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A SIMPLE Kind of Plan

Nov 20th, 2017
by jblankenship.
1 comment

The SIMPLE Plan is a type of retirement account for small businesses that is simpler (ah hah!) to administer and more portable than the 401(k) plans that are more appropriate for larger businesses.  SIMPLE is an acronym (probably a backronym, more likely) which stands for Savings Incentive Match PLan for Employees.

a simple kind of plan

Photo credit: coop

A SIMPLE typically is based on an IRA-type account, but could be based on a 401(k) plan. What we’ll cover here is the IRA-type of SIMPLE plan.  The difference (with the 401(k)-type) is that there are more restrictions on employer activities, and less room for error (as can be the case with 401(k) plans).

A SIMPLE Kind of Plan

Much like a regular 401(k) plan, a SIMPLE Plan is an agreement between the employer and employee where the employee agrees to a salary deferral.  This deferral effectively reduces the employee’s taxable take home pay, and the employer then contributes the deferred amount into the SIMPLE IRA account on behalf of the employee.  These contributions must be made to a SIMPLE IRA account, not a Traditional IRA.

To be eligible for a SIMPLE Plan, the employee must have received at least $5,000 in compensation during any two years (need not be consecutive) prior to the current tax year, and can reasonably expect to receive at least $5,000 in compensation in the current tax year (calendar year).  For the purposes of the SIMPLE Plan, a self-employed individual would be considered an employee if she received earned income as described (at least $5,000).

Also, certain classes of employees can be excluded from participation, such as union members subject to collective bargaining, or nonresident aliens who have received no compensation from US sources. The employer can have no more than 100 employees who are in the class that are allowed to participate in the SIMPLE plan.

No eligible employee may “opt out” of participation – however, eligible employees are not required to defer salary into the plan. This just means that they would have no deferral contributions or company matching contributions to the plan while they choose not to defer. Nonelective contributions by the employer would still be added to the account, regardless of whether the eligible employee defers salary for that year.

Types of Contributions

There are three different types of contributions that can be made to a SIMPLE Plan – salary deferrals, employer matches, and nonelective contributions.

Salary Deferrals are much the same as 401(k) salary deferrals.  The employee decides to defer a percentage of his salary, which reduces his taxable take-home pay, and the deferral is contributed to a SIMPLE IRA on his behalf.

Employer Matches are also similar to the same activity in a 401(k) plan.  The employer elects to match the employee contributions, dollar-for-dollar, up to 3% of the employee’s salary, although this amount can be less.  (see Limits below for additional information)

Nonelective Contributions – in some cases, the employer may decide to make contributions on behalf of ALL eligible employees, rather than only for those that are participating in the SIMPLE Plan.  In this case, the employer has opted for making the Nonelective Contributions instead of Employer Matching Contributions.  These Nonelective Contributions are for 2% of employee salary.

Limits

For Employer Matching contributions, the employer has some leeway in making the contributions for a particular tax year, but there are quite a few restrictions on how this leeway can be applied:

  • as described above, in general the matching contribution must be dollar-for-dollar up to 3% of the employee’s deferral for the year; however –
  • the matching contribution can be reduced to as little as 1% (or any amount between 1% and 3%) for a tax year as long as the amount is not reduced below 3% for more than two out of five tax years (including the current tax year) and the employees are informed in a timely fashion of the reduction in match.
  • the Nonelective Contribution of 2% can be substituted for the Employer Matching Contribution for any given year as long as employees are notified.

Contributions (for 2016-2018) are limited to $12,500 in employee deferrals, plus a catch up provision of $3,000 if the employee is age 50 or older during the tax year. (These figures are subject to annual adjustment due to inflation.)

Employer matches are limited to the amount the employee defers, up to 3%.

Note that SIMPLE deferral is counted toward the overall 401(k) limit ($18,000 for 2017; $18,500 for 2018; $24,000 and $24,500 respectively if over age 50) in deferrals for the tax year.  If an employee is subject to more than one retirement plan, this limit applies to all deferrals to 401(k)’s and SIMPLE plans for the tax year.

Gallimaufry*

There are a few additional things of interest regarding rollovers and the SIMPLE plan that must be pointed out:

  • After you’ve had the SIMPLE IRA open for 2 or more years, you are allowed to rollover other IRA funds into a SIMPLE IRA. Before that, you are not allowed to rollover IRA or other accounts (besides another SIMPLE IRA) into your SIMPLE IRA.
  • In order to rollover amounts from your SIMPLE IRA into a Traditional IRA, the account must have been in existence for at least two years; otherwise your only option for a rollover is into another SIMPLE IRA (which then inherits the earlier SIMPLE IRAs starting date for rollover purposes).
  • The same two-year rule applies to Converting a SIMPLE IRA to a Roth IRA. There is no SIMPLE Roth IRA.
  • Early distributions (not subject to any of the exceptions) that occur during the first two years of the account’s existence are subject to a 25% additional penalty (instead of the usual 10% penalty for other IRA accounts).

Other than those restrictions, all of the other distribution rules apply to SIMPLE IRAs that apply to Traditional IRAs:  distributions are taxable as ordinary income; with some exceptions, qualified distributions can not begin until age 59½; rollovers and trustee-to-trustee transfers are allowed as non-taxable events (subject to the two year rule above); conversions to Roth IRAs are allowed without penalty (subject to the two-year rule); and early distributions not subject to exception are subject to an additional 10% penalty (25% in the first two years as described above).

(* a hodgepodge of additional stuff)

Contest for today:  The first person to leave a comment that explains why I used the particular picture above for this article will receive a pound of our delicious virtual back-bacon.  Extra points if you can mention something unique about that particular picture, as well.  Best of luck to all participants! (Canadians are welcome to guess this time as well!) :-)

Photo by Thomas Hill

Social Security Terms

Nov 13th, 2017
by jblankenship.
2 comments

social security termsAs you learn about Social Security and your possible benefits, there are several unique Social Security terms that you should understand. Below is a list and brief definitions of the most important of these Social Security terms.

Average Indexed Monthly Earnings (abbreviated as AIME) – this is the average of the highest 35 years of your lifetime earnings, indexed to inflation. Each year’s earnings is indexed based on when you reach age 60, and the highest 35 years are averaged. This average is divided by 12, to result in the monthly average. The AIME is used to determine your PIA. Your AIME can increase after age 62 if you’re continuing to work and earn in excess of some of your earlier indexed earnings amounts.

Bend Points – these two amounts are determined for each individual based upon the year that you will reach age 62. The Bend Points are applied to your AIME to calculate the PIA.

Delayed Retirement Credits (DRCs) – when you delay filing for benefits after your FRA, you accrue credits for the delay, known as a DRCs. You earn DRCs for delaying your filing for Social Security benefits after your FRA up to age 70 at maximum. No DRCs are earned after you reach age 70. Presently this delay credit is equal to 2/3% for each month of delay, or a total of 8% for each year of delay. These credits are accumulative – meaning that if you delay for 3 years your DRCs are 24%.

Full Retirement Age (FRA) – this is the age at which your Social Security benefit is equal to your PIA. The age is 66 for folks born between 1946 and 1954. FRA increases by 2 months for each birth year after 1954, up to a (current) maximum of 67 for those born in 1960 or later. For each month before this age that you file for benefits, your benefit will be reduced from the PIA amount; for each month after this age that you delay filing, your benefit is increased from the PIA amount.

Primary Insurance Amount (PIA) – Using the AIME, three amounts (bound by Bend Points) are applied to the average. The amount of your AIME up to the first Bend Point is multiplied by 90%; the amount of your AIME from the first Bend Point to the second Bend Point is multiplied by 32%; and the amount above the second Bend Point up to your total AIME is multiplied by 15%. These three amounts are added together to result in your PIA.

Recharacterizing

Oct 30th, 2017
by jblankenship.
1 comment

big-cedar-tree-tiny-girl-by-woodleywonderworks1/1/2018 Note: Recharacterization of Roth conversion is no longer allowed as of tax year 2018. The last tax year that you could recharacterize Roth conversions is 2017. See Roth Recharacterization is No Longer Allowed for more details.

For 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 (Modified Adjusted Gross Income).  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 Recharacterizing.

Recharacterization of IRA Contributions

This is a relatively simple process, but, as with most things, the Code makes it seem like rocket surgery.  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 with recharacterizing

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 (TIRA) to a Roth IRA (RIRA)… if you’re converting funds from your TIRA to a 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, and 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 (which is not allowed), 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 cannot 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

IRA Distribution Pro-Rata Rule

Oct 16th, 2017
by jblankenship.
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rata-tat-tat

Photo credit: dido

It is important to understand the Pro-Rata rule for IRAs – which comes into play when you have both deductible and after-tax contributions in your Traditional IRA account. As you take distributions from the account, each distribution is treated as partly taxable and partly non-taxable, in proportion of the after-tax contributions related to the overall account balance.

So How Does The Pro-Rata Rule Work?

For an example, let’s say you have a Traditional IRA (TIRA) with a balance of $100,000.  Over the years you made both deductible and after-tax contributions to this account… and your after-tax contributions amount to $25,000.  It’s not necessary to know the amount of the deductible contributions (for this exercise), just the after-tax contributions.

For this tax year, you’ve chosen to take distribution of $10,000 from your TIRA.  When  you prepare your tax return next year, you’ll include $7,500 in ordinary income, excluding the $2,500 which is the proportionate amount of your distribution representing your after-tax contributions.  In this example, one dollar out of every four is considered return of your after-tax contributions.

That’s pretty simple, right?  So why is this deemed worthy of a whole blog post?  Hold your horses, I’m about to tell you…

Why This Is Worthy Of A Whole Blog Post?

This is especially important when planning your Roth IRA conversions, among other distributions.  When you do a conversion, this is essentially a distribution from your TIRA, and as such you are liable for ordinary income tax on the taxable portion of your distribution.

This is one of the reasons that well-meaning financial advisors often recommend that, if you’re going to make non-deductible contributions to a TIRA with the intent to convert the account to a RIRA, you should make them to a completely separate account.  This way, (presumably) the only portion that would be taxable at the distribution (conversion) would the be the growth of the funds, such as capital appreciation and dividends.

Unfortunately, that’s not the way it works. The pro-rata rule takes into account the balance and makeup of ALL of your Traditional IRA accounts, not just the one that you’re taking a distribution from.

For example, Joe has $50,000 in one Traditional IRA account (from only pre-tax contributions). Joe’s income is too high for him to make Roth IRA contributions or deductible Traditional IRA contributions. He’s heard of the “back-door Roth IRA contribution” strategy, and would like to put this into play for his situation. Joe opens a new Traditional IRA and contributes $5,500 to the account. This contribution is non-deductible to Joe.

Now, following the back-door strategy, Joe converts his entire new IRA over to a Roth IRA. He thinks he has done this with no tax. But the problem is in the way the pro-rata rule works. Joe must pay tax on his conversion in proportion to the total of all of his IRA account balances, less the portion that is after-tax.

Adding his two IRAs together, he has a total of $55,500 in IRAs before the conversion. Of this, only 9.9% is after-tax contributions ($5,500 divided by $55,500). So of his converted $5,500, he must pay tax on $4,954.95 (90.1%). Plus, he still has $4,954.95 of non-deductible contributions that he must continue to keep track of as he makes future distributions from the account.

This can cause a lot of headache since there may be many years between the initial contribution and final distribution from the account. For each year that you have non-deductible contributions in your IRAs, you should track these contributions via IRS Form 8606, even if you have not taken any distributions for the year. This will keep your records up-to-date for when you do take distributions later on.

But I want to only convert the after-tax portion!

There is still a way to convert only the after-tax amounts to a Roth IRA, but there are some restrictions as well.

If you have access to a 401(k) plan or other employer-sponsored retirement plan (other than an IRA) that will accept rollover amounts (you’ll have to check this with your plan sponsor, some do not accept rollovers), you may be allowed to rollover the amount from your IRA that represents everything but your after-tax contributions.  Make sure you don’t accidentally rollover the post-tax (nondeductible) contributions, because that’s not allowed and you could get into dutch with the IRS and your 401k administrator if you do. However, if you can rollover everything but the non-deductible contributions, then you can convert the remainder amounts to your Roth IRA without a taxable event.  Pretty cool, huh?

It’s important to note that this only works for 401(k), 403(b) and other employer-sponsored retirement plans. You can’t rollover the excess above the non-deducted contributions to another IRA – you’d still be in the same boat as before.

All of these transactions can carry significant tax penalties if you make a mistake, so you need to be doubly sure that you’re doing it right before you make a move.  There are no “do overs” for these transactions (well, not without jumping through hoops or other places that you don’t want to consider).  Consult your tax advisor to make sure you’re doing it correctly if you’re not sure.

5 No-No’s for IRA Investing

Sep 18th, 2017
by jblankenship.
1 comment
no-no

Photo credit: jb

It is generally well-known that in an IRA account you have a wide range of investment choices. These choices are typically only limited by the custodian’s available investment options.  However, there are specific prohibited transactions that cannot be accomplished with IRA funds. Often these prohibited transactions can cause your IRA to be disqualified, which can result in significant tax and penalty, along with loss of the tax-favored status of the funds.

What’s Not Allowed for IRA Accounts?

  1. Self-Dealing.  You are not allowed, within your IRA, to make investments in property which benefits you or another disqualified person.  A disqualified person includes your fiduciary advisor and any member of your family, whether an ancestor, spouse, lineal descendant (child) or spouse of a lineal descendant.  It is important to note that this limit applies to both present and future use of a property. So if you purchased a condo and rented it out exclusively for several years and then decided to convert it to personal use, this act would disqualify the investment and potentially classify it as a distribution, to be taxed and penalized (with interest) retroactively.
  2. Borrowing.  You are not allowed to borrow funds from your IRA account.  Likewise, you are not allowed to put up your IRA account as collateral for a loan.
  3. Selling.  You are not allowed to personally sell property that you own outside of the IRA, to your IRA account.
  4. Collectibles.  The single class of investments that you may not invest in with your IRA account is collectibles.  This includes art, antiques, gems, coins, and alcoholic beverages, among other items.  There is an exception to the coin prohibition, in that you are allowed to invest in one, one-half, one-quarter, or one-tenth ounce U.S. gold coins, or one-ounce silver coins minted by the United States Treasury Department with your IRA funds (if your custodian allows). You can also invest in certain platinum coins and certain gold, silver, palladium, and platinum bullion.
  5. Unreasonable Management Costs.  It is prohibited to pay an exorbitant amount to an advisor to manage your account.  This is due to the fact that it IS an allowed transaction to pay your advisor, tax-free, from your IRA specifically for managing the account.  If the amount is deemed unreasonable (e.g., obviously for services above and beyond managing the IRA account), this transaction is prohibited. An example of this is if you have both IRA and non-IRA funds with your advisor, but you pay the advisor’s entire fee strictly from your IRA account. Unless the non-IRA funds are an inconsequential amount, the fee paid from the IRA will be deemed exorbitant to the size of the IRA account.
  6. (bonus!) Life Insurance. You may not purchase life insurance contracts with your IRA account funds. This is a strict prohibition.

Beyond these transactions, IRAs have a pretty wide scope of available investment options. As I indicated before, your options are mostly limited by the custodian’s available investments.  In cases where the IRA funds are to be used for more unique investments, such as individual real estate transactions or gold bullion, a special custodian is often required.  These transactions can be very difficult to complete and manage over time and maintain the tax-qualified status.  If you’re interested in such a transaction, there is more information available in the article Where to Establish Your IRA Account.

Comprehensive Financial Planning – Explained

Sep 5th, 2017
by jblankenship.
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comprehensive

Photo credit: jb

From time to time, the question is asked of me: What exactly makes up a comprehensive financial planning engagement?  Since you know from reading about my practice that I operate in an hourly, fee-only fashion, you should know that a truly comprehensive financial planning engagement requires 10 to 15 hours of effort (or more) by the financial planner.

What exactly makes up a comprehensive financial planning engagement?

Each individual situation is going to be different, and so your mileage is likely to vary from my explanation.  What I’ll do, as a starting point, is list out the areas that are typically covered in what I’d call a comprehensive plan:

  • goal-setting – spending time understanding the wishes and desires of the client, and quantifying them in terms of time horizon and costs for use in planning; this can include retirement, college, home purchase or remodel, opening a business, parents moving in, and just about any major financial event
  • priority-setting – understanding the relative importance of each goal
  • risk analysis – explaining to the client the concepts of risk, how risk is required for return, and garnering an understanding of the tolerance level for risk given the timelines and current financial condition
  • cash flow – review of financial flows, finding those “unknown” expenditures that can be managed to help meet financial goals; understanding near-term and long-term requirements for cash flow; review of prior tax returns for any issues or overlooked opportunities
  • present financial condition – review of present accounts, allocation, future planned inflows into those accounts; present position with regard to debt, as well as future debt planned and how debt is to be retired
  • projection of future cash flows – modeling the future as it pertains to the goals stated, with regard to the present financial condition and assumptions made about holdings, inflows, taxes, debt, and timelines
  • risk management – review of current insurance coverage(s), especially with regard to life, disability, and long-term care insurance needs, both now and in the future, given results from the future cash flow projections; this often also entails a review of employer-provided benefits and recommendations for participation therein
  • estate planning – review of present accounts, ensuring appropriate titling and beneficiary designation both now and in the future, given results from other components of the planning process
  • strategy development – this can entail anything from tax planning to portfolio development to insurance recommendations, debt reduction plan, distribution planning, as well as opening and funding any new accounts deemed appropriate
  • communication of the results/recommendations – sometimes this takes a couple of hours or more on its own. The point is that the client comes away with a thorough understanding of the recommendations and the reasoning behind them; additionally, the client has an understanding of how to implement the recommendations
  • implementation – not always required, but often is requested. We spend time helping the client open accounts and making allocations if required, implementing any needed additional insurance coverage (reviewing policies and the like), implementing tax strategies, etc. – or sometimes the client turns the implementation completely over to us
  • follow up – plans are reviewed after approximately one year to ensure that circumstances have not changed dramatically (with regard to the information used in the original plan). If the client doesn’t wish to engage in formal follow up review, then the engagement is complete.

The Reality – What Really Is Involved

Now, given the fact that a typical comprehensive financial plan entails at least three meetings with the client, each lasting on average one and a half hours, that leaves five and a half hours (on the low end) or ten and a half hours (on the high end of my estimate) to cover the remainder of the activities I’ve listed. In the case of the lower end of the spectrum, some of the components are either eliminated or reduced in scope. For example, if the client only has a 401(k), no debt other than his mortgage, is single and has no children – then obviously the planning cycle is reduced, due to the reduction in planning factors.

Now, the other thing is that many financial planners (myself included) notoriously under-recover – that is, we often spend more time on the plan than what we bill, due to additional research required, or additional time required for communication of the recommendations, or any of a myriad of activities.

Hope this gives you an idea of what is involved in a typical financial planning engagement.

Taxpayer Bill of Rights – Do You Know Your Rights?

Aug 28th, 2017
by jblankenship.
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bill of rightsThere is a set of Rights that are available to all of us as taxpayers – the Taxpayer Bill of Rights. This group of basic rights is available to us so that the government (and specifically the Treasury Department and the IRS) don’t over-step their boundaries when dealing with taxpayers.

It’s important to know your rights, and those set forth in the Taxpayer Bill of Rights can be very helpful if you’re having trouble working with the government. The rights scattered throughout the Internal Revenue Code, but are published in total in IRS Publication 1, readily available on the internet to all taxpayers.

Recently the IRS published their Summertime Tax Tip 2017-21, which outlines the Taxpayer Bill of Rights. The text of the Tip follows below:

Know Your Taxpayer Bill of Rights

Every taxpayer has a set of fundamental rights and the IRS has an obligation to protect them. The “Taxpayer Bill of Rights” groups the taxpayer rights found in the tax code into 10 categories. Know these rights when interacting with the IRS. A good way to learn about them is by reading Publication 1, Your Rights as a Taxpayer.

Below are the descriptions of each right, as listed in Publication 1:

  1. The Right to Be Informed. Taxpayers have the right to know what to do in order to comply with the tax laws. They are entitled to clear explanations of the laws and IRS procedures on all tax forms, instructions, publications, notices and correspondence. They have the right to know about IRS decisions affecting their accounts and receive clear explanations of the outcomes.
  2. The Right to Quality Service. Taxpayers have the right to receive prompt, courteous and professional assistance in their interactions with the IRS. They also have the right to be spoken to in a way they can easily understand, to receive clear and easily understandable communications from the IRS, and to speak to a supervisor about inadequate service.
  3. The Right to Pay No More Than the Correct Amount of Tax. Taxpayers have the right to pay only the amount of tax legally due, including interest and penalties and to have the IRS apply all tax payments properly.
  4. The Right to Challenge the IRS’s Position and Be Heard. Taxpayers have the right to raise objections and provide additional documentation in response to formal IRS actions or proposed actions. They also have the right to expect the IRS to consider their timely objections promptly and fairly and to receive a response if the IRS does not agree with their position.
  5. The Right to Appeal an IRS Decision in an Independent Forum.Taxpayers are entitled to a fair and impartial administrative appeal of most IRS decisions, including many penalties and have the right to receive a written response regarding the Office of Appeals’ a decision. Taxpayers generally have the right to take their cases to court.
  6. The Right to Finality. Taxpayers have the right to know the maximum amount of time they have to challenge an IRS position as well as the amount of time the IRS has to audit a particular tax year or collect a tax debt. Taxpayers have the right to know when the IRS has finished an audit.
  7. The Right to Privacy. Taxpayers have the right to expect that any IRS inquiry, audit or enforcement action will comply with the law and be no more intrusive than necessary, and will respect all due process rights, including search and seizure protections and will provide, where applicable, a collection due process hearing.
  8. The Right to Confidentiality. Taxpayers have the right to expect that any information they provide to the IRS will not be disclosed unless authorized by the taxpayer or by law. Taxpayers have the right to expect appropriate action will be taken against employees, return preparers, and others who wrongfully use or disclose taxpayer return information.
  9. The Right to Retain Representation. Taxpayers have the right to retain an authorized representative of their choice to represent them in their dealings with the IRS. Taxpayers have the right to seek assistance from a Low Income Taxpayer Clinic if they cannot afford representation.
  10. The Right to a Fair and Just Tax System. Taxpayers have the right to expect the tax system to consider facts and circumstances that might affect their underlying liabilities, ability to pay, or ability to provide information timely. Taxpayers have the right to receive assistance from the Taxpayer Advocate Service if they are experiencing financial difficulty or if the IRS has not resolved their tax issues properly and timely through its normal channels.

The IRS will include Publication 1 when sending a taxpayer notices on a range of issues, such as an audit or collection matter. Publication 1 is available in English and Spanish. All IRS facilities will publicly display the rights for taxpayers.

Avoid scams. The IRS will never initiate contact using social media or text message. First contact generally comes in the mail. Those wondering if they owe money to the IRS can view their tax account information on IRS.gov to find out.

Additional IRS Resources:

IRS YouTube Videos:

Divorced with Children? Social Security Benefits for You

Aug 21st, 2017
by jblankenship.
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divorced with childrenThere are special rules that apply for Social Security benefits when you are divorced with children. While the ex-spouse is living, there is a discriminatory effect on benefits, but after the ex-spouse dies, a surviving ex-spouse with children under age 16 has one advantage over a surviving ex-spouse with no children. (The age of the child is not a factor if the child is permanently disabled and the disability began before age 22.)

During the life of your ex-spouse

Beth and Steve are divorced with children, three kids under age 16. Steve, age 62, started receiving Social Security benefits this year. As we know from this article on children’s benefits, all three of their children are eligible for Social Security benefits based on Steve’s record.

Plus, if they were still married, Beth would be eligible for a parent’s benefit based on Steve’s record as well. But since they’re divorced, a special rule applies to Beth’s situation. Being divorced, Beth is not eligible for the parent’s benefit that is otherwise available to a parent caring for a child (under age 16) of a Social Security recipient.

The parent’s benefit is only available to the current spouse of the Social Security recipient who is under Full Retirement Age. Ex-spouses are not at all eligible for this benefit.

This is the discriminatory effect for divorcees versus married folks. Although everything else is the same, this benefit is not available to Beth since they are divorced.

Once she’s reached age 62 Beth can be eligible for a regular ex-spouse benefit (as long as she and Steve were married for 10 years or more). If at least one of the children is still under age 16 at the point Beth reaches age 62 and she’s still unmarried (and Steve is still alive), Beth can be eligible for an unreduced Spousal Benefit from that point until Full Retirement Age, or when the child reaches age 16, whichever is earlier. Deemed filing will not apply to this situation – in other words, if Beth becomes ineligible (child reaches 16, or she remarries), Social Security benefits cease for her until she applies for another benefit type.

After the ex-spouse has died

Drawing out our example of Steve and Beth a bit further, let’s say Steve dies at the age of 63. As we know, since the kids are all under age 18, they are eligible for survivor benefits based on Steve’s record. Beth’s situation becomes more interesting with this development…

Beth is 49 at the time of Steve’s death. Since at least one of the children (of Steve and Beth) is under age 16, Beth is eligible for a surviving parent’s benefit. The advantage here is that the length of Beth and Steve’s marriage is not a requirement. In other words, for this surviving divorced parent’s benefit, the 10-year marriage length is not a factor.

The youngest child of Beth and Steve’s will reach age 16 when Beth is 60 years of age. Up to that point, Beth can continue to receive the parent’s benefit, regardless of the length of their marriage. However, if Beth remarries during this period, she will become ineligible for the parent’s benefit – it’s only available to her while she’s unmarried.

After the last child reaches age 16, Beth is no longer eligible for this surviving parent’s benefit. At this point, if their marriage did not last at least 10 years, Beth is not eligible for any benefits now or in the future based on Steve’s Social Security record. If the marriage lasted 10 or more years, Beth becomes eligible for a regular surviving ex-spouse benefit at age 60 – as long as she doesn’t remarry before age 60. After age 60, she’s still eligible for the survivor benefit.

The Earliest Age You Can Withdraw Retirement Money Without Penalty

Aug 14th, 2017
by jblankenship.
4 comments

numbersQuick – what’s the earliest age you can withdraw money from a retirement account without paying a penalty? Is it 59½?

Well, if that was your answer, you are probably in the majority. That’s the general overall rule regarding withdrawal of IRA and 401(k) money. And definitely, you should be able to withdraw money from your account after that age without penalty (unless it’s in a 401(k), you’re still employed, and your plan restricts in-plan distributions). But this is much later than the real answer.

If your answer was 55, you’re in an elite group. You know about the age 55 provision that provides the ability to withdraw 401(k) funds without penalty if you’ve left employment at or after age 55. This is a good answer, but the real answer using this provision is age 54. This is because the rule specifically states that you can take withdrawals penalty-free from your plan if you leave employment “during the calendar year that you will reach age 55”. So, technically, if your birthday is in December, you could leave employment as early as January of that year (at age 54 and one month) and still be eligible for penalty-free withdrawals from your 401(k) plan (but not an IRA). This is still much later than the real answer.

So, looking at the age 55 paragraph, you might guess age 50 if you’re a public safety employee – which you would immediately adjust to age 49. This is an even younger (and clever) answer, but still not the earliest age.

The real answer is that this is a trick question. If you meet one of the exceptions noted in either the 401(k) withdrawal exceptions or the IRA withdrawal exceptions articles, you can take a withdrawal at ANY AGE without penalty, as long as you are an eligible participant in the retirement account. Technically there is no minimum age at which you could take a penalty-free withdrawal from your retirement plan!

Where To Establish Your IRA Account

Aug 7th, 2017
by jblankenship.
1 comment

Establishing and contributing to an IRA (Traditional or Roth) is pretty simple and straightforward. There are many institutions where you can establish your IRA accounts:  banks, savings and loans, credit unions, insurance companies, mutual fund companies, and brokerages.  There are pros and cons to each type of institution, as we’ll list below.  These alternatives represent the major options for opening your IRA, in no particular order.

where-to-establish-IRA-account

Photo credit: jb

Institution

Pros

Cons

Banks, Savings and Loans & Credit Unions

 Banks are well-known as some of the most stable and conservative institutions in our financial industry.  For many folks, this is an assurance that there is additional safety in placing funds with these institutions, and in a way, with FDIC insurance, there is additional safety. This is mitigated quite a bit with the protections provided by law to IRA accounts. Since banks are conservative, until recently, their options for investment of IRAs were somewhat limited.  Traditionally, cash-oriented investments such as CDs and money market savings were the primary means of investment within banks.  This has changed lately with some deregulation of the banks, as many offer mutual fund investments in addition to the traditional offerings.
Insurance Companies While there are many arguments about the merits (or demerits) of placing annuity investments into IRAs, this is one of the options that insurance companies bring to the table.  Annuity investments can provide a stable guaranteed income stream for retirement. A Qualified Longevity Annuity Contract (QLAC) is one example of an annuity used in an IRA. Many times the products that insurance companies have to offer have significantly higher costs than can be found in other similar investment choices.  Annual expense ratios run in the 2% plus range. The increased expenses are used to pay for the unique features (longevity insurance, for example) of the insurance products.
Mutual Fund Companies Typically the lowest-cost providers of IRAs, with a wide variety of investment offerings.  In addition, once the account is established, there often are no transaction costs for additional contributions (if the investments are no-load).  This supports the concept of dollar-cost-averaging through low- or no-cost additions to the account. Many mutual funds have minimum investment levels that make investment into the funds difficult within the IRA. This is especially true in the early years of the account when the balance is smaller.  In addition, with the exception of no-load mutual funds, there can be sales charges associated with the funds, ranging anywhere from 2% up to 5% and more.
Brokerage Wide variety of investment choices. Depending upon the brokerage, can be a very cost effective option, in terms of transaction costs. Typically have a transaction cost with each contribution, which is in contention with the concept of dollar-cost averaging, as each individual contribution, if invested immediately, can generate a transaction fee ranging from $10 to $50, depending upon the brokerage.
Self-Directed IRA Custodian These custodians provide access to more specialized and unique investment choices, such as real estate, private offerings, and tax liens. The custodian provides expertise in the form of attorneys and other advisors to assist in the diverse selection of investments within the IRA in order to maintain the legal status of the deferred account. Generally the highest-cost option of all choices due to the additional back-office support. Due to the investment choices, may be very limited in flexibility.

As you can see, there are positives and negatives to each type of institution.  You need to be comfortable with your choice of financial institution to establish your IRA, as you will likely be dealing with the company for many years in the future.  Although you could make a change (rollover your funds) to a different institution at pretty much any time within limits, making those changes can be a hassle, so it’s best to use careful consideration in your choice.

Traveling for Charity? You may have deductions

Jul 31st, 2017
by jblankenship.
3 comments

traveling for charityMost of us realize that donating money and goods to a charity can be beneficial on our tax returns. But did you know that traveling for charity can also be deducted? It’s true – with some limitations, of course.

When you do work for a charity, whether building houses, manning a recruitment booth, or picking up items donated, travel may be required. If you use your own personal vehicle (or your company vehicle if you own the company) your travel involved with this work can often be deducted as well.

For example, you might volunteer at your church to help with the annual winter clothing drive. Your job is to visit the homes of donors to pick up the clothing for the drive, making the donation much simpler for folks who don’t have time to come down to the church. Your mileage for driving around to the donors’ homes can be counted as a deductible out of pocket expense on your tax return for the year.

A more involved example would be if you volunteer to help build a water filtration plant for a community in a third-world country, sponsored by a qualified charitable organization. Your out-of-pocket costs for airfare, lodging, and ground transportation can be deductible if those costs are strictly related to the charitable work, and the trip is predominantly associated with the work. That is to say, your trip is not a “vacation” with a small amount of time spent working for the charity – the trip should be about the charitable work first and foremost.

The IRS recently published a Summertime Tax Tip (2017-2) that gives some broad overview information on deducting expenses while traveling for charity. The text of the Tip follows below.

Tips to Keep in Mind for Taxpayers Traveling for Charity

During the summer, some taxpayers may travel because of their involvement with a qualified charity. These traveling taxpayers may be able to lower their taxes.

Here are some tax tips for taxpayers to use when deducting charity-related travel expenses:

  • Qualified Charities. For a taxpayer to deduct costs, they must volunteer for a qualified charity. Most groups must apply to the IRS to become qualified. Churches and governments are generally qualified, and do not need to apply to the IRS. A taxpayer should ask the group about its status before they donate. Taxpayers can also use the Select Check tool on IRS.gov to check a group’s status.
  • Out-of-Pocket Expenses.  A taxpayer may be able to deduct some of their costs including travel. These out-of-pocket expenses must be necessary while the taxpayer is away from home. All costs must be:
    • Unreimbursed,
    • Directly connected with the services,
    • Expenses the taxpayer had only because of the services the taxpayer gave, and
    • Not personal, living or family expenses.
  • Genuine and Substantial Duty. The charity work the taxpayer is involved with has to be real and substantial throughout the trip. The taxpayer can’t deduct expenses if they only have nominal duties or do not have any duties for significant parts of the trip.
  • Value of Time or Service.  A taxpayer can’t deduct the value of their time or services that they give to charity. This includes income lost while the taxpayer serves as an unpaid volunteer for a qualified charity.
  • Travel Expenses a Taxpayer Can Deduct. The types of expenses a taxpayer may be able to deduct include:
    • Air, rail and bus transportation,
    • Car expenses,
    • Lodging costs,
    • Cost of meals, and
    • Taxi or other transportation costs between the airport or station and their hotel.
  • Travel Expenses a Taxpayer Can’t Deduct. Some types of travel do not qualify for a tax deduction. For example, a taxpayer can’t deduct their costs if a significant part of the trip involves recreation or vacation.

For more on these rules, see Publication 526, Charitable Contributions. Get it on IRS.gov/forms at any time.

Downside to the Age 55 Rule for 401k

Jul 24th, 2017
by jblankenship.
64 comments
5 cents

Photo credit: jb

In other articles we’ve covered the Age 55 rule for 401k plans – where you’re allowed to withdraw money from your 401k penalty-free if you leave employment at or after age 55. But there’s a downside to the Age 55 rule that you need to know about. We’ll cover the downside today.

When you reach age 55 and leave employment, you may be looking to use your 401k plan as your source of income needs for a few coming years. Perhaps you plan to withdraw from the 401k until you reach age 59½, when you’ll have access to other deferred money, or maybe until you reach age 62 and start receiving Social Security.

But there could be a problem in your strategy. Your 401k administrator might only allow a one-time lump-sum withdrawal from the plan! Many plans have this restriction – the reasoning being that they see the plan primarily as an accumulation vehicle, and they do not want to be in the position of maintaining long-term distributions.

So, for example, Steve retires from his job at age 56, knowing that he can take withdrawals from his 401k plan without penalty. So when he maps this out, he needs approximately $50,000 from his 401k plan each year. He needs this amount until he reaches age 62, when he’ll start taking his Social Security and drawing his pension.

When Steve contacts the 401k administrator to set this up, he learns that the plan only allows a lump sum distribution! This means that Steve would have to take a distribution of $150,000 to get him to age 59½. Of course this would result in significantly more tax than Steve anticipated, but there’s not much else he could do, other than going back to work. (It should be noted that not all 401k plans have this restriction – many will allow multiple withdrawals, but many do restrict withdrawals to a one-time lump sum. Check with your plan administrator as you devise your strategy.)

If he rolls over the 401k plan to an IRA, the Age 55 rule no longer applies. However, Steve has another option that can help the overall tax situation, by staging his withdrawals.

Staging Withdrawals

If Steve took the entire lump sum of $150,000 from his 401k in one year (rolling over the rest of the account to an IRA), the tax would be approximately $32,070, since he’s single. If he was married, the tax would be approximately $23,778. But, since he only needs $50,000 in the first year, he could withdraw that $50,000 for a tax cost of approximately $5,940 ($3,448 if he was married). The remaining 401k would be rolled over into an IRA.

Then in the subsequent years, Steve could take “early” withdrawals of $50,000 each year, paying the 10% penalty. His total tax each of the two following years (his age 57 and 58) would work out to $10,940 per year (or $8,448 if he was married). So his total tax for the three years amounts to $27,820 – a savings of $4,250. If he was married the total tax would have been $20,344, saving $3,434 by staging. However, any way you look at it, this is costing an extra $10,000 in penalties, so it’s not the boon you thought it would be (if your plan is restricted like this).

Often, the best option to deal with this downside to the Age 55 rule is to come up with some other source of income during the intervening years. A part-time job could be the answer, helping Steve through the couple of years before he reaches age 59½. Or perhaps one of the other exceptions to early withdrawal could apply for a portion of his income needs. At age 59½ he could have the entire amount rolled over into an IRA and he’d have unfettered (unpenalized) access to the money in any amount.

Public Safety Employee Retirement Plan Withdrawal at Age 50

Jul 10th, 2017
by jblankenship.
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public safety employee age 50For certain types of workers, specifically someone employed as a public safety employee, there is a special exception to the normal distribution rules. For a public safety employee, retirement plan withdrawal can begin without penalty as early as age 50, rather than age 55 or 59½.

Public Safety Employee

The list of public safety employees includes government or municipal firefighters, police, and emergency medical service employees. Recent expansion of this definition was put in place to include federal employees who work in certain public safety professions. These additional classifications include federal law enforcement, customs and border protection officers, federal firefighters, air traffic controllers, nuclear materials couriers, and members of the US Capitol Police, Supreme Court Police, and diplomatic security special agents of the Department of State.

This provision has been put in place to allow for an earlier withdrawal from the workforce by these individuals. These professions often exact a toll on the worker that results in a shortened career span versus other occupations.

Separation from Service on or after age 50

In order to take advantage of this provision, the worker must be employed in the public safety profession and leaves service upon reaching age 50 or at any point after that age. This allows the individual to make withdrawals from retirement plans without penalty prior to age 59½. Otherwise, unless another exception applies to the retirement account, any early distribution from a retirement plan would result in a 10% penalty applied to the distribution.

The age 50 exception applies to all government-based retirement plans, including defined benefit and defined contribution plans. This exception does not apply to Individual Retirement Arrangement (IRA) plans.

So, if Patricia, a firefighter who has a 457 retirement plan, a pension from her county, and an IRA, decides to retire at age 51 she can withdraw funds from the 457 and begin receiving payments from her pension without penalty. She cannot take distributions from her IRA (unless another early-withdrawal exception applies). Tax will be owed on any normally-taxable distributions from these accounts.

In addition, if Patricia rolls over her 457 plan into an IRA or another employer’s retirement plan, she loses the age 50 distribution exception. This exception only applies to her original retirement account.

Interaction of Survivor Benefits with Your Own Benefits

Jun 25th, 2017
by jblankenship.
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interactionSocial Security Survivor Benefits can be a critical lifeline for surviving spouses. The interaction of survivor benefits with your own benefits can be a bit confusing though. Does starting to receive one benefit affect your future amount of the other benefit? How about vice-versa? There’s a lot written about the topic in Social Security’s POMS manual, but it becomes very simple after you study it a bit.

The interaction of survivor benefits with your own benefits can be played out in one of two ways: either you take your own benefit first and the survivor benefit later; or vice versa, taking the survivor benefit first followed by your own benefit. We’ll look at each of these methods and review the interaction of survivor benefits with your own benefits.

Note: in our examples, we are assuming that the survivor benefit has been calculated correctly per the late spouse’s circumstances. See How is the Social Security Survivor Benefit Calculated? for more details on the calculations. It’s also important to understand that there is a difference between Survivor Benefits and Spousal Benefits. Survivor Benefits are only available once your spouse has passed away, while Spousal Benefits are only available during his or her lifetime.

Survivor Benefits First

In this case, you will be filing for your survivor benefit first, and then filing for your own benefit at some point in the future. You might do this if you’re under FRA when you become eligible for the survivor benefit and wish to delay filing for your own benefit until later. Or you want to delay your own benefit until it’s maximized at your age 70. Generally speaking, the only way this would make sense is if your survivor benefit is something less than what your own future benefit can be.

Filing for your Survivor Benefit has zero impact on your own benefit in the future. Receipt of the Survivor Benefit in prior years (from filing for your own benefit) isn’t even noted when you file for your own benefit later.

For example, Robin, a widow age 62, has a survivor benefit coming to her that would amount to $1,000 at her present age. Her own benefit will be $1,500 when she reaches FRA (at age 66 and 4 months), or it could grow to $1,950 if she waits until she reaches age 70.

Robin can take the survivor benefit right away and collect $1,000 per month for the next several years, and then file for her own benefit (at any point). There will be no reduction to her own benefit from her “early” filing for the survivor benefit.

Own Benefits First

This is the reverse of the above situation: you are filing for your own benefit first, and then later filing for the survivor benefit. This occurs when the survivor benefit will be something more than your own benefit – and of course the amount would be maximized when you reach FRA. In the meantime you are collecting your own benefit until you decide to file for the survivor benefit.

Jack is a surviving widower, age 63. He has a benefit based on his own record that will pay him $900 per month now, at his current age. He also has a survivor’s benefit that will pay him $1,200 per month if he waits until FRA to file for the survivor benefit.

When Jack files for his own benefit, it is reduced from the amount that could be paid to him if he waits until FRA, a total reduction of $225 (his FRA amount would be $1,125). When he later files for the survivor benefit, SSA does a calculation to determine the amount of benefit he will receive:

The reduced retirement benefit is subtracted from the total survivor benefit. That difference will become the survivor portion of the benefit, and the individual will also continue to receive his or her own benefit. The two are added together.

So in Jack’s case, the survivor portion of his benefit will be $1,200 minus $900 ($300). So Jack will receive one check each month in the amount of $1,200, which is made up of his own benefit ($900) plus the survivor portion ($300).

The bottom line

The bottom line is this: in either case, starting one benefit early has zero impact on starting the other benefit at a later date. So – if you find yourself in a position where you’re widowed and eligible by age for your own benefit and a survivor benefit you should definitely look into starting one or the other benefit. It’s likely that if you don’t do this, you’ll be leaving money behind that you should have received.

Higher Education Expenses Paid From an IRA

Jun 5th, 2017
by jblankenship.
2 comments
education

Photo credit: malomar

Another way to pull funds from an IRA  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 education expenses 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 an 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.

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.

What to do When You Owe Taxes

May 30th, 2017
by jblankenship.
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owe taxesFor all your good intentions, you’ve found yourself in a position where you owe taxes to the IRS that you can’t pay right away. All is not lost, there are ways to deal with this situation that can be helpful if you can’t pay. The IRS has several methods you can use to arrange a plan to pay the IRS taxes that you owe over time.

The most important part is to not ignore the situation, you need to take action and make arrangements. If you ignore it, like most things, your situation will only get worse, costing you more in interest and penalties.

Recently the IRS published a Special Edition Tax Tip 2017-09 which details what you can do in this situation. the actual text of the Tip follows below:

Tips for Taxpayers Who Owe Taxes

The IRS offers a variety of payment options where taxpayers can pay immediately or arrange to pay in installments. Those who receive a bill from the IRS should not ignore it. A delay may cost more in the end. As more time passes, the more interest and penalties accumulate.

Here are some ways to make payments using IRS electronic payment options:

  • Direct Pay. Pay tax bills directly from a checking or savings account free with IRS Direct Pay. Taxpayers receive instant confirmation once they’ve made a payment. With Direct Pay, taxpayers can schedule payments up to 30 days in advance. Change or cancel a payment two business days before the scheduled payment date.
  • Credit or Debit Cards. Taxpayers can also pay their taxes by debit or credit card online, by phone or with a mobile device. A payment processor will process payments.  The IRS does not charge a fee but convenience fees apply and vary by processor.

Those wishing to use a mobile devise can access the IRS2Go app to pay with either Direct Pay or debit or credit card. IRS2Go is the official mobile app of the IRS. Download IRS2Go from Google Play, the Apple App Store or the Amazon App Store.

  • Installment Agreement. Taxpayers, who are unable to pay their tax debt immediately, may be able to make monthly payments. Before applying for any payment agreement, taxpayers must file all required tax returns. Apply for an installment agreement with the Online Payment Agreement tool.

Who’s eligible to apply for a monthly installment agreement online?

  • Individuals who owe $50,000 or less in combined  tax, penalties and interest and have filed all required returns
  • Businesses that owe $25,000 or less in combined tax, penalties and interest for the current year or last year’s liabilities and have filed all required returns

Those who owe taxes are reminded to pay as much as they can as soon as possible to minimize interest and penalties. Visit IRS.gov/payments for all payment options.

IRS YouTube Videos:

Traditional IRA v. Roth IRA – Compare & Contrast

May 22nd, 2017
by jblankenship.
4 comments

What’s the difference between the two types of IRAs?  And what is similar?

compare-contrast

Photo credit: jb

You probably know a little bit about this subject – like one IRA is deductible on your income taxes, and the other one has some kind of tax benefit… but the differences are hard to understand, and can be even harder to explain!  Below are the major differences between the two, followed by the similarities.  This discussion is liable to be useful as you consider which kind of IRA is best for you (and both could be best for you, at different times in your life).

Differences Between Traditional IRA and Roth IRA

Deductibility is a feature of the Traditional IRA (Trad) that is not available in the Roth IRA (Roth).  What this means is that, subject to the limits we discussed here, you may be able to deduct the amount of your contribution to your Trad from your Gross Income in the year of the contribution.  When the Traditional IRA was originally introduced in 1974, the deductibility feature was not included.  This was added in 1986, and is one of the primary reasons that Trads have remained as popular as they are to this day.  At the time of the introduction of the deductibility feature, very few companies offered 401(k) plans so the Trad offered one of the only tax shelters available to nearly every taxpayer.

Tax treament is another major difference between the two kinds of IRA.  The Trad’s distributions are always taxable (if not rollover distributions) as ordinary income, while the Roth’s distributions are always tax-free (as long as they meet the requirements, such as after age 59½).  What is also very different about the two is that your contributions to a Roth are always available for withdrawal at any time for any reason – tax free.  The growth in the Roth (interest, dividends, capital gains) would be taxed and subject to penalty if withdrawn for an ineligible reason, though.  The Trad does not have such a provision.

Required distributions are the final major difference covered here.  The Trad has Required Minimum Distributions (RMDs) that must begin at the owner’s age 72, while the Roth has no requirement for distribution.  In other words, the Roth IRA never needs to be distributed during the IRA owner’s life, while the Traditional IRA must be distributed beginning at the owner’s age 72.

Similarities Between Traditional IRA and Roth IRA

Income requirement. A component of the requirements of both the Trad and the Roth is that the holder (or the holder’s spouse) must have earned income in the year of the contributions.  The income must be at least equal to the total of all IRA contributions for the year.  This includes two additional types of contributions: spousal contributions and non-deductible contributions.

Spousal contributions are allowed for both the Trad and the Roth, and they essentially allow a spouse with income to contribute to the IRA (either variety) of the spouse who either does not have income, or whose income is below the maximum available contribution for the tax year.  The contributions are limited, however, to the total of both spouses’ earned income for the tax year.

Earned income, for the purposes of IRA contributions, includes wages, salaries, tips, commissions, self-employment income, or alimony (or separate maintenance payments).  Not included as earned income are earnings and profits from property (rental or royalty), interest income, dividends, pensions, annuities, deferred compensation (such as 401(k) distributions), certain non-participatory partnership income, and capital gains.

Non-deductible contributions to a Traditional IRA are allowable when your MAGI is above the limits (described here).  In essence, if your income is too high to make either a Roth contribution or a deductible Trad contribution, you are allowed to make a non-deductible contribution of up to the maximum amount allowable for the year into your Trad IRA.  These contributions are after tax, and so when distributed there will be tax only on the growth that has occurred on that contribution.  Non-deductible contributions are a way to defer tax on the growth of funds in an account, and are also available as a spousal contribution.

Tax Year Specification. Trad and Roth contributions must be made for a specific tax year.  That is, since there are strict limits on the amounts that can be contributed, you must specify the tax year of the contribution to your IRA.  You are generally allowed to contribute for a tax year beginning on January 1 and ending on the tax due date for the year (generally April 15 of the following year).  In other words, you may make your 2019 contribution to your IRA at any time between January 1, 2019 and April 15, 2020.

The same deadline applies to establishing the account as well.  You can even file your tax return early, indicating a contribution to your Trad IRA (and deducting it from your gross income) before you make the contribution!  Just make sure that you do go ahead and make the contribution… the IRS has very little sense of humor about things like that!

Penalty for withdrawal applies to ineligible distributions from either type of account.  A 10% penalty will be applied to any distribution from an IRA of either variety that is not specifically allowed under §72(t), above and beyond the ordinary tax that would be applied to the distribution.

The Remarriage Rule (Possibly the Dumbest Social Security Rule)

May 15th, 2017
by jblankenship.
9 comments

remarriageIf you’re familiar with the remarriage rule for Social Security survivor benefits, you likely know what I’m talking about. This is, in my opinion, quite possibly the dumbest rule that we have in the whole Social Security system. There are several really dumb rules, but this one takes the cake.

Briefly, here’s the remarriage rule: If you are a widow or widower who is otherwise eligible for survivor’s benefits from your late spouse, you must be unmarried as of reaching age 60 to actually receive the benefit. If you remarried even one day before reaching age 60 (and remain married) you are not eligible for survivor benefits. If you remarried the day after your 60th birthday, you’re still eligible to receive the survivor benefits based on your late spouse’s record.

Example of remarriage rule

Joan and Richard were married for 27 years when Richard died. Joan was 57 years old at the time of Richard’s passing. Upon reaching age 60, Joan will be eligible to receive a survivor’s benefit based on Richard’s record.

Joan met David when she was 59 years old, and the two plan to marry soon. The timing of this marriage is critical to Joan, as explained above. If Joan remarries before she reaches age 60, she loses her eligibility to receive the survivor’s benefit while she’s married to David. If she waits until some time after her 60th birthday, Joan will retain eligibility for the survivor benefit.

Likewise, if Joan’s (early) marriage to David ends, either through divorce or David’s death, Joan’s eligibility for the survivor benefit based on Richard’s record will be restored. In fact, if David has died, as long as he and Joan were married for at least 1 year (and still currently married upon David’s passing), Joan will be eligible for survivor benefits on either Richard’s or David’s record, whichever is more advantageous to her.

What does this rule protect?

What exactly are we trying to resolve with this rule? I can’t for the life of me figure that one out – except that apparently we want to provide disincentive for widow(er)s to remarry prior to age 60. If anyone in readerland has other ideas for the value of this rule, I’d love to hear them!

I doubt seriously if this particular rule results in much benefit to the bottom line for Social Security as a system. But what it does is to cause much confusion for individuals who could be affected by it. I’ve heard from more than one individual who made changes to their remarriage plans because of the rule.

Plus, I’ve also heard from multiple individuals who were planning a quiet divorce in order to get around the rule. This could be done, restoring eligibility, and then after at least 12 months has passed the two could be remarried again (as long as the widow(er) is over age 60).

In a system that’s fraught with much confusion and complexity, it’s my opinion that this is a rule we could definitely do without, and no one would be harmed for the lack of it. What do you think?

IRS’ Offer in Compromise

May 8th, 2017
by jblankenship.
1 comment

compromiseYou’ve heard the ads on radio and TV:

Settle your debt with the IRS for pennies on the dollar! Our staff of former IRS employees will work with you and make your problems go away!

They’re talking about an Offer in Compromise. It’s a real thing, and it is possible to settle your debt with the IRS for less than you owe. But it’s nowhere near that simple. And it’s certainly not automatic, nor is it available to everyone. Recent information from the IRS indicates that approximately 60% of all requests for an Offer in Compromise (OIC) are not successful in reducing the amount of the tax owed. The good news is that 40% have been accepted, and the taxpayer was allowed to compromise on the tax they owe.

If you are successful with an Offer in Compromise, you’re truly in dire straits, financially speaking. You need to prove to the IRS that you have no (or severely diminished) capacity to pay, either from your wages or assets (such as your retirement plans, bank accounts, or other assets). This review of your wherewithal is rigorous. The IRS will impose its will on how you budget – no paying off other debts in advance of the IRS debt, for example. And you may have to give up certain lifestyle items that you have become accustomed to as part of this budgeting process. If it turns out that you have the capacity to pay the debt, instead of compromising you’ll wind up with a payment plan to pay the full amount.

It’s not a fair system; it’s based on how collectible the debt is, not on whether it’s applied fairly to all taxpayers. These factors aren’t divulged in those ads – odd how that works.

Recently the IRS issued a Special Edition Tax Tip 2017-07 that details some information you need to know about how the Offer in Compromise works, in addition to several resources to help you decide if this is something that can help in your situation. The text of the Tip follows:

IRS Explains How Offer in Compromise Works

Taxpayers who have a tax debt they cannot pay may have heard that they can settle their tax debt for less than the full amount owed. It’s called an Offer in Compromise.

Before applying for an Offer in Compromise, here are some things to know:

  • In general, the IRS cannot accept a settlement offer if the taxpayer can afford to pay what they owe. Taxpayers should first explore other payment options. A payment plan is one possibility. Visit IRS.gov for information on Payment Plans – Installment Agreements.
  • A taxpayer must file all required tax returns first before the IRS can consider a settlement offer. When applying for a settlement offer, taxpayers may need to make an initial payment. The IRS will apply submitted payments to reduce taxes owed.
  • The IRS has an Offer in Compromise Pre-Qualifier tool on IRS.gov. Taxpayers can find out if they meet the basic qualifying requirements. The tool also provides an estimate of an acceptable offer amount. The IRS makes a final decision on whether to accept the offer based on the submitted application.
  • Taxpayers wishing to file for an Offer in Compromise should visit IRS website’s Offer in Compromise page for more information. There taxpayers can find step-by-step instructions as well as the required forms. Taxpayers can download forms anytime at www.irs.gov/forms or call 800-TAX-FORM (800-829-3676) and ask for Form 656-B, Offer in Compromise booklet.

Additional IRS Resources:

IRS YouTube Videos:

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