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Facts About the 72t Early Distribution

Feb 1st, 2012
by jblankenship.
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Ossekeag Creek Marsh
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In case you don’t know what a 72t distribution is, this is shorthand for the Internal Revenue Code Section 72 part t, and the most popular provision of this code section is known as a Series of Substantially Equal  Periodic Payments – SOSEPP for short.

Enough about the code section already.  What is this thing?  A SOSEPP is a method by which you can access your IRA funds prior to age 59½.  In order to take advantage of this rule, you determine the amount of the annual distribution from your IRA (this is done in a prescribed manner, more on this in a bit) and then begin taking the distributions.  Once you start the SOSEPP, you have to keep it going for the longer of five years or until you reach age 59½.

Methods of Distribution

There are three ways that you can determine the amount of the distribution from your IRA, and all are based upon the balance of the IRA account and your age.  The first method is the simplest, known as the Required Minimum Distribution method.

The Required Minimum Distribution method for calculating your Series of Substantially Equal Periodic Payments (under IRC §72(t)(2)(A)(iv)) calculates the specific amount that you must withdraw from your IRA (or other retirement plan) each year, based upon your account balance at the end of the previous year, divided by the life expectancy factor from either the Single Life Expectancy table, the Uniform Lifetime table, or the Joint Life and Last Survivor Expectancy table, using the age(s) you have reached (or will reach) for that year. This annual amount will be different each year.

The second method is called the Fixed Amortization Method.  Calculating your annual payment under this method requires you to have the balance of your IRA account, from which you then create an amortization schedule over a specified number of years equal to your life expectancy factor from either the Single Life Expectancy table, the Uniform Lifetime table, or the Joint Life and Last Survivor Expectancy table, using the age(s) you have reached (or will reach) for that year, coupled with a rate of interest of your choice that is not more than 120% of the federal mid-term rate published by regularly the IRS in an Internal Revenue Bulletin (IRB).

The third method is similar to the second, but it is called the Fixed Annuitization Method.  Calculating your annual payment under this method requires you to have the balance of your IRA account and an annuity factor, which is found in Appendix B of Rev. Ruling 2002-62 using the age you have reached (or will reach) for that year, coupled with a rate of interest of your choice that is not more than 120% of the federal mid-term rate published by regularly the IRS in an Internal Revenue Bulletin (IRB).

Once you’ve calculated your annual payment under one of the two fixed methods, your future payments will be exactly the same until the SOSEPP is no longer in effect. There is a one-time opportunity to change to the Required Minimum Distribution method, described here.

An Important Note

It’s important to know that the amounts you’ve calculated are and will be the exact figures for your payments from the account, no more, no less.  It’s not allowable to simply name your own amount and take that each year – you have to use the prescribed amount from one of the methods.

The way to impact the amount of the payment is to adjust the balance in the IRA.  If you have more than one IRA available, you can rollover funds into one account and therefore increase or decrease your payment.  This has to be done prior to establishing the SOSEPP though – it’s not allowed to deposit money into or remove funds from your IRA while the SOSEPP is in place (well, other than the required payments from the account each year).

Any deviation from the prescribed payments will cause the SOSEPP to be “busted”, which can result in some not-so-nice consequences – which you can read more about here.  For more about the SOSEPP, see the IRA Owner’s Manual.

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Pre-Death Planning: Roth Conversion

Jan 25th, 2012
by jblankenship.
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Eilaine Roth
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Financial planning often requires us to face our own certain demise – something that we often don’t want to do, but still a certainty that we all must face.

Among the things that we want to do when planning for the inevitable would be to make certain that our surviving loved ones have access to adequate monetary resources to support themselves, in the most cost-effective manner.  Another thing that we hope to accomplish is to make the transition as easy as possible for our loved ones.  One way to do this is to convert a good portion of your IRA or other tax-deferred funds to a Roth IRA account.  Here’s why:

By converting to a Roth account, you will make the funds in that account available to your heirs totally tax free.

Granted, your estate will also be smaller by the amount of tax that you paid on the conversion.  At the same time, your heirs will also not have to go through the rather painstaking process of managing the IRD deduction, if the estate is of a size that requires estate tax to be paid.  This will simplify the overall process dramatically, and depending upon the size of your overall estate this could be a significant.

On the downside of this, it’s likely that if you convert your account in a single year the tax paid on the conversion would be much, much higher than if your heirs paid tax on the ordinary required distributions if the account is left as a traditional IRA.

However, if you converted your account over several years in smaller amounts using a strategy like filling up the brackets, the overall tax cost of the conversion will be less, maybe even less than the cost that your heirs would experience otherwise.

You can always use recharacterization strategies to make sure that the whole process is as tax-efficient as possible. And in today’s tax climate (and market volatility) there are literally very few reasons not to go ahead with a Roth conversion strategy.

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Net Unrealized Appreciation Treatment

Jan 18th, 2012
by jblankenship.
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NUA ALONE
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When you have a 401(k) plan that contains stock in your company, there is a special provision in the tax law that may be beneficial to you. This special provision is called Net Unrealized Appreciation, or NUA, treatment. It allows you to take advantage of potentially lower tax rates on the growth, or unrealized appreciation, of the stock in your company.

When your company stock is withdrawn from the account, you pay ordinary income tax only on the original cost of the stock. Then later when you sell the appreciated stock at a gain, you pay capital gains tax (at a lower rate) on the growth in the value of the stock.

The Way It Works

The distribution from your 401(k) must be a total Lump Sum Distribution in a single calendar year.  This means that your entire 401(k) balance, including not only the stock, but also any other funds in the 401(k) plan, must be withdrawn in one year.

Commonly the funds that are not company stock will be rolled over into an IRA or another 401(k) plan.  Only company stock (and only your company) can be treated with the NUA provision.

The company stock is moved into a taxable investment account – in kind.  This means that you move the actual stock rather than selling the stock and moving the money.  If you sell the stock before you move it, you won’t have NUA treatment available to you.

When you move the stock over from your 401(k) into a taxable account, you will have to pay ordinary income tax on the original cost of the stock.  This means that you need to know what is the basis (the amount you originally paid) for the stock.  Your company or 401(k) administrator will have this information for you.

Although the entire account has to be withdrawn in a single year, you don’t have to elect NUA treatment for the entire holding of company stock.  You could move only a portion of the stock if you choose to, and rollover the remaining stock to an IRA.  You may choose to do this because the amount of company stock is more than you care to pay ordinary income tax on during that tax year.  More on this a bit later.

An Example

For example, let’s say you have a 401(k) with a $500,000 balance.  $200,000 is invested in the stock of your company, and the basis is $100,000.  You can move the company stock into a taxable investment account, and pay ordinary income tax on $100,000.  If you’re in the 25% bracket, this would amount to $25,000.

The remaining $300,000 is rolled over to an IRA.  When you take money out of the IRA, as with any IRA, you’ll pay ordinary income tax on the money that you withdraw from the IRA.

At any point later you can sell the stock in the taxable account and pay tax at the capital gains rate, which is 15% these days, much lower than the ordinary tax rate. (That 15% rate is for long-term capital gains, and any stock that you elect NUA treatment for is taxed at that rate. This rate could be as low as 0% if you are otherwise in the 10% or 15% income tax bracket.)

Since paying tax on the entire $100,000 basis in your company stock would require a significant tax payment ($25,000 in our example), you might wish to work this out in a different fashion, reducing the tax.  Here’s where a twist to the tax code could REALLY be helpful – possibly eliminating taxation.

Basis Allocation Twist

When you move only a portion of the company stock, you need to allocate the basis between the NUA stock and that which was rolled over.  Since, in our example, the basis was $100,000 and the total company stock was worth $200,000, you could elect to rollover $100,000 worth of the stock to your IRA (along with the other $300,000 of funds), allocating the basis of $100,000 to the rolled over stock.  Then, when the remaining $100,000 of stock is moved from the 401(k) to the taxable account, there is no basis to be taxed at ordinary income tax rates.  The entire transaction has occurred without tax – and when you sell the stock, the entire value is taxed at capital gains rates.

This move is allowed because the tax law states that when there is a partial rollover of an account into an IRA, the rolled portion is “treated as consisting first of the portion that is includible in gross income” – meaning the basis in the stock, plus the other funds in the account.

So there you have it – Net Unrealized Appreciation in a nutshell.  If you need more details, you can check out the IRA Owner’s Manual for additional information.

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Charitable Contributions From Your IRA – 2012 and Beyond

Jan 4th, 2012
by jblankenship.
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K S Hegde Charitable hospital
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At the end of December, 2011, the provision for Qualified Charitable Distributions (QCD) expired.  That provision allowed the taxpayer age 70½ or older to make direct distributions from an IRA account to a qualified charity, bypassing recognition of the distribution as income.  For more information on the expired provision, see the original article about charitable distributions from your IRA.

With the expiration of this provision, you can still make charitable contributions of money distributed from your IRA.  The difference is that these contributions are no different from a contribution that you’ve made from your savings account or regular income.  In order to achieve a tax advantage from the contribution, you will itemize the charitable contribution on your tax return.  Of course, in addition to this, if the money is from your IRA you’ll also have to recognize the distribution as income.

Let’s look at both ways to fully understand what’s different now.

The old way

Under the expired provision if you qualified, you could make a direct distribution from your IRA account to the qualified charity of your choice.  Then when you were ready to file your tax return for the year, you wouldn’t include the amount of the direct distribution to the charity as income.  This could also include your Required Minimum Distribution (RMD) for the year, as well.

By doing this, you didn’t have to recognize this income at all – which doesn’t seem so important until you see how it works in the new way.

The new way

Now that the QCD provision has expired, you can still make charitable contributions from your IRA, but it’s not as advantageous as the old way.  Under this method (which can be enacted by anyone over age 59½ without penalty) you take a distribution from the IRA, and then send it to the charity of your choice.

(In actuality, the distribution doesn’t have to be from an IRA, but we’re doing a compare and contrast against the expired QCD arrangement, so that’s what we’ll use for the examples.)

When you get around to filing your tax return for the year now, you’ll have to recognize the distribution from your IRA as income.  Later on the return, you can include the charitable contribution as an itemized deduction, eventually lowering your taxable income by the same amount.  However, since you have to include the distribution as income, this will increase your overall income (unless you have Net Operating Losses from your business to offset the income), and will therefore also increase your Adjusted Gross Income (the bottom line of your Form 1040).  The significance to this is that many tax provisions depend upon the Adjusted Gross Income (AGI) figure.

An example is deductible medical expenses – these are only deductible to the extent that they are in excess of 7.5% of your AGI.  Miscellaneous Itemized expenses are subject to a similar “floor”: they must be greater than 2% of your AGI in order to be deductible.  In addition, certain phase-outs are impacted by AGI level as well.

So you can see that increasing your income can have a significant impact on your overall tax return.  Here’s a quick example of how this could impact a taxpayer.

Example

Taxpayer is single, age 73, and is subject to RMDs from his IRA.  He wishes to make a charitable contribution of $50,000 from his IRA funds to his church.  If this were 2011, he could make his distribution directly from the IRA to the church. Here’s how his tax return worked out:

Income (pension and IRA, plus his $10,000 additional distribution)

$50,000
Adjusted Gross Income

$50,000
Medical Expenses

$10,000
Deductible Medical Expenses (above 7.5% of AGI)

$6,250
Charitable Contributions

$10,000
Exemption

$3,700
Taxable Income

$39,050
Tax

$5,888

Under the 2012 method, Taxpayer takes the distribution from his IRA and then sends it to his church.  Here’s how the tax return works out now:

Income (pension and IRA, plus his $10,000 additional distribution)

$60,000
Adjusted Gross Income

$60,000
Medical Expenses

$10,000
Deductible Medical Expenses (above 7.5% of AGI)

$5,500
Charitable Contributions

$11,000
Exemption

$3,800
Taxable Income

$39,700
Tax

$5,955

Under the new method in our example, the tax cost was increased by $67.  This doesn’t seem like a lot, but if the circumstances were a bit different this could become sizeable – and who likes to pay extra taxes of any amount?

Bear in mind that this provision has expired and subsequently been extended in the past, so it’s possible that it could be extended again at some point in the future.  Stay tuned.

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2012 IRA MAGI Limits – Married Filing Separately

Jan 1st, 2012
by jblankenship.
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if there was ever a doubt
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Note: for the purposes of IRA MAGI qualification, a person filing as Married Filing Separately, who did not live with his or her spouse during the tax year, is considered Single and will use the information on that page to determine eligibility.

For a Traditional IRA (Filing Status Married Filing Separately):

If you are not covered by a retirement plan at your job and your spouse is not covered by a retirement plan, there is no MAGI limitation on your deductible contributions.

If you are covered by a retirement plan at your job and your MAGI is less than $10,000, you are entitled to a partial deduction, reduced by 50% for every dollar (or 60% if over age 50), and rounded up to the nearest $10.  If the amount works out to less than $200, you are allowed to contribute at least $200.

If you are covered by a retirement plan at your job and your MAGI is more than $10,000, you are not entitled to deduct any of your traditional IRA contributions for tax year 2012.  You are eligible to make non-deductible contributions, up the annual limit, and those contributions can benefit from the tax-free growth inherent in the IRA account.

If you are not covered by a retirement plan but your spouse is, and your MAGI is less than $10,000, you are entitled to a partial deduction, reduced by 50% for every dollar over the lower limit (or 60% if over age 50), and rounded up to the nearest $10.  If the amount works out to less than $200, you are allowed to contribute at least $200.

Finally, if you are not covered by a retirement plan but your spouse is, and your MAGI is greater than $10,000, you are not entitled to deduct any of your traditional IRA contributions for tax year 2012.  You are eligible to make non-deductible contributions, up the annual limit, and those contributions can benefit from the tax-free growth inherent in the IRA account.

For a Roth IRA (Filing Status of Married Filing Separately):

If your MAGI is less than $10,000, your contribution to a Roth IRA is reduced ratably by every dollar, rounded up to the nearest $10.  If the amount works out to less than $200, you are allowed to contribute at least $200.

If your MAGI is $10,000 or more, you can not contribute to a Roth IRA.

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Using An IRA Rollover to Eliminate Federal Spousal Rights

Dec 14th, 2011
by jblankenship.
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Marriage
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Qualified Retirement Plans (QRPs), which include 401(k), 403(b) and many other employer-based plans, are governed by federal law under ERISA.  One of the tenets of ERISA is that there are certain rights for the spouse of the employee-participant in the plan.  One of those rights is that the spouse must consent to any distribution from that plan that is in the form of anything other than a Qualified Joint and Survivor Annuity (QJSA).

Depending upon your circumstances, this might not be the way you would like for things to work out.  For example, if you’re planning to get married and you want to ensure that your future spouse doesn’t control distributions from your retirement plan, you could rollover your QRP to an IRA before your marriage – because an IRA isn’t covered by ERISA like the QRP is.  A prenuptial agreement could be used to limit a spouse’s rights to an IRA, but it cannot usurp the ERISA rules.

If you’re already married and you have a reason to consider this option, hopefully it’s not because there are storm-clouds on the horizon for your marriage.  If this is the case, you will likely have some difficulty in enacting this rollover.  The problem, as mentioned before, is that the spousal rights provision requires that your spouse signs off on any distribution other than the QJSA.

If you’re going through a divorce, it’s possible that you’d need to have your ex-spouse sign off on a distribution from your QRP if the QRP isn’t part of the assets to be split.  If the QRP isn’t being split for the divorce, you’ll want to make sure that you have a statement in the decree that ensures that the QRP is positively identified as belonging solely to you. Otherwise, your ex could make a claim against a portion of your QRP later, under ERISA.

Bear in mind that the spousal distribution rights from the QRP also apply to death benefits from the plan, in addition to lifetime benefits.

One other thing to keep in mind is that your own state’s law may provide rights to your IRA to your spouse anyhow.  If that is the case, the rollover to the IRA would not have the effect you expected.

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Year End Income Tax Planning

Dec 5th, 2011
by jblankenship.
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Estate
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Once you’ve reached the last month of the tax year, there aren’t a lot of things that can be done to minimize your income taxes.  But there are a few things that could be done.

For example, you could double up your real estate taxes by prepaying next year’s tax during December.  Doing this with, for example, a $3,000 per year real estate tax bill could result in a reduction of tax for the year of $750 if you’re in the 25% bracket.  Keep in mind though, that you’ll have forked out this money long before it is actually due in most cases, and for the next year you won’t have this deduction available if you used it in this year.

The same could be done with your charitable contributions – there’s no reason that you can’t make additional contributions to your favorite charities at the end of this year instead of waiting until next year.

You could also send your final estimated state income tax payment due in January of next year during December and claim that payment on this year’s itemized deductions as well.

Prepaying your January mortgage payment will credit that mortgage interest to this year as well, further increasing your itemized deductions.

Other itemized deductions could be “stacked” in one year, such as medical expenses (subject to the 7.5% floor) and miscellaneous deductions (subject to the 2% floor).

It’s important to keep in mind that the moves that you make this year might reduce your tax now – but you might have an adverse impact on next year’s income tax by doing so.  It will pay to run the calculations based on what you know about this year’s tax and next year’s tax to make sure that it is in your best interest to do this.

Here’s how it might play out: if you prepaid your next year’s real estate tax during this year, it might reduce your deductions below the Standard Deduction – which could be a good thing.  In doing this, you would get to use the Standard Deduction to increase your tax deductions on next year’s return when you specifically reduced your deductions for that year by prepaying the deductible real estate tax in during this year.  In this fashion you might be making the most of the standard deduction and your itemized deductions year after year – one year using the “stacked” deductions, the next using the standard deduction.

These prepayment options could have a negative affect if you are subject to the Alternative Minimum Tax (AMT).  Prepaying your state tax, mortgage interest and some medical expenses might trigger or cause an increase in AMT.

One tactic that you might consider is selling a taxable investment that has an inherent loss; this is especially useful if you’ve sold another investment at some point in the tax year that has resulted in a taxable gain.  Losses can be used to offset those capital gains dollar for dollar, and an additional $3,000 in capital losses can be used to reduce your ordinary income as well.

You can also make up for underpayment of estimated tax by taking a withdrawal from an IRA (especially if you’re over age 59½) and having tax withheld from the withdrawal.  This can also be accomplished by having more tax withheld from your paycheck if you’re still working, by filing a new W4.

Another move you can make includes the Qualified Charitable Distribution from your IRA – allowing you to bypass recognizing that income, including your RMD.  This can only be done if you’re at least age 70½ and subject to Required Minimum Distributions.

You can also delay your first RMD (if you reached age 70½ this year) until as late as April 1 of next year, although that will mean you have to take two RMDs next year.  But in some circumstances that may be the better option.

You can also make a deductible contribution to your IRA, if you qualify – but you don’t have to do that before the end of the year, you have until April 15 to do that.

This isn’t an exhaustive list of year-end tax moves, just several of the more prominent ones.  Hopefully you’ll find what you need here to help with your year-end tax plans.

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Converting an Inherited 401(k) to Roth

Nov 30th, 2011
by jblankenship.
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Lillian Roth
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One of the provisions that is available to the individual who inherits a 401(k) or other Qualified Retirement Plan (QRP) is the ability to convert the fund to a Roth IRA.

This gives the beneficiary of the original QRP the option of having all of the tax paid up front on the account, and then all growth in the account in the future is tax free, as with all Roth IRA accounts.

What’s a bit different about this kind of conversion is that, since it came from an inherited account, the beneficiary must take distribution of the account over his or her lifetime, according to the single life table.  This means that, in order for this maneuver to be beneficial, the heir should be relatively young, such that there will be time for a lengthy growth period for the account – making the tax-free nature of the Roth account worthwhile.

A downside to this move is that the heir should be in a position to pay the tax on the account from other funds, otherwise the tax pulled from the account will drastically reduce the funds that can grow over time.

If the heir has an IRA of his or her own that could be converted, and there are only enough other funds for paying tax to enable the conversion of one account or the other, the IRA should be converted rather than the QRP.  This is because the IRA has a much better chance for long-term growth than the inherited QRP due to the requirement for distribution of the account (as discussed above).

This is yet another reason that an individual might want to leave funds in a 401(k) plan rather than rolling it over to an IRA – since the heir does not have this Roth conversion option available if the money is in a traditional IRA.  This option is only available for an inherited 401(k) or QRP.

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Which Account to Take your RMDs From

Nov 23rd, 2011
by jblankenship.
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Scrambling may be required
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When you’re subject to the Required Minimum Distributions (RMDs) and you have more than one IRA account to take the distributions from, you have a choice to make.  Even though you have to calculate the RMD amount from all of your IRA accounts combined, the IRS provides that you could take the total of all your RMDs from a single account if you wish.

With this provision in mind, you could take all of your RMDs from the smallest account, which would provide you the opportunity to eliminate one of the accounts in your list, thereby simplifying things.  By reducing the number of accounts that you have, you could simplify the calculation of RMDs, estate planning, and just general paperwork.

However, it might not always work to your best interests to reduce the number of accounts that you have.  You may have multiple accounts in order to simplify your estate planning process, so that you can direct each account to a specific beneficiary or class of beneficiaries, for example.

In addition, if you’re hoping to eliminate some of your IRA accounts, you could always combine several IRAs together by rollovers – the end result is essentially the same.

This combination of accounts for RMDs can also be used with 403(b) accounts – if you happen to have several 403(b) accounts from previous employers, you can combine the RMDs and take them all from one account.  This doesn’t work with 401(k) plans, though, and you also cannot combine unlike accounts (IRAs with 403(b)s or 401(k)s) to take the RMDs for the dissimilar accounts.

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Arguments in Favor of a Rollover

Nov 16th, 2011
by jblankenship.
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Mutual fund
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If you have a 401(k), 403(b), a (gasp!) tax-sheltered annuity or other qualified retirement plan from a former employer, you may have considered if it would be beneficial to leave it where it is, or perhaps enact a rollover to an IRA.

While it might be easiest to leave the account where it is, it’s possible that you are sacrificing flexibility and/or paying higher fees in exchange for the easier path.

Quite often, 401(k) plans (and other qualified retirement plans, QRPs) are restricted to managed mutual fund investment options.  Managed funds often carry high expense ratios, often greater than 1% and more.  As you know, if you’ve read much about index funds, it is possible to reduce most of your investing expense ratios to far below .5%, in some cases as low as .1% or less.  Over the course of many years, reducing these expenses can have a profound impact on your investment returns.

For example, if you were to save even 1/2 of a percent in expenses, over 20 years this could compound to a 11.05% improvement in your overall investment returns.  This also assumes that the new funds you’ve chosen will perform at the same rate that the funds you’re leaving behind would have.

It’s not a pure “no brainer” to enact the rollover.  There could be compelling reasons to leave the money where it sits, such as if you believe the funds in your plan are superior to options that you could choose outside the plan (such as restricted-access or closed funds), or maybe you have access to investment advice from the custodian.  In addition, if you left the employer during or after the year when you reached age 55, you might want to leave the money where it is until you’re at least age 59½ – see this article on post-55 withdrawals for more information.  There is also the chance that you could benefit by leaving the funds in the former plan if there is Net Unrealized Appreciation of your former employer’s stock that you intend to have treated by the NUA rules.

In general though, the flexibility to reduce your expenses by choosing any investment available is a pretty compelling argument in favor of the rollover.

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