Chapter 10: Retirement Plans and Other Tax Advantaged Accounts Flashcards
(43 cards)
Qualified plans
Qualified plans require IRS approval and the dollars invested are before-tax dollars (contributions are deductible), creating a zero cost basis for the investor. Therefore, when the investor takes the money out at retirement, the entire withdrawal is taxable. Additionally, qualified plans are not allowed to discriminate between employees, meaning that no one who meets the minimum requirements for inclusion in the plan can be left out.
Nonqualified plans
Nonqualified plans may discriminate and do not need IRS approval. The dollars that are invested in nonqualified plans are generally after-tax dollars, which establish the investor’s cost basis. When money is withdrawn at retirement, the investor pays taxes on the amount of the withdrawal that exceeds the cost basis. All investments grow tax-deferred, so the investor is not taxed on any gains until money is withdrawn at retirement.
Qualified vs. Nonqualified Plans
-A qualified retirement plan meets the guidelines set out by ERISA.
-Qualified plans qualify for certain tax benefits and government protection.
-Nonqualified plans do not meet all ERISA stipulations.
-Nonqualified plans are generally offered to executives and other key personnel whose needs cannot be met by an ERISA-qualified plan.
Deferred compensation plans
Deferred compensation is a type of nonqualified plan in which the employer promises to pay compensation to the employee in the future. Compensation is effectively deferred until a specified future date or retirement. The plan is authorized under IRS Code 457.
A 457(b) plan is a nonqualified, tax-deferred account that is made available to employees of public institutions, such as state and local governments, and to private, or nongovernmental, tax-exempt organizations, such as hospitals. Currently, 457(b) plans are not available to churches.
Public governmental 457 plans are required to be funded and the funds are held in trust for the sole benefit of the plan participants or their beneficiaries. In contrast, private 457 plans generally only allow a select group of employees designated by the employer to participate in the plan and are funded by a trust or annuity.
In 457(b) plans, employees set aside current compensation into the account on a pretax basis through a salary deferral agreement with the employer. Contributions are not taxed because the employee has not received the income – it is deferred income. Monies in the plan grow tax deferred until they are withdrawn at retirement or when the employee terminates employment. In the case of termination of employment, the employee may transfer 457(b) account funds into another retirement account such as a new employer’s retirement plan if such plans accept transfers. Additionally, public 457(b) plan funds may be transferred into an IRA account.
As with other retirement plans, withdrawals from a 457(b) must begin by age 73. However, unlike the other plans, there is no 10% penalty on early withdrawals made before age 59½ or after terminating employment. This exemption is lost if 457(b) funds are transferred into a qualified plan, such as a 401(k), 403(b), or IRA.
Summary of features of a deferred compensation plan:
1) Contributions currently are not tax-deductible because the employee has not “received” the money.
2) Plan does not require IRS approval.
3) Employer may discriminate in plan offering (therefore, it is a nonqualified plan).
4) Funds in the plan grow on a tax-deferred basis.
5) Any excess over the cost basis is taxed when received.
Employee stock options plans (ESOPs)
common form of employee noncash compensation. An ESOP allows the employee to purchase company stock in the future at a predetermined price. An employee stock option is similar to a stock warrant in that it is long term and at issue its exercise price is above the stock’s current market value. ESOPs are generally given to executives and firm management as an incentive toward the employer’s future growth. These may also be granted to nonemployees who are important to the company, such as nonemployee directors, attorneys, and key suppliers. Employee stock options are granted with a vesting schedule. Remember that vesting is the systematic ownership transfer to the employee.
For example, an employee may be granted 1,000 options with 100 vesting each year for 10 years. At the end of each year the employee may exercise 100 options.
Incentive stock options - basics
An incentive stock option, also called a qualified stock option, is a tax-qualified employee stock purchase plan. The plan is similar to an ESOP, except there is no employee tax liability when the option is exercised.
To meet IRS guidelines, stock must be held for at least 1 year from exercise and at least 2 years from the date the option was granted.
Gains realized upon sale of the stock are treated as long-term capital gains. One note of caution is that incentive stock options may trigger alternative minimum tax (AMT).
Because incentive stock options are tax qualified, the plan must be approved by company shareholders 1 year prior to the plan taking effect.
Defined benefit plan
Under a defined benefit plan, the employer specifies an amount of benefits promised to the employee at his or her normal retirement date. The payments are based on a specified formula that considers age, years of service and salary history, and is adjusted each year for inflation.
In defined benefit plans, the employer is responsible for maintaining adequate funds to provide the promised benefit, and an actuarial calculation is required to determine the annual deposit for each year. It helps to remember that defined benefit plans favor older employees nearing retirement age, and allow for higher benefits for high-salaried owners and key employees.
Defined contribution plan
Ex: 401k, 403b.
Defined contribution plans have become much more popular than defined benefit plans because they are generally more flexible and less expensive for employers to administer. These plans are focused on contributions rather than on the benefits they will pay out. These plans favor young employees just starting out, with many years to retirement.
Annual contributions to a defined contribution plan are limited to the greater of 25% of the employee’s gross compensation, or the maximum dollar amount set by the IRS (currently $58,000). This annual limit includes employer and employee total contributions. Employer contributions are required without regard to the company’s profitability in a given year.
IRA
An individual retirement account (IRA) is a type of tax-qualified retirement plan. Anyone who has earned income is allowed to contribute to a traditional IRA, regardless of age. The SECURE Act of 2019 removed the prior age limit for all contributions starting in tax year 2020 (The acronym SECURE stands for Setting Every Community Up for Retirement Enhancement.). The contribution may or may not be deductible, depending on whether the individual qualifies for a retirement program through an employer and the level of earned income. However, the earnings in an IRA always grow tax-deferred, whether or not the contribution is deductible, and taxes are not paid on the deferred earnings until the money is withdrawn from the account.
Contributions — The maximum amount an individual can contribute annually to an IRA is the lesser of the two following amounts:
$6,500* (younger than age 50) or $7,500 (catch-up provision for age 50 and older); or
100% of earned income.
* All dollar amounts are current for 2023.
Know This! Anyone who is working and has earned income can contribute to a traditional IRA, regardless of age.
IRA contributions must be made in cash (or cash equivalent) in order to be tax deductible. The term cash includes any form of money, such as cash, check, or money order. The money invested in the account can be used to buy stocks, bonds, mutual funds, or annuities. The money used for IRA contributions cannot be used to purchase life insurance policies or collectibles such as art, antiques, or stamps. Also, investors cannot trade on margin in an IRA account.
A traditional IRA is a top choice for immediate tax savings because contributions can be deducted from that year’s taxable income. Generally, taxes are not due until withdrawals are made, usually after retirement. At that time, unless nondeductible contributions were made to the account, the total amount withdrawn is included as income.
Spousal IRA
In a marriage where only one spouse has earned income and has contributed to an IRA, the nonwage earning spouse may also contribute to a spousal IRA if the earned income from the wage-earning spouse is greater than the total contributions to both IRAs. Each spouse must maintain a separate account not exceeding the individual limit. By contributing to a spousal IRA, a married couple younger than age 50 may contribute up to a total of $13,000 ($6,500 to each IRA).
IRA catch up provision
Taxpayers who are age 50 or older are entitled to make additional “catch-up” contributions. Currently, the taxpayers may contribute up to an additional $1,000 each year, making their total contribution $7,500.
For example, a married person with a nonworking spouse may currently contribute $6,500 annually to a spousal IRA, making the total contribution for the couple $13,000 (with catch-up provisions: $14,000 may be contributed if only one spouse is age 50 or older, and $15,000 may be contributed if both spouses are 50 or older).
IRA Rollover and Transfer Rules
An individual may choose to move the monies in a qualified retirement plan to another qualified retirement plan. However, benefits that are withdrawn from any qualified retirement plan are taxable the year in which they are received if the money is not moved properly. There are two ways to move money from plan to plan:
A rollover; and
A custodian-to-custodian transfer.
A rollover describes a cash and or asset contribution to a new IRA by an individual within 60 days of receiving an eligible rollover distribution from an old plan. The individual may roll over all or any part of the actual amount received. The individual is subject to 20% federal withholding on the distribution from the old plan. However, the individual must then deposit the full rollover amount into the new plan (including 20% from outside sources to compensate for the withheld 20%) within 60 days. The individual then files for a refund of the 20% withholding in their next federal income tax return. A rollover can be done no more than once every 12 months, and if the rollover is not completed within 60 days, the withdrawal is considered a permanent distribution and subject to ordinary income tax and a 10% penalty. This applies to both IRA-to-IRA rollovers and employer plan-to-IRA rollovers.
A transfer describes a movement of cash and/or assets that takes place directly between the trustee/custodian of an old plan and the trustee of a new plan. By directly transferring the distribution from one custodian to another (as opposed to personally receiving the funds and then depositing them into the new plan), the individual can avoid the 20% federal income tax withholding. Technically, a direct transfer takes place between trustees, and the investor never touches the money. There is no annual limit on the permissible number of direct transfers.
IRA tax deductibility
Tax deductibility — In many cases, individual contributions to traditional IRAs are tax deductible for the year of the contribution. Any eligible person not participating in a qualified retirement plan can take a full deduction from taxable income up to the maximum limit. If an individual is a participant in an employer’s qualified retirement plan, there are income limitation tests to determine how much, if any, of the individual’s IRA contribution is tax deductible. Contributions into an IRA for the current tax year can be made up to April 15 of the following year. Anyone with earned income may contribute to an IRA, even if the contributions are not tax deductible.
IRA excess contributions
If an individual’s IRA contribution exceeds the maximum allowable amount, a 6% penalty is assessed on the excess contributions every year until it is removed from the plan. The excess contribution is not deductible, and earnings on the excess portion do not accumulate tax deferred.
IRA distributions
Distributions from IRAs are divided into pretax and after-tax contributions (if applicable) for tax purposes. All investment income and pretax contributions are taxed as ordinary income in the year received. After-tax contributions are not taxed when distributed.
If both tax deductible and nondeductible contributions were made to the IRA, each distribution is partially taxable and partially nontaxable. The IRS requires the IRA owner to complete a special tax form annually that figures the taxable and nontaxable distributions.
Taxes/penalties - premature IRA distributions
If withdrawals from an IRA are made prior to age 59½, they are considered premature distributions, and a 10% early withdrawal penalty is assessed by the IRS. The amount of the premature withdrawal is also taxed as ordinary income to the recipient in the year received.
Penalty-free premature IRA distributions
Early withdrawal without penalty is allowed under certain circumstances, although the amount received is still taxable as ordinary income to the recipient in the year received. The following circumstances determine how a penalty-free premature distribution can occur:
-Death of the account owner;
-Permanent disability or terminal illness of the owner;
-Unreimbursed medical expenses in excess of 10% of adjusted gross income (7.5% if over age 65);
-Distributions are made in equal periodic installments for a minimum of 5 years or until the recipient reaches age 59½, whichever period is greater;
-Education expenses for the owner or the owner’s immediate family;
-Down payment on a first-time home purchase of the primary residence of the owner, limited to a lifetime amount of $10,000; or
-Childbirth or adoption expenses up to $5,000.
IRA Required minimum distributions (RMDs)
Normal distributions from a traditional IRA can occur at any point after the account holder reaches the age of 59½. An IRA owner must begin taking annual required minimum distributions (RMDs) no later than April 1 of the year following the year in which the participant turns 73.*
*Effective year 2023, the SECURE Act 2.0 raised the required minimum distribution age from 72 to 73, and reduced the penalty for failing to take an RMD from 50% to 25%.
The owner of an IRA is required to take their first RMD by April 1 of the year following the year that the individual turns 73. If the first RMD is taken by April 1, the individual will have to take a second RMD by December 31 of the same year, and every year thereafter. Failure to take an RMD results in a 25% tax penalty (50% prior to 2023) levied on the amount of the required distribution that was not taken, which drops to 10% if corrected in a timely manner. Distributions can be received in a lump sum or as periodic payments using a number of different methods. If periodic distributions do not begin until age 73, the amount received must pay out at least as fast as a schedule (IRS actuarial life expectancy table), which theoretically would reduce the account to zero by the time the retiree dies.
IRA Distributions after Owner’s Death
At the IRA owner’s death, the beneficiary may cash in the IRA. Taxes will be due, but the early withdrawal 10% penalty will NOT apply.
For the year of the account owner’s death, the RMD is based on the RMD the account owner would have received. For the year following the owner’s death, the RMD will depend on the identity of the designated beneficiary. There is a distinction between an eligible designated beneficiary and other beneficiaries who inherit an IRA.
Eligible designated beneficiaries may take their distributions over the beneficiary’s life expectancy. An eligible designated beneficiary includes a(n):
-Surviving spouse;
-Disabled individual;
-Minor child; or
-Individual who is not more than 10 years younger than the deceased IRA owner.
However, minor children must still take the remaining distributions within 10 years of reaching age 18.
A surviving spouse beneficiary may delay the start of distributions until the later of, the end of the year that the IRA owner would have attained age 73 or the surviving spouse’s required beginning date.
Designated beneficiaries, who are not eligible designated beneficiaries, such as a non-spouse heir, must withdraw the entire account within 10 years of the IRA owner’s death.
Non-designated beneficiaries must withdraw the entire account within 5 years of the IRA owner’s death if distributions had not begun prior to death.
Roth IRA
Roth IRAs differ from traditional IRAs in several ways. Roth IRA contributions and all earnings may be withdrawn tax free as long as the account is open for at least 5 years, and if certain requirements are met. Another important distinction between Traditional IRAs and Roth IRAs is that Roth IRAs must be funded with after-tax dollars.
Roth IRAs are an excellent choice for future tax savings. Distributions, including investment gains, are not taxed when withdrawn. Roth IRA conversions from traditional IRAs can also help save taxes on future earnings.
Modified Adjusted Gross Income (MAGI) phase-out ranges for Roth IRA contributions
Single or Head of Household: $138,000 to $153,000
Married filing jointly $218,000 to $228,000
Married filing separately $0 to $10,000
Roth IRA contributions and limits
Roth IRA contributions are not tax deductible and are made with after-tax dollars.
SAME AS IRA: An individual can contribute 100% of earned income up to a specified maximum which is indexed for inflation. Currently, as with traditional IRAs, these amounts are $6,500 if younger than age 50, and $7,500 for age 50 or older (catch-up provision).
Should a taxpayer make an excess contribution to a Roth IRA, there is a 6% tax penalty. A traditional IRA can be converted to a Roth IRA if a person’s adjusted gross income is less than the applicable limit. The converted funds are considered income, and therefore taxed at income tax rates applicable in the year that the traditional IRA is rolled into a Roth IRA.
Roth IRA eligibility
Eligibility — Unlike a traditional IRA, Roth IRA eligibility is phased out based on the individual’s earned income level. These specified dollar limits are periodically increased to compensate for inflation.
Participation in an employer’s retirement plan does not affect a person’s eligibility for a Roth IRA. Total contributions to all traditional and Roth IRAs, other than employer contributions, cannot exceed a specified maximum.
Roth IRA rollovers
Rollovers — Note that rollovers from an employer’s pre-tax qualified plan cannot be directed to Roth IRAs. Rollovers must be directed to traditional IRAs. That traditional IRA may subsequently be rolled into a Roth IRA.
