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The Post-55 Exception to the 10% Penalty for Withdrawals from 401(k)

Nov 4th, 2024
by jblankenship.
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do these mountains look smoky?

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Most of the time, when taking a distribution from a 401(k) or other Qualified Retirement Plan (QRP) prior to age 59½, there generally is a 10% penalty that applies. That is, unless one of the exceptions applies.

If you happen to be over age 55 when you leave employment, there is another exception that applies. Any distribution that you take from the QRP, as long as you were at least 55 years of age when you left employment, will not be subjected to the 10% penalty. Only ordinary income tax will apply to the withdrawal.

This provision only applies to QRPs, such as a 401(k) or 403(b), and not to IRAs. So if you’re leaving employment at or after age 55 but before reaching 59½, it can be in your best interest to not rollover your QRP to an IRA, at least until after you reach 59½. Even if you don’t need the money right away, it could be beneficial to have the source of funds available penalty-free.

For retiring police, firefighters and medics, the age for this exception is 50 – so these folks can take distributions from their QRPs after age 50 if they’ve left employment without penalty.

Posted on Nov 4th, 2024
by author: jblankenship.

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Posted in: 401 k 403 b, Early Distribution, qrp, qualified retirement plan.
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Converting an Inherited 401(k) to Roth

Oct 21st, 2024
by jblankenship.
2 comments
inherited

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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 the prescribed distribution period, which could be 10 years, or it could be over the lifetime of the beneficiary. This means that, in order for this maneuver to be beneficial, the heir should be in a relatively low tax bracket during the year of the conversion – making the future tax-free withdrawals during the distribution period 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 reduce the funds that can be converted to Roth to grow tax free 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).

At any rate, 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, and if your heir is likely to want the option of conversion to Roth, it would need to come from the inherited QRP.

Posted on Oct 21st, 2024
by author: jblankenship.

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Posted in: 401k, 403 b, conversion, inherited IRA, IRA, minimum distributions, qrp, qualified retirement plan, retirement plan, Roth Conversion, Roth IRA.
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Which Account to Take your RMDs From

Oct 14th, 2024
by jblankenship.
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combining

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When you’re subject to 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 using all of your IRA accounts combined, the IRS allows you to take the total of all your RMDs from a single account if you wish. The RMDs could also be taken from each account separately, or any combination of all of your traditional IRA accounts.

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

Likewise, if one of your IRAs is held at a custodian that has limited choices or more costly options than your other IRAs, you could take your RMDs from that account, to eventually eliminate the undesired custodian. Or, perhaps one IRA holds an investment that has run up considerably, prompting you to rebalance – this could be an opportunity to take some earnings out of that holding to reduce losses with an anticipated drawback in value.

Another situation is where you have an IRA that owns something very thinly-traded or otherwise difficult to sell. You might bypass taking an RMD from this account, taking the RMD in combination with your other IRA accounts so that you don’t have to suffer a potential loss for this holding.

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 separately with 403(b) accounts – if you happen to own several 403(b) accounts from previous employers, you can combine the RMDs and take them all from one account. However, this doesn’t work with 401(k) plans, you must take a separate RMD from each 401(k) plan. You also cannot combine unlike accounts (IRAs with 403(b)s or 401(k)s) to take the RMDs for those dissimilar accounts.

Posted on Oct 14th, 2024
by author: jblankenship.

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Posted in: IRA, ira money, minimum distributions, qrp, qualified retirement plan, required minimum distribution, retirement accounts.
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Arguments in Favor of a Rollover

Oct 7th, 2024
by jblankenship.
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rolloverIf you have a 401(k), 403(b), a 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%. 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%. 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 decide to do a 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 at no additional cost. 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 for flexibility in withdrawals without penalty – 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.

Posted on Oct 7th, 2024
by author: jblankenship.

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Posted in: employer plan, IRA, qrp, qualified retirement plan, retirement plan.
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Using an IRA Distribution and Withholding to Reduce Estimated Tax Payments

Sep 16th, 2024
by jblankenship.
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eliminate

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A little-known fact about how withholding works for IRA distributions can work in your favor. While withholding from a paycheck and estimated tax payments are credited as paid during the quarter actually paid, it’s different for withholding from an IRA distribution.

When you have taxes withheld from a distribution from an IRA, no matter when it occurs during the calendar year, it is treated by the IRS as having been withheld evenly throughout the tax year. This means that if you had the bulk of your income in the first quarter of the year, you could take care of the tax burden with a distribution from an IRA and withholding enough tax even in late December of the same year, and there would be no penalty for underwithholding.

So – many folks find themselves in this position, especially in years when income is is not equal in each quarter, or if the tax burden was not known or misunderstood throughout the year.

This method could be used by anyone at any time, as long as you have access to your IRA funds. For example, if you are required to take a distribution, that is, if you’re over age 73 these days or you have an inherited IRA, you could use that distribution to cover your tax burden for the entire year (if it was enough).

Rather than making quarterly estimated tax payments throughout the year, toward the end of the year you could instruct your IRA custodian to distribute enough funds to cover the tax burden for the year (and don’t forget to include the amount of your IRA distribution in your calculation). Then you would also instruct the custodian to withhold the distribution as taxes, using form W-4P.

The one downside to this method is that if the IRA account owner dies before the distribution with withholding for the tax year (and let’s face it, this will probably happen at some point), then the estate will owe penalties for underpayment of estimated tax for that year.

Posted on Sep 16th, 2024
by author: jblankenship.

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Posted in: income tax, IRA, ira funds.
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Using the Prohibited Transaction Rules to Your Advantage

Sep 2nd, 2024
by jblankenship.
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I’ve written in the past about the types of transactions that are prohibited in your IRA, and how these transactions are generally quite onerous if you happen to use one of them. In fact what happens is that your entire IRA becomes disqualified as of the first of the year in which the transaction occurred.

So – if you’re inquisitive you might wonder: How could I use this to my advantage?

It is possible to work this rule in your favor – but I don’t necessarily recommend it. I present this option here as an exercise of what could be done according to the rules. I learned this one from Natalie Choate, by the way, who you may recall I regard as a rock star in the world of IRA law.

Working in your favor

So, given that the rule against prohibited transactions requires that the IRA is considered to have been entirely distributed on the first day of the tax year when the prohibited transaction occurred, this is a factor that could be used to work to your advantage.

Let’s say for example you owned an investment in your IRA that was worth $10,000 as of the first of the year. Over the course of the year, the investment has now grown in value to something ridiculous, let’s say $500,000. If you were particularly inventive, you might take advantage of the rules and perform some sort of prohibited transaction with your IRA before the end of the tax year. By doing so, your IRA would be disqualified as of the first of the year, and the investment you owned would have been considered distributed at that point in time.

This means that you would owe ordinary income tax on the original $10,000 value, and your investment then has a basis of $10,000 – if you sold it now at its $500,000 value, the additional $490,000 would be taxed at the capital gains rate. If your ordinary income tax rate is 25%, the tax on the full $500,000 would work out to $125,000. But under this plan, only $10,000 is taxed at 25% ($2,500), and $490,000 is taxed at 15% ($73,500), for a total tax on the IRA of $76,000, a savings of $49,000. You’d have to wait until at least the second day of the following year in order to qualify for long-term capital gains. (The above tax calculation is oversimplified. In the real world, the rate of tax would be considerably higher since you’d be bumped up several tax brackets, and Net Investment Income Tax would also apply. Since we’re working in hypotheticals, forgive the simplification.)

If you were caught in just such a situation, this is a way you might use the tax law in your favor for a bit of hindsight tax planning.  It doesn’t happen often, but this is one case where you could work the rules to your advantage.

Note: Bear in mind that I have not used this method myself or with clients, and the example I have given is purely hypothetical. If you choose to use this method, although the rules appear to be in your favor, but there are no guarantees that the IRS would agree with this. On face value I believe it will work exactly as I have written, but I have not seen any cases where this set of facts was put into play, successfully or not. Proceed at your own risk.

Posted on Sep 2nd, 2024
by author: jblankenship.

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Posted in: capital gains rate, IRA, prohibited transaction.
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Earned Income Credit and Due Diligence

Aug 26th, 2024
by jblankenship.
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For those familiar with the Earned Income Credit (EIC), you hopefully are familiar with the preparer’s due diligence checklist. This is a checklist that the preparer uses to help determine if the taxpayer’s circumstances are in keeping with the conditions that are required to be met in order to be eligible for the credit. The checklist is formally known as Form 8867, and is available at www.IRS.gov.

When it originally appeared, this checklist was been filled out by the preparer and kept in the preparer’s files. This fact has changed a bit over time – the IRS changed the requirements, such that now the due diligence checklist must be filed along with the return. This filing requirement is the only thing that has changed, the due diligence is the same as before.

Form 8867 is a multi-use checklist, as many of the due diligence requirements cross over between the various tax credits. This form is used for due diligence for the Earned Income Credit (EIC), American Opportunity Tax Credit (AOTC), Child Tax Credit (CTC), Additional Child Tax Credit (ACTC), and Credit for Other Dependents (ODC). It is also used for proof of due diligence in determining the Head of Household (HOH) tax filing status.

The checklist

You can refer to the actual form to see the actual questions that are asked regarding Earned Income Credit. These questions change from time to time. The general emphasis is on proving that the taxpayer is in fact eligible for the EIC based on the number of children claimed, or is claiming the EIC without a qualifying child. Additionally, the checklist requests information about the explanation of half-year residence of a child with the taxpayer, along with tiebreaker rules when the child could possibly be claimed as an eligible child by more than one taxpayer.

Tax Preparer Questions

The tax preparer has to answer a few questions to round out the due diligence. Again, the form itself has this checklist, which will be a much better place to view the questions. The gist of the tax preparer portion makes certain that the taxpayer has taken appropriate steps to ensure that the information collected regarding the EIC is based on facts received from the taxpayer, and not simply on verbal statements. There is requirement for the tax preparer to receive and maintain documentation for the residence of any eligible child, as well as information about income, residency status and the like for the taxpayer and spouse if applicable.

The point of all of this is to ensure that the tax preparer has exerted due diligence in gathering information to ensure that the credit being claimed is allowable and correct. Without this sort of checklist, in the past there have been substantial abuses of this particular credit. Because of this abuse, the due diligence checklist was implemented, along with prescribed penalties to the preparer for not filing the appropriate due diligence, or incomplete due diligence.

This penalty is $560 per credit per return to the preparer – so of course, this can add up pretty quickly if the preparer isn’t doing a good job. Since Form 8867 is used by up to four classes of credits (CTC, ACTC and ODC are considered one class of credits), there can be a penalty of up to $2,240 on a single return if all four credits are being claimed and due diligence is missing or incomplete.

Posted on Aug 26th, 2024
by author: jblankenship.

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Posted in: earned income credit, EITC, income tax, income tax credit, irs.
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What to Expect If You Owe Money to the IRS

Jul 22nd, 2024
by jblankenship.
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somebody owes him

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Often we find ourselves in situations that we never dreamed of – like owing the IRS a considerable amount of money. Maybe you earned a lot more than you expected, perhaps you had a filing status change that dramatically changed your tax rate, or maybe there was a change to your deductions. It doesn’t matter, you’ve found yourself in the situation – what should you expect?

While the majority of Americans get a tax refund from the Internal Revenue Service each year, there are many taxpayers who owe and some who can’t pay the tax all at once. The IRS has a number of ways for people to pay their tax bill.

The IRS has an effort to help struggling taxpayers get a fresh start with their tax liabilities. The goal of this effort is to help individuals and small businesses meet their tax obligations, without adding unnecessary burden. Specifically, the IRS has policies and programs to help taxpayers pay back taxes and avoid tax liens.

Here are ten tips for taxpayers who owe money to the IRS.

  1. Tax bill payments. If you get a bill for late taxes, you are expected to promptly pay the tax owed including any penalties and interest. If you are unable to pay the amount due, it is often in your best interest to get a loan to pay the bill in full rather than to make installment payments to the IRS.
  2. Additional time to pay. Based upon your circumstances, you may be granted a short additional time to pay your tax in full. A brief additional amount of time to pay can be requested through the Online Payment Agreement application or by calling 800-829-1040.
  3. Credit card payments. You can pay your bill with a credit card. The interest rate on a credit card may be lower than the combination of interest and penalties imposed by the Internal Revenue Service. To pay by credit card go to the IRS page Pay your taxes by debit or credit card. There are several options to choose from for this type of payment.
  4. Electronic Funds Transfer. You can pay the balance by electronic funds transfer, check, money order, cashier’s check or cash. To pay using electronic funds transfer, use the Electronic Federal Tax Payment System by either calling 800-555-4477 or using the online access at www.eftps.gov.
  5. Installment Agreement. You may request an installment agreement if you cannot pay the liability in full. This is an agreement between you and the IRS to pay the amount due in monthly installment payments. You must first file all required returns and be current with estimated tax payments.
  6. Online Payment Agreement. If you owe $25,000 or less in combined tax, penalties and interest, you can request an installment agreement using the Online Payment Agreement application.
  7. Form 9465. You can complete and mail an IRS Form 9465, Installment Agreement Request, along with your bill in the envelope you received from the IRS. The IRS will inform you (usually within 30 days) whether your request is approved, denied, or if additional information is needed.
  8. Collection Information Statement. You may still qualify for an installment agreement if you owe more than $25,000, but you are required to complete a Form 433F, Collection Information Statement, before the IRS will consider an installment agreement.
  9. User fees. If an installment agreement lasting more than 180 days is approved, a one-time user fee will be charged. The user fee for a new agreement ranges from $22 to $107 depending on the circumstances of your agreement. For eligible individuals with lower incomes, the fee can be waived or reduced to $43.
  10. Check withholding. Taxpayers who have a balance due may want to consider changing their W4, Employee’s Withholding Allowance Certificate, with their employer. A withholding calculator at www.irs.gov can help taxpayers determine amount that should be withheld.

For more information about the Fresh Start initiative, installment agreements and other payment options visit www.irs.gov. IRS Publications 594, The IRS Collections Process, and 966, Electronic Choices to Pay all Your Federal Taxes, also provide additional information regarding your payment options.  The publications and Form 9465 can be obtained from www.irs.gov or by calling 800-TAX-FORM (800-829-3676).

Posted on Jul 22nd, 2024
by author: jblankenship.

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Posted in: income tax, irs.
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Age Adjustments for Social Security

Jul 8th, 2024
by jblankenship.
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limiter

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With all the talk about how Social Security is running out of money (or will be, currently projected at 2035), one of the topics that often comes up is the age limits for benefits. As you’re probably aware, the Full Retirement Age (FRA) has been adjusted upward from the original age 65, gradually to age 67 for folks who were born in 1960 or later. This upward adjustment was put into place with the 1983 amendments, ostensibly to reduce the outflows for the system.

With that adjustment in place, and the resulting benefit that the system has received from making that change, you might wonder why some of the other age limits have not been changed. Specifically, why has the early retirement age remained at 62, and the upper limit (maximum benefit age) has also remained set at 70?

I don’t have any definitive information to back this up, but I think there may be a reason behind the lack of change in these upper and lower limits. Look at how the lower limit interplays with the FRA. When the FRA was 65, as it was for folks born prior to 1937, the maximum amount of reduction that could occur by taking benefits at the earliest age of 62 was 20%. As FRA has increased, the amount of time for reduction (the time between age 62 and the increased FRA) has also increased. This resulted in an increase in the amount of reduction for folks starting benefits at the earliest age, to 30% for those with an FRA of 67.

Since a large percentage of folks will inevitably file for benefits at the earliest possible age, leaving the early filing age at 62 results with a high percentage of people receiving benefits at a lower and lower rate. The result is a lower outflow from the system, which extends the period of time before the system starts running out of money.

At the other end of the spectrum, increasing the FRA while leaving the maximum benefit age the same results in a reduced amount of time for Delayed Retirement Credits (DRCs) to accrue. For folks with FRA of 65, the maximum amount of DRC that could accrue was 32.5%. Given changes to the formula, this amount remained fairly constant for the increase up to FRA of age 66. Once that FRA is in effect, the DRC was set at 8% per year, with no change as the FRA increased. So when the FRA increases gradually to age 67, the maximum DRC will correspondingly reduce to 24%.

As the FRA increases, the maximum reduction increases by leaving the early retirement age at 62. While at the same time, the maximum delay credit reduces by leaving the maximum age at 70. The system benefits more by leaving these ages set at 62 and 70 than if they were adjusted, at least in the short term.

I don’t think there’s anything nefarious about this, it’s just another way that the system has benefited from those changes to the FRA.

Posted on Jul 8th, 2024
by author: jblankenship.

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Posted in: delayed benefit, early retirement, reduction factors, retirement benefits, social security credit, social security retirement.
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Leaving Your IRA to Your Family First, Then to Charity

Jun 24th, 2024
by jblankenship.
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Clydesdale rigged team (CRT)

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Suppose you have a situation where you’d like to leave your IRA (or at least some of it) to a family member or a group of beneficiaries, and then leave the remainder of the IRA to a charity of your choice.

One way to do this is to split the beneficiary designation between your family members and the charity. This is a simple way to make this designation, but it might not really achieve the purpose you’re hoping to. Suppose you’d like to make certain that a non-spouse family member has adequate income from your IRA for the remainder of his or her life, but you don’t want to overdo the bequest with a large appropriation (and taxes on the distribution). There’s a way to do this that may fit your needs: the Charitable Remainder Trust, or CRT.

The Charitable Remainder Trust

Using a Charitable Remainder Trust, or CRT, can be a useful way to ultimately pass your IRA or Qualified Retirement Plan (QRP) to a charity, while at the same time providing income to other beneficiaries for life. The way this works is that the CRT would receive a distribution of the IRA’s assets (within 5 years of the death of the original owner), and the beneficiaries can then receive income for the remainder of their lives. Because the remainder of the trust (at least 10% of the original value distributed at the death of the original owner) will ultimately pass to the charity, the estate receives a charitable contribution deduction for a portion of the account, actuarially-defined.

Since the funds are no longer in the IRA or QRP, the beneficiaries are not subjected to Required Minimum Distributions (RMDs) from the account – these can be tailored to the individual beneficiary’s requirements. Amounts between 5% to 50% of the IRA value can be distributed to these beneficiaries. On the downside, the amount of income will have to be pre-set, either a set amount or a set percentage of the account, and this amount cannot be changed. In other words, if the beneficiary wants more than the set amount of distribution, the distribution amount cannot be increased.

If there are multiple beneficiaries of the trust, as members of the beneficiary group die the other remaining beneficiaries will receive the income attributed to those beneficiaries, until all beneficiaries have passed on. Since there are restrictions on the CRT that require that at least 10% of the total trust value remains to be distributed to the charity, it won’t work well if the beneficiary class includes very young members. If there is a very long period of time to pay income, the remaining account value may be reduced below that restricted amount – and the distributions will slowly diminish.

This method may not be useful to everyone, but it could be useful for certain specific situations. An example would be if you had multiple IRAs, and had one in particular that you wanted to eventually pass on to a charity. At the same time you want to ensure that you don’t short-change your family or friends – maybe you have a couple of siblings that you’d like to pass along a life income to, perhaps in addition to leaving other assets these beneficiaries.

The CRT also has the benefit of passing along favorable taxation to the beneficiaries, which can include capital gains and dividends rates as well as ordinary income tax rates. Working with your tax advisor and other professionals is recommended to fully understand this potential.

Posted on Jun 24th, 2024
by author: jblankenship.

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Posted in: charitable contribution, Charitable Remainder Trust, CRT, IRA, qrp, qualified retirement plan.
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Roth IRA for Youngsters

Jun 10th, 2024
by jblankenship.
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Many times it is among the best of ideas to establish a Roth IRA for your child. This way, your child can benefit from the long-term growth in the account and have a very good head start on retirement savings for later in life. There are other benefits, including the fact that retirement funds are not included when financial aid is being calculated for college expenses, as well as providing funds for the child to use when the time comes to buy a house, for example.

One thing can cause a real problem though: if you undertake to make contributions to a Roth IRA for your child that aren’t based in fact. What’s that? How can this be? So there’s a way you can make contributions to Roth IRA that aren’t based in fact? What fact is that??

The rules for making contributions to Roth IRAs (actually, any IRA) include the fact that the person who owns the account must have earned income. This means that the individual whose account is being contributed to must have earned at least the amount that is being contributed from some sort of job – which could include self-employment or any sort of employment. In addition, scholarships or fellowships that are reported in box 1 of Form W2 are considered earnings for IRA contributions.

If your child doesn’t have income of any realistic form, it is not allowed for you to make contributions to a Roth IRA (or any IRA) on behalf of the child. And it doesn’t work for you to invent income, such as paying the child to clean up his or her room. The income has to be “real” – making contributions without some sort of real income will result in some nasty penalties. The penalty for over-contribution to a Roth IRA is 6% per year, meaning each year that the money is in the account. If several years have gone by, you’ll get hit with this penalty for each and every one of those years – which is even worse than just putting the money in a savings account the first place.

So, if your child has legitimate income, such as from mowing yards or a paper route, it’s perfectly legitimate for the child to make a contribution to a Roth IRA. You can even donate the funds to the child to make that contribution if you like. Just don’t contribute more than the child’s actual earnings.

Posted on Jun 10th, 2024
by author: jblankenship.

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Posted in: financial aid, IRA, ira contribution limits, retirement plans, Roth IRA.
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Is It Really Allowed – Making a Non-Deductible IRA Contribution Followed By a Roth Conversion?

Jun 3rd, 2024
by jblankenship.
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backdoor

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I occasionally receive this question: Can I make a non-deductible IRA contribution, and then shortly after convert the IRA into a Roth IRA? My income is too high for me to make a contribution directly to a Roth IRA. (This is also known as a back-door Roth IRA contribution.)

According to the rules in place today, you can do this. Here are the applicable rules:

  • There is no income limit for an individual to make a non-deductible IRA contribution.
  • There is no income limit for an individual to make a Roth Conversion.
  • There is no time limit on how long a contribution must be in a traditional IRA before converting it to a Roth IRA.

Essentially this situation provides the individual with an income above the limits for a regular Roth Contribution with an avenue to accomplish the funding of a Roth IRA. It seems too good to be true. And even though you may feel like it’s flaunting the law, it’s really okay. Here’s why – even though you don’t realize it, the specific rule of law that could apply is called the Step Transaction Doctrine.

Step Transaction Doctrine

Wikipedia defines the step transaction doctrine as follows:

The step transaction doctrine is a judicial doctrine in the United States that combines a series of formally separate steps, resulting in tax treatment as a single integrated event. The doctrine is often used in combination with other doctrines, such as substance over form. The doctrine is applied to prevent tax abuse, such as tax shelters or bailing assets out of a corporation. The step transaction doctrine originated from a common law principle in Gregory v. Helvering, 293 U.S. 465 (1935) that allowed the court to recharacterize a tax-motivated transaction.

The doctrine states that:

interrelated yet formally distinct steps in an integrated transaction may not be considered independently of the overall transaction. By thus linking together all interdependent steps with legal or business significance, rather than taking them in isolation, federal tax liability may be based on a realistic view of the entire transaction.

There are three tests for applying the step transaction doctrine: (1) a “binding commitment”; (2) a “mutual interdependence” of steps; or (3) the intent of particular result.

Lots of legalese, I know. Let’s see how those three tests would apply to our situation with the non-deductible IRA to Roth Conversion.

Test 1

The Binding Commitment test determines that a particular action has been taken that binds the taxpayer in a commitment to later take another step in the series. Clearly, making a non-deductible IRA contribution does not bind you to take the next step in the series. Since we only have two steps in our series, we only have to apply the test to the first step.

Test 1: Pass

Test 2

The Mutual Interdependence test looks at each step in the series to determine if any of the steps along the line would have been meaningless without the overall series. Again, making a non-deductible IRA contribution can stand on its own without the series and is therefore not meaningless without the series. The same goes for the Roth Conversion – this step could occur without the non-deductible contribution step and is also not meaningless without the series.

Test 2: Pass

Test 3

The Intent test (also known as the “End Result” test) is the most likely to be applied. This test considers the series as a whole to determine if the individual steps were taken solely to achieve the end result, and not simply a group of non-related steps. So – is it likely that the only reason you’ve made the first step (non-deductible IRA contribution) is to enable the second step (Roth IRA conversion) possible so that you can achieve the end result (money in your Roth IRA account).

Test 3: Unclear

Application

The IRS has not (to date) raised any qualms against this series of transactions, although it’s possible that they could at some point. In looking at the Intent test, you could see how they might have a case. But it’s really not too likely that the IRS will undertake this position.

Since it’s a given that Roth Conversions are allowed with no restrictions by law, and it’s also a given that non-deductible IRA contributions are allowed with no restrictions by law, it’s unlikely that any law will be written to make changes to these rules in the near future. The only way it could be possible is if there were a holding period requirement within an IRA before converting the account’s holdings to a Roth IRA – and that sounds like a messy bit of law (although nowhere near as messy as some current laws are). I’d say if you are in a position to use this strategy, go ahead and do it. The worst that could happen would be a requirement to de-convert the account back into an IRA.

Keep in mind that making a non-deductible IRA contribution doesn’t automatically allow a no-tax impact conversion to Roth. If you happen to have another IRA (or IRAs) that contain deductible contributions, you will have to apply the pro rata tax rules to the conversion. This may result in additional tax on the conversion.

Posted on Jun 3rd, 2024
by author: jblankenship.

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Posted in: contribution limit, conversion, income tax, irs, non deductible ira contribution, Roth Conversion, Roth IRA.
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How PIA Relates to Your Benefit

May 27th, 2024
by jblankenship.
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Photo credit: jb

If you’ve been looking into your Social Security projected benefits for long, you’ve probably run across the term Primary Insurance Amount, or PIA. Click on the link to see how the PIA is calculated if you need more background information on the PIA.

What’s important to know is that the PIA is essentially the amount of your retirement benefit if you file for it exactly on your Full Retirement Age (FRA) month. But it’s quite common for an individual to file for retirement benefits either before or after FRA. If you file for your retirement benefit before or after FRA, even by a month, there is a difference between your PIA what your benefit will be.

Before FRA

If you file for benefits before the month when you reach FRA, there are two reduction rates that may apply to your benefit, reducing it from the PIA amount. The reason there are two rates is because originally the FRA for everyone was 65. This made it simple to cause a 20% reduction for anyone who started benefits at the earliest age, 62, which was 36 months before FRA. So the reduction factor for any filing up to 36 months before FRA is calculated at a rate of 5/9% (approximately 0.5556%) per month, which works out to 20% for the full 36 months.

Later, when the rules changed such that FRAs could be at ages beyond 65, the original rate of 5/9% per month was deemed too aggressive of a reduction. So a smaller value was determined for reductions beyond the first 36 months of reduction, at 5/12% per month, (approximately 0.4167%). This works out to a 5% reduction for each 12 months beyond the first 36.

Wow, that’s not complicated at all, is it? Geez. Here’s a walkthrough of the formula that you can use to help you calculate the reduction for your benefit before FRA:

1.  Enter your Full Retirement Age, years and months:
2.  Enter the age you plan to file for benefits, years and months:
3.  Subtract line 2 from line 1 in months only
4.  Subtract 36 from line 3 (if less than zero, enter zero)
5.  If line 4 is zero, skip to line 7; otherwise, multiply line 4 by 5/12% (or 0.004167)
6.  If line 4 is zero, multiply line 3 by 5/9% (or 0.005556); otherwise, enter .2
7.  Add line 6 to line 5
8.  Subtract line 7 from 1.0000
9.  Multiply line 8 by your PIA.  This is your reduced benefit amount.

Let’s run an example. An individual born in 1955, so his FRA is 66 years and 2 months. His PIA is $2,000, and he intends to file for benefits at age 64 years and 6 months.

1.  Enter your Full Retirement Age, years and months:

66y 2m
2.  Enter the age you plan to file for benefits, years and months:

64y 6m
3.  Subtract line 2 from line 1 in months only

20
4.  Subtract 36 from line 3 (if less than zero, enter zero)

0
5.  If line 4 is zero, skip to line 7; otherwise, multiply line 4 by 5/12% (or 0.004167)

6.  If line 4 is zero, multiply line 3 by 5/9% (or 0.005556); otherwise, enter .2

.11112
7.  Add line 6 to line 5

.11112
8.  Subtract line 7 from 1.0000

.88888
9.  Multiply line 8 by your PIA.  This is your reduced benefit amount.

$1,777.76

Now let’s adjust the example so that it uses the additional factor. Same individual as above, but now he plans to retire at age 62 years and 8 months.

 

1.  Enter your Full Retirement Age, years and months:

66y 2m
2.  Enter the age you plan to file for benefits, years and months:

62y 8m
3.  Subtract line 2 from line 1 in months only

40
4.  Subtract 36 from line 3 (if less than zero, enter zero)

4
5.  If line 4 is zero, skip to line 7; otherwise, multiply line 4 by 5/12% (or 0.004167)

.016668
6.  If line 4 is zero, multiply line 3 by 5/9% (or 0.005556); otherwise, enter .2

.200000
7.  Add line 6 to line 5

.216668
8.  Subtract line 7 from 1.0000

.783332
9.  Multiply line 8 by your PIA.  This is your reduced benefit amount.

$1,566.66

 

Now let’s look at how applying after FRA works.

After FRA

For every month after FRA that you delay applying, your benefit will grow by a factor. For folks born in 1943 and later, the factor is 2/3 of a percent, or roughly 0.6667%. If you were born in 1941 or 1942 (earlier years don’t matter at this point, you’re already 70), the factor is 15/24 of a percent, or approximately 0.625%. These factors equate to 8% per year for those born in 1943 or later, or 7.5% per year for those born earlier.

Here’s a formula to use to help calculate the delay factor and benefit amount for your situation:

 

1.  Enter your Full Retirement Age, years and months:
2.  Enter the age you plan to file for benefits, years and months (if after 70, enter 70y 0m):
3.  Subtract line 1 from line 2 in months only
4.  If your FRA is less than 66, multiply line 3 by 15/24% (or 0.00625); otherwise multiply line 3 by 2/3% (or 0.006667)
5.  Add 1.00000 to line 4
6.  Multiply line 5 by your PIA.  This is your increased benefit amount.

 

Let’s run through an example. The individual from above, with a FRA of 66 years and 2 months, and a PIA of $2,000, decides to file for benefits at the age of 68 years and 6 months.

1.  Enter your Full Retirement Age, years and months:

66y 2m
2.  Enter the age you plan to file for benefits, years and months (if after 70, enter 70y 0m):

68y 6m
3.  Subtract line 1 from line 2 in months only

28
4.  If your FRA is less than 66, multiply line 3 by 15/24% (or 0.00625); otherwise multiply line 3 by 2/3% (or 0.006667)

.186676
5.  Add 1.00000 to line 4

1.186676
6.  Multiply line 5 by your PIA.  This is your increased benefit amount.

$2,373.35

 

And that’s it.  Hope this has helped you to better understand how your PIA and your benefit are related.

Posted on May 27th, 2024
by author: jblankenship.

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Posted in: delayed benefit, early retirement, social security benefits.
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2 Good Reasons to Use Direct Rollover From a 401(k) Plan

May 20th, 2024
by jblankenship.
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medigap

Photo credit: jb

If you have a 401(k) plan (or any Qualified Retirement Plan (QRP) such as a 403(b) plan), when you leave employment at that job you can rollover the plan funds to an IRA or another QRP at a new job. Listed below are 2 very good reasons that you should use a Direct rollover (also known as a trustee-to-trustee transfer) instead of the 60-day rollover.

A 60-day rollover is where the former plan distributes the funds from your account to you, and in order to make the rollover complete you must deposit the entire distributed amount into the new plan or IRA within 60 days.

Reasons to Use a Direct Rollover

  1. You must complete the rollover to the new account or IRA within 60 days. There is little if any leeway on this 60-day period – and though it seems as if this is a simple task to accomplish, there are many cases where well-intentioned individuals missed the bus on this one. All it takes is a lost letter in the mail, or the check falling through the cracks, or any of myriad ways to miss the deadline.
  2. When funds are distributed from a QRP to an individual, the plan administrator is required to withhold 20% of the distribution for income tax. This presents a problem if you were planning to rollover the full amount of the QRP distribution into your new plan or IRA, since you’ll now need to come up with the missing 20% from other sources. Granted, if all things remain the same you should get the withheld 20% back from the IRS when you file your taxes, but that could be a long wait if you don’t have a lot of excess cash lying around.

Using the direct rollover eliminates both of the issues listed above. When then QRP administrator enacts a direct rollover for you, most often the distribution is directly to the administrator or custodian of the new plan or IRA. Sometimes the QRP administrator will send a check to you, the plan participant, made out to the new administrator or custodian, so you’ll still need to make sure that the check gets to the new plan. You’re in a much better position to get around the 60-day window if the check is made out to the new custodian, since technically the 60-day rollover requires that you have the funds at your disposal (for use or deposit in another account).

In addition, using a direct rollover eliminates the 20% withholding requirement altogether. There’s no amount to make up later.

Posted on May 20th, 2024
by author: jblankenship.

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Posted in: 401 k, 403 b, eligible rollover distribution, IRA, qrp, qualified retirement plan, retirement accounts, tax.
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Spouse May Be Your Best Option for IRA Beneficiary

May 13th, 2024
by jblankenship.
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Since a surviving spouse gets the most flexibility and tax breaks of all possible beneficiaries (other than perhaps a charity), it seems that choosing your spouse as the beneficiary of your IRA may be the best way to go.

This is partly due to the availability of delaying taking distributions. Any other eligible designated beneficiary must begin taking Required Minimum Distributions (RMDs) by the end of the year following the year of the original IRA owner’s death. The spouse beneficiary may defer distributions to the year in which the deceased would have reached RMD age, which would be 73 or 75 these days, without taking any action.

In addition, any other eligible designated beneficiary besides the spouse is required to take the RMDs over his or her fixed-term single-life expectancy, while the spousal beneficiary can choose to take the RMDs over his or her single-life expectancy recalculated annually, so that the distributions will actually stretch out over his or her entire life. The fixed-term single-life expectancy often winds up ending sometime in the beneficiary’s 80’s.

The best part of all is that the surviving spouse beneficiary can choose to rollover the IRA to an IRA in his or her own name, which could have the effect of delaying the start of RMDs even further, if the spouse beneficiary is younger than the decedent. When this option is chosen, the surviving spouse could also choose to roll the IRA into a Qualified Retirement Plan (QRP) such as a 401(k). If the surviving spouse is still working for this employer past regular RMD age, RMDs could be delayed even further – up until the surviving spouse retires.

An added bonus to the option of the surviving spouse using a rollover, he or she can name another designated beneficiary of this rolled over IRA, providing flexibility to the overall process. Plus, with an IRA in his or her own name, when the time comes to begin RMDs, the surviving spouse can use the Uniform Lifetime Table (instead of the Single Life Table) which will allow for further stretching of the benefits, potentially far beyond his or her lifetime.

I specifically noted above that the spouse is in a superior position to other eligible designated beneficiaries. For any non-eligible designated beneficiaries, there’s not even a comparison since these beneficiaries are required to drain the inherited IRA within 10 years at the very most, no other options.

Posted on May 13th, 2024
by author: jblankenship.

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Posted in: employer plan, inherited IRA, IRA.
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Caregiver Costs Qualify as Medical Expenses

Apr 8th, 2024
by jblankenship.
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h dumpty

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It’s a little known fact that certain costs for caregivers, licensed or unlicensed, may qualify as medical expenses for tax deductions. Maintenance and personal care service costs can be considered qualified medical expenses in cases where the patient receiving the care has been certified by a health-care professional as unable to perform two or more of the six activities of daily living: Bathing, Eating, Dressing, Toiletting, Continence, and Transferring (moving from bed to chair, for example).

Note: An easy way to remember these six activities is to use the first characters in the order I presented them above – B E D To C – this gives us the first five, and the entire mnemonic provides the sixth, Transferring from BED To Chair.

The health-care professional who certifies the patient as incapable of these activities can be a doctor, a nurse, or a licensed social worker, and the certifying professional is required to approve of the care program for the patient.

Another example of such qualifying expenses would be where an individual has dementia which causes serious health concerns requiring 24-hour supervision, determined by the doctor. Both licensed and unlicensed caregivers are hired to care for the individual. Payments for these caregivers are deductible as medical expenses. These expenses are considered qualified long-term care expenses.

Of course, all medical expense deductions are limited to the extent that they exceed 7.5% of the AGI of the taxpayer, and deduction is only relevant if all itemized deductions are greater than the standard deduction (if the standard deduction is available to the taxpayer).

Posted on Apr 8th, 2024
by author: jblankenship.

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Posted in: income tax, tax.
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One Way to Use IRA Funds to Invest in Your Business

Apr 1st, 2024
by jblankenship.
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making a statement

Photo credit: jb

As you know, it is against all the rules to use your IRA to invest in anything which benefits you or a related party. This is one quick way to get your entire IRA disqualified, quite likely owing a big tax bill and penalties as well.

However – and there’s always a however in life, right? – there is one possible way that you could use funds from an IRA to invest in your own business. It’s a bit tricky, but it is a perfectly legal, in fact encouraged, method.

Howzat? The IRS encourages the use of IRA funds for your own business? Not exactly. There’s more to it than that. The IRS encourages by preferential law the use of 401(k) funds to invest in the business sponsoring the plan. A 401(k) is a type of qualified retirement plan that is allowed specifically to invest in the stock of the employer.

So, if you start a business and it’s incorporated (specifically a C corporation, not an S corporation), you can adopt a 401(k) and roll your IRA into the plan, then use the 401(k) funds to invest in your business. You have to make certain that the 401(k) follows all the usual rules – the plan has to be primarily designed to provide retirement benefits, it must be permanent in nature, you must make substantial and recurring contributions, and the plan must not discriminate against employees. Generally this business must be a new start up in order for the process to fit in with the rules.

Done correctly, this is a tax-free way to access your retirement savings funds to underwrite your new business. Since it’s not a loan per se, there is no requirement for lender approval or specific credit requirements, either.

This sort of use of your retirement funds comes with risks, for sure. The IRS admits that a high percentage of businesses adopting a ROBS strategy ultimately fail. And this means that a significant portion of your retirement savings will be lost as well.

This is definitely not for the faint of heart. Although all the statutes allow the method as legal, the IRS is well aware of the method and they don’t seem to like it much. They’re referring to this activity as “rollovers as business startups”, or ROBS, and they are siccing their auditors on abusers of the option. I suspect that the main reason that folks run afoul of the IRS on this is if they don’t stick with the requirements for a valid plan and abuse the privilege. I recommend getting a professional (accountant or lawyer, or both) to assist with setting up the plan so that you don’t make any mistakes.

As with many of these sorts of schemes, I don’t recommend it for regular use. It could work for special circumstances though – but you should definitely be very careful if you decide to give it a shot. The downside could be significant and painful.

Posted on Apr 1st, 2024
by author: jblankenship.

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Posted in: 401 k, IRA, ira funds, ira money.
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