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Early Distribution

Are 72t Payments Also Exempted in 2009?

Jun 4th, 2009
by jblankenship.
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This is a follow-up to my original post regarding the RMD Holiday for 2009.

free-blue-baby-angel-by-pink-sherbet-photographyIf you’re taking a Series of Substantially Equal Periodic Payments (SOSEPP), also known as 72t payments, from an IRA or other plan, you are not allowed to “skip” a payment for 2009.  The reasoning behind this is that your 72t payments are not Required Minimum Distributions (RMD), even though you may be using the RMD calculations to determine the amount of the distribution, and also even though, once begun the distributions are required to continue.

Now, in a different scenario, if you have inherited an IRA and are taking it out over either your life span (or an alternate life span) or the default five-year period, you are allowed to skip your distribution for 2009.  These payments, along with your garden-variety, over age 70½ distributions, are considered to be Required Minimum Distributions, and are specifically exempted for 2009 via the Worker, Retiree, and Employer Recovery Act of 2008.

Photo by Pink Sherbet Photography
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Recharacterizing

May 8th, 2009
by jblankenship.
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big-cedar-tree-tiny-girl-by-woodleywonderworksFor IRA contributions, the concept is simple:  a certain amount may be contributed to the account each year, dependent upon the type of IRA and your MAGI (this is all covered here if you need a refresher).  But what if you find out that you are ineligible to contribute to a Roth IRA due to the MAGI limitation?  How about if you made contributions to a Trad IRA and, upon filing your taxes found out it would be in your best interest to put those funds in your Roth instead?  Enter the Recharacterization.

Recharacterization of IRA Contributions

This is a relatively simple process, but, as with most things, the Code makes it seem like rocket science.  Essentially, if you make a contribution to one type of IRA and then decide that you’d rather have it in the other type of IRA, you can affect this recharacterization by:

  • notifying both trustees (the original IRA and the second IRA) of the transfer
  • requesting a trustee-to-trustee transfer
  • include in the transfer any net income attributable to the contributions being recharacterized
  • report the recharacterization on your tax return for the year (Form 8606)
  • treat the contribution to the second IRA as if made on the date of the contribution to the first IRA (in other words, as if you had done it the right way the first time)
  • if the first IRA was a Traditional IRA, you are not allowed a deduction for that contribution for the tax year (obviously, since it wasn’t left there)
  • All of this has to happen before the due date of your tax return, plus 6 months – for most calendar-year taxpayers this is October 15. (see Footnote below  for additional info)

Wrinkles

Now, if you thought that was way too many steps to get something really simple accomplished, look at the following examples of additional confusion to add to the mix:

Conversion by Rollover from Traditional IRA to a Roth IRA… if you’re converting funds from your TIRA to the RIRA and the transfer occurs within two tax years (but still within the allowed 60 days)  you would treat the activity as having been completed before the end of the first tax year if you needed to later recharacterize the conversion.

Rollovers… if you’ve already made a tax-free transfer of the funds, in general those funds are not eligible to be recharacterized.

Recharacterizing Excess Contributions… since excess contributions must be removed prior to filing that tax return for the applicable tax year, any recharacterization of those amounts would have to be accomplished strictly by the due date of the return – no extra 6 months in this case.

Recharacterizing SEP or SIMPLE funds… if you’ve converted funds from a SEP-IRA or a SIMPLE IRA to a Roth IRA and wish to recharacterize those funds, they must go back to the type of IRA that they came from, either a SEP or a SIMPLE, but not a Traditional IRA.  But these can be new accounts if the old account was closed.

Mistaken Rollover to SEP or SIMPLE… if you mistakenly made a rollover transfer of Traditional IRA funds to a SEP or SIMPLE, you can recharacterize those amounts back into a Traditional IRA.

Employer Contributions… it is not allowed to recharacterize employer contributions to a SEP or SIMPLE plan as contributions to another type of plan.

NOT a Rollover… when considering the “once a year” restriction on rollover transfers, recharacterization is not counted as a rollover, so roll away!

No Reconversions (within limits)… if you converted from a TIRA to a RIRA and the recharacterized the conversion, you can not then re-convert those funds to the RIRA again in the same tax year, or within 30 days of the recharacterization (if after the end of the tax year).

Decedent… the election to recharacterize can be made on behalf of a deceased IRA owner by the executor, administrator, or other person responsible for the decedent’s final tax return.

So as you can see, there are lots of ways to complicate the process, but in general the act of recharacterization is pretty simple, as long as you follow the rules and pay attention to the dates.

Footnote: In this one case, the IRS allows additional time for completing the recharacterization activity even if you have not completed it by the prescribed dates.  There are some specific things that have to be accomplished in order to receive this extra time:

  • your return must have been filed on time
  • you must have done the following within 6 months of your filing date:
    • notify the trustees of the intent to recharacterize
    • provide trustees with all necessary information
    • request the transfer

Once complete, you must amend the return, write “Filed pursuant to section 301.9100-2” on the return, and refile with the recharacterization noted.  File the return at the same address as your original return.

Photo bywoodleywonderworks
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2010 Conversions to Roth: Six Factors to Consider

Apr 16th, 2009
by jblankenship.
12 comments

If you have considered converting funds to a Roth (the IRA, not David Lee)  from a traditional IRA or a qualified (tax-deferred) plan like a 401(k), undoubtedly you have run across this tax code item: in 2010, the income limit for Roth conversions is lifted.  On top of that, the IRS will give you two years to pay the tax on your conversion, with the tax for a conversion in 2010 evenly split, coming due in 2011 and 2012.  You don’t have to split the tax, you could pay it all in 2010 if you like, which might be useful if it would be more expensive to delay the tax.

dlr-by-its_meSo – why is this a big deal?  Well, in the past, there has been an income limit of $100,000; meaning that you could not convert traditional IRA funds to a Roth IRA if your MAGI was above that level.

So, back during the bad old Bush days (Remember when?  That was before hope and change…), when the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) was passed in 2001, this particular provision was put into place.  And so, some folks have been looking forward to 2010 ever since (in spite of all of the other tax provisions that are expiring in 2010).

Six Factors to Consider Before Converting to a Roth IRA

If this provision impacts you, it makes good sense to begin planning now for the potential of converting your IRA to a Roth next year.  Here are six factors to consider:

  • If you convert funds from an IRA to a Roth IRA, it is most advantageous if you are able to pay the tax on the conversion from funds outside of your IRAs.  If you can’t do this, realize that any funds used to pay tax on the conversion will also be subject to the 10% early withdrawal penalty if no other exception applies and you’re under age 59½.
  • What is your outlook on tax rates? A Roth conversion, especially when there is a sizeable amount to convert, may be taxed at some very high rates, depending upon your situation.  For example, a couple who would normally have a MAGI of $110,000 would have a marginal 25% rate.  Add in a $200,000 Roth IRA conversion, and a portion of those funds would be taxed at as high as the 33% rate.  It only makes sense to convert if you believe the rates in the future would be higher than the rate you’d pay tax on the conversion today.
  • Does your IRA contain nondeductible contributions?  If, in years past, you have contributed nondeductible amounts to your IRA due to income limits, the Roth conversion of those amounts is a no-brainer for you.  However, you must be careful about how you do a conversion in this case, because any amount that doesn’t represent your nondeductible contributions would be considered taxable upon the conversion. (see Note below for additional explanation)
  • When do you plan to access your funds?  If it’s going to be several years (10 or more) then you will have a better chance of having recouped the tax outlay by way of the tax-free growth in the account. 
  • If you need to access the funds from this account much sooner, bear in mind that funds converted to a Roth IRA can’t be distributed for five years after the conversion.  This could throw a wrench in the entire process if you needed access sooner.
  • If you don’t plan to ever access these funds, a conversion may may sense for you, since a Roth IRA has no Required Minimum Distribution.  This way, you won’t have to deplete your IRA balance (after age 70½), and your heirs will reap the benefits of a much larger account, all tax free.

Note: A complication comes up when you have a combination non-deductible contributions and otherwise taxable growth or deductible contributions housed in the same account:  IRA rules require that distributions (including conversions) must be taken out ratably, or in the proportions of the entire account. 

For example, if you had an IRA with a $100,000 balance, of which $50,000 was non-deductible contributions, $30,000 was deductible contributions, and $20,000 was growth, then for every dollar that is distributed by conversion, fifty cents would be taxed and fifty cents would be tax-free return of your basis.

One way around this is to rollover the amounts above and beyond your nondeductible contributions into a 401(k), or other eligible plan (but not an IRA), and then convert the remaining amount (the nondeductible contributions) to your Roth IRA.  This would effectively be a tax-free maneuver.  Consult your tax advisor to make sure you’re doing this correctly.

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Higher Education Expenses Paid From A Qualified Plan

Apr 11th, 2009
by jblankenship.
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Another way to pull funds from an IRA or a qualified retirement plan (401(k), 403(b), 457, etc.) without having to pay the 10% penalty is to use those funds for Qualified Higher Education Expenses (QHEE).  This comes up quite often, as parents are faced with the issues surrounding the dueling requirements of retirement saving and paying for college for the young ‘uns.

We’ve been talking about the components of Internal Revenue Code Section 72, and specifically here we’re talking about §72(t)(2)(E).  In this portion of the code, the provision is made for a taxpayer qualified retirement plan or IRA owner to withdraw, without penalty, amounts “not to exceed the Qualified Higher Education Expenses for the tax year”.

So, you may ask, what is a QHEE? Essentially, this includes tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible educational institution.  Also included are expenses for special needs services incurred by or for special needs students in connection with their enrollment or attendance.

Room and board also qualifies, but only to the extent that it is not greater than the educational institution’s allowance for room and board, or the amount that the institution actually charges for room and board.  In addition, with the passage of the ARRA 2009, computing equipment and services (including internet service) can be included as QHEE, at least for 2009 and 2010 (likely to be extended).

Who is the student? For the purpose of this provision, the student can be the IRA account owner, her spouse, eligible children (generally dependents), and grandchildren.

Amounts withdrawn must be no more than the QHEE for the tax year, reduced by any additional tax benefits applied: 529 or Coverdell ESA account withdrawals; QHEE covered by HOPE or Lifetime Learning credits; or any grants or scholarships received.

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Separation From Service On or After Age 55

Apr 6th, 2009
by jblankenship.
2 comments

Did you realize that there is a provision within the Internal Revenue Code that allows you to start taking distributions from your 401(k) plan before you reach age 59½?  This little-known section of the code, §72(t)(2)(A)(v), can be a real dandy if you happen to fit the requirements. 

55-kings-parade-by-dumbledad

Note: although we will refer to the 401(k) throughout this article, this code provision applies to all ERISA-qualified, employer-established defined contribution plans, which includes 401(k), 403(b), 501(a), and others.

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Here’s how it works:  if you are working for a company and are participating in the company’s 401(k) plan, should you decide to leave employment with that company at any time during or after the year in which you reach age 55, there will be no penalty for taking distributions from the plan.  Normally, any distribution (other than specifically-qualified distributions) prior to age 59½ would result in the 10% penalty being applied. 

It is important to note that these distributions only qualify when received from a company-established defined contribution plan – NOT an IRA account.  Just to be clear: THIS PROVISION DOES NOT APPLY TO IRA ACCOUNTS.  In order to maintain this penalty-free distribution, the funds must not be rolled over into an IRA.  This is a critical distinction that you need to understand – a mistake would take away this option completely.  Make certain that you completely understand how this works before starting a distribution, as it could be costly to make a mistake.

Lastly, the Pension Protection Act of 2006 made one additional change to the code:  The age limit is reduced to 50 for retiring police, firefighters, and medics - so they can take distributions from their plans penalty-free at that age or after.

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Penalties for Changing SOSEPP

Mar 27th, 2009
by jblankenship.
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broken-bamboo-by-kimberlyfayeSo – 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 by accident.  What happens?

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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 is the Code section that should strike the most fear in the hearts of folks who are considering establishing an SOSEPP.  If you think about it, the possibilities for error are numerous – your brokerage fails 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 you plan.  And from what I read, the IRS has very little in terms of a sense of humor when dealing with these cases – not many are overturned. 

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SOSEPP & How a QDRO Affects It

Mar 20th, 2009
by jblankenship.
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In addition to the 72(t) exception available for folks with a QDRO (see this post), there is also the question of how a QDRO impacts an established Series of Substantially Equal Periodic Payments (SOSEPP) – which, as we know, once established can only be changed one time.

separati-en-casa-near-divorce-by-mirko-macariAlthough not definitive, below are summaries of three Private Letter Rulings (PLRs) that seem to suggest first of all that making the distribution is not subject to the 10% penalty when a QDRO or divorce decree is involved, pursuant to the regulation in Code section 72(t)(4)(A)(ii).

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1) The transfer to a taxpayer’s spouse pursuant to a divorce decree of 50% of each of three separate IRAs owned by the taxpayer from which the taxpayer had already begun receiving “substantially equal periodic payments” did not result in a modification where the taxpayer’s spouse was two years younger and would commence receiving similar payments such that the total of periodic payments to the taxpayer and his spouse subsequent to the division would be substantially equal to the periodic payments received by the taxpayer prior to the division. PLR 9739044

2) In PLR 200027060, the IRS rules that a spouse after the divorce, that  received a portion of the client’s IRA accounts that were being used to fund a SEPP,  didn’t need to continue the payments since it was a transfer under Code section 408(d)(6). What about the client – did all the payments have to be continued out of what remained of his accounts?

2a) Later in PLR 200050046 (with similar facts) the IRS ruled in favor of the taxpayer. “The reduction in the annual distribution from IRA 1 to Taxpayer A beginning in calendar year 2001, prior to Taxpayer A’s attaining age 59 1/2 , and assuming Taxpayer A has not died and has not become permanently disabled, will not constitute a subsequent modification in his series of periodic payments, as the term “subsequent modification” is used in Code section 72(t)(4), and will not result in the imposition upon Taxpayer A of the 10 percent additional income tax imposed by Code section 72(t)(1) pursuant to Code section 72(t)(4)(A)(ii).

In other PLRs, it has further been ruled that the IRA owner may reduce the 72(t) payment amount by the same percentage as the reduction in the overall account by distribution to the former spouse.  This is the case for a QDRO granting a division of a qualified plan or a divorce decree granting a division of an IRA when the SOSEPP has already been set up.  In these cases, the former spouse who receives the proceeds from the IRA or qualified plan was not required to continue a 72(t) payment plan – the funds could be rolled over into an IRA, or left in the plan as is.

It is also important to note that the RMD (Required Minimum Distribution) for the year of the transfer is still dependent upon the previous end-of-year balance in the account – and could be adjusted for the following year if a favorable PLR is reached for the case.

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401(k) & Qualified Domestic Relations Orders (QDRO)

Mar 19th, 2009
by jblankenship.
4 comments

An exception to the 10% penalty on distributions from a qualified plan (but not an IRA) is when the distribution is pursuant to the imposition of a Qualified Domestic Relations Order, or QDRO (cue-DRO).

love-lasts-by-foundphotoslj1A QDRO is often put into place as part of a divorce settlement, especially when one spouse has a considerably larger retirement plan balance than the other.  What happens in this case is that the court determines what amount (usually a percentage, although it could be a specific dollar amount) of retirement plan’s balance is to be presented to the non-owning spouse.  Once that amount is determined and finalized by the court, a QDRO is drafted and provided to the non-owning spouse, which allows the non-owning spouse to direct the retirement plan custodian to distribute the funds in the amount specified. 

In the case of a QDRO, the owning spouse will not be taxed or penalized on the distribution.  In addition, if the non-owning spouse chooses to roll the distribution into an IRA, there would be no tax or penalty on the distribution to her, either.  If the non-owning spouse chooses to use the funds in any fashion other than rolling over into another qualified plan or IRA, there will be tax on the distribution, but no penalty.

Many times it may make sense for the non-owning spouse to leave the account with the qualified plan (rather than rolling into an IRA) if there may be a need for the funds at some point in the future.  This will be dependent upon just how “divorce friendly” the qualified plan custodian will be.

Of course other 72(t) exceptions could apply, but if there was a need that did not fit the exceptions and the distributee did not wish to establish a series of substantially equal payments for five years, the QDRO would still apply to the distribution from the qualified plan (as long as the funds are still in the plan that the QDRO was written to apply to).

As an example, let’s say Lester and Edwina (both age 40) are divorcing, and as a part of the divorce settlement, Edwina’s 401(k) plan is to be shared with Lester, 50/50, with a QDRO enforcing the split.  After a couple of years Lester decides he would like to use some of the funds awarded to him from the divorce to purchase a new fishing boat.  As long as the funds are still held in Edwina’s 401(k) plan, Lester can request withdrawal and receive the funds without penalty, due to the existence of the QDRO.  However, had Lester rolled over the funds into an IRA (or other qualified plan), the QDRO would no longer be in effect, and he would be unable to access the funds without paying the penalty for early withdrawal.  (It is important to note that, in either case, Lester would be required to pay ordinary income tax on the distribution.)

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The Ultimate “Do Over”

Mar 15th, 2009
by jblankenship.
3 comments

12/8/2010 update – the SSA revised the “Do Over” a bit.   See the article “SSA Revises Withdrawal Policy” for details.

We’ve talked about it before – the decision of when to begin taking your Social Security retirement benefit is very important.  (you can see my post on the subject here)  The problem is, sometimes we aren’t in a position to delay receiving the benefit… or maybe we didn’t consider what a difference it would make to delay taking payment (it’s substantial).

It’s a little-known fact that you can re-set your Social Security payout amount, even if it’s been a few years since you started.  You may have heard of this, but usually discussions have few details on how to do it.  That’s what I intend to provide for you in this article:

hunger by cliff1066Let’s say for example that you had a choice to begin your Social Security payout at your early retirement age of 62, at a reduced amount of $750 per month.  Had you waited until “normal” retirement age (66), your benefit would have been 33% greater, or $1,000 per month.   (For the purposes of simplicity of illustration, the annual cost-of-living increases have not been included in this example.)

Yes, these are real world numbers, and yes, the difference is that great.  So, by the time you have reached age 66, you have received four years’ worth of benefits at the reduced rate, or a total of $36,000.  It is possible for your to re-set your payout to begin at your attained age of 66, instead of continuing at the reduced rate for the rest of your life.

And it gets better, the longer you’ve received the reduced benefit:  From your normal retirement age to age 70, there is an 8% bonus applied for each year that you delay receiving the benefit.  If, in our example, the retiree had waited until age 70, his monthly payout (again, not counting cost-of-living adjustments) would be approximately $1,320 per month.

So how does it work?  It’s fairly simple, once you understand the details – you pay back the Social Security Administration all of the money that has been paid out since you opted to begin receiving the benefit.  That’s it, no interest, no penalties.  Then you re-apply for benefits at your current age.

So – from our example if you started your benefit at age 62 at $750/month, and then at age 66 decided you’d rather have the greater payout – for the cost of $36,000, you will increase your payout by $3,000 per year.  That’s a 8.33% return on your money.  And if the same retiree had waited to do his “do over” at age 70, the cost is $72,000 in our example, but the payout increase is even better:  $6,840 per year, or a 9.5% return on your money.

That works out to better than a 75% increase in annual benefit.  Seems like, as long as you’re planning on living a while, this is a pretty good deal.

The only problem with this whole plan is this:  you can do this once, and it’s not revokable.  So, if you sent in your $72,000 yesterday and accidentally stepped in front of a bus today, your heirs do not get the money back.  However, as is the case with each of these decisions, if you are the higher wage earner and your spouse survives you, he or she will be eligible to receive the increased benefit.

Obviously this isn’t a consideration for everyone, and it may not be an appropriate decision for many that do have the funds available to make such a move, but for some folks in specific situations it can be a pretty good move.  As we mentioned in the earlier article about this, though, as long as you are in good health, the longer you work and wait to start taking the Social Security benefit, the better.  This is especially true for the higher earning spouse.

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In a Pinch for Cash? Be Smart About Your Options

Jan 28th, 2009
by jblankenship.
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Here’s an article with some very good advice on what or where it makes good sense to raise cash when you’re in a pinch, as many folks are now. 

Most importantly, the article points out, you need to consider the consequences of options like raiding your 401(k) or taking a home equity loan.  You may trigger some unintended things to occur if you’re not careful.

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