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Withdrawals from an IRA – death, disability, and 59 1/2

key to ageThree of the most common ways that you can withdraw funds from your IRA without penalty are: 1) reaching age 59½; 2) death; and 3) disability. Below is a brief review of each of these conditions for penalty-free withdrawal:

  1. Reaching Age 59½ When you reach age 59½, you can withdraw any amount from your IRA without penalty, for any reason. The only thing you have to remember is that you must pay ordinary income tax on the amount that you withdraw. This means that, once you have reached the date that is 6 months past your 59th birthday, you are free to make withdrawals from your IRA without penalty. You are not required to take distributions at this age (that happens at age 70½).
  2. Death Upon your death at any age, the beneficiaries of your account or your estate if you have not named a beneficiary, can take distributions from your IRA in any amount for any reason without penalty. In fact, your IRA beneficiaries in most cases must begin withdrawing from the IRA, taking required minimum distributions annually, or taking the entire account balance out within 5 years after the death of the original owner. See the article RMD from an Inherited IRA for more details.These distributions are taxable as ordinary income to the beneficiary, but no penalty is applied.
  3. Disability If you are deemed “totally and permanently disabled” you are also eligible to withdraw IRA assets for any purpose without penalty. Total and permanent disability means that you have been examined by a physician and the disability is such that you cannot work, and the condition is expected to last for at least one year or result in your death.

RMD from an Inherited IRA

inheritanceIf you have inherited an IRA you are required to begin taking distributions from the account according to a set schedule. If you are the sole beneficiary of the IRA, how you handle your distributions is up to you. If there are two or more beneficiaries of the IRA, the process becomes more complicated – see the article at the link for more on multiple beneficiary arrangements.

There are actually two different schedules that you can use, lifetime distributions and a distribution over 5 years.

5-year distribution

The 5-year distribution method is the default period for distribution of an inherited IRA. As the name of the method suggests, in this method the inherited IRA must be completely withdrawn within 5 years of the death of the original owner. There is no specific amount that must be withdrawn in any particular year, as long as the entire account is withdrawn within 5 years.

I mentioned that the 5-year method is the default – this is because if no distributions are taken within the first year following the death of the original owner, it is assumed that the 5-year method is being used. However, if you are using the lifetime distribution method, you would take a specific distribution (or more) during the first year following the year of the death of the original owner.

Lifetime distribution

If using the lifetime distribution method, you are intending to extend the time period of distribution for some length of time in excess of the default 5-year distribution. To accomplish this, there is a specific amount which must be withdrawn each year – and as long as at least that amount is withdrawn annually, the required minimum distribution has been satisfied.

The amount of the withdrawal required each year is determined by the age of the beneficiary upon the death of the original owner. The IRS has a table, known as Table I, that indicates a life expectancy figure for the beneficiary.

So if the beneficiary is, for example, 28 upon inheriting an IRA her life expectancy figure is 55.3. If the inherited IRA is worth $240,000, dividing the value of the IRA by 55.3 results in $4,339.96 – this is the first year’s required distribution. As long as at least that amount is withdrawn during the first year following the year of the death of the original IRA owner, the RMD has been satisfied.

The following year, the original life expectancy figure is decreased by 1 to 54.3. So now, if the IRA is worth $236,000 as of the end of the prior year, dividing that amount by 54.3 results in a RMD of $4,346.22.

The inheritant can take a larger distribution at any time – the only requirement is that at least the prescribed amount is withdrawn every year.

Age 70½ RMD Rules

give-us-this-day-by-mr-krisAs an owner of an IRA or other qualified retirement plan (such as a 401k), when you reach age 70½ you are required to begin taking distributions from the account(s).  There are several important factors about these distributions that could trip you up if you’re not careful.  Listed below are some of the more important rules – but keep in mind that these RMD rules are only for the original owner of the account, not for a beneficiary of an inherited account. There is a different set of rules for inherited IRA RMDs.

Required Minimum Distribution Rules

Calculation of RMD

  1. Determine your account balance from the end of the calendar year prior to the year for which the distribution is being calculated.  Any additions or withdrawals after December 31 of the previous year are not included in this balance, even if an addition is for the previous calendar year.  Also, any “in flight” rollovers or recharacterizations that effectively would impact the end of year balance are included (or excluded) in the balance as applicable.
  2. You must learn your distribution period, which can be found in Table III, using your age at the end of the current year (not the previous year).
  3. Divide the balance determined in #1 by the distribution period found in #2.  This is your RMD for the current year.
  4. For each subsequent year, go back through #1 for a new balance at the end of the prior year, then go to the table from #2 to get a new distribution period, and do the math.

More Than Minimum – for any year in which you withdraw more than the RMD amount you are NOT allowed a credit against future year RMD.  The result is that your balance at the end of the current year would be less, so future RMD would be less as well, but not by the amount of your extra withdrawal.

No Rollovers or Conversions of RMD Amounts – Although you’re allowed to rollover or convert IRA funds after age 70½, you can not rollover or convert the amount attributable to your RMD for the year. This amount (the RMD) must be taken completely out of tax-deferred accounts.

Multiple Accounts – For the purposes of calculating RMD, the IRS considers all traditional IRAs owned by one individual as one aggregate IRA.  This means that you can determine your RMD by adding together the balances of all your trad IRA accounts at the end of the prior year, and then taking your RMD from any one account (or as many accounts as you wish) as long as it totals at least the RMD for that year.  Other qualified retirement plans such as a 401(k) must be treated separately – that is, RMD must be calculated only on that account and distribution received from only that account.

Multiple Payments – For the tax year, you are allowed to take from as little as one to as many payments as you wish from your IRAs, as long as they add up to at least the RMD for the year.

Photo by Mr. Kris

Early Withdrawal of an IRA – 72t Exceptions

If you have done much studying about IRAs and 401k plans, you probably know that there 72ts1are several exceptions in the Internal Revenue Code that allow an early withdrawal from your IRA or 401k plan without the 10% penalty being imposed. The section of the IRC that deals with quite a few of these exceptions is called Section 72t (referred to as 72t for short), and there are several subsections in this piece of the Code. Each subsection, listed below, has specific circumstances that must be met in order to provide exception to the 10% penalty. Clicking on the link for each subsection will provide you with additional details about that exception.

§72(t)(2)(A)(i) – age 59½ – this is the standard age allowing for penalty-free withdrawals from your IRA or 401k. In some cases there is an exception allowing for penalty-free withdrawals from a 401k at or after age 55; and after age 50 in even more limited cases. See §72(t)(2)(A)(v) below for more details.

§72(t)(2)(A)(ii) – death at any age – upon your death, your heirs as beneficiaries of the IRA or 401k can take penalty-free withdrawals. In fact, in most cases the beneficiaries are required to begin taking withdrawals from the account.

§72(t)(2)(A)(iii) – disability at any age – if you are disabled (per IRS definition) you may take withdrawals from your IRA or 401k without penalty. Disability (per IRS) means that you have been examined by a physician and the disability is such that you cannot work, and the condition is expected to last for at least one year or result in your death.

§72(t)(2)(A)(iv) – series of substantially equal periodic payments (SOSEPP) – this is the classic “72t” exception, allowing for withdrawals from your IRA or 401k in equal payments to last at least five years or until you reach age 59½, whichever is later.

§72(t)(2)(A)(v) – separation from service on or after age 55 (401k only) – this is the section alluded to above, where if you leave the employer during or after the year you will reach age 55, you can take withdrawals from your 401k without penalty. If you are in a public safety job (police, firemen, etc.), then this early withdrawal age is 50.

§72(t)(2)(B) – medical expenses – withdrawals from an IRA or 401k may be penalty-free if used to pay for certain qualified medical expenses.

§72(t)(2)(C) – qualified domestic relations order (QDRO) – upon a divorce settlement, if the 401k has been divided using a QDRO, the withdrawals by the spouse who is receiving the 401k (not the original owner) may be penalty-free. This only applies to 401k plans – IRAs cannot be split with a QDRO.

§72(t)(2)(D) – health insurance premiums – in certain circumstances, health insurance premiums may be paid for with penalty-free IRA withdrawals. This only applies to IRAs, not 401k plans.

§72(t)(2)(E) – higher education expenses – qualified higher education expenses may be paid for with penalty-free withdrawals from an IRA. This does not apply to 401k plans.

§72(t)(2)(F) – first time home purchase – if you have never used this exception, you may be eligible to withdraw up to $10,000 ($20,000 if your spouse qualifies) from your IRA for the purpose of purchasing a first home. This is also only allowed with an IRA; 401k plans do not allow this exception.

5 Options for Your Old 401k

old 401kWhen you move from one job to another, often there is an old 401k plan at the former employer. You have several choices for what you can do with the old 401k plan, and some options are better than others. Some of the options are dependent upon the balance in your old 401k account, as well.

Cash it out. This is typically the worst option. You took advantage of tax-deferral (and company matching) when you contributed the funds to the account. If you simply cash out the old 401k, you’ll have to pay tax on the funds, and if you were under age 55 when you left the employer you will also likely be hit with a 10% penalty for the early withdrawal.

In addition to the tax and penalty, when you take a withdrawal from your 401k plan there is an automatic 20% withholding requirement. You will have credit for this withholding on your tax return, but that could cause a delay of many months before you receive the money.

If your old 401k balance is less than $1,000, your employer has the option to cash out your account without your consent. But all is not lost, you can still complete a rollover into an IRA or a 401k at a new employer – but it must be completed within 60 days (see Indirect Rollover below).

Indirect Rollover. An indirect rollover occurs when you request a distribution of the funds from the old 401k to be given to you in the form of a check made out to you. This is (at the start) the same as cashing out your old 401k – but then you re-deposit the check into an IRA or a new employer’s 401k. If you deposit the entire amount of your old 401k into a new tax-deferred account, there will be no tax ramifications.

This is where the previously-mentioned 20% withholding can cause problems. As mentioned before, when you take a cash-out withdrawal from your 401k there is a mandatory 20% withholding. When you go to re-deposit the funds, in order to avoid taxation you’ll need to come up with the withheld 20% to make the rollover complete.

For example, Laura left her former employer, where she had a 401k plan. This old 401k had a balance of $25,000. Laura wanted to do an indirect rollover – so she asked for a check from the 401k administrator. When she receives her check, the amount is only $20,000. This is because 20% was withheld, as required.

So when Laura completes the indirect rollover, unless she comes up with the missing $5,000 from her savings or some other source, the result will be that she has only rolled over $20,000 – and when she pays taxes for the year, she’ll have an extra $5,000 of income to report. Since Laura was under age 55 when she left the employer, she’ll also have a 10% penalty to pay. Granted, she has the credited $5,000 of withheld tax, but the end result is that her retirement fund is $5,000 less and she had to pay tax and a penalty on the unintended withdrawal.

For this reason alone it’s almost always better to do a Direct Rollover.

Direct Rollover. This is where you direct the old 401k administrator to transfer the funds to either an IRA or a 401k at a new employer. In doing so, the funds have never left the “protection” of a tax-deferred account, so there is no taxation or penalty involved.

In the case of either a direct or indirect rollover into a new employer’s 401k plan, you’ll need to make sure that the new 401k plan allows for this sort of “roll-in” contribution. Most plans do allow this, but some still don’t.

Once you have completed the rollover (either kind) you can then invest the funds in the new account as you wish, and treat the entire account as if it was contributed from your deductible contributions.

Leave it alone. In some cases it can be advantageous to leave the money in the old 401k plan. Typically this is only allowed when your balance is significant, often around $5,000 or more.

You might want to leave the funds at the old employer for a few reasons: first, if you left the employer at or after the age of 55 (but less than 59½), leaving the money with the old 401k provides you the option to utilize the age 55 exception to the 10% penalty. If you transferred the money away from the old 401k you would lose this treatment.

Second, your old 401k may have valuable investment options available that may not otherwise be available to you, such as investments closed to new investors.

Third, if you have highly-appreciated company stock in the old 401k plan, if you don’t stage a rollover properly you might lose valuable tax treatment on the net unrealized appreciation on the stock.

Roth conversion. In addition to the traditional rollovers described above, you can also convert the money to a Roth IRA. Naturally this will cause income tax on the conversion, but depending upon the tax situation this can be a good option to pursue.

You would just transfer the money over to the Roth IRA account and pay tax on the distribution on your tax return for the year. Then you’ll have money in the Roth account that is protected from taxation on qualified withdrawals forever.

Net Unrealized Appreciation

beauty unrealized by brew ha haThis widely misunderstood section of the IRS code can be quite a benefit – if it happens to fit your situation. Net Unrealized Appreciation (NUA) refers to the increase in value of your company’s stock held within your 401(k), either due to a company match or your own investment in the company stock within the 401(k). Other company-sponsored deferred accounts can apply here as well, but the primary type of account is the 401(k), so we’ll refer to all company-sponsored tax-deferred accounts as 401(k)’s for the purpose of this discussion.

In order to take advantage of the Net Unrealized Appreciation provision, first of all you must hold your company’s stock in your 401(k), and you must be in a position to roll over the account. That is, either you must have separated from service by leaving employment (voluntarily or involuntarily), or the 401(k) plan is being terminated.

As you consider the rollover of your funds, if the company stock has increased in value, you have net unrealized appreciation. That is, there is a net increase or appreciation in value that has not yet been realized by sale of the stock. The IRS allows for this net unrealized appreciation to be treated as a capital gain, which can result in much lower tax rates on the gain versus ordinary income tax rates.

In order to take advantage of this special NUA treatment, the 401(k) account must be completely rolled over in one tax year. There is one thing that you must do differently from other rollovers, however: The company stock will be rolled over into a taxable (non-IRA) account, while everything else will be rolled over into a traditional IRA.

When you rollover the company stock, this will be considered a distribution. As with any distribution, you will be required to pay the tax on the basis (or cost) of the stock as well as the 10% penalty if you were under age 55 when you left the employer. Your employer or plan administrator will have records on your basis of the stock.

As an example, let’s say Frank has participated in the company’s 401(k) plan for several years and he’s now ready to retire. Part of the 401(k) funds were invested over the years in Frank’s company’s stock, which has cost Frank a total of $10,000 through the years (this is the basis). Frank’s company has done well, and now the stock is worth $150,000 in the market. If Frank rolled over the company stock into an IRA, when he withdraws the money he would pay ordinary income tax on that growth of $140,000 – at whatever his current marginal income tax rate at that time. Instead of going that route, Frank decides to use the NUA provision in the tax law – much to his advantage.

So, Frank sets up an IRA and a taxable account at the custodian of his choice, and he directs the 401(k) administrator to roll over his company stock to the taxable account, and all other funds to the IRA. When Frank rolls over the company stock into the taxable account, he will be taxed at ordinary income tax rates (plus the 10% penalty if he was under age 55) on the basis of the stock – which is $10,000. Now, not only will the growth of the stock ($140,000) have a tax rate of 15% or less as capital gains, Frank also will not have to take required minimum distributions (RMD) from those funds upon reaching age 70½ . Frank can leave the company stock in that taxable account forever if he wishes, and then hand it over to his heirs. (Note: NUA stock doesn’t receive a step-up in basis like other appreciated stock.)

Here’s the math: Frank pays tax at an example rate of 25% on the $10,000 basis of the stock, or $2,500.  Frank is over age 55, so no 10% penalty applies.  Then, as he sells the stock, the total amount of capital gains tax would be 15% at today’s rates of $140,000 (just the growth!) or a total of $21,000. Compare that to the non-NUA treatment, where Frank would be taxed with ordinary income tax rates on the entire $150,000 stock value over time, for a total of $37,500! In this example, Frank has saved a total of $14,000 in taxes! Wow…

Now, NUA treatment doesn’t work for all situations. For example, if your company stock has only grown minimally in value, or has gone down in value, there is little or no benefit to utilizing the NUA option. Also, if the basis of the stock is fairly high relative to the growth, it might make sense to only apply NUA treatment to a portion of your company stock, which is also allowed. One last thing – this NUA treatment only applies to the stock of your employer. No other stock can receive this treatment.

Early Withdrawal of an IRA or 401k – Medical Expenses

medical expensesThere are several ways to get at your IRA funds before age 59½ without having to pay the 10% penalty. In this post we’ll cover the Medical Expenses which allow for a penalty-free distribution.

There are three different Medical reasons that can be used to qualify for an early withdrawal: high unreimbursed medical expenses, paying the cost of medical insurance, and disability. Disability and high unreimbursed medical expenses are also applicable reasons allowing for early withdrawal of 401k funds without penalty. We’ll cover each of these topics separately below.

High Unreimbursed Medical Expenses

If you are faced with high medical expenses for yourself, your spouse, or a qualified dependent, you may be eligible to withdraw some funds from your IRA or 401k penalty-free to pay for those expenses. The amount that you can withdraw is limited to the actual amount of the medical expenses you paid during the calendar year, minus 10% (7.5% if you or your spouse is age 65 or older during 2016) of your Adjusted Gross Income, or AGI.  Your AGI is the amount on your Form 1040, line 38, or Form 1040A line 22.

You can only count medical expenses that are otherwise deductible as medical expenses on Schedule A of Form 1040 – but, you don’t have to itemize your deductions in order to take advantage of this exception to the 10% penalty.

For this exception to apply to withdrawals from a 401k, often you are also required to have left the employer.

Medical Insurance Premiums

You may be able to take a penalty-free distribution from your IRA (but not your 401k) to help pay for medical insurance premiums for yourself, your spouse, and your dependents, as long as the amount you withdraw does not exceed the amount you actually paid for medical insurance premiums, and all of the following apply:

  • You lost your job.
  • You received unemployment compensation paid under any federal or state law for 12 consecutive weeks because you lost your job.
  • You receive the distributions during either the year you received the unemployment compensation or the following year.
  • You receive the distributions no later than 60 days after you have been reemployed.

There is no income limitation on this provision.

Disability

If you become disabled prior to age 59½, distributions in any amount from your IRA or 401k are not subject to the 10% penalty. Your disability must be considered of a long duration (greater than one year) or expected to result in death. The disability (physical or mental) must be determined by a physician.

Keep in mind, as we mentioned previously, these avenues provide a way to withdraw funds from your IRA penalty-free, but not tax-free. You will still be liable for ordinary income tax on any distributions that you take from your deductible IRA or 401k. In addition, you will need to check with your 401k administrator to find out about the rules and limitations that are specific to your particular plan.

Early Withdrawal of an IRA – First Time Homebuyer

Early stage of a developing white-capped mushroom 2When you have money in an IRA, you are allowed to begin taking withdrawals once you’ve reached age 59½. But sometimes you’d like to take your money out earlier… and you’ve probably already discovered that there is a 10% penalty for taking funds out of your IRA early, right? So – is there a way to avoid that penalty? Perhaps as a first time homebuyer.

There are several ways to withdraw IRA funds without penalty, as a matter of fact. There are several sections of the Internal Revenue Code that deal with these early distributions – including 72(t) which includes the first time homebuyer exception. We’ll explain the first time homebuyer exception in this post.

First Time Homebuyer

If you are buying, building, or re-building your first home (defined later), you are allowed to take a distribution of up to $10,000 (or $20,000 for a married couple) from your IRA to fund a portion of your costs, without paying the 10% penalty. There are a few restrictions, though – here is the official wording from the IRS:

  1. It must be used to pay qualified acquisition costs (defined later) before the close of the 120th day after the day you received it.
  2. It must be used to pay qualified acquisition costs for the main home of a first time homebuyer (defined later) who is any of the following.
    1. Yourself.
    2. Your spouse.
    3. Your or your spouse’s child.
    4. Your or your spouse’s grandchild.
    5. Your or your spouse’s parent or other ancestor.
  3. When added to all your prior qualified first-time homebuyer distributions, if any, total qualifying distributions cannot be more than $10,000.

If both you and your spouse are first time homebuyers (defined later), each of you can receive distributions up to $10,000 for a first home without having to pay the 10% additional tax.

Qualified acquisition costs. Qualified acquisition costs include the following items.

  • Costs of buying, building, or rebuilding a home.
  • Any usual or reasonable settlement, financing, or other closing costs.
First time homebuyer. Generally, you are a first time homebuyer if you had no present interest in a main home during the 2-year period ending on the date of acquisition of the home which the distribution is being used to buy, build, or rebuild. NOTE: If you are married, your spouse must also meet this no-ownership requirement. This provision might cause you to re-think the timing of a purchase of a home if you are about to get married and your soon-to-be spouse has had ownership within the past 2 years.

Date of acquisition. The date of acquisition is the date that:

  • You enter into a binding contract to buy the main home for which the distribution is being used, or
  • The building or rebuilding of the main home for which the distribution is being used begins.

The keys here are to make sure that you qualify as a first time homebuyer (by the IRS’ definition above), that you use the funds in time (before 120 days has passed since the distribution), and that you haven’t taken this option previously (or previous distributions were less than $10,000). For many folks this can be very helpful when buying a home.

Another important point to note is that although you do not have to pay the 10% penalty on the distribution, you WILL be required to pay ordinary income tax on any money taken from your IRA. This can be a surprise to some folks who weren’t expecting it. However, if you have post-tax (non-deductible) contributions in your IRA, these will be non-taxable, but pro rata in this distribution.

A Social Security Hat Trick for $24,000

hat trickDid you know that even with the new Social Security rules, it’s possible to work out a strategy to maximize your Social Security benefits? There are options still available (if you were born before 1954) that can provide you with some vestiges of the old “get some now, get more later” option.

Since the restricted application option is still open for those born on or before January 1, 1954, a married couple can still work this strategy to their advantage to maximize benefits.

Here’s how it works:

Jessica and Robert are both age 66 this year. Robert’s Primary Insurance Amount, or PIA, is $1,000 per month. This is the amount of benefits he’d receive if he files for his Social Security benefit upon reaching age 66. Jessica’s PIA is $2,600 per month.

Robert files for his benefit when he turns 66 in June. Jessica reaches age 66 on her birthday in August. At that time, since Robert has filed for his Social Security benefit, Jessica is eligible to file a restricted application for spousal benefits, receiving $500 per month, 50% of Robert’s PIA. So Robert and Jessica are receiving a total of $1,500 per month at this point, and they continue to do so for the next four years.

When Jessica reaches age 70, her Social Security benefit has maximized due to the earned delay credits. When she files, she’s eligible for $3,432 per month, a 32% increase from her PIA. At the same time, now that Jessica has filed, Robert is eligible for a spousal benefit based on Jessica’s record. This means that Robert can file for the spousal “excess” benefit – which is calculated as:

50% of Jessica’s PIA ($1,300) minus Robert’s PIA ($1,000) = $300

This $300 is then added to Robert’s current benefit, and he now can receive a monthly benefit of $1,300. So together, Robert and Jessica will now receive a total of $4,732 per month.

Regardless of which of the two dies first, the smaller benefit (Robert’s) will cease, and the larger benefit (Jessica’s) will continue. So the benefit that was maximized by delaying will be paid out for the longest period of time – to the death of the second-to-die of the couple.

While maximizing the larger benefit, Robert and Jessica were able to receive four years’ worth of benefits at $1,500 per month. Then upon maximizing Jessica’s benefit, Robert received a step-up for spousal excess benefits. This strategy results in $24,000 more benefits for the couple.

5 Secrets About Your 401k Plan

401k plan secretMany folks have a 401k plan – it’s the most common sort of retirement savings vehicle that employers offer these days. But there are things about your 401k plan that you probably don’t know – and these secrets can be important to know!

The 401k plan is, for many, the only retirement savings you’ll have when you reach your golden years. Used properly, with steady contributions over time, a 401k plan can generate a much-needed addition to your Social Security benefits. But you have to make contributions to the 401k plan for it to work, and invest those contributions wisely.

So how much do you know about your 401k plan? Below are 5 secrets that you probably don’t know about your 401k plan. Check with your 401k plan administrator to see if these provisions are available – some plans are more restrictive than others.

Secrets You Don’t Know About Your 401k Plan

1. You can take a loan. You may not realize it, but you have a source of ready cash available for any purpose you need, in the form of a 401k loan. Of course, once you take the money out you have to pay it back, which can make your already small take-home pay even smaller. But if you have no other source for cash and a true crisis is ahead of you, a 401k loan could be the answer. For more details on 401k loans, see the article How to Take a Loan from Your 401k, and check with your 401k plan administrator for information.

2. You may have access to the money in your plan before you retire. Not all 401k plans allow this, but many do: once you’ve reached age 59½ (for some plans it’s 55), you may be eligible to take an “in-service distribution” from the plan while you’re still employed. This can be a way to make up for a spouse who has retired before you, and who is waiting for other retirement funds such as Social Security or a pension. As mentioned before, check with your 401k plan administrator to see if this option is available to you.

3. You can start with very small contributions, and grow the amount over time. Many times, especially early in our careers, the thought of trimming our already meager take-home pay with a contribution to a 401k plan is scary. The problem is that you’re faced with peers and bosses who tell you things like “If you don’t put in up to the company match amount, you’re throwing money away!” – which doesn’t help if you can’t hardly afford to set aside even 1%.

There is no rule that says you must put aside the amount to take advantage of the company match (often 6% or so) – you can start with a small amount, such as 1%, and see how it goes. My experience with folks who’ve done this is that they learn to budget around the smaller paycheck, and they’re happy they’ve done so. Then when you have an increase to your pay, figure out how much your increase is and put aside a portion of that in additional 401k plan contributions. Over time, you’ll build your contributions up to a point where you’re taking full advantage of the employer match, and then some!

4. You can stop and restart your contributions. Bad things happen to good people all the time. Unexpected expenses arise that we’re not prepared to deal with (hence the name “unexpected”!) and so it sure would be handy to put the 401k plan contributions on pause for a while. Most 401k plans will allow you to stop your contributions (or simply reduce the amount), although some may limit the frequency of making such changes. Just don’t get too comfy with the reduced or eliminated contribution level – set a time for yourself to bump it back up so that you keep putting money away for retirement!

5. Making contributions is very smart – in several ways. As mentioned above, your 401k plan may be your only source of money in retirement (besides Social Security) – and making contributions is the only way to build up this account. This by itself is smart, but there are xx other really smart things about making 401k plan contributions:

Employer Match – when you make a contribution to your 401k plan, many times your employer will match a portion of your contribution. If you don’t contribute, the employer won’t either, in most cases. So if you’re making $30,000 and your employer will match 50¢ for every dollar up to 5% for example, if you contribute the full 5% you’ll have credit for $2,250 in your account. That’s 7.5% – which only cost you 5%. Or $2,250 in your account that only cost you $1,500. Pretty sweet, right?

Payroll Deduction – making contributions to your 401k plan via payroll deduction is, for most folks, a relatively painless way to save money. If you don’t see the money in your checking account, you won’t miss it. And the tax treatment of 401k plan contributions helps out more (see the next point).

Tax Treatment – since traditional 401k plan contributions are taken out before income tax, the amount of reduction to your paycheck will be less than the amount you’re putting into the 401k plan. Think about that for a moment, because it’s a bit confusing…

What happens is when you make a contribution to the 401k plan, that money isn’t counted toward income taxes. So as a result, fewer dollars are withheld from your remaining paycheck to cover the tax bite. I have a good example over in the article How a 401(k) Contribution Affects Your Paycheck that works through the numbers for you.

Making contributions to your 401k plan is a smart move for you, tax-wise and savings-wise. Check with your 401k plan administrator to see what provisions are available to you.

Canceled debt and your taxes

canceled debtWhen you have a canceled debt, you may think you’re done with that old nuisance. Unfortunately, the IRS sees it otherwise. Technically, since you owed money beforehand and now you don’t, your financial situation is increased by the amount of canceled debt. When you have an increase to your financial situation, this is known as income. And income, as you know, is quite often taxable – but sometimes there are ways to exclude the canceled debt from your income for tax purposes.

The IRS recently issued a Tax Tip (Tax Tip 2016-30) which details some important information that you need to know about canceled debt, including HAMP modifications and other items. The actual text of the Tip follows:

Top 10 Tax Tips about Debt Cancellation

If your lender cancels part or all of your debt, it is usually considered income and you normally must pay tax on that amount. However, the law allows an exclusion that may apply to homeowners who had their mortgage debt canceled. Here are 10 tips about debt cancellation:

1. Main Home. If the canceled debt was a loan on your main home, you may be able to exclude the canceled amount from your income. You must have used the loan to buy, build or substantially improve your main home to qualify. Your main home must also secure the mortgage.

2. Loan Modification. If your lender canceled part of your mortgage through a loan modification or ‘workout,’ you may be able to exclude that amount from your income. You may also be able to exclude debt discharged as part of the Home Affordable Modification Program, or HAMP. The exclusion may also apply to the amount of debt canceled in a foreclosure.

3. Refinanced Mortgage. The exclusion may apply to amounts canceled on a refinanced mortgage. This applies only if you used proceeds from the refinancing to buy, build or substantially improve your main home and only up to the amount of the old mortgage principal just before refinancing. Amounts used for other purposes do not qualify.

4. Other Canceled Debt. Other types of canceled debt such as second homes, rental and business property, credit card debt or car loans do not qualify for this special exclusion. On the other hand, there are other rules that may allow those types of canceled debts to be nontaxable.

5. Form 1099-C. If your lender reduced or canceled at least $600 of your debt, you should receive Form 1099-C, Cancellation of Debt, by Feb. 1. This form shows the amount of canceled debt and other information.

6. Form 982. If you qualify, report the excluded debt on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness. File the form with your federal income tax return.

7. IRS.gov Tool. Use the Interactive Tax Assistant tool on IRS.gov to find out if your canceled mortgage debt is taxable.

8. Exclusion Extended. The law that authorized the exclusion of canceled debt from income was extended through Dec. 31, 2016.

9. IRS Free File. IRS e-file is fastest, safest and easiest way to file. You can use IRS Free File to e-file your tax return for free. If you earned $62,000 or less, you can use brand name tax software. The software does the math and completes the right forms for you. If you earned more than $62,000, use Free File Fillable Forms. This option uses electronic versions of IRS paper forms. It is best for people who are used to doing their own taxes. Free File is available only on IRS.gov/freefile.

10. More Information. For more on this topic see Publication 4681, Canceled Debts, Foreclosures, Repossessions and Abandonments.

Each and every taxpayer has a set of fundamental rights they should be aware of when dealing with the IRS. These are your Taxpayer Bill of Rights. Explore your rights and our obligations to protect them on IRS.gov.

Additional IRS Resources:

The Madoff Scam: What Can We Learn?

scandalNote: This is a re-publish of an article from early 2009 – but the lessons are still very useful in today’s world.

You’d have to be living under a rock to not know about the scandal of Bernie Madoff’s firm – wherein the supposedly legitimate Madoff bilked some of the most sophisticated investors in the world out of something like $50 billion. The Ponzi scheme has been around forever, for the very fact that it works – much to the chagrin of those caught in its web.

The bright spot for all of us (as long as you weren’t caught in the Madoff scheme) is that the losses we’ve all seen in the the stock market pale in comparison to the losses by Madoff investers. Plus, we have the opportunity to make it back (eventually). These folks lost literally everything invested there, in some cases entire life savings. The vexing part is that many of those folks should have known better. Included in the ranks of people who lost money with Madoff were big banks, Wall Street economists, and, surprisingly, Stephen Greenspan, an emeritus psychology professor who just published a book titled Annals of Gullibility: Why We Get Duped and How to Avoid It.

So How Did This Happen? The way folks were fooled into believing this scheme is that Madoff had a reputation as a forthright and above-board individual. Why, he had once been the chairman of the Nasdaq stock exchange! Most of the large institutions victimized had personal relationships with Madoff and his marketing team, in part owing to the scammer’s earlier position on Wall Street. It is this kind of personal relationship that evokes trust and, in the wrong kind of individual, exploitation of that trust.

But the real enticement came from the consistency of the returns – not earth-shattering in scope, these were relatively modest returns of approximately 1% a month. Considered one month at a time, that’s pretty minimal, but even the average investor should have begun to ask questions when that return continued through up markets and down, with nary a change. Had Madoff offered 10% per month, he wouldn’t have even gotten off the ground, but with this smaller return folks came in by the busload, checkbooks in hand.

And lastly, he came across as an independently-wealthy individual. What motive would someone of his means have for stealing even a dime from someone else? As it turns out, he had every motive in the world, and appearances were quite deceiving.

Lesson #1 from Madoff: If it looks too good to be true, it probably is too good to be true.

Lesson #2 from Madoff: No one can deliver a 1% return per month, every month, in up markets and down. It just doesn’t happen.

What Else Can We Learn? One of the easiest ways to keep something like this from happening is to keep your investing simple. It seems that when complex investment activity is added to an investor’s portfolio, bad things can begin to happen. By complexity I mean getting involved in frequent trading, playing with options, shorting positions, fooling with derivatives, and things along those lines. These are the sorts of investments at the root of today’s financial crisis. While the products in question (mortgage derivatives) are not new to the scene, the history of these products was shaky at best even before September of last year – and we saw what happens when the “perfect storm” of risks comes together. With little forewarning, the entire house of cards comes falling down.

When asked his investment strategy, Madoff touted a complex “split-strike conversion” methodology. That was all the explanation given, and all that the investors (apparently) required. Whatever he was doing seemed to be working, and that was fine with anyone who cared to wonder. It’s unknown if Madoff ever invested a single dollar, or if he just churned the new money back out the door to the earlier investors, in the classic Ponzi style.

It is a common belief that there is a group of folks (the “smart money”) who can beat the market all the time. It’s my opinion that no such group or individual exists. Just look around you: if there was any “smart money” around, you’d have seen those companies or mutual funds faring well during the meltdown last quarter. Unfortunately there is no crystal ball – and given the firehose of information available to us these days, very little can escape notice.

This is not to say that no one ever beats the stock market averages. On the contrary, there are some mutual fund managers every year who beat the average, and some do it consistently (although not many). As I have mentioned on these pages in the past, less than 3% of all fund choices in a particular category will beat the index for an extended period. With odds like that, why not stick with the simple, tried and true index strategy?

Lesson #3 from Madoff: Keep it simple. Understand your investments, and why they make money.

In addition, Madoff acted not only as advisor, but also as brokerage for his client-victims. In other words, when making an investment, clients would just hand over the money to Madoff, rather than a third-party brokerage. With everything under one roof, Madoff was free to do whatever he wanted (and he did) with no checks and balances.

Lesson #4 from Madoff: Know where your money is going, and check on it regularly. Utilize a third-party between you and your advisor so that you can independently verify that your money is invested as you desire.

It’s a terrible thing that the folks who trusted Madoff have nothing to show for their lifetime of investing. Knowing what we know today, he probably still would have suckered in quite a few folks. But if we pay close attention to the lessons that we can learn from this scam, hopefully you and I will avoid being pulled in to the next scheme like this that comes along.

New Rules for File and Suspend

file and suspendSo the heyday is over, file and suspend under the old rules is gone forever as of April 30, 2016. Those were the days, my friend. We thought they’d never end. We’d file and suspend forever and a day. But not any more…

Or, may we still file and suspend?

Of course we can still file and suspend, the rules are just more restrictive now. When you suspend your benefits these days, all benefits that are payable based upon your record are suspended as well. For example, if you have a child who is eligible for benefits based on your record, when you suspend your benefits the child’s benefits will be suspended as well.  The same goes for spousal benefits based on your record.

To be clear, the rules about suspending benefits are:

  • You must be at least Full Retirement Age
  • When you suspend benefits, your own benefit will not be paid to you
  • Since you are not receiving benefits, you will earn delay credits at the rate of 8% for every year of delay
  • ALL OTHER BENEFITS based on your record will also be suspended, including spousal benefits and child’s benefits

File and Suspend

Before the rules changed, it was common to file and suspend at the same time. Now, with the new rules, it would likely not make much sense to file and suspend at the same time.

The action of filing for benefits is enough to enable benefits for others (spouse or child) to receive benefits based on your record. Under the old rules, if you suspended your benefits, these auxiliary benefits could continue – so, file and suspend at the same time made a lot of sense. By doing so, you would enable others to receive the auxiliary benefits, while at the same time delaying your own actual filing to some later date, receiving the delay credits for the delay.

With today’s rules, file and suspend at the same time doesn’t actually accomplish anything for you, other than establish a filing date.

What you might do though, is file for benefits at one point, and then later suspend them. For example, if you are 62 years old and you have a child who is under 18 (for example’s sake we’ll say 12 years old), you could file for your own benefits and enable your child to receive benefits based on your record. When the child reaches age 18, he will no longer be eligible to receive the benefits – so you could suspend your benefits at this point (you’d be 68 by now) and receive an 8% increase to your benefits for each year that you delay.

The strategy above would be important to you to provide some benefits to the auxiliary dependents (such as a child or spouse) for a short period of time, while allowing you to then enhance your benefits later by suspending.

If the concept isn’t thrilling to you, you’re not alone. Suspending benefits just isn’t what it used to be.

401k Loan versus Early Withdrawal

loaned motorcycleWhen you have a 401k and you need some money from the account, you have a couple of options. Depending upon your 401k plan’s options, you may be able to take a 401k loan. With some plans you also have the option to take an early, in-service withdrawal from the plan.

These two options have very different outcomes for you, in terms of taxes and possible penalties. Let’s explore the differences.

401k Loan

If your plan allows for a 401k loan, this can be a good option to get access to the money, for virtually any purpose. Being a loan, there is no tax impact when you take out a 401k loan. Plus you can use the money for any purpose that you need, at any age.

As a loan, it must be paid back over the a five-year period (at most). You’ll pay interest on the loan, but since it is from your own account, you’re paying interest to yourself.

There is a limit of $50,000 for a 401k loan, or 50% of your account balance if that amount is less.

If you leave the employer (retirement or otherwise) and there is still a balance outstanding on your 401k loan, the outstanding balance will be considered a withdrawal from the 401k account – which is taxable as ordinary income and possibly subject to the 10% early withdrawal penalty (unless you meet one of the exceptions, see below).

If you are not currently employed by the sponsoring employer, a 401k loan is generally not available.

401k Withdrawal

If you’re still employed by the company and want to take a withdrawal from your 401k, the 401k plan must have an option to allow for in-service withdrawals. Often there are restrictions on the availability of an in-service withdrawal. For many plans it’s necessary to be above a certain age (such as 59½ years of age), or that a particular requirement is met, such as hardship by the employee, defined by the plan administrator.

In addition, if you’re taking a withdrawal from the plan instead of a 401k loan, the money withdrawn from the 401k plan will be taxable to you as ordinary income. Plus if you’re under age 59½ your withdrawal could be subject to an early withdrawal penalty unless you meet one of the exceptions. See the article 16 Ways to Withdraw Money From Your 401k Without Penalty to see the exceptions to the 10% penalty.

The good news is that you won’t have to pay the money back to the plan when you make a withdrawal as you would with a 401k loan.

Focus on the Things You Can Control

Left a good job in the city, workin’ for the man every night and day. But I never lost one minute of sleepin’ worryin’ ’bout the way things might have been.

— John Fogerty

heathrowSometimes the answer to our stresses in life is to get back to basics and figure out what’s important to us, as well as what things we can control in our life. In the song quoted above, Fogerty’s writing was most likely tempered by his recent discharge from the Army Reserve (1967), after which the protagonist explores an awakening to a simpler side of life, and what turns out to be important to him.

We are often faced with similar situations – maybe we’ve been laid off or some financial calamity strikes us, and from that perspective we often discover what’s really important to us. Other times we just come to realize that our life seems out of control, and we’re searching for a way to get our comfort level back. Most importantly we can learn to not “worry ’bout the way things might have been”, and instead focus on the things about our lives that we can control.

At times we worry about interest rates, inflation, overseas unrest, the current political cycle, whether stocks are going up or down, and the baggage retrieval system they’ve got at Heathrow*. None of these things are items that you can control – for example, stocks are going to go either up or down, and no amount of worry on your part will affect the end result. The same goes with obsessing over the interest rate or inflation. Nothing you can do will change the course of these things. It’s best just to let them go, and don’t worry about them.

Now, I’m not advocating a “don’t worry, be happy” attitude, at least not completely. But there is something to be said for not letting things get you down. This can be more easily understood if you think about your life resources that you have available to you as similar in that there is a finite amount of each that is yours to use as you please:

  1. Money
  2. Time
  3. Talent
  4. Energy

In our lives we’re always making choices about how to “spend” these resources. Setting aside money for the moment, the other three (time, talent and energy) can be exchanged for money, and you can use the money to provide yourself with more time (sometimes) and more talent. Energy is one that can’t be expanded easily – and this one is where you lose out by worrying too much.

You only have so much energy available to accomplish things in your life. Whatever amount of that energy that you spend worrying about whatever is on the business news channel, then you have that much less energy to teach your son to play catch. And the end result for your financial well-being is likely to be the same whether you’re playing catch or watching the business news circus.

In addition, we often allow “the way things might have been” to dig at us over time. This stress that we put upon ourselves has no purpose – as the saying goes, “don’t cry over spilled milk”. Learn from the bad things that have happened to you, for sure. But don’t let the bad things that happened to you in the past define your future.

You have control over certain things, and it’s different for everyone. Instead of worrying about the stock market, shut off the tv, play catch with your son (or daughter), and then use your extra energy to figure out a way to maximize your IRA contributions. You’ll be far better off in the long run.

* That line is from a Monty Python routine called I’m So Worried – not their best work, but if you’re amused by the Python, I recommend giving it a listen.

Changing Your SOSEPP – Once, just once

sosepp-carIf you’re taking (or planning to take) early distributions from an IRA using the 72(t) provision with a Series of Substantially Equal Periodic Payments, also known as a SOSEPP, you need to know a few things about this arrangement. For more information on SOSEPPs in general, see the article Early Withdrawal of an IRA or 401(k) – SOSEPP for more details.

Generally when you establish a SOSEPP you have to stick with your plan for the longer of five years or until you reach age 59½ years of age. However, the IRS allows changing your SOSEPP one time, and only one time. And then, the rules only allow changing your SOSEPP from either the fixed annuitization method or the fixed amortization method to the Required Minimum Distribution method.

This is the only exception allowed for changing your SOSEPP during its enforcement period, which is the later of five years after you started the SOSEPP or when you turn age 59½. The exception is documented in Rev. Ruling 2002-62, 2.03(b).

If you’re planning on changing your SOSEPP in a manner other than the above-described methods, you will effectively “break” the plan, meaning that the SOSEPP is no longer in place. Doesn’t sound like such a bad thing, right? That’s where you’re wrong though… because if you break a SOSEPP, there are some very nasty ways that the IRS will get back at you.

This can be as simple as increasing or decreasing the amount you withdraw slightly, or forgetting to make a withdrawal altogether, or possibly taking two distributions (a double-dip) in one year. There’s not much room for “forgive and forget” on this from the IRS. For more on the consequences of breaking a SOSEPP, see the article Penalties for Changing a SOSEPP.

There is no specific provision in the Internal Revenue Code for relief from the penalty if you have broken your SOSEPP.  On the other hand, the IRS has in some cases granted relief in several private letter rulings by determining that a change in the series of payments did not materially modify the series for purposes of the rules.

If the series is broken due to an error by an advisor (for example), some prior PLRs have been issued in favor of the taxpayer.  PLR 201051025 and PLR 200503036 each address the situation of an advisor making an error and the distributions were allowed to be made up in the subsequent year.  Bear in mind that PLRs are not valid for any other circumstances other than the specific one in the ruling, and cannot be used to establish precedence for subsequent cases.

But in reality, the likelihood of your getting a favorable PLR for your case of a broken SOSEPP is small – unfortunately, breaking the series usually results in application of the penalty for previous payments received, and the SOSEPP is eliminated.  If you wish to restart the series you can do so, but you are starting with a new five-year calendar (the series must exist for at least five years, or until you reach age 59½, whichever is later).

Don’t Forget to Make Your IRA Contribution by April 18!

forgetmenotsWhen filling out your tax return, it’s allowable to deduct the amount of your regular IRA contribution when filing even though you may not have already made the contribution.

You’re allowed to make an IRA contribution for tax year 2015 up to the original filing deadline of your tax return. This year, that date is April 18, 2016.

The problem is that sometimes we file the tax return way early in the year, and then we forget about the IRA contribution. As of the posting of this article, you have 1 week to make your contribution to your IRA to have it counted for tax year 2015.

What To Do If You Miss the Deadline

If you don’t make the contribution on time, you’re in for some nasty surprises unless you take some corrective actions.

If you find yourself on April 19, 2016 without having made your IRA contribution and you had deducted one from your taxes for 2015, you need to amend your return. This means that you’ll fill out a Form 1040X and eliminate the IRA contribution that you originally deducted from your income. This will (most likely) result in additional taxes that you’ll owe, so when you send in the amendment you’ll have to send an additional tax payment.

Failure to amend your return in a timely fashion will result in the IRS contacting you later, requiring you to pay the additional tax plus interest. In addition, since your tax return was erroneous, the IRS will consider this to be “under-reporting of income” and “under payment of tax” – both of which carry penalties. Even if it was an honest mistake, you’ll owe these penalties.

You may even owe some penalties and interest if you file your amendment right away, since technically you’ve under-reported and underpaid. But if you amend as soon as you can, these penalties and interest should be minimized.

Taxes and Your Child

childrenWhen a child has unearned income from investments in his or her own name, taxes can be a bit tricky. Depending on how much the unearned income is, part of it may be taxed at the child’s parent’s tax rate, for example.

Recently the IRS published their Tax Tip 2016-52, which details What You Should Know about Children with Investment Income. The text of the Tip is below:

What You Should Know about Children with Investment Income

Special tax rules may apply to some children who receive investment income. The rules may affect the amount of tax and how to report the income. Here are five important points to keep in mind if your child has investment income:

  1. Investment Income. Investment income generally includes interest, dividends and capital gains. It also includes other unearned income, such as from a trust.
  2. Parent’s Tax Rate. If your child’s total investment income is more than $2,100 then your tax rate may apply to part of that income instead of your child’s tax rate. See the instructions for Form 8615, Tax for Certain Children Who Have Unearned Income.
  3. Parent’s Return. You may be able to include your child’s investment income on your tax return if it was less than $10,500 for the year. If you make this choice, then your child will not have to file his or her own return. See Form 8814, Parents’ Election to Report Child’s Interest and Dividends, for more.
  4. Child’s Return. If your child’s investment income was $10,500 or more in 2015 then the child must file their own return. File Form 8615 with the child’s federal tax return.
  5. Net Investment Income Tax. Your child may be subject to the Net Investment Income Tax if they must file Form 8615. Use Form 8960, Net Investment Income Tax, to figure this tax.

Refer to IRS Publication 929, Tax Rules for Children and Dependents. You can get related forms and publications on IRS.gov.

Each and every taxpayer has a set of fundamental rights they should be aware of when dealing with the IRS. These are your Taxpayer Bill of Rights. Explore your rights and our obligations to protect them on IRS.gov.

Break Even Points for Social Security Filing Ages

break evenLast week my article 3 Myths About Social Security Filing Age included some information about year-to-year break even points for the various Social Security filing ages. This prompted some questions about the break even points between all filing ages, not just the following year.

So for example, what are the break even points between choosing to file at age 62 versus age 66 or age 70?

This article shows the approximate break even points between all of the various filing ages. The first chart shows the break even points when your Full Retirement Age is 66. To use the chart, select your first filing age decision on the left, then move right to the second filing age you’re considering:

image

So, for the decision between filing at age 62 versus age 66, you can see that the break even point is at the age of 78. Comparing filing at age 66 with age 70, the break even point is at age 82.

It should be noted that these break even points are the age you will be when cumulative benefits received at the later filing age becomes greater than the cumulative benefits received based on the earlier filing age. The specific break even points occur sometime during the year indicated, as the analysis is done on an annual basis (not month-to-month). In other words, the actual break even month might be any month during that year. With this difference in mind, the prior article has been updated to reflect the same. Previously the analysis showed the first full year that the later filing age was superior to the earlier filing age.

This second chart shows the break even points for when your FRA is 67. It is used exactly the same as the chart above.

image

As before, choose the first filing age in the left column, and then move to the right for the break even points for the various filing ages. If you were choosing between age 63 and 66, for example, the break even point is age 77. Between age 65 and age 70, the break even point is 82.