Fact and Fiction for IRA RMDs

by | Dec 1, 2015 | Retirement & IRAs, Uncategorized

If you are age 70 1/2 or older and if you have a traditional IRA (or SEP or SIMPLE IRA or 401k), you must take your 2015 required minimum distributions (“RMD”) by December 31, 2015. In short, the RMD rules require you to distribute a portion of funds from your retirement account to yourself personally. These distributed funds are subject to tax and need to be included on your personal tax return. Let’s take an example to illustrate how the rule works. Sally is 72 and is required to take RMD each year. She has an IRA with $250,000 in it. According to the distribution rules, see IRS Publication 590, she will need to distribute $9,765 by the end of the year. This equates to about 4% of her account value. Next year, she will re-calculate this annual distribution amount based on the accounts value and her age. Once you know how to calculate the RMD, determining the distribution amount is relatively easy. However, the rules of when RMD applies and to what accounts can be confusing. To help sort out the confusion, I have outlined some facts and fiction that every retirement account owner should know about RMDs. First, let’s cover the facts. Then, we’ll tackle the fiction.

Fact

  1. No RMD for Roth IRAs: Roth IRAs are exempt from RMDs. Even if you are 70/12 or older, you’re not required to take distributions from your Roth IRA. Why is that? Because there is no tax due when you take a distribution from your Roth IRA. As a result, the government doesn’t really care whether you distribute the funds or not as they don’t receive any tax revenue.
  2. RMD Can Be Taken From One IRA to Satisfy RMD for All IRAs: While each account will have an RMD amount to be distributed, you can total those amounts and can satisfy that total amount from one IRA. It is up to you. So, for example, if you have a self directed IRA with a property you don’t want to sell to pay RMD and a brokerage IRA with stock you want to sell to pay RMD, then you can sell the stock in the brokerage IRA and use those funds to satisfy the RMD for both IRAs. You can’t combine RMD though for 401(k) and IRA accounts. Only IRA to IRA or 401(k) to 401(k).
  3. 50% Excise Tax Penalty: There is a 50% excise tax penalty on the amount you failed to take as RMD. So, for example, if you should’ve taken $10,000 as RMD, but failed to do so, you will be subject to a $5,000 excise tax penalty. Check back next month where I will summarize some measures and relief procedures you can take if you failed to take required RMD.
  4. 401(k) Account Holder Still Working for 401(k) Employer: If you have a 401(k) with a current employer and if you are still working for that employer, you can delay RMD for as long as you are still working at that employer. This exception doesn’t apply to former employer 401(k) accounts even if you are otherwise employed.

Fiction

  1. RMD Due by End of Year: You can make 2015 RMD payments until the tax return deadline of April 15, 2016. Wrong! While you can make 2015 IRA contributions up until the tax return deadline of April 15, 2016, RMD distributions must be done by December 31, 2015.
  2. Roth 401(k)s are Subject to RMDs: While Roth IRAs and Roth 401(k)s are both tax-free accounts, the RMD rules apply differently. As I stated above, Roth IRAs are exempt from RMD rules. However, Roth 401(k) owners are required to take RMD. Keep in mind, you could roll your Roth 401(k) to a Roth IRA and thereby you would avoid having to take RMD but if you keep the account as a Roth 401(k) then you will be required to start taking RMD at age 70 ½. The distributions will not be subject to tax but they will start the slow process of removing funds from the tax-free account.
  3. RMD Must Be Taken In Cash: False. Required Minimum distributions may be satisfied by taking cash distributions or by taking a distribution of assets in kind. While a cash distribution is the easiest method to take RMD, you may also satisfy RMD by distributing assets in kind. This may be stock or real estate or other assets that you don’t want to sell or that you cannot sell. This doesn’t occur often but some self directed IRA owners will end up holding an asset they don’t want to sell because of current market conditions (e.g. real estate) and they decide to take distributions of portions of the real estate in-kind in order to satisfy RMD. This process is complicated and requires an appraisal of the asset(s) being distributed and partial deed transfers (or partial LLC membership interest transfers, if the IRA owns an LLC and the LLC owns the real estate) from the IRA to the IRA owner. While this isn’t the recommended course to satisfy RMD, it is a potential solution to IRA owners who are holding an asset, who have no other IRA funds to distribute for RMD, and who wish to only take a portion of the asset to satisfy their annual RMD.

The RMD rules are complicated and it is easy to make a mistake. Keep in mind that once you know how the RMD rules apply in your situation it is generally going to apply in the same manner every year thereafter with only some new calculations based on your age and account balances each year thereafter.

Click here for a nice summary of the RMD rules from the IRS.

Avoiding the 20% Withholding Tax on 401(k) Distributions

by | Nov 17, 2015 | Tax Planning, Uncategorized

Distributions from a 401(k) to its owner are subject to a 20% withholding tax whereas distributions from an IRA are not subject to a withholding tax. As a result, any amounts distributed from a 401(k) to its owner will be reduced by 20% and that 20% will be sent to the IRS in expectation of the taxes that will be due from the account owner for the distribution. Any amounts distributed from an IRA, however, are not subject to the 20% withholding as the IRA owner can elect out of withholding. The discrepancy in the rules is one advantage of using an IRA in retirement as opposed to a 401(k) since the amounts distributed from the IRA can be received in their entirely. Keep in mind, the tax owed on a distribution from an IRA or 401(k) is the exact same. The difference is when you are required to pay it. In both instances you will receive a 1099-R from your custodian/administrator but in the 401(k) distribution you are required to set aside and effectively pre-pay the taxes owed.

The 401(k) Withholding Rule in Practice

Let’s walk though a common situation that outlines the issue. Sarah is 64 and has a 401(k). She would like to distribute $100,000 from the 401(k). She contacts her 401(k) administrator and is told that on a $100,000 distribution they will send her $80,000 and that $20,000 will be sent to the IRS for her to cover the 20% withholding requirement. Since this 20% withholding requirement does not apply to IRAs, Sarah decides to roll/transfer the $100,000 from her 401(k) directly to an IRA. Once the funds arrive at the IRA, Sarah takes the $100,000 distribution from the IRA and there is no mandatory 20% withholding so she actually receives $100,000 in total. Keep in mind, Sarah will still owe taxes on the $100,000 distribution from the IRA and she will receive a 1099-R to include on her tax return. That being said. Sarah has given herself the ability to access all of the amounts distributed for her retirement account without the need for sending withholding to the IRS at the time of distribution.

It’s that simple. Don’t take distributions from a 401(k) and subject yourself to the 20% withholding tax when you can roll/transfer those 401(k) funds to an IRA and receive the entire distribution desired without a 20% withholding.

Maximizing 2015 401(k) Contributions with Your S-Corp

by | Oct 20, 2015 | Uncategorized

It’s time to start thinking about year-end tax planning and as every savvy business owner knows, effective 2015 tax planning happens before December 31, 2015. One of the most commonly used strategies for our clients is an s-corporation and a 401(k). A properly structured s-corporation is utilized best for tax purposes when the business owner adopts and contributes to a 401(k) plan as the contributions to 401(k) are tax deductible. Whether the business has only one owner/employee (or spouses only) or whether the business has dozens or even hundreds of employees, a 401(k) is a great tool to help defer taxable income. Simply put, a 401(k) plan can be used as a tool for putting the income of the business owner (and applicable employees) away for retirement with the added benefit of a tax deduction for every dollar that can be contributed. There are numerous benefits and options in a 401(k) plan.  For example, you can do Roth 401(k) account, you can self direct a 401(k) account, and you can even loan money to yourself from your 401(k) account. While books have been written about all of these options and benefits, one of the most misunderstood concepts of 401(k) plans is how s-corporation owners can contribute their income to the plan. That is the focus of this article.

Rules for 401(k) Contribution

In order to understand how s-corporations income can be contributed to a 401(k) plan, you need to understand the following three basic rules.

  1. Only W-2 Salary Income can be Contributed to a 401(k). You cannot make 401(k) contributions from dividend or net profit income that goes on your K-1. See IRS.gov for more details. Since many s-corporation owners seek to minimize their W-2 salary for self-employment tax purposes, you must carefully plan your W-2 and annual salary taking into account your annual planned 401(k) contributions. In other words, if you cut the salary too low you won’t be able to contribute the maximum amounts. On the other hand, even with a low W-2 Salary from the s-corporation you’ll still be able to make excellent annual contributions to the 401(k) (up to $18,000 if you have at least that much in annual W-2 salary).
  1. Easy Elective Salary Deferral Limit of $18,000 or 100% of Your W-2, whichever is less. If you have at least $18,000 of salary income from the s-corporation, you can contribute $18,000 to your 401(k) account.  Every employee under the plan is allowed to make this same contribution amount. As a result, many spouses are added to the s-corporation’s payroll (where permissible) to make an additional $18,000 contribution for the spouse’s account. If you are 50 or older, you can make an additional $6,000 annual contribution.  Follow this link for the details from the IRS on the elective salary deferral limits. The elective salary deferral can be traditional dollars or Roth dollars.
  1. Non-Elective Deferral of 25% of Income Up to a $53,000 total Annual 401(k) Contribution. This is usually maximized best in solo 401(k) plans where you as the business owner decided to offer them most generous company match allowed by law (25% of wages). Rarely is this offered or maximized like this in a group 401(k) scenario where you have other employees because what you offer yourself, you must offer to all employees who qualify for the plan (full-time, worked for you a year, over 21). If you are in the solo 401(k) situation, this additional 25% deferral is an excellent tool because in addition to the $18,000 annual elective salary contribution, an s-corporation owner can contribute 25% of their salary compensation to their 401(k) account up to a maximum of a $53,000 total annual contribution.  This non-elective deferral is always made with traditional dollars and cannot be Roth dollars. So, for example, if you have an annual W-2 of $100,000, you’ll be able to contribute a maximum of $25,000 as a non-elective salary deferral to your 401(k) account. If you have employees who participate in the plan besides you (the business owner) and your spouse, then the non-elective deferral calculation gets much more complicated because you’d have to offer it to those employees too. But for now, let’s assume there are no other employees and run through the examples.

Examples

Let’s run through two examples. The first is an s-corporation business owner looking to contribute around $30,000 per year. The second is a business owner looking to contribute the maximum of $53,000 a year.

Example 1: Seeking a $30,000 Annual Contribution.

  • S-Corporation Owner W-2 Salary = $50,000
  • Elective Salary Deferral = $18,000
  • 25% of Salary Non-Elective Deferral = $12,500 (25% of $50,000)
  • Total Possible 401(k) Contribution = $30,500

Example 2: Seeking Maximum $52,000 Annual Contribution

  • S-Corporation Owner W-2 Salary = $140,000
  • Elective Salary Deferral = $18,000
  • 25% of Salary Non-Elective Deferral = $35,000 (25% of  $140,000)
  • Total Possible 401(k) Contribution  (maximum) = $53,000

As a result of the calculations above, in order to contribute the maximum of $53,000, you need a W-2 salary from the s-corporation of $140,000. Keep in mind that if you have other employees in your business (other than owner and spouse) that you are required to do comparable matching on the 25% non-elective deferral and as a result such maximization is often difficult to accomplish in 401(k)s with employees other than the owner and their spouse. Consequently, the additional 25% non-elective salary deferral is best used in owner only 401(k) plans. If you do have employees though you can at least do $18,000 per year without having a matching requirement for your employees. That’s still three times what you can contribute to a traditional or a roth IRA. There are also common matching formulas used where you end up matching yourself and your employees contributions  at a rate of 4% of salary (safe harbor).

Keep in mind that while 401(k) contributions can be made until the tax return deadline (personal, 4/15/16 and s-corp 3/15/16), including extensions, that the 401(k) must be established before the end of 2015 in order to later make 2015 contributions. As a result, you just need to establish the 401(k) before the end of 2015 and that will allow you to later make 2015 contributions prior to filing your 2015 returns.

California Rollover IRAs Can Receive ERISA-Style Creditor Protection

by | Sep 15, 2015 | Retirement & IRAs

Have you rolled over your 401(K) plan or other employer based plan to a rollover IRA? Has someone told you that your rollover IRA in California isn’t protected from creditors. They’re wrong.

California Exemptions

Retirement plans are known for being great places to build wealth and they have numerous tax and legal advantages. One of the key benefits of building wealth in a retirement account is that those funds are generally exempt from creditors. However, some states have laws that protect employer based retirement plans (aka, ERISA Plans) more extensively than IRAs. California is one of those states as their laws treat IRAs and ERISA based plans differently (the California Code refers to ERISA based plans, such 401(k)s, as private retirement plans) .

California Code of Civ. Proc., § 704.115, subds. (b),(d), treats funds held in a private retirement plan as fully exempt from collection by creditors. “Private retirement plans” include in their definition “profit-sharing” plans. The most common type of profit sharing plan is commonly known as a 401(k) plan.

IRAs, on the other hand, are only exempt from creditors up to an amount “necessary to provide for the support of the … [IRA owner, their spouse and dependents] … taking into account all resources that are likely to be available…” In other words, the exemption protection for IRAs is “limited”. California Code of Civ. Proc., § 704.115, subdivision (e).

McMullen v. Haycock

Notwithstanding the limited creditor protections for IRAs outlined above, the California Court of Appeals has ruled that rollover IRAs funded from “private retirement plans” receive full creditor protection as if they were a fully protected private retirement plan under California law. McMullen v. Haycock, 54 Cal.Rptr.3d 660 (2007). In McMullen v. Haycock, McMullen had a judgement against Haycock for over $500,000.  McMullen attempted to get a writ of execution against Haycock’s IRA at Charles Schwab. In defending against the writ of execution, Haycock claimed that the entire IRA was a rollover IRA funded and traceable to a private retirement plan and thus fully protected from collection as a private retirement plan. Haycock relied on California Code of Civ. Proc., § 703.80, which allows for the tracing of funds for purposes of applying exemptions.

Haycock lost at the trial court level but appealed and the appellate court found in his favor and ruled that his rollover IRA was fully protected from the collection of creditors as the funds in the rollover IRA were traceable to a fully exempt private retirement plan (e.g. former employer’s 401(k) plan).

As a result of McMullen v. Haycock, California IRA owners whose IRAs consist entirely of funds rolled over from a private retirement plan of an employer are fully protected from the collection efforts of creditors. IRAs that consist of individual contributions and are not funded from a prior employer plan rollover will only receive limited creditor protection. It is unclear so far how an IRA would be treated that consists of both private retirement plan rollover funds and new IRA contributions. Presumably, the Courts will trace the funds and separate out the private retirement plan rollover IRA portions from the regular IRA contributions and the regular IRA contributions would then receive the limited protection. Unfortunately, there is no case law or guidance yet as to rollover IRAs with mixed rollover and regular IRA contributions.

McMullen v. Haycock was a big win for IRA owners with funds rolled over from a private retirement plan and one that should be kept in mind when planning your financial and asset protection plan.

Avoiding State Income Tax on Retirement Plan Distributions

by | Jul 21, 2015 | Uncategorized

When a retiree begins taking distributions from a traditional IRA, 401(k), or pension plan, those distributions are taxable to the retiree under federal income tax and any applicable state income tax rules. While federal taxation cannot be avoided, state taxation may be avoided depending on your state of residency. In general, there are some states that have zero income tax and therefore don’t tax retirement plan distributions, some states that have special exemptions for retirement plan distributions, and other states that do in fact tax retirement plan distributions. This article breaks down the basics and discusses some of the states where income taxes can be avoided.

The No State Income Tax States

First, the easiest way to avoid state income tax on retirement plan distributions is to establish residency in a state that has no state income tax. It isn’t just the fun and sun of Florida that helps attract all of those retirees. It’s the tax free state income treatment that you’ll get from all of that money stocked away in your retirement account. The other states with no income tax and therefore no tax on retirement plan distributions are Alaska, Nevada, South Dakota, Texas, Washington, and Wyoming.

States with Retirement Income Exclusions

Second, there are some states that have a state income tax but who exempt retirement plan distributions for retirees from state income taxes. There are 36 states in this category that have some sort of exemption for retirement plan distributions. As each of these states are very different, so too are their exemptions. The type of retirement account, however, does tend to govern the exemptions available. Here’s a quick summary of the common exemptions found in the states.

  1. For Public Pensions and Retirement Plans. Distributions from federal or state employer plans are exempt from taxation in many states. This is the most common exemption amongst states that have an income tax but who exempt some types of retirement plan distributions from income. Most of the 36 states that have an exemption for retirement plan income provide an exemption for public employee pensions and retirement plans.
  2. For Private Pensions and Retirement Plans. About 10 states offer a full exclusion for private pensions and retirement plans. Some of them differ between pension and contributory plans (e.g. 401(k)) and some of them make no distinction. Pennsylvania, for example, excludes all income distributions. Hawaii excludes certain distributions from state income tax for private retirement plans and for portions from company plans rolled over to a rollover IRA and then distributed from the rollover IRA.
  3. For IRAs. There are some states that do no tax any retirement pan distributions, including IRA distributions to retirees. Illinois for example does not tax distributions from retirement plans at all (pensions, IRAs, 401(k) s). Tennessee and New Hampshire are states that do not tax wage income and therefore they do not tax retirement plan distributions of any kind (IRA, 401(k), etc.). There are also numerous states that exclude a certain limit of retirement plan income from taxation. For example, Main exempts the first $10,000 of income from any retirement plan, including IRAs.

In sum, the state tax rules for retirement plan distributions are complicated and vary significantly. Each state can be understood rather quickly though and everyone planning for retirement should understand how state income taxes may eat into their planned retirement plan distributions. I, for example, looked into Arizona and found that there is no exemption for 401(k) or IRA income in the state of Arizona. While we do have a low state income tax rate, Arizona state income tax includes income from private retirement plans (pensions and 401(k) s) and IRAs and has a modest deduction for distributions from public retirement plans. Each state is unique to the type of plan, and the amounts being distributed but don’t just think you need to be in a state with zero income tax to avoid taxes on retirement plan distributions. For example, you could be in Illinois, Tennessee, or New Hampshire and could realize state income tax-free distributions of your IRA or 401(k).  The National Conference of State Legislators has an updated 2015 chart that is very useful and can be used to look up your state’s tax treatment of retirement plan distributions for retirees.