for the amendments to process.

b) You can file a request for extension (see this link for information about filing an extension) on Return #2. Then once the amendment has completely processed, assuming that it is processed before October 15, you can go forward with the filing of Return #2. The downside to this method is that you must pay any tax anticipated upon filing the request for extension, but that would be the case if you were able to file the original return on time.

6. Question: I filed my original tax return and have received my refund already. I’ve discovered that I need to file an amendment to my return. Can I cash the check, or do I need to send it back and wait for my amendment to process?

Answer: You are free to do what you wish with your original refund. However, if your amendment results in a negative difference in your refund – that is, if it results in a payment required – you should send along the payment required with your amended return. If your amendment results in additional refund, you’ll receive an another check.

7. Question: My husband and I are in the process of getting a divorce, but it was not finalized before the end of the year. I filed my tax return with the status of Married Filing Separately, and he filed his return with the status of Married Filing Jointly. His return was rejected – what do we do?

Answer: While you are married, either you both file your returns with the filing status of Married Filing Separately or you file one return together with the status of Married Filing Jointly. You can resolve this by amending your (accepted) return to change to Married Filing Jointly and include your husband on the return. Otherwise, your husband can file a return with Married Filing Separately as the status.

In most cases the status of Married Filing Separately (MFS) is a disadvantage over the status of Married Filing Jointly (MFJ). Many credits and deductions are not allowed when using the MFS status.

8. Question: I didn’t use my tuition payment (1098T) on my 2015 tax return. Can I just claim this payment when I file my 2016 income tax return?

Answer: Tax years are separate units for most every item. Income, credits, and deductions are specific to the tax year that they were earned or paid out. So if you want to claim credit for tuition payment made in 2015, you will need to amend your 2015 income tax return. It is not allowed to claim a 2015 credit or deduction on your 2016 return.

Do you have questions? Leave your questions in the comments below and we’ll do our best to answer them where we can!

IRS Warns of Phishing Scam

fishingThis tax season the IRS has been tracking a scam that targets certain employers. It’s a particularly nasty one, hitting where the email targets clerical employees, impersonating someone higher in the organization, asking for W-2 information. With this information the scammer can steal identities.

The scam started out targeting corporations, but now it has evolved to start hitting schools, restaurants, and other organizations. It’s possible that some of these organizations’ less formal management structure may introduce gaps in the process which might provide exploitation opportunities for the scammers.

The complete text of the IRS’s most recent notice about this scam follows below:

Dangerous W-2 Phishing Scam Evolving;
Targeting Schools, Restaurants, Hospitals, Tribal Groups and Others

 

IR-2017-20, Feb. 2, 2017

WASHINGTON – The Internal Revenue Service, state tax agencies and the tax industry issued an urgent alert today to all employers that the Form W-2 email phishing scam has evolved beyond the corporate world and is spreading to other sectors, including school districts, tribal organizations and nonprofits.

In a related development, the W-2 scammers are coupling their efforts to steal employee W-2 information with an older scheme on wire transfers that is victimizing some organizations twice.

“This is one of the most dangerous email phishing scams we’ve seen in a long time. It can result in the large-scale theft of sensitive data that criminals can use to commit various crimes, including filing fraudulent tax returns. We need everyone’s help to turn the tide against this scheme,’’ said IRS Commissioner John Koskinen.

When employers report W-2 thefts immediately to the IRS, the agency can take steps to help protect employees from tax-related identity theft. The IRS, state tax agencies and the tax industry, working together as the Security Summit, have enacted numerous safeguards in 2016 and 2017 to identify fraudulent returns filed through scams like this. As the Summit partners make progress, cybercriminals need more data to mimic real tax returns.

Here’s how the scam works: Cybercriminals use various spoofing techniques to disguise an email to make it appear as if it is from an organization executive. The email is sent to an employee in the payroll or human resources departments, requesting a list of all employees and their Forms W-2.  This scam is sometimes referred to as business email compromise (BEC) or business email spoofing (BES).

The Security Summit partners urge all employers to be vigilant. The W-2 scam, which first appeared last year, is circulating earlier in the tax season and to a broader cross-section of organizations, including school districts, tribal casinos, chain restaurants, temporary staffing agencies, healthcare and shipping and freight. Those businesses that received the scam email last year also are reportedly receiving it again this year.

Security Summit partners warned of this scam’s reappearance last week but have seen an upswing in reports in recent days.

New Twist to W-2 Scam: Companies Also Being Asked to Wire Money

In the latest twist, the cybercriminal follows up with an “executive” email to the payroll or comptroller and asks that a wire transfer also be made to a certain account. Although not tax related, the wire transfer scam is being coupled with the W-2 scam email, and some companies have lost both employees’ W-2s and thousands of dollars due to wire transfers.

The IRS, states and tax industry urge all employers to share information with their payroll, finance and human resources employees about this W-2 and wire transfer scam. Employers should consider creating an internal policy, if one is lacking, on the distribution of employee W-2 information and conducting wire transfers.

 

Steps Employers Can Take If They See the W-2 Scam

Organizations receiving a W-2 scam email should forward it to and place “W2 Scam” in the subject line. Organizations that receive the scams or fall victim to them should file a complaint with the Internet Crime Complaint Center (IC3,) operated by the Federal Bureau of Investigation.

Employees whose Forms W-2 have been stolen should review the recommended actions by the Federal Trade Commission at www.identitytheft.gov or the IRS at www.irs.gov/identitytheft.

Employees should file a Form 14039, Identity Theft Affidavit, if the employee’s own tax return gets rejected because of a duplicate Social Security number or if instructed to do so by the IRS.

The W-2 scam is just one of several new variations that have appeared in the past year that focus on the large-scale thefts of sensitive tax information from tax preparers, businesses and payroll companies. Individual taxpayers also can be targets of phishing scams, but cybercriminals seem to have evolved their tactics to focus on mass data thefts.

Be Safe Online

In addition to avoiding email scams during the tax season, taxpayers and tax preparers should be leery of using search engines to find technical help with taxes or tax software. Selecting the wrong “tech support” link could lead to a loss of data or an infected computer. Also, software “tech support” will not call users randomly. This is a scam.

Taxpayers searching for a paid tax professional for tax help can use the IRS Choosing a Tax Professional lookup tool or if taxpayers need free help they can review the Free Tax Return Preparation Programs. Taxpayers searching for tax software can use Free File, which offers 12 brand-name products for free, at www.irs.gov/freefile. Taxpayer or tax preparers looking for tech support for their software products should go directly to the provider’s web page.

Tax professionals also should beware of ongoing scams related to IRS e-Services. Thieves are trying to use IRS efforts to make e-Services more secure to send emails asking e-Services users to update their accounts. Their objective is to steal e-Services users’ credentials to access these important services.

Tax Refund Myths Debunked

Recently the IRS published a Special Edition Tax Tip which debunks some very common myths about your income tax refund. You may find some of these surprising. These myths are pervasive and can lead you astray if you believe them. In my experience the information in the Tip below is great advice for finding information about your tax refund.

The complete text of the Tip (IRS Special Edition Tax Tip 2017-02) follows below:

IRS Debunks Myths Surrounding Your Tax Refund

As millions of people begin filing their tax returns, the Internal Revenue Service reminds taxpayers about some basic tips to keep in mind about refunds.

During the early parts of the tax season, taxpayers are anxious to get details about their refunds. In some social media, this can lead to misunderstandings and speculation about refunds. The IRS offers these tips to keep in mind.

Myth 1: All Refunds Are Delayed

While the IRS issues more than 90 percent of federal tax refunds in less than 21 days, some refunds take longer. Recent legislation requires the IRS to hold refunds for tax returns claiming the Earned Income Tax Credit (EITC) or the Additional Child Tax Credit (ACTC) until mid-February. Other returns may require additional review for a variety of reasons and take longer. For example, the IRS, along with its partners in the states and the nation’s tax industry, continue to strengthen security reviews to help protect against identity theft and refund fraud. The IRS encourages taxpayers to file as they normally would.

Myth 2: Calling the IRS or My Tax Professional Will Provide a Better Refund Date

Many people mistakenly think that talking to the IRS or calling their tax professional is the best way to find out when they will get their refund. In reality, the best way to check the status of a refund is online through the “Where’s My Refund?” tool at IRS.gov or via the IRS2Go mobile app.

Taxpayers eager to know when their refund will be arriving should use the “Where’s My Refund?” tool rather than calling and waiting on hold or ordering a tax transcript. The IRS updates the status of refunds once a day, usually overnight, so checking more than once a day will not produce new information. “Where’s My Refund?” has the same information available to IRS telephone assistors so there is no need to call unless requested to do so by the refund tool.

Myth 3: Ordering a Tax Transcript a “Secret Way” to Get a Refund Date

Ordering a tax transcript will not help taxpayers find out when they will get their refund. The IRS notes that the information on a transcript does not necessarily reflect the amount or timing of a refund. While taxpayers can use a transcript to validate past income and tax filing status for mortgage, student and small business loan applications and to help with tax preparation, they should use “Where’s My Refund?” to check the status of their refund.

Myth 4: “Where’s My Refund?” Must be Wrong Because There’s No Deposit Date Yet

The IRS will update “Where’s My Refund?” ‎on both IRS.gov and the IRS2Go mobile app with projected deposit dates for early EITC and ACTC refund filers a few days after Feb. 15. Taxpayers claiming EITC or ACTC will not see a refund date on “Where’s My Refund?” ‎or through their software package until then. The IRS, tax preparers and tax software will not have additional information on refund dates.

The IRS cautions taxpayers that these refunds likely will not start arriving in bank accounts or on debit cards until the week of Feb. 27 – if there are no processing issues with the tax return and the taxpayer chose direct deposit. This additional period is due to several factors, including banking and financial systems needing time to process deposits. Taxpayers who have filed early in the filing season, but are claiming EITC or ACTC, should not expect their refund until the week of Feb. 27. The IRS reminds taxpayers that President’s Day weekend may impact when they get their refund since many financial institutions do not process payments on weekends or holidays.

Myth 5: Delayed Refunds, those Claiming EITC and/or ACTC, will be Delivered on Feb. 15

By law, the IRS cannot issue refunds before Feb. 15 for any tax return claiming the Earned Income Tax Credit (EITC) or Additional Child Tax Credit (ACTC). The IRS must hold the entire refund, not just the part related to the EITC or ACTC. The IRS will begin to release these refunds starting Feb. 15.

These refunds likely won’t arrive in bank accounts or on debit cards until the week of Feb. 27. This is true as long as there is no additional review of the tax return required and the taxpayer chose direct deposit. Banking and financial systems need time to process deposits, which can take several days.

See the What to Expect for Refunds in 2017 page and the Refunds FAQs page for more information.

Taxpayers should keep a copy of their tax return. Beginning in 2017, taxpayers using a software product for the first time may need their Adjusted Gross Income (AGI) amount from their prior-year tax return to verify their identity. Taxpayers can learn more about how to verify their identity and electronically sign tax returns at Validating Your Electronically Filed Tax Return.

IRS YouTube Videos:

Substantial Earnings Years of Credit

substantial earningsHow does the substantial earnings years of credit work for Windfall Elimination Provision?

In this article I wanted to expand on a question that came in via the comments recently, because it addresses a theme I’ve seen often:

I have several years where I was just under the substantial earnings cutoff and 25 that are way over. Do you get partial credit for the years that did not reach the substantial floor?

Overview of Substantial Earnings

When your Social Security benefits are subject to the Windfall Elimination Provision (WEP), there is a way to reduce and possibly eliminate the effect of the WEP. This reduction is accomplished by way of the substantial earnings credit. Substantial earnings years of credit are earned when you have worked in a Social Security-covered job and you have earned at least the substantial earnings limit for that particular year.

The substantial earnings limit is set for each year (click the link to see the substantial earnings limits). This figure is specific to the year.

In order to begin reducing the WEP impact, you must have earned substantial earnings in 21 or more years. For each year earned, from 21-30 years, 10% of the WEP impact is eliminated. With 30 or more years of substantial earnings, WEP impact is completely eliminated.

It’s Black or White

However, if in any particular year you earned even one dollar less than the figure for the year in question, you do not earn the credit for that year. On the other hand, if you have earned more than the substantial earnings limit in any particular year, the excess earnings above the limit are not credited to another year – you can only earn one year of credit in any tax year. And you can’t combine years where you were under the limit to produce additional years of credit.

So in answer to the reader’s question, “just under the substantial earnings cutoff” doesn’t provide a partial credit. So, those several years where the reader was just under the limit produce no years of credit for him. Plus, even though he earned “way over” the limit in 25 other years, he has only earned 25 years of credits for those years.

My response to the question, with the above facts in mind, is as follows:

Unfortunately, no. It’s black or white, you either earned above the threshold or you didn’t. And there is no combining years, either.

Rollover Risk

rollover-risk-by-marcin-wicharyThe idea of an IRA rollover, or a rollover IRA, isn’t necessarily a cosmic mystery – this happens all the time.  You leave your job, and you rollover your 401(k) to an IRA.  No problem, right?  Unfortunately, there often are problems with the process of moving funds from one account to another – because there are a couple of very restrictive rules regarding how this process can and cannot be done.  It’s not terribly complex, but you’d be surprised how easily these rules can trip you up.

Rollover Risk

Let’s start with a few definitions:

A Rollover is when you take a distribution from one qualified plan or IRA custodian, in the form of a check made out to you, and then you re-deposit that check into another qualified plan or IRA account (at a different custodian).

A Trustee-to-Trustee Transfer (TTT), even though it is often referred to as a “direct rollover”, is treated differently from the Rollover (described above).  These transfers, being from one custodian to another (the money never gets into the taxpayer’s hands) is an instantaneous transfer, so the 60-day rule has no bearing on it.  Also, the TTT is not restricted to the OPY rule.

The restrictions on a true Rollover (from one IRA to another IRA) are:

  1. the deposit into the new account must be made no more than 60 days after the distribution from the old custodian; and
  2. a rollover can only be done once every 365 days (and yes, 366 days if February 29th is included!).

One exception to the “once-per-year” (OPY) rule is that this only applies to IRA-to-IRA rollovers.  Rollovers to or from an employer plan (either to or from an IRA or another employer plan) are not subject to the OPY rule.  Also, Roth conversion is not subject to the OPY rule as well.  This rule allows only one Rollover for ALL IRAs per year. See the article The One-Rollover-Per-Year Rule: Revised for more information.

 

There are a few situations where an automatic waiver of the OPY rule can be applied:

You qualify for an automatic waiver if all of the following apply:

  • The financial institution receives the funds on your behalf before the end of the 60-day rollover period.
  • You followed all of the procedures set by the financial institution for depositing the funds into an IRA or other eligible retirement plan within the 60-day rollover period (including giving instructions to deposit the funds into a plan or IRA).
  • The funds are not deposited into a plan or IRA within the 60-day rollover period solely because of an error on the part of the financial institution.
  • The funds are deposited into a plan or IRA within 1 year from the beginning of the 60-day rollover period.
  • It would have been a valid rollover if the financial institution had deposited the funds as instructed.

If you do not qualify for an automatic waiver, you can apply to the IRS for a waiver of the 60-day rollover requirement or use the self-certification procedure to make a late rollover contribution.

Why is this so important? When would you make more than one rollover in a year?  One case might be where you were waiting for maturity of certain instruments in one IRA (like a CD, for example) and through the course of less than a year, you had two CDs come due and you took rollover distribution from each in separate checks.  The second (and any subsequent) check in the 12 month period would be disallowed and considered a taxable (and most likely penalized) distribution.

Two more rules on rollovers

In addition, the TTT helps to avoid any issues with another rule on rollovers: you are required to rollover the same property that was distributed.  This means that the IRA account owner cannot receive cash as a distribution and then rollover stock shares that he’s purchased with the cash.  Likewise, you couldn’t receive shares of stock in one company, sell the shares and purchase stock in another company and rollover the new shares. One exception to this rule is that if you receive property from a company plan (like a 401(k)), you can sell the property and rollover the cash into an IRA.

If one of those transactions occurs, your rollover funds are considered excess contributions (above and beyond the annual limit) and you would be subject to 6% excess accumulation tax per year that the funds were in the account, on top of being taxed on the original distribution, and quite likely penalized as well.

The last rule I have to offer is the fact that a non-spouse beneficiary can never do a 60-day rollover; they must always do a TTT – as any check written to a non-spouse beneficiary is considered a taxable distribution, and there is no relief available if this mistake is made.

So a good rule of thumb is this: unless there is a very compelling reason, you should always go with a Trustee-to-Trustee transfer when rolling funds to an IRA – this way you’ll avoid some very unpleasant results.  If you have to do the other kind of rollover – make sure you haven’t done another within a year and you’ll be golden.

Filing for Social Security Survivor Benefit alone, preserving Retirement for later

7cdfzmllwom-william-boutAfter all of the changes that have been put in place for Social Security benefits in the past year, there is still one situation that allows for some planning. Knowing about this situation can help if you happen to be in the right circumstances.

If your spouse has passed away and you are due a Survivor Benefit, there may be a strategy for you to maximize benefits. This is because, of all types of Social Security benefits, the Survivor Benefit may still be filed for separately from the Retirement benefit based on your own record.

Why would you want to do this? Well, if your own Retirement benefit either is or will be larger than the Survivor Benefit, it might make sense for you to delay receiving your Retirement Benefit until later. In the meantime, if you’re at least age 60 and not earning more than the income limits, you may want to take advantage of the Survivor Benefit while you delay your Retirement Benefit.

Restricting the Survivor Benefit

For example, Marie’s husband Jake recently passed away. Jake was 66 years old, and had been receiving his own Social Security retirement benefit for a couple of years. His current benefit was $1,500 per month.

Marie is 64, and her own benefit will be $1,500 when she reaches Full Retirement Age (FRA) of 66. Marie is ready to retire from work, and she has two options available at this point:

1) She could file for all available benefits, which would result in a monthly benefit of approximately $1,352. If Jane does nothing more, that would be her benefit (basis) for the rest of her life, except for COLAs.

2) On the other hand, Marie could file for Survivor Benefits only, which would provide her with the same benefit as above, $1,352. But by restricting her application to the Survivor Benefit only, Marie has the option to later file for her own retirement benefit. If she only waits until her Full Retirement Age, Marie could step up her benefit amount to $1,500 per month upon reaching age 66.

Further, Marie could delay filing for her own benefit as long as possible, to age 70, and thereby maximize her retirement benefit to $1,980.

How it works

In the example above, Marie’s own retirement benefit at her age 64 is reduced to $1,300. The Survivor Benefit based on Jake’s record is reduced as well, but only to $1,352. When Marie files for benefits, if she makes no action to restrict her application, she is filing for (effectively) the largest possible benefit, considering all benefits that are available to her.

If Marie doesn’t restrict her application specifically to the Survivor Benefit alone, she has effectively filed for her own Retirement Benefit at the same time. This is because an application for any Social Security benefit is considered to be an application for all available benefits unless the application’s scope is restricted.

However, if Marie does restrict her application to the Survivor Benefit only, she preserves the option to later file for her own retirement benefit. Having restricted her application only to the Survivor Benefit, her own retirement benefit can continue to grow in value since she has not filed for it. Then later she can file for her own benefit – at any time when her own benefit is larger than the Survivor Benefit.

Note: It doesn’t matter if Marie and Jack were divorced, as long as the marriage lasted at least 10 years. As a surviving divorced spouse, Marie would have the same options available to her as a widowed spouse.

How do you do this?

There are a couple of different ways to accomplish the restricted application for Survivor Benefits.

In the online application for benefits, there is a screen called Additional Benefits (ADDB), which has a question:

If claimant is filing as a surviving spouse, is the claimant filing for benefits on own record?

Answering “No” to this question will restrict your application to only the Survivor Benefit.

Another way to restrict the application is to include an unequivocal statement on your application such as:

I do not wish this application to be considered an application for retirement benefits on my own earning’s record.

or

I filed on <date> for all benefits for which I may be eligible except for retirement benefits on my own earnings record.

or

I wish to exclude retirement benefits on my own earnings record from the scope of this application.

If including a statement (instead of the online answer of “No”) it is important to NOT include qualifying phrases in your statement. Examples of such statements are “at this time” or any statement regarding planning to file for other benefits in the future. These qualifying statements will cause the statement to be rejected.

4 Things to Consider About Healthcare in Retirement

heres-health-by-robert-brookAs we all are painfully aware, the costs and complexity of healthcare are skyrocketing, and nothing seems to be slowing things down.  Granted, the incoming administration is making overtures to give attention to the problem, but… as we all know, paths to places we don’t want to go are often paved with good intentions.  At this point I would not hold my breath for the next great proposal on healthcare costs, the problem is enormous and not easily resolved.

Recent information from Fidelity suggests that a 65-year-old couple who retired in 2016 can expect lifetime healthcare costs to top $260,000 over their remaining lifetimes.  And that doesn’t include long-term care (nursing home or assisted-living) costs.

Four Things to Consider About Healthcare in Retirement

  1. It’s not solely Medicare. If you haven’t checked into it yet and you believe that Medicare could be your only insurance in retirement, you’re in for a surprise. With the co-payments, “holes” in coverage, and coinsurance payments, it’s almost a requirement that you have a supplemental healthcare policy to help out. Industry averages for a couple, aged 65 and in good health, start around $7,000 per year and go up from there.
  2. Retiring early increases the costs. If you’re planning to retire early (and therefore lose employer-provided health coverage) you’ve got to replace it somehow.  These policies are even more expensive than the Medicare supplement policies discussed above – and much more variable due to the complexities of coverage.  This portion of your early retirement deserves (requires!) quite a bit of planning ahead, as healthcare costs could be a significant portion of your monthly expenses in retirement.
  3. It doesn’t help to wait. Are you just starting to consider your options and are close to retirement?  If so, you’re quite a bit behind the curve – there are several things that could be done in the five to ten years prior to retirement that might help you with the costs.  For example, if you’re a little overweight, or a smoker, rectifying these things five or ten years before retirement can have a significant impact on your costs. Participating in a health savings account (HSA) coupled with a high-deductible health plan (HDHP) can position you well for a transition into retirement as well.
  4. Knowledge is helpful. Health insurers use a special report, called a Medical Information Bureau (MIB) report to help determine your eligibility for coverage.  Think of it like a credit report on your health.  You can order your own MIB report, in order to look things over to see if there are any red flags (much the same as reviewing your credit report).  If you have a denial of coverage on your report or any issues that could adversely impact your ability to get coverage, it’s best to know that up front and work with an agent or broker who specializes in your issues.

Although these things may seem like a lot of work, they’re excellent considerations to take into account as you plan for your healthcare in retirement.  And – most financial planners these days, myself included, can help you work through the decision-making process.  It’s not simple, and mistakes can be quite costly.

IRS’ 2017 Mileage Rates for Taxes

The Internal Revenue Servicmileagee today issued the 2017 optional standard mileage rates used to calculate the deductible costs of operating an automobile for business, charitable, medical or moving purposes. These rates are for use on your 2017 income tax return, filed by April 2018.

Beginning on Jan. 1, 2017, the standard mileage rates for the use of a car (also vans, pickups or panel trucks) will be:

  • 53.5 cents per mile for business miles driven, down from 54 cents for 2016
  • 17 cents per mile driven for medical or moving purposes, down from 19 cents for 2016
  • 14 cents per mile driven in service of charitable organizations

The business mileage rate decreased half a cent per mile and the medical and moving expense rates each dropped 2 cents per mile from 2016. The charitable rate is set by statute and remains unchanged.   The standard mileage rate for business is based on an annual study of the fixed and variable costs of operating an automobile. The rate for medical and moving purposes is based on the variable costs.

Taxpayers always have the option of calculating the actual costs of using their vehicle rather than using the standard mileage rates.

A taxpayer may not use the business standard mileage rate for a vehicle after using any depreciation method under the Modified Accelerated Cost Recovery System (MACRS) or after claiming a Section 179 deduction for that vehicle. In addition, the business standard mileage rate cannot be used for more than four vehicles used simultaneously.

These and other requirements are described in Rev. Proc. 2010-51. Notice 2016-79, posted today on IRS.gov, contains the standard mileage rates, the amount a taxpayer must use in calculating reductions to basis for depreciation taken under the business standard mileage rate, and the maximum standard automobile cost that a taxpayer may use in computing the allowance under a fixed and variable rate plan.

Many Happy Returns*

Al Capone Arrest Record

I was recently talking with an acquaintance who told me about a friend of his that had not filed a tax return for several years… Now, we all know that burying our head in the sand is no way to deal with *any* problem – but especially this one.

Right off the top of your head, I’m sure you can name a few folks who have been “taken down” by the IRS for tax evasion.  Let’s see… for starters, Wesley Snipes, Sophia Loren, Richard Hatch, Leona Helmsley, Richard Pryor, Pavaratti, Martha Stewart, Elton John, Nicholas Cage, Heidi Fleiss… the list goes on.

And then there is probably the most powerful, certainly the most influential, of all of these:  Al Capone.  The granddaddy of ’em all. Legend has it that the notorious gangster once remarked that tax laws were a joke because “the government can’t collect legal taxes on illegal money.”  The IRS charged the infamous Chicago mob boss with failure to pay four years’ worth of taxes. Capone was sentenced to 11 years in jail and an $80,000 fine in 1931.

My point in listing all these names is to show just how pervasive and powerful the IRS can be.  Even the likes of Al Capone (as well as, believe it or not, former Vice President Spiro Agnew, and even a former IRS commissioner, Joseph Nunan) couldn’t escape the long arm of the Treasury Department.

Now, if you happen to be in a position where you have not filed tax returns for some time, or if you are simply having difficulty paying the taxes that you owe, Uncle Sam has many options to help you work things out.  On the IRS’ website (www.IRS.gov) you’ll find information on how to work out a plan with the Treasury Department in order to get you back on track.

And if you need help in working with the IRS for any reason, don’t hesitate to contact me.

* My original tax preparation service was named MHR Income Tax Service – MHR stood for “Many Happy Returns”

New IRS Site for Taxpayer Information

toolsQuick, how do you find out what your balance is at the IRS? Call somebody? Wait for a paper notice? Who knows??

The bureaucracy that is the Internal Revenue Service just got a bit easier, and it’s bound to continue improving. The IRS recently launched a new online tool to assist taxpayers with basic account information, starting with balance inquiries. As part of the IRS vision to improve the taxpayer experience, more feature are expected to be added soon.

Below is the text of the actual announcement from the IRS, IR-2016-155:

IRS Launches New Online Tool to Assist Taxpayers with Basic Account Information

The Internal Revenue Service announced today the launch of an online application that will assist taxpayers with straightforward balance inquiries in a safe, easy and convenient way.

This new and secure tool, available on IRS.gov allows taxpayers to view their IRS account balance, which will include the amount they owe for tax, penalties and interest. Taxpayers may also continue to take advantage of the various online payment options available by accessing any of the payment features including: direct pay, pay by card and Online Payment Agreement. As part of the IRS vision for the future taxpayer experience, the IRS anticipates that other capabilities will continue to be added to this platform as they are developed and tested.

“This new tool is part of the IRS’s commitment to improve and expand taxpayer services by providing additional online taxpayer options,” said IRS Commissioner John Koskinen. “The new ‘balance due’ feature, paired with the existing online payment options, will increase the availability of self-service interactions with the IRS. This will give taxpayers another way to take care of their tax obligations in a fast and secure manner.”

Before accessing the tool, taxpayers must authenticate their identities through the rigorous Secure Access process. This is a two-step authentication process, which means returning users must have their credentials (username and password) plus a security code sent as a text to their mobile phones.

Taxpayers who have registered using Secure Access for Get Transcript Online or Get an IP PIN may use their same username and password. To register for the first time, taxpayers must have an email address, a text-enabled mobile phone in the user’s name and specific financial information, such as a credit card number or specific loan numbers. Taxpayers may review the Secure Access process prior to starting registration.

As part of the security process to authenticate taxpayers, the IRS will send verification, activation or security codes via email and text. The IRS warns taxpayers that it will not initiate contact via text or email asking for log-in information or personal data. The IRS texts and emails will only contain one-time codes.

In addition to this new functionality, the IRS continues to provide several self-service tools and helpful resources available on IRS.gov for individuals, businesses and tax professionals.

Penalties for Changing SOSEPP

broken-bambooSo – you’ve begun your Series of Substantially Equal Periodic Payments (SOSEPP) from your IRA to satisfy your §72(t) requirement.  Allofasudden, something happens that causes you to make a change to your payment – either purposely or through unforeseen circumstances.  What happens? You were supposed to keep the same payment for the longer of 5 years or until age 59½. What do you do now?

.Well – first of all, we must understand the timeline associated with an SOSEPP:  once begun (notwithstanding the “one-time change” exception which you can read about here), you have to continue those periodic payments without change for the longer of five years or until you reach age 59½.

If you make a change to your periodic payments (other than the one-time change), §72(t)(4) indicates that ALL of your payments, beginning with your first payment under the SOSEPP, will be subject to 1) ordinary income tax (should have already been assessed); 2) the 10% non-qualified withdrawal penalty; and 3) interest on any unpaid tax or penalty, calculated from the date(s) of the disbursal(s) forward to the date you “broke” the SOSEPP.

This Code section should strike fear in the hearts of folks who are considering a SOSEPP.  If you think about it, the possibilities for error are numerous. Your brokerage can fail to execute a disbursement the way you directed; you forget to take your withdrawal; you mistakenly take more (or less) than your SOSEPP prescribes… And if it’s been in place for several years, you’ll owe penalties back to the beginning of the plan, plus interest.

It doesn’t take much imagination to envision a scenario where you could be in pretty deep with such an error on your plan.  The IRS has no sense of humor when dealing with these cases – not many are overturned.

 

Earlier W2 Filing Requirement in 2017

One of the new wrinkles forearlier-w2-filing tax filing requirements for 2017 is that employers must adhere to an earlier W2 filing date than in years’ past. For 2017,all W2 and W3 (employer records) must be filed with the Social Security Administration by January 31.

The previous deadline was the last day of February if the W2 and W3 forms are filed on paper; by the end of March if filed electronically.

Many employers will be caught off-guard by the earlier W2 filing requirement. I wouldn’t think it would be a problem to meet this requirement. The deadline of January 31 for distribution of employee Form W2’s has been the rule for quite a while now. The primary problem is if there are any corrections necessary. This will just cause the employer to have to amend his forms W2/W3 filings with SSA after the fact.

This earlier W2 filing requirement should not have an impact either way for most employees. Tax preparers preparing employer payroll tax forms may be a bit overwhelmed in January. This portion of W2/W3 filing is often delayed until after the employee copies of Form W2 have been distributed. Filings must now be complete by the end of January. This compresses the timeline for distribution to employees and submission to Social Security.

The IRS recently published a Reminder about this change, which was passed into law in December 2015 as part of the Protecting Americans from Tax Hikes (PATH) Act. The reminder is IR-2016-143. As part of this Reminder, IRS also notes that these changes (from the PATH Act, specifically if claiming Earned Income Tax Credit or Additional Child Tax Credit) may delay some tax refunds until after February 15, 2017.

Delayed Retirement Credits – When are These Applied?

delayed retirement credits are like marching in the snowIf you delay filing for your Social Security benefit, for each month that you delay you will earn delayed retirement credits. The increase for each month of delayed retirement credit is 2/3% (0.667%) for every month. This equates to 8% in delayed retirement credits for every year of delay. But when are these credits applied to your benefit?

As with so many Social Security-related calculations, timing is everything. With delayed retirement credits, the key is exactly when you stop delaying and start collecting benefits.

Starting Benefits Before Age 70

When you’re delaying benefits past your full retirement age (FRA), you can start receiving benefits at any age after FRA up to age 70. So, for example, if you decided to start your benefits upon the month of your 67th birthday, you’d have 8% in credits earned if your FRA was age 66. For the sake of this example, let’s say your birthday is June 15.

When you file for benefits beginning in the month of your 67th birthday, you would receive a benefit calculated as:

PIA + (PIA * 4%) = Benefit for the remainder of the year

And then, in January of the following year, your benefit will be recalculated as follows:

PIA + (PIA * 8%) = Benefit for this year

(In each year, of course the PIA is assumed to have any COLA already applied before the calculation.)

You are credited with the delayed retirement credits only once a year, in January. So when you applied for your benefit, being mid-year, you had only been credited with 6 months’ worth of delayed retirement credits by that point. Then the following January, the remaining 6 months’ of delayed retirement credits are applied.

Simon, who has a PIA of $1,000 and a date of birth of September 15, 1950, is going to delay his benefit until his age 67 and 6 months (March, 2018). His benefit for the first year (2018) will be calculated as follows:

$1,000 + ($1,000 * 10%) = $1,100

This is because as of January, 2018, he has earned a total of 15 months’ worth of delayed retirement credits. The remaining 3 months are credited to him in January of 2019:

$1,000 + ($1,000 * 12%) = $1,120

Of course, there is an exception to this rule – when you start your benefits at or after age 70.

Starting Benefits at or After Age 70

The exception to the rule is when you start your benefits at or after age 70. In this case, Social Security tosses out this notion of waiting until January to apply delayed retirement credits and applies them immediately.

So, in the case of Simon (from earlier), if he waits until age 70 to file for his benefits (September, 2020), his benefit at that point would be calculated as:

$1,000 + ($1,000 * 32%) = $1,320

And no further increases need to be applied, since all delayed retirement credits are already applied to his record.

Foresight from Experience in Planning

marriage-with-foresightWe can make a difference in our own lives if we make a simple change in our outlook. If we changed from a hindsight to a foresight perspective, many things about our society could improve dramatically. This foresight can help with retirement planning, marriage, and any major event in our lives.

I don’t mean that we should disregard history – of course not. On the contrary, we need to use history to provide us with foresight into the potential outcomes of our choices. The experiences we’ve encountered (and our friends/families/acquaintances have experienced) can help us to predict the outcome of various choices and decisions that we make in the future.

Consider these factors:

  • The divorce rate in the U.S. has been high for a very long time, causing a great deal of heartache and expense, not only for the couple but for family and friends as well. And one of the primary factors that causes a rift for young married couples is money problems.
  • The average cost of a wedding nowadays (according to this article on The Knot) is $31,213. Of course, most weddings cost far less than that, but for many folks the cost of the wedding is a very significant figure nonetheless. Often, paying the cost of a wedding can cause a young couple to go into debt before the knot is even tied.
  • The average college graduate in 2016 could expect to owe around $37,172 in student loans (per Student Loan Hero). If you assume that both members of the newly-married couple are college graduates, that amounts to nearly $75,000 in debt.
  • A “starter home” used to mean a 1 to 2 bedroom, 1 bath home at a price something on the order of one times the take home pay of a young family. Nowadays, the “starter home” has morphed into a 3+ bedroom, 2+ bath home, and the price can be as much as 2.5x to 3x the income of the family. This occurred for two reasons: the size of the average home increased dramatically; and most importantly, the amount of money that could be borrowed (as a percentage of the value of the home) increased significantly over time. Payments on mortgage loan debt have increased to an average of more than 25% of pre-tax income for folks right out of college.
  • Most people have a hard time talking openly about money. Money is one of those “taboo” subjects for most folks; conversations about money are uncomfortable. Because of this, most young couples don’t have serious discussions about finances until they start seeing problems.

Is it any wonder that divorce rates are high? A significant factor in divorces is financial issues, and the average young couple is starting out far in the hole – no wonder there are problems! Most of these young couples facing issues in their marriages can readily point out certain things that they wish they’d done differently in hindsight.

So the outcomes we see are a reaction to the factors. But what if we start using the experience of others to give foresight, to improve our own outcome? What if a young couple used the factors that can be working against the success of their marriage to try to avoid what seems inevitable?

Using Experience as Foresight for Marriage

Below are a few items to consider with your foresight:

Consider whether the wedding must be as expensive as originally planned, or as expensive as your friends’ wedding (or whatever is your gauge). Many, many long-lasting marriages were simple affairs that took place all in one church (reception in the basement). Of course you want to make the event memorable – but it doesn’t have to cost a fortune to make memories.

Make sure that you each understand one another’s debts – including what kinds of debt and how much. Have a plan for dealing with these payments, eliminating them over time. Also have a plan in place for how to keep these current if one of you is unemployed.

Instead of keeping the finances separated and only discussing money when it becomes a problem, talk about money up-front. Probably not on the first date, that might be a bit of a buzzkill, but definitely before marriage.

The accounts can remain separated after marriage if that’s a personal preference, but the couple should share the information with each other. Using this information, the couple can produce a household net worth statement. Don’t get hung up on the terminology, it’s just a report showing your assets (savings and things) minus your debts (loans and credit balances). You’ll need to do this when it comes time to get a mortgage; might as well get a head start on it.

It’s not a one-time thing, either. On a regular basis the couple should share in decision-making. Talk over things such as starting a new subscription or a membership to a fitness club, for example.

Often one member of the couple is responsible for paying the bills. This can be a mistake if the other member doesn’t have knowledge of the state of the month-to-month finances. It often makes sense to either do this together or split the responsibility (every other month, for example). At the very least, each spouse needs to know the household’s position – positive or negative cash flow. More income than expenses is positive, vice versa is negative.

The wedding example above is but one of many that illustrates the benefit of foresight. Review any major purchase, job change, retirement, or change in family similarly. Look at the potential pitfalls and use that information as foresight to guide your decisions.

I know many folks already use past experience as a guide – and kudos to those that do. But many more of us can use this change in perspective to improve our financial futures.

2017 Retirement Plan Contribution Limits

even-turtle-riders-have-limitsThe IRS recently published the new contribution limits for various retirement plans for 2017.  These limits are indexed to inflation, and as such sometimes they do not increase much year over year, and sometimes they don’t increase at all. This year for the third year in a row we saw virtually no increases contribution amounts, and the income limits increased for slightly as they did for 2016.

IRAs

The annual contribution limit for IRAs (both traditional and Roth) remains at $5,500 for 2017 (third year without an increase).  The “catch up” contribution amount, for folks age 50 or over, also remains at $1,000.

The income limits for traditional (deductible) IRAs increased slightly from last year: for singles covered by a retirement plan, your Modified Adjusted Gross Income (MAGI) must be less than $62,000 for a full deduction; phased deduction is allowed up to a MAGI of $72,000.  This is an increase of $1,000 over the limits for 2016.  For married folks filing jointly who are covered by a retirement plan by his or her employer, the MAGI limit is increased to $99,000, phased out at $119,000, also up $1,000 versus last year’s limits.  For married folks filing jointly who are not covered by a workplace retirement plan but are married to someone who is covered, the MAGI limit for deduction is $186,000, phased out at $196,000; this is an increase of $2,000 over 2016’s limits.

The income limits for Roth IRA contributions also increased: single folks with a MAGI less than $118,000 can make a full contribution, and this is phased out up to a MAGI of $133,000, an increase of $1,000 at each end of the range.  For married folks filing jointly, the MAGI limits are $186,000 to $196,000 for Roth contributions, up by $2,000 over 2016.

401(k), 403(b), 457 and SARSEP plans

For traditional employer-based retirement plans, the amount of deferred income allowed remains the same as the past two years. For 2016, employees are allowed to defer up to $18,000 with a catch up amount of $6,000 for those over age 50.  If you happen to work for a governmental agency that offers a 457 plan in addition to a 401(k) or 403(b) plan, you can double up and defer as much as $36,000 plus catch-ups, for a total of $48,000 deferred.

The limits for contributions to Roth 401(k) and Roth 403(b) are the same as traditional plans – the limit is for all plans of that type in total.  You are allowed to contribute up to the limit for either a Roth plan or a traditional plan, or a combination of the two.

SIMPLE

Savings Incentive Match Plans for Employees (SIMPLE) deferral limit is also unchanged at $12,500 for 2017.  The catch up amount is unchanged as well at $3,000, for folks at or older than age 50.

Saver’s Credit

The income limits for receiving the Saver’s Credit for contributing to a retirement plan increased for 2017.  The MAGI limit for married filing jointly increased from $61,500 to $62,000; for singles the limit is unchanged at $30,750; and for heads of household, the MAGI limit is $46,500, an increase from $46,125.  The saver’s credit rewards low and moderate income taxpayers who are working hard and need more help saving for retirement.  The table below provides more details on how the saver’s credit works:

Filing Status/Adjusted Gross Income for 2017
Amount of Credit Married Filing Jointly Head of Household Single/Others
50% of first $2,000 deferred $0 to $37,000 $0 to $27,750 $0 to $18,500
20% of first $2,000 deferred $37,001 to $40,000 $27,751 to $30,000 $18,501 to $20,000
10% of first $2,000 deferred $40,001 to $62,000 $30,001 to $46,500 $20,001 to $30,750

2016 Retirement Plan Contribution Limits

The IRS recently published the new contribution limits for various retirement plans for 2016.  These limits are indexed to inflation, and as such sometimes they do not increase much year over year, and sometimes they don’t increase at all. This year we saw a few increases for some contribution amounts, and the income limits increased for most types of accounts after virtually no changes to the contribution amounts in 2015.

IRAs

unusual contribution limitsThe annual contribution limit for IRAs (both traditional and Roth) remains at $5,500 for 2016 (second year without an increase).  The “catch up” contribution amount, for folks age 50 or over, also remains at $1,000.

The income limits for traditional (deductible) IRAs increased slightly from last year: for singles covered by a retirement plan, your Modified Adjusted Gross Income (MAGI) must be less than $61,000 for a full deduction; phased deduction is allowed up to a MAGI of $71,000.  This is the same as the limits for 2015.  For married folks filing jointly who are covered by a retirement plan by his or her employer, the MAGI limit is increased to $98,000, phased out at $118,000, also unchanged versus last year’s limits.  For married folks filing jointly who are not covered by a workplace retirement plan but are married to someone who is covered, the MAGI limit for deduction is $184,000, phased out at $194,000; this is an increase of $1,000 over 2015’s limits.

The income limits for Roth IRA contributions also increased: single folks with a MAGI less than $117,000 can make a full contribution, and this is phased out up to a MAGI of $132,000, an increase of $1,000 at each end of the range.  For married folks filing jointly, the MAGI limits are $184,000 to $194,000 for Roth contributions, up by $1,000 over 2015.

401(k), 403(b), 457 and SARSEP plans

For traditional employer-based retirement plans, the amount of deferred income allowed remains the same. For 2016, employees are allowed to defer up to $18,000 with a catch up amount of $6,000 for those over age 50.  If you happen to work for a governmental agency that offers a 457 plan in addition to a 401(k) or 403(b) plan, you can double up and defer as much as $36,000 plus catch-ups, for a total of $48,000 deferred.

The limits for contributions to Roth 401(k) and Roth 403(b) are the same as traditional plans – the limit is for all plans of that type in total.  You are allowed to contribute up to the limit for either a Roth plan or a traditional plan, or a combination of the two.

SIMPLE

Savings Incentive Match Plans for Employees (SIMPLE) deferral limit is also unchanged at $12,500 for 2016.  The catch up amount is unchanged as well at $3,000, for folks at or older than age 50.

Saver’s Credit

The income limits for receiving the Saver’s Credit for contributing to a retirement plan increased for 2016.  The MAGI limit for married filing jointly increased from $61,000 to $61,500; for singles the new limit is $30,750 (up from $30,500); and for heads of household, the MAGI limit is $46,125, an increase from $45,750.  The saver’s credit rewards low and moderate income taxpayers who are working hard and need more help saving for retirement.  The table below provides more details on how the saver’s credit works:

Filing Status/Adjusted Gross Income for 2016
Amount of Credit Married Filing Jointly Head of Household Single/Others
50% of first $2,000 deferred $0 to $37,000 $0 to $27,750 $0 to $18,500
20% of first $2,000 deferred $37,001 to $40,000 $27,751 to $30,000 $18,501 to $20,000
10% of first $2,000 deferred $40,001 to $61,500 $30,001 to $46,125 $20,001 to $30,750

Roth 401k – Is It Right for You?

up-to-5-people-wonder-about-roth-401k-a-dayMany employers are now offering a Roth 401k option in addition to the traditional 401k option. And with this new choice comes many questions: What is the benefit? Is a Roth 401k a good idea for me? How can I choose between the traditional 401k and the Roth?

Benefits of Roth 401k

Much like a Roth IRA, the Roth 401k can provide you with tax-free income when you retire. This benefit comes to you in exchange for no tax deduction when you contribute your funds to the Roth account.

Contributing money to a traditional 401k account results in a reduction from your income for the year. Then when you withdraw money from the account in your retirement, you will have to pay tax on the money withdrawn. This is the primary difference between the traditional 401k and the Roth.

Another benefit of the Roth 401k is that when you retire (or leave the job) you can rollover the money directly to a Roth IRA – this will eliminate RMDs from ever being required on the account, once the account has been held for 5 years.

Making the Choice Between Traditional and Roth 401k

So, knowing the benefits of a Roth 401k you may wonder if a Roth 401k is right for your situation. This is not a simple answer, as with many investing and savings activities. It all depends on two primary factors: your applicable tax rate now, and the tax rate in the future.

Your applicable tax rate now is important because if you choose a Roth 401k you’ll be paying taxes on the income you are deferring into the account. On the other hand, if this same money was going into a traditional 401k account you would avoid tax on the money deferred.

So if your current applicable tax rate is high, there is much value in deferring tax on some of your income. With a lower (or zero) applicable tax rate then the benefit of deferring tax on contributions is reduced or eliminated.

Looking into the future, if you anticipate that your tax rate in retirement is going to be lower than your tax rate today, then the traditional 401k is likely your best option. This is because you are deferring income at one rate and then paying tax another lower rate in the future.

On the other hand, if you anticipate higher taxes in the future (and who doesn’t?) then the Roth 401k might make more sense. This is due to the fact that, by using the Roth 401k you can pay taxes today at your lower rate and then later withdraw those funds at a zero tax rate.

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