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.

How to Avoid the $15000 Solo 401(k) “Failure to File 5500-EZ” Penalty

by | Dec 8, 2014 | Uncategorized

Do you have a solo 401(k)? Have you been filing form 5500-EZ each year for the 401(k)? Are you aware that there is a penalty up to $15,000 per year for failure to file? While many solo 401(k)s are exempt from the 5500-EZ filing requirement, we have run across many solo 401(k) owners who should have filed and who have failed to do so. If you have a solo 401(k) and have no idea what I’m talking about, stay calm, but read on.

One of the benefits of a solo 401(k) is the ease of administration and control because you can be the 401k trustee and administrator. However, as the 401(k) administrator and trustee it is your own responsibility to make the appropriate tax filings. This would include filing any required tax returns for the 401(k).  In general, there is no tax return to file for a self-directed solo 401(k).  However, one exception to this rule is if the plan assets exceed $250,000 at the end of the plan year, in which case, a tax return filing is required.  The return the 401(k) files is called a 5500-EZ.  Recently, more and more solo 401(k) owners have contacted us because they set up their solo 401(k) online or with some other company and they were never made aware that they are supposed to file a 5500-EZ when their plan assets exceed $250,000.  Some of these individuals have multiple years in which they should have filed the 5500-EZ but failed to do so.  The penalties for failing to file a 5500-EZ when it is required can be quite severe, with fees and penalties as high as $15,000 for each late return, plus interest.

Fortunately, the IRS has a temporary pilot program that provides automatic relief from IRS Late filing penalties on past due 5500-EZ filings.  This temporary program began on June 2, 2014, and will end on June 2, 2015. The IRS has yet to decide if they will continue with this program and make it permanent after June 2, 2015, but if they do, they plan to charge a filing fee.  Under this temporary program, there is no filing fee.

In order to qualify for this program, your solo 401(k) plan must not have received a CP 283 Notice for any past due 5500-EZ filings, and the only participants of your solo 401(k) plan can be you and your spouse, and your business partner(s) and their spouse.  This program is available to all solo 401(k) plans, regardless of whether it is a self-directed plan.

The IRS has provided a step-by-step process that can be found at http://www.irs.gov/Retirement-Plans/New-Penalty-Relief-Program-for-Form-5500-EZ-Late-Filers and at http://www.irs.gov/pub/irs-drop/rp-14-32.pdf.   In order to qualify and receive a waiver of penalties under the program, you must follow the program exactly.  Basically, you must do all of the following:

  1. File all delinquent returns using the IRS form in the year the filing was due.
  2. Write in red letters at the top of the first page of each filing, “Delinquent return submitted under Rev. Proc. 2014-32, Eligible for Penalty Relief”.
  3. Attach a one-page transmittal schedule to the front of each filing.
  4. Mail all documents to the IRS.

In sum, if you have a solo 401(k) plan that should have filed a 5500-EZ for years past because the plan assets exceeded $250,000 at the end of the plan year, then you should take advantage of this program, which will save you literally thousands of dollars in penalties and fees.  Under this program, the IRS must receive your past due to 5500-EZ filings before June 2, 2015.  If you have any questions about this program or would like assistance with submitting your late 5500-EZ filings under this program, please contact the law firm as we are assisting clients with current and past due 5500-EZ filings for their solo 401(K)s.