Financial Ducks In A Row • Independent financial advice: IRA, Social Security, income tax, and all things financial

Posted in: drac, IRA, qrp, qualified retirement plan, retirement plans, rollover, Roth 401(k), Roth IRA.
Tagged: IRA · qrp · rollover · roth 401 k · roth ira

Mortgage Debt Forgiveness and Taxes

Mar 12th, 2012

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When you have a debt canceled, the IRS considers the canceled debt to be be income for you, taxable just like a paycheck. There are cases where you don’t have to include all of it though, and mortgage debt forgiven between 2007 and 2012 may be partly excepted from being included as income.

The IRS recently issued their Tax Tip 2012-39, which lists 10 Key Points regarding mortgage debt forgiveness. Below is the actual text of the Tip.

Mortgage Debt Forgiveness: 10 Key Points

Canceled debt is normally taxable to you, but there are exceptions. One of those exceptions is available to homeowners whose mortgage debt is partly or entirely forgiven during tax years 2007 through 2012.

The IRS would like you to know these 10 facts about Mortgage Debt Forgiveness:

1. Normally, debt forgiveness results in taxable income. However, under the Mortgage Forgiveness Debt Relief Act of 2007, you may be able to exclude up to $2 million of debt forgiven on your principal residence.

2. The limit is $1 million for a married person filing a separate return.

3. You may exclude debt reduced through mortgage restructuring, as well as mortgage debt forgiven in a foreclosure.

4. To qualify, the debt must have been used to buy, build or substantially improve your principal residence and be secured by that residence.

5. Refinanced debt proceeds used for the purpose of substantially improving your principal residence also qualify for the exclusion.

6. Proceeds of refinanced debt used for other purposes – for example, to pay off credit card debt – do not qualify for the exclusion.

7. If you qualify, claim the special exclusion by filling out Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, and attach it to your federal income tax return for the tax year in which the qualified debt was forgiven.

8. Debt forgiven on second homes, rental property, business property, credit cards or car loans does not qualify for the tax relief provision. In some cases, however, other tax relief provisions – such as insolvency – may be applicable. IRS Form 982 provides more details about these provisions.

9. If your debt is reduced or eliminated you normally will receive a year-end statement, Form 1099-C, Cancellation of Debt, from your lender. By law, this form must show the amount of debt forgiven and the fair market value of any property foreclosed.

10. Examine the Form 1099-C carefully. Notify the lender immediately if any of the information shown is incorrect. You should pay particular attention to the amount of debt forgiven in Box 2 as well as the value listed for your home in Box 7.

For more information about the Mortgage Forgiveness Debt Relief Act of 2007, visit www.irs.gov. IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions and Abandonments, is also an excellent resource.

You can also use the Interactive Tax Assistant (ITA) available on the IRS website to determine if your canceled debt is taxable. The ITA tax you through a series of questions and provides you with responses to tax law questions.

Posted on Mar 12th, 2012

by author: jblankenship.

Posted in: 2008 Tax Year, 2009 tax year, 2010 Tax year, 2011 tax year, 2012 tax year, income tax, irs, mortgage debt.
Tagged: income tax · irs · mortgage

Calculating the PIA

Mar 9th, 2012

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WOMEN’S HISTORY MONTH (Photo credit: mademoiselle louise)

In determining your retirement benefits from Social Security, as well as those of any dependents who may claim benefits based upon your record, the Primary Insurance Amount, or PIA, is an important factor. The PIA is the amount of benefit that you would receive if you began receiving benefits at exactly your Full Retirement Age, or FRA. (see this article for information about determining your FRA).

The PIA is only one of the factors used in determining the actual amount of your retirement benefit – the other factor being the date (or rather your age) when you elect to begin receiving retirement benefits.

So, how is PIA calculated?

There are several factors that go into the calculation of the PIA. You start off with your Average Indexed Monthly Earnings (AIME – which we defined in this article about the AIME). Then, we take into account the bend points for the current year. For 2016 the bend points are $856 and $5,157. Here’s the calculation:

the first $856 of your AIME is multiplied by 90%
the amount between $856 and $5,157 is multiplied by 32%
any amount in excess of $5,157 is multiplied by 15%

Note: these are the figures for 2016. Each year the bend points are increased slightly (or most years they are), and so the PIA calculation may change.

So let’s work through a couple of examples:

Our first retiree is age 62 in 2016, and is hoping to begin taking Social Security benefits immediately upon eligibility – to get what’s coming to her. Her AIME has been calculated as $6,500. Applying the formula, we get the following:

first bend point: $770.40 ($856 * 90%)
second bend point: $1,376.32 ($5,157 – $856 = $4,301 * 32%)
excess: $201.45 ($6,500 – $5,157 = $1,343 * 15%)
For a total PIA of: $2,348.10 ($770.40 + $1,376.32 + $201.45 = $2,348.17 rounded down)

The second example retiree also is age 62 in 2016. His AIME has been calculated as $4,000. Applying the formula:

first bend point: $770.40
second bend point: $1,006.08 ($4,000 – $856 = $3,144 * 32%)
excess: $0
For a total PIA of: $1,776.40 ($770.40 + $1,006.08 = $1,776.48 rounded down)

You should note that the PIA is always rounded down to the next multiple of $0.10.

And that’s it. As mentioned, your PIA is the basis for many of your benefit calculations. The bend point amounts also control the amount of reduction the the Windfall Elimination Provision can have – for 2016 the maximum reduction for WEP is $428 per month.

Posted on Mar 9th, 2012

by author: jblankenship.

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Posted in: primary insurance amount, Social Security, social security benefits, Social Security spousal benefit, social security survivor benefits.
Tagged: primary insurance amount · Social Security

The Rollover

Mar 7th, 2012

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You’ve heard it millions of times – on the radio or tv – “when you leave your job, you should roll over your retirement account”. You may know that it makes sense (or at least you assume it makes sense, otherwise why would these folks admonish you to do so?), but do you know why it’s important? And do you have the first clue as to how to accomplish a rollover?

Why rollover? Among the reasons that it is important to rollover your retirement account when you leave employment is that you want to have control over your money. If you leave the account with the former employer, you are effectively handing over a portion of the control of your money to the administrator.

This administrator’s primary job is to ensure that the plan remains as effective and efficient as possible, for your former employer. Your interests are not taken into account at all, and in fact, many activities that the administrator undertakes (and subsequently charges the cost of to the plan accounts) are of no benefit to you whatsoever, as a former employee. By rolling your funds over to a self-directed IRA, you can make sure that the costs associated with your account’s maintenance are directly benefiting your own account.

In addition, by rolling over your retirement funds into an IRA, you now have more flexibility in the investment choices that you can utilize. Remember how your employer’s qualified plan only had five or ten mutual funds to choose from? Now, you can invest in just about any fund, stock, bond, or ETF available in the marketplace, plus some that you can dream up on your own.

How to roll over? We’ve covered (albeit briefly) the “why”, so now we’ll cover the “how”. It’s actually pretty simple, as long as you follow a couple of important rules. Both of these are related to maintaining the tax-deferred nature of your investment.

The first rule is that you should always have an account set up to receive the monies before requesting the withdrawal from your current plan. If you don’t have a place to put the money, the plan administrator will assume that you’re taking a “cash out” distribution, and they’ll withhold 20% tax on the withdrawal. The way to resolve this is to ensure that your withdrawal paperwork (with your old account) indicates a “direct rollover” is occurring. At the same time, your deposit paperwork with your new account will indicate the same. The old plan administrator may still send a check to your home address, but it will be made out to the new account custodian.

The second rule is related to the first, but this is one that you can foul up even if you’ve gotten the paperwork filled out correctly: your rollover must occur within the span of 60 days, or you’ll be penalized as if you withdrew the money to cash out the plan – 10%, plus ordinary income tax on the withdrawal.

As I indicated earlier, the current (old) plan administrator may send you a check for your rollover, made out to the new custodian – but it’s up to you to make sure that you get the check sent to the new plan custodian as soon as possible, so that there’s no danger of taking more than 60 days to complete the roll over.

The entire process is simple enough, following the steps below:

1. establish your new account
2. request a “direct rollover” withdrawal from your old plan
3. receive the rollover check
4. submit the check with the appropriate “direct rollover” deposit slip at your new account.

As you can see, the process is straightforward, but if you don’t pay close attention to what’s going on, or if one of your plan administrators (either the new one or your old one) has a special “twist” to the process, it can become a mess.

Note: steps 3 and 4 are not required if the transfer is done in a trustee-to-trustee manner, meaning that the old account administrator sends the funds directly to the new account trustee, and you never see a check. This is one of the most common ways to ensure that you don’t miss the 60-day window. For more information, see An IRA Owner’s Manual.

Posted on Mar 7th, 2012

by author: jblankenship.

Posted in: Early Distribution, eligible rollover distribution, employer plan, IRA, qrp, retirement plans, rollover.
Tagged: eligible rollover distribution · IRA · qrp · rollover

Tax Credits That Can Increase Your Refund

Mar 5th, 2012

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The IRS recently issued their Tax Tip 2012-41, which lists out some of the tax credits that are refundable. Most tax credits are not refundable, meaning that if the amount of the credit is more than your tax for the year, the credit is limited only to the amount of your tax.

For example, if you had tax payable of $1,500 and then had Education Credits, Energy Credits, and/or Foreign Tax Credits amounting to more than $1,500. Your credits will be limited to $1,500 since that’s your tax payable and the credits are not refundable.

On the other hand, there are a few credits that are refundable, as listed below in the actual text from Tax Tip 2012-41.

Four Tax Credits that Can Boost Your Refund

A tax credit is a dollar-for-dollar reduction of taxes owed. Some tax credits are refundable meaning if you are eligible and claim one, you can get the rest of it in the form of a tax refund even after your tax liability has been reduced to zero.

Here are four refundable tax credits you should consider to increase your refund on your 2011 federal income tax return:

1. The Earned Income Tax Credit is for people earning less than $49,078 from wages, self-employment or farming. Millions of workers who saw their earnings drop in 2011 may qualify for the first time. Income, age and the number of qualifying children determine the amount of the credit, which can be up to $5,751. Workers without children may qualify as well. For more information, see IRS Publication 596, Earned Income Credit.

2. The Child and Dependent Care Credit is for expenses paid for the care of your qualifying children under age 13, or for a disabled spouse or dependent, while you work or look for work. For more information, see IRS Publication 503, Child and Dependent Care Expenses.

Note: this credit was incorrectly identified in the IRS Tax Tip as refundable. It is not refundable – sorry for the confusion.

3. The Additional Child Tax Credit is for people who have a qualifying child. The maximum credit is $1,000 for each qualifying child. You can claim this in addition to the Child and Dependent Care Credit. The Child Tax Credit is non-refundable, but if you qualify you can utilize the Additional Child Tax Credit to receive the remainder of the non-refundable credit as a refund. See IRS Publication 972, Child Tax Credit for more details.

4. The Retirement Savings Contributions Credit, also known as the Saver’s Credit, is designed to help low-to-moderate income workers save for retirement. You may qualify if your income is below a certain limit and you contribute to an IRA or workplace retirement plan, such as a 401(k) plan. The Saver’s Credit is available in addition to any other tax savings that apply. For more information, see IRS Publication 590, Individual Retirement Arrangements (IRAs).

Note: this credit was incorrectly identified in the IRS Tax Tip as refundable. It is not refundable – sorry for the confusion.

There are many other tax credits that may be available to you depending on your facts and circumstances. Since many qualifications and limitations apply to various tax credits, you should carefully check your tax form instructions, the listed publications and additional information available at www.irs.gov. IRS forms and publications are available on the IRS website at www.irs.gov and by calling 800-TAX-FORM (800-829-3676).

Posted on Mar 5th, 2012

by author: jblankenship.

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Posted in: 2011 tax year, EITC, income tax credit, IRA, qualified retirement plan, saver's credit, tax credits.
Tagged: 2011 tax year · EITC · income tax credit · tax credits

Example Using Spousal Benefits and Delayed Retirement Credits for Social Security

Mar 2nd, 2012

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Note: with the passage of the Bipartisan Budget Act of 2015 into law, File & Suspend and Restricted Application have been effectively eliminated for anyone born in 1954 or later. If born before 1954 there are some options still available, but these are limited as well. Please see the article The Death of File & Suspend and Restricted Application for more details.

This particular situation was presented to me by a reader. Since the facts represent a fairly common situation that we haven’t addressed here in the past, I thought I’d present it here for discussion.

Here’s the original question (altered a bit for clarity):

My wife and I are age 65 & 67 respectively. We’re both still working part-time, and my wife has now 20 years of earnings on her Social Security record. At this point her PIA is approximately 45% of my PIA, and increasing with each additional year of earnings added to her record. We are in a position to delay retirement benefits to age 70 to increase our Delayed Retirement Credits (DRCs) to the maximum. What is a good strategy for us to maximize Social Security retirement and Spousal Benefits?

Given that the wife in this example has a PIA equal to something less than half of the husband’s PIA, once the wife reaches FRA she can begin receiving the Spousal Benefit alone, which would amount to 50% of the husband’s PIA. The husband will need to file and suspend in order for her to do this, but as we know, this will have no negative consequence to either of the retirement benefits in the future.

As the wife’s own benefit increases due to her additional work record and the Delayed Retirement Credits (DRCs), her own retirement benefit will continue to increase in value. Eventually there will be a crossover point when the Spousal Benefit is actually less than her retirement benefit. At that time she can choose to switch over to her retirement benefit (instead of the Spousal Benefit) or she could continue to receive the Spousal Benefit and earn DRCs.

As it turns out for this couple, the crossover point will occur when they reach the ages of 68 and 70. At that time, he will go ahead and file for his retirement benefit since it has maxed out the DRCs; she will probably continue to receive the Spousal Benefit and allow her own retirement benefit to continue accruing DRCs.

It should be noted that if she chooses to switch over to her own retirement benefit at some point, her husband could file solely for the Spousal Benefit based upon his wife’s record – if he is under age 70. Once he reaches age 70 there is no further increase to his retirement benefit from DRCs, so he may as well go ahead and take his retirement benefit.

Posted on Mar 2nd, 2012

by author: jblankenship.

Posted in: retirement benefits, Social Security, Social Security spousal benefit, spousal benefits.
Tagged: retirement benefits · social security benefits · spousal benefit

5 Facts You Need to Know About Your Retirement Plan

Feb 29th, 2012

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Many of us are covered by one or more types of defined contribution retirement plans, such as a 401(k), 403(b), 457, or any of a number of other plans. What many of these plans have in common is that they are referred to as Cash Or Deferred Arrangements (CODA), as designated by the IRS. These plans are also often referred to as Qualified Retirement Plans (QRPs). Each type of plan has certain characteristics that are a little different from other plans, but most of them have the common characteristic of deductibility from current income and deferred taxation on growth. (Note that this list of plans does not include IRAs. IRAs have certain characteristics that are completely different from QRPs, and vice-versa.)

1. Each dollar you defer is worth more than a dollar. It’s true. As you defer money into your retirement account, each dollar that you defer could be worth as much as $1.54. How, you might ask?

Since you are not taxed on each dollar that has been deferred into the retirement account, your “take home” pay only reduces by the amount that is left over after taxation. For example, if you’re in the 25% income tax bracket, generally your income will only reduce by 75¢ for every dollar that you defer into your retirement plan. Therefore, the 75¢ that you’ve effectively “spent” is worth 33% more ($1.00) in your retirement account.

If you happened to be in the 35% income tax bracket, this works out to a 54% increase in the value of each dollar deferred. This doesn’t even take into account the potential for matching dollars from your employer!

2. Matching – FREE MONEY. Well, it’s not exactly free, you must defer some funds in order to take advantage of it, but other than that, your employer is actually chomping at the bit to give you this money. The reasons can be far-reaching, but the point is that it’s literally yours for the taking (and totally yours if you’re vested in the plan). It should be noted that some companies do not match your funds at any level in a plan.

So, what should you do about this? If you aren’t currently participating in your company’s 401(k) or other deferred compensation plan and they match your funds, you are throwing money away by not participating. Depending upon the options in your plan, you could be turning your back on as much as a 100% return on your investment – guaranteed! Everyone should take advantage of AT LEAST the matched portion of your deferred compensation plan. After that, it may make good sense to put money aside in a Roth IRA (up to the maximum annual amount), before adding more to your deferral to max out your 401(k).

3. Don’t Overload On Company Stock. Even (especially?) if you’re in a company where the stock has experienced dramatic increases in recent history, you need to make sure that your overall exposure to any one company is limited. A rule of thumb that I use is: no more than 5% of your overall net worth should be invested in any one company. If you are inclined to have a larger stake in your company because you work there and enjoy the sense of ownership, I wouldn’t put any more than 10% in that stock. The figure is doubled for the company that you work in because, at least presumably, you are more in tune with the value and internal events of that company and could make adjustments if an event were coming up that could seriously impact your holdings.

Of course, the reason behind this is to limit your exposure to the ebb and flow of a single company’s stock price. For example, what if you held stock in one company that amounted to 30% of your overall net worth, and that stock took a major hit of a 25% price reduction? This one event would have the impact of yanking down your net worth balance by 7.5% – quite a serious impact, to say the least. The folks at Enron (and countless other dot-com craze companies) found out the hard way how much damage can be done by having too large of an exposure in a single company.

4. Diversify, diversify, diversify. Most of us understand the concept of diversification, but how do you actually accomplish it?

In order to properly diversify, you need to review the available investment choices in your plan, and then use those choices to spread your investments among capitalization categories (large-cap and small-cap), as well as between value-oriented and growth oriented, as well as domestic companies and international companies. You should also consider what amount of fixed-income investment (bonds) makes the most sense in your portfolio.

Keep in mind, diversification doesn’t simply mean you put an equal amount of money in each available choice of investment. Each person needs to consider this individually, in respect to their overall portfolio and risk tolerance, including assets held outside of the deferred compensation plan, such as other IRAs or taxable accounts. You need to make a decision as to what allocation makes the most sense for you and apply it across all of your accounts. If you’re fairly young and have a lot of years to grow your funds (as well as recover from any downturns), you can probably take on a greater amount of risk. If you’re nearing retirement, most likely your risk profile will be much less risky.

5. Don’t Take A Loan. No matter how tempting it is, taking a loan out from your qualified retirement plan in more cases than not, results in derailing your hard work in saving and building up your account. Not only are you strapped with having to pay back the funds to your account (with interest), but you have also given up whatever growth might occur within your account (since the funds are being used for another purpose).

Experience tells us that you would be much better off to temporarily suspend or reduce your contributions to your retirement plan in order to save up money instead of taking a loan from your retirement plan. It may take a little while longer, but you’ll probably appreciate it a bit more as a result of your saving.

Posted on Feb 29th, 2012

by author: jblankenship.

Posted in: 401 k 403 b, employer plan, qrp, qualified retirement plan, retirement accounts, retirement plans.
Tagged: 401 k · employer plan · qrp · qualified retirement plan · retirement accounts

11 Facts About the Child Tax Credit (2011)

Feb 27th, 2012

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The IRS recently issued their Tax Tip 2012-29, which provides some key points about the Child Tax Credit.

Below is the text of the tip:

The Child Tax Credit is available to eligible taxpayers with qualifying children under age 17. The IRS would like you to know these eleven facts about the Child Tax Credit.

Amount With the Child Tax Credit, you may be able to reduce your federal income tax by up to $1,000 for each qualifying child under age 17.
Qualification A qualifying child for this credit is someone who meets the qualifying criteria of seven tests: age, relationship, support, dependent, joint return, citizenship and residence.
Age Test To qualify, a child must have been under age 17 – age 16 or younger – at the end of 2011.
Relationship Test To claim a child for purposes of the Child Tax Credit, the child must be your son, daughter, stepchild, foster child, brother, sister, stepbrother, stepsister or a descendant of any of these individuals, which includes your grandchild, niece, or nephew. An adopted child is always treated as your own child. An adopted child includes a child lawfully placed with your for legal adoption.
Support Test In order to claim a child for this credit, the child must not have provided more than half of his/her own support.
Dependent Test You must claim the child as a dependent on your federal tax return.
Joint Return Test The qualifying child cannot file a joint return for the year (or files it only as a claim for refund). Note: this means that a qualifying child can file a joint return if only filing it for a refund – for no other purpose, no other credits, etc..
Citizenship Test To meet the citizenship test, the child must be a US citizen, US national or US resident alien.
Residence Test The child must have lived with you for more than half of 2011. There are some exceptions to the residence test, found in IRS Publication 972, Child Tax Credit.
Limitations The credit is limited if your modified adjusted gross income is above a certain amount. The amount at which this phase-out begins varies by filing status. For married taxpayers filing a joint return, the phase-out begins at $110,000. For married taxpayers filing a separate return, it begins at $55,000. For all other taxpayers, the phase-out begins at $75,000. In addition, the Child Tax Credit is generally limited by the amount of the income tax and any alternative minimum tax you owe.
Additional Child Tax CreditIf the amount of your Child Tax Credit is greater than the amount of income tax you owe, you may be able to claim the Additional Child Tax Credit.The Additional Child Tax Credit is not available for any of the Child Tax Credit that was reduced by MAGI Limitation (#10) – this credit is only to replace any Child Tax Credit limited by the amount of tax you owe. In other words, although the Child Tax Credit is not a refundable credit, any amount limited by the non-refundability can be replaced by the Additional Child Tax Credit.
The Additional Child Tax Credit is applied for via Form 8812, and the maximum additional Child Tax Credit is as follows:

Taxpayers with one or two children. The lesser of:
* The disallowed portion of the regular child tax credit, or
* 15% of the taxpayer’s earned income in excess of $3,000

Taxpayers with three or more children. The lesser of:
* The disallowed portion of the regular child tax credit, or
* The larger of:
* 15% of earned income in excess of $3,000.
* FICA and Medicare tax paid minus earned income credit.

Posted on Feb 27th, 2012

by author: jblankenship.

Posted in: #noTOP, 2011 tax year, income tax, income tax credit, tax credits.
Tagged: 2011 tax year · income tax · income tax credit · tax credits

8 Things to Consider Before Rolling Over Your 401(k)

Feb 22nd, 2012

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K’nex (Photo credit: -Snugg-)

Employers have been giving us lots of opportunities to make this decision of late: when leaving an employer, whether voluntarily or otherwise, we have the opportunity to rollover the qualified retirement plan (QRP) such as a 401(k) from the former employer to either an IRA or a new employer’s QRP.

This decision shouldn’t be taken lightly – although often it is the best option for you. Moving to an IRA gives you much more control over your destiny, so to speak, by allowing you to choose from the entire universe of allowable investment choices. Using your new employer’s QRP can give you a better sense of control over the account as well, although the flexibility of an IRA is generally preferable to another QRP.

But sometimes it makes the most sense to leave your money in the old plan. Listed below are eight possible reasons that you might want to do just that.

If you are happy with your former employer’s plan, consider it well-managed, low cost, and possibly with some investment options that are not readily available (such as desirable mutual funds that are closed to new investors), you may want to leave the plan intact. This would be especially beneficial if you don’t have another employer plan to roll over into, or you are squeamish about establishing your own IRA.
If you have commingled deductible and non-deducted IRA contributions in your outside IRA accounts, having an active 401(k) plan can help you to “separate” the deductible IRA assets from the non-deducted. See this article for more information. Essentially this benefit gives you a way to bypass the “little bit pregnant” rule wherein the IRS treats all IRA funds pro-rata taxable and non-taxable when making distributions… a common issue when doing a Roth IRA conversion, for example. If you don’t have an active 401(k) plan available, this option is lost.
If you have an investment in your former employer’s stock in your 401(k), you need to consider the ramifications of utilizing the Net Unrealized Appreciation (NUA) option – before doing a rollover. The point is, if you’ve taken even a partial rollover of your 401(k) in a prior year, the NUA treatment is no longer available to you.
If you think you may be returning to this employer, it might make sense to leave your funds where they are. This is especially true for government employers with section 457 plans – due to the nature of these plans’ ability to provide you with retirement income without penalty much earlier than an IRA or a 401(k) plan could. With the vagaries of governmental policy changes, if you’ve withdrawn and closed your account and come back to work for the same agency, the old plan may no longer be available to you since you’re a “new” participant.
If you’re in the year when you’ll reach age 55 or older, and are not moving to a new employer (either retiring or undertaking self-employment), maintaining the 401(k) plan gives you an option to begin taking distributions prior to age 59½ without penalty. If you move these funds over to an IRA, this option is lost.
On the off-chance that you might need a loan from your retirement funds, you should know that IRAs do not have this provision. Retain at least some balance in the plan if you might need this option – but also you should check with your plan administrator to see if this option is available for non-employee plan participants, because it might not be (and actually, it likely is not). But keeping in mind #4, if you’ve maintained a healthy balance in the plan and you return to work with this same employer, you’d have a much larger account to work with if you needed to borrow.
Funds in a 401(k) account are protected by ERISA – and as such are generally not available to creditors. Depending upon the state you live in, IRA assets may be available to your creditors in the event of a bankruptcy. At any rate, ERISA protection is pretty much an absolute, so this is yet another reason you might consider leaving funds in a former employer’s 401(k) plan. Funds moved from an ERISA-protected account can carry the protection on, but new contributions to the account do not.
Take your after-tax contributions out first, if your plan happens to include these. If you’ve made after-tax contributions, as some plans allow, it makes sense to separate these contributions from the pre-taxed amounts. You can convert these contributions directly over to a Roth IRA in most cases. This is because the 401(k) isn’t subject to the “little bit pregnant” rule alluded to earlier. Once you’ve removed the after-tax contributions and put them into a Roth IRA, you can then rollover the rest of your 401(k) if it makes sense.

Posted on Feb 22nd, 2012

by author: jblankenship.

Posted in: 401 k, 401 k 403 b, employer plan, IRA, qrp, qualified retirement plan, Roth Conversion.
Tagged: employer plan · IRA · qrp · qualified retirement plan

Book Review: Investment Mistakes Even Smart Investors Make

Feb 13th, 2012

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Investment Mistakes Even Smart Investors Make

This book is a must read for all investors. Author Larry Swedroe has demonstrated once again how he has a full understanding of the average investor’s situation, by listing 77 real-life mistakes that all of us have encountered at one time or another.

What’s more, Mr. Swedroe also takes the time to provide examples of where the mistakes listed have damaged investors’ situations, as well as to show how the investors could have avoided the mistakes.

Larry Swedroe, for the uninitiated, is a best-selling author of many books which explain his concepts of investing – including The Only Guide series, The Quest for Alpha, and others. These books cover primarily passive investing, or investing without active management, and as such he is a sort of guru in the self-managed investment world.

The listed mistakes in this book include everything from hindsight bias (believing after the fact that a particular occurrence was predictable) to believing that there are experts who can predict the future, as well as believing “this time it’s different”.

The list of the types of mistakes is broken up into four categories: Understanding and Controlling Human Behavior is Important for Investment Success; Ignorance is Not Bliss; Mistakes Made When Planning an Investment Strategy; and Mistakes Made When Developing a Portfolio.

Anyone who owns an IRA or invests in a 401(k) can benefit from this list of mistakes. Often these mistakes can be a part of our investing life without even knowing it – like having too many eggs in one basket (it’s not as easy realize as you think), or being too conservative (it’s easier to do than you think). Swedroe’s insights are helpful in explaining how the mistake can come to pass, as well as how to avoid these mistakes in the future.

All of this is designed to help you to become a better, more successful and less-stressed investor… all the way down to the last mistake – Do You Keep Repeating the Same Mistakes? Do yourself a favor and pick up a copy – it will be well worth the effort and your investing habits will be much better off for it.

Posted on Feb 13th, 2012

by author: jblankenship.

Posted in: Book review, financial planning, investing.
Tagged: book review · financial planning · investment

Working While Receiving Social Security

Feb 10th, 2012

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[Hank Gowdy, Dick Rudolph, Lefty Tyler, Joey Connolly, Oscar Dugey (baseball)] (LOC) (Photo credit: The Library of Congress)

For many folks, starting to receive Social Security as early as possible is important – even if they’re still actively working and earning a living.

Something happens when you do this though: depending on how much you’re earning, you will be giving up a portion of the Social Security benefit that you would otherwise receive. Up to the year that you will reach Full Retirement Age, for every two dollars that you earn over the annual limit ($14,640 for 2012, or $1,220 per month), your Social Security benefit will be reduced by one dollar.

Then in the year you will reach Full Retirement Age (FRA) there is a different income limit – actually $3,240 per month. For every three dollars over that limit, your Social Security benefit will be reduced by one dollar – up until the month that you actually reach FRA. Once you’ve reached FRA, there is no income limit, and you can earn as much as you want, without any of the reductions that are applied to earnings prior to FRA.

These reductions aren’t lost – you’ll actually get credit for them later on at FRA. So if you’re earning enough (for example) to reduce your benefit down to a point where your benefit is eliminated, you’ll get credit for that “lost” month once you reach FRA.

As you most likely already know, your Social Security benefit is reduced based upon the number of months prior to FRA that you’ve applied for and begin receiving benefits. For every month that your benefit is eliminated (or reduced and withheld by SSA) prior to FRA, these months will be credited back to your account, reducing the number of months that were originally used to calculate your reduced early retirement benefit.

As with all of these explanations, an example is in order. Dick, age 62, has a Primary Insurance Amount of $2,000. When he files for benefits at age 62 his benefit is reduced by 25%, to $1,500. Dick is still working, and his job pays him $60,000 per year ($5,000 per month). With that income, Dick’s Social Security benefit will be reduced by $2 for each dollar over $1,220 that he earns. So $5,000 minus $1,220 equals $3,780, so his benefit will be reduced by $1,890 – more than his benefit. This means his benefit will be completely withheld.

When Dick reaches FRA, assuming he’s continued earning at that same pace up to that point, he will begin receiving his benefit at the same amount as if he had waited until FRA to apply for the benefit. This is because he’s gotten credit back for all of those months that he had his benefit withheld.

Why would Dick do this, you might ask? One reason might be if he had dependents, such as his wife and/or children, that could receive benefits based on his record if he’s actively filed. Even though his benefit is being withheld, the dependents’ benefits can continue – these benefits are limited by the income of the individual receiving them. So if his wife was receiving Spousal Benefits based on his record, she would have the same earnings limits as listed above, and the same goes for the children.

Posted on Feb 10th, 2012

by author: jblankenship.

Posted in: earnings test, Social Security, social security benefits, social security retirement.
Tagged: earnings limits · social security benefits · social security retirement

Ordering Rules for Roth IRA Distributions

Feb 8th, 2012

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Tax (Photo credit: 401K)

Did you know that there is a specific order for distributions from your Roth IRA? The Internal Revenue Service has set up a group of rules to determine the order of money, by source, as it is distributed from your account. This holds for any distribution from a Roth account.

Ordering rules

First, over-contributions or return of your annual contribution for the tax year. This means that if you’ve made a contribution to the Roth IRA in the tax year, the first money that you withdraw from the account will be the money that you contributed that year. If you over-contributed to your account a prior year. Growth on this over-contribution or annual contribution needs to be removed at this time as well, with tax and penalty paid as required.

Second, regular annual contributions to the account. The next money that comes out is the total of all of the money you’ve contributed to the Roth IRA over the years. Of course, this is reduced by all previous distributions from the account. This amount would include rolled over contribution amounts from other Roth IRA or Roth 401(k) accounts. Growth (interest, capital gains, or dividends) on these contributions comes out later.

Third, tax-free converted amounts from IRAs or 401(k) accounts would be distributed. Only the amount of the conversion is counted at this point. As with the contributions, the growth or earnings within the account comes out last.

Fourth, conversion amounts that were taxed at the time of the conversion are distributed.

Fifth and last, earnings, capital gains, and growth on your contributions will be distributed. This is everything left in the account after the other categories of funds have been removed.

Here’s an example: Jane, age 50, has a Roth IRA with a balance of $50,000. She has made annual contributions to the account over the years in the amount of $25,000 – part of which was a contribution this tax year of $5,000. She also made a conversion into this account with $10,000, all taxed, from an IRA a couple of years ago.

When Jane takes money out of the account, she can remove this year’s contribution of $5,000 first of all – no tax on that distribution. After that, the remaining $20,000 of contributions to the account would come out, also tax free. This money is followed by her conversion of $10,000. If it’s been less than five years since the conversion, there will be a 10% penalty on the conversion since she’s under age 59½. Any withdrawal above and beyond $35,000 would represent growth and earnings on the account, which would also be subject to the penalty since she’s under age 59½.

Posted on Feb 8th, 2012

by author: jblankenship.

Posted in: contribution limit, conversion, IRA, ira contribution limits, Roth Conversion, Roth IRA, roth ira contributions.
Tagged: contribution limit · IRA · roth ira · roth ira conversion

Avoid Email Scammers Claiming to be IRS

Feb 6th, 2012

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The IRS recently produced Tax Tip 2012-08, which talks about scams you need to be aware of, really heinous contacts where the scammers pretend to be the IRS. But here’s the key: the IRS doesn’t use email as the regular communication to deliver notices of deficiency, requests for additional information, and the like. The IRS is big about the paper notice – you’ll recognize it immediately, with the official IRS seal and all.

The information that the IRS presents is good to know, you should be familiar with what they have to say.

Here is the text of the tax tip:

Don’t be Scammed by Cyber Criminals

The Internal Revenue Service receives thousands of reports each year from taxpayers who receive suspicious emails, phone calls, faxes or notices claiming to be from the IRS. Many of these scams fraudulently use the IRS name or logo as a lure to make the communication appear more authentic and enticing. The goal of these scams – known as phishing – is to trick you into revealing your personal and financial information. The scammers can then use your information – like your Social Security number, bank account or credit card numbers – to commit identity theft or steal your money.

Here are five things the IRS wants you to know about phishing scams.

The IRS never asks for detailed information like PIN numbers, passwords or similar secret access information for credit card, bank or other financial information.
The IRS does not initiate contact with taxpayers by email to request personal or financial information. If you receive an email from someon claiming to be the IRS or directing you to an IRS site:

Do not reply to the message.
Do not open any attachments. Attachments may contain malicious code that will infect your computer.
Do not click on any links. If you clicked on links in a suspicious email or phishing website and entered confidential information, visit the IRS website and enter the search term ‘identity theft’ for more information and resources to help.

The address of the official IRS website is www.irs.gov. Do not be confused or misled by sites claiming to be the IRS but ending with .com, .net, .org, or other designations instead of .gov. If you discover a website that claims to be the IRS but you suspect it is bogus, do not provide any personal information on the suspicious site and report it to the IRS.
If you receive a phone call, fax, or letter in the mail from an individual claiming to be from the IRS but you suspect they are not an IRS employee, contact the IRS at 1-800-829-1040 to determine if the IRS has a legitimate need to contact you. Report any bogus correspondence. You can forward a suspicious email to phishing@irs.gov.
You can help shut down these schemes and prevent others from being victimized. Details on how to report specific types of scams and what to do if you’ve been victimized are available at www.irs.gov. Click on “phishing” on the home page.

Posted on Feb 6th, 2012

by author: jblankenship.

Posted in: irs.
Tagged: irs

Facts About the 72t Early Distribution

Feb 1st, 2012

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

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

Methods of Distribution

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

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

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

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

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

An Important Note

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

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

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

Posted on Feb 1st, 2012

by author: jblankenship.

Posted in: Early Distribution, IRA, retirement plan, traditional ira.
Tagged: early retirement · IRA · retirement plan · traditional ira

What Changed About the Earned Income Credit?

Jan 30th, 2012

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I’ve received a lot of questions about this. Apparently as folks file their returns for the year, they are finding a difference in the amount of refund that they are due to receive this year versus last year. And as they look for answers, they often focus on the Earned Income Credit (EIC) and wonder if something changed.

The answer is – very little changed. Certainly nothing that would have a significant impact on your income tax refund. There was one significant change, in that beginning in 2011 there was no advance payment of the EIC – in years past it was an option available for the taxpayer to receive his or her EIC in advance payments throughout the year rather than waiting until the tax return has been filed. Beginning with 2011, you have to wait to receive the EIC payment.

Other than that, the credit tables changed slightly, but this would likely increase your EIC rather than decrease it.

Nothing else changed about the EIC in 2011. You need to look elsewhere for whatever is different about your return.

Nothing is changing for 2012 either. Beginning with 2013 (under current law) the additional EIC available for the third child will no longer be available, and we’ll revert back to the way the old rules worked. But let’s wait until next year to worry about that one.

Hope this helps.

Posted on Jan 30th, 2012

by author: jblankenship.

Posted in: 2011 tax year, earned income credit, EIC, EITC, income tax credit.
Tagged: 2011 tax year · earned income credit · EITC · income tax credit

When to File For Social Security Benefits

Jan 27th, 2012

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All future Social Security recipients face this question at some point: When should I file for benefits?

As you are likely aware, age 62 is the earliest that you can file for benefits. By filing at this age, you will begin receiving your benefit at a reduced amount – perhaps as much as 30% reduced.

Waiting to file until your Full Retirement Age (FRA) will allow you to receive the full benefit amount, without reductions. You could also wait until age 70 to file for benefits, which would result in an overall increase to your monthly benefit amount, by as much as 32% in some cases. Granted, you will have foregone several years’ worth of payments if you wait to file at some age later than 62, but on average, it all works out about the same (with a few exceptions).

The way that these reductions and increases are designed is to ensure that, on average, all Social Security recipients, regardless of the age that they begin receiving benefits, ultimately receive roughly the same amount of benefits during their lifetimes. This is all calculated by actuaries, and it involves the population’s average lifespan.

So if you start receiving your benefit earlier, even though it’s reduced you’re receiving it for a longer period of time than waiting until later. On the other hand, if you delay filing until FRA or age 70, your benefit is greater each month, but you’ll be receiving it for a shorter period of time. Eventually these strategies “cross over” – that is, one method begins to work more in your favor than another – at around age 82.

What I mean by that is that, filing earlier at the reduced rate will pay you more in overall benefits up to age 82, at which point the later filing ages will begin paying you more over your lifetime. If you take into account the annual cost-of-living adjustments (COLAs), the break-even point is actually quite a bit lower, possibly as early as age 76. This is due to the fact that the COLA is a percentage applied to your monthly benefit – and if your monthly benefit is reduced by filing early, your COLA adjustments will be smaller as well, and vice versa when you file later.

So if you plan to live past age 76, it most likely is in your best interest to wait until the latest point to file for your benefit. And if you need more reasons to consider delayed application, read on.

Survivor Benefits

One additional reason that you might want to delay applying for your benefit is if you have family members that will depend upon your benefit upon your passing. This is due to the fact that your survivors’ benefits are based upon the actual benefit that you were receiving at your death. So, if you delayed filing for benefits and therefore received a higher benefit amount, your surviving spouse (and other family members, if eligible) will receive a higher benefit amount for the remainder of his or her life, assuming that the Survivor Benefit is greater.

This gives you another reason that delaying benefits could be the better option. Otherwise, if your benefit is the same as or smaller than your spouse’s benefit, or if you don’t have a spouse, then it’s up to you: if you think you’ll outlive the average, it’s better to wait. If you don’t think you’ll live that long, then start as early as you like.

* The above review doesn’t take into account a situation where you may still be working while receiving Social Security retirement benefits. I’ll cover that in another article.

Posted on Jan 27th, 2012

by author: jblankenship.

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Posted in: cost of living adjustment, early retirement, social security benefits, social security survivor benefits.
Tagged: cost of living adjustment · early retirement · social security survivor benefits

Pre-Death Planning: Roth Conversion

Jan 25th, 2012

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Financial planning often requires us to face our own certain demise – something that we often don’t want to do, but still a certainty that we all must face.

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

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

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

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

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

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

Posted on Jan 25th, 2012

by author: jblankenship.

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Posted in: conversions, estate tax, financial planning, IRA, qrp, qualified retirement plan, Roth conversion, Roth IRA, roth ira conversion.
Tagged: estate tax · IRA · roth ira conversion

The Social Security Survivor Benefit – Part 2

Jan 20th, 2012

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Note: you can find the first part of this discussion of Social Security Survivor Benefits at the link. Part 1 covered the basics of Survivor Benefits, and this article covers other considerations with the Survivor Benefit, including non-spouse survivor’s benefits and coordinating the Survivor Benefit with your own benefit. As mentioned in the prior articles, don’t expect to fully understand these calculations and definitions in the first run-through. Check over the other articles (Part 1 here, Spouse Benefits here and especially the further explanation of Spouse Benefits here) for more information, and post questions in the comment section if they come up.

Coordinating the Survivor Benefit With Your Own Benefit

The Survivor Benefit is exclusive of the surviving spouse’s own retirement benefit. If the surviving spouse is eligible for a retirement benefit that is greater than the Survivor Benefit, only the greater of the two will be payable.

Technically the surviving spouse can choose between the two benefits, if he or she is eligible for both at the same time. This can work to the surviving spouse’s advantage if the Survivor Benefit was taken early. By starting the Survivor Benefit early, the Surviving Spouse could wait to take his or her retirement benefit, allowing this retirement benefit to earn the delayed retirement credits up to age 70. This generally amounts to an increase in the retirement benefit of 8% for each year delayed beyond Full Retirement Age.

Here’s an example – Dick and Jane, both age 62 with retirement benefits available when they reach Full Retirement Age of $2,000 and $1,300, respectively. Neither of them has filed for Social Security retirement or Spousal Benefits. Dick has recently passed away.

If we run the calculation, we find that Dick’s current-age benefit would have been 75% of his Full Retirement Age benefit of $2,000 since he would be 62 at this date. (You can take my word for this reduction, or you could look it up on the table in the earlier article.) Then, if Jane was to apply for Survivor Benefits at this age, her benefit would be further reduced by the early filing, a 19% reduction from the table above.

So here’s the calculation for the Survivor Benefit: Dick’s Full Retirement Age Benefit is $2,000, reduced to 75%, or $1,500. That amount is then reduced by the 19% reduction factor, since Jane is filing early for Survivor Benefits, to total $1,215.

Notice that Jane’s own benefit at Full Retirement Age would be greater than this reduced Survivor Benefit – but at this point, her own benefit would be 75% of $1,300, or $975. So Jane could start taking the reduced Survivor Benefit now, and then later at Full Retirement Age she could switch over to her own retirement benefit, which would be the full $1,300 (plus Cost-of-Living Adjustments), or even later to age 70 when the delayed retirement credits would apply, making her own benefit even greater.

Non-Spouse Dependents

Survivor Benefits aren’t only for spouses. Other dependents can be eligible for Survivor Benefits as well. These dependents include children, grandchildren, and even parents, if they qualify. Just like leaving a sinking boat, children first.

Children

The children of a deceased Social Security participant can be eligible for a Survivor Benefit of 75% of the participant’s Primary Insurance Amount or PIA (effectively the amount of benefit that the participant would receive at Full Retirement Age) if the child is under age 18. As long as the child was the dependent of the deceased participant, whether his or her own son or daughter, step-child, or grandchild, and the deceased participant provided at least half of the support for the child, this Survivor Benefit is available. The child didn’t have to live with the late parent to be eligible.

In addition, the surviving mother or father of the dependent child described above is also eligible for a Survivor Benefit at any age, equal to 75% of the Primary Insurance Amount of the deceased participant. This benefit is available until the child or children are age 16 (no age limit if the child is disabled and entitled to benefits). The only remaining qualification is that the surviving spouse and the deceased participant must have been married for at least 9 months (less if the death is accidental). A divorced spouse can receive this benefit if he or she was married to the decedent for at least 10 years.

Parents

The parents of a deceased participant may be eligible for Survivor Benefits as well, if they were considered dependents of the deceased. If the parents were receiving more than half of their support from the deceased participant and they are over age 62, they can be eligible for this benefit.

If there is only one parent surviving the participant, the Survivor Benefit is equal to 82.5% of the Primary Insurance Amount of the deceased participant. If there are two surviving parents and both are eligible, each would receive a benefit of 75% of the Primary Insurance Amount.

This benefit is exclusive to any retirement benefit that the parents may have available to them. If the parent is eligible for a retirement benefit that is greater than the Survivor Benefit, he or she (or both of them) may receive the Survivor benefit at age 62 (with no reduction) and then later switch over to the retirement benefit at Full Retirement Age or later.

Maximum Family Benefit

Each of these Survivor’s Benefits could be limited by a Maximum Family Benefit that each family unit must adhere to. Essentially there is a limit prescribed by the Social Security Administration on the amount of benefits, based upon the deceased participant’s Primary Insurance Amount (a good explanation of the Primary Insurance Amount and Full Retirement Age can be found by clicking this link). The Maximum Family Benefit ranges between 150% and 180% of the Primary Insurance Amount. Once total benefits exceed the limit, each recipient’s benefit is reduced by the same ratio down to the limit. For a detailed explanation of the Maximum Family Benefit, click the link.

So that completes our discussion of Survivor Benefits. For more information on any of these factors, click the links within the text above – and you can also find all of this information in the book A Social Security Owner’s Manual. If you have comments and questions, I invite you to leave post them below and we’ll try to work out answers for you.

Posted on Jan 20th, 2012

by author: jblankenship.

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Posted in: social security benefits, social security survivor benefits, spousal benefits.
Tagged: social security benefits · social security survivor benefits

Net Unrealized Appreciation Treatment

Jan 18th, 2012

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

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

The Way It Works

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

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

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

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

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

An Example

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

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

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

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

Basis Allocation Twist

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

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

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

Posted on Jan 18th, 2012

by author: jblankenship.

Posted in: capital gains tax rates, IRA, net unrealized appreciation, NUA.
Tagged: IRA · net unrealized appreciation · NUA

Do You Need to File a Tax Return This Year?

Jan 9th, 2012

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Have you ever wondered if it was actually necessary to file a tax return? Perhaps your income is relatively low, and so you wonder if it’s really required of you to file a return.

Often it’s not entirely a case of a return being required, but rather it might be in your best interest to file a return in order to receive certain credits against your income. Recently the IRS issued their TAX TIP 2012-02 which goes over some of the things you need to be aware of when considering if it’s necessary or in your best interest to file a return. Portions of this TIP are listed below, with additional information added.

Do I Need to File a Tax Return This Year?

You are required to file a federal income tax return if your income is above a certain level, which varies depending on your filing status, age and the type of income you receive. However, the Internal Revenue Service reminds taxpayers that some people should file even if they aren’t required to because they may get a refund if they had taxes withheld or they may qualify for refundable credits.

The amount of income that a couple filing jointly (filing status Married Filing Jointly) with only the Standard Deduction and only the two exemptions (no child exemptions) without needing to file is $19,000 for 2011. For single folks (filing status Single) using the Standard Deduction and one exemption, the amount of income is $9,500 for 2011. These are only general rules of thumb, if you’re near that level of income you’ll want to spend some more time on it to be sure.

To find out if you need to file, check the Individuals section of the IRS website at www.irs.gov or consult the instructions for Form 1040, 1040A or 1040EZ for specific details that may help you determine if you need to file a tax return with the IRS this year. You can also use the Interactive Tax Assistant available on the IRS website. The ITA tool is a tax law resource that takes you through a series of questions and provides you with responses to tax law questions.

Even if you don’t have to file for 2011, here are six reasons why you may want to:

1. Federal Income Tax Withheld You should file to get money back if your employer withheld federal income tax from your pay, you made estimated tax payments, or had a prior year overpayment applied to this year’s tax.

2. Earned Income Tax Credit You may qualify for EITC if you worked, but did not earn a lot of money. EITC is a refundable tax credit; which means you could qualify for a tax refund. To get the credit you must file a return and claim it.

3. Additional Child Tax Credit This refundable credit may be available if you have at least one qualifying child and you did not get the full amount of the Child Tax Credit.

4. American Opportunity Credit Students in their first four years of postsecondary education may qualify for as much as $2,500 through this credit. Forty percent of the credit is refundable so even those who owe no tax can get up to $1,000 of the credit as cash back for each eligible student.

5. Adoption Credit You may be able to claim a refundable tax credit for qualified expenses you paid to adopt an eligible child.

6. Health Coverage Tax Credit Certain individuals who are receiving Trade Adjustment Assistance, Reemployment Trade Adjustment Assistance, Alternative Trade Adjustment Assistance or pension benefit payments from the Pension Benefit Guaranty Corporation, may be eligible for a 2011 Health Coverage Tax Credit.

Eligible individuals can claim a significant portion of their payments made for qualified health insurance premiums.

For more information about filing requirements and your eligibility to receive tax credits, visit www.irs.gov.

Posted on Jan 9th, 2012

by author: jblankenship.