by Mat Sorensen | Aug 13, 2018 | Investing
I’m routinely asked questions about what taxes and rules apply when a distribution occurs from a retirement account. Here are the top ten rules you should know about distributions from retirement accounts:
The first 5 facts apply to Traditional IRA and 401(k) accounts
1. Early Withdrawal Penalty
A distribution from a traditional IRA or 401(k) before the account owner reaches 59 1/2 causes a 10% early withdrawal penalty on the amount distributed. This is in addition to taxes owed on the amount distributed. So, for example, if you take a $10,000 distribution from your traditional IRA at age 45 then you will be subject to a $1,000 penalty and you will also receive a 1099-R from your IRA custodian and will need to report $10,000 of income on your tax returns. Once you reach age 59 1/2, the 10% early withdrawal penalty does not apply.
2. Required Minimum Distributions
Whether you need the money or not, at age 70 1/2, the IRS requires a traditional IRA or 401(k) owner (unless still employed by employer 401(k)) to begin taking distributions from their retirement account. These distributions are subject to tax and the account owner will receive a 1099-R of the amount distributed that will be included on their tax return. The amount of the distribution is based on the person’s age and the account’s value. For example, someone with a $100K IRA who has turned 70 1/2 and is taking their first RMD would take $3,639 (3.79%).
3. Avoid Taking Large Distributions In One-Year
Because distributions from traditional retirement accounts are subject to tax at the time of distribution, it is wise to avoid taking too much in one year as a large distribution can push your distribution income and your other income into a higher tax bracket. For example, if you have employment and or rental/investment income of $50,000 annually then you are in a joint income tax bracket of 15% on additional income. However, if you take $100,000 as a lump-sum that year this will push your annual income to $150K and you will be in a 28% income tax bracket. If you could instead break up that $100K over two tax years then you could stay in 15% to 25% tax bracket and could reduce your overall tax liability. In short, only pull out what you need when you need it to lesson the immediate year’s tax liability.
4. Distribution Withholding
Most distributions from an employer 401(k) or pension plan (including solo K), before the age of 59 1/2, will be subject to a 20% withholding that will be sent to the IRS in anticipation of tax and penalty that will be owed. In the case of an early distribution from an IRA, a 10% withholding for the penalty amount can be made but you can also elect out of this automatic withholding provided you make an estimated tax payment or that you will otherwise be current on your tax liability.
5. If You Have Tax Losses, Consider Converting to a Roth IRA or Roth 401(k)
When you have tax losses on your tax return you may want to consider using those losses to offset income that would arise when you convert a traditional IRA or 401(k) to a Roth account. Whenever you convert a traditional account to a Roth account, you must pay tax on the amount of the conversion. In the end though, you’ll have a Roth account that grows entirely tax-free and that you don’t pay taxes on when you distribute the money. Using the losses when they are available is a good way to get your Traditional retirement funds over to Roth.
The final 5 rules are for Roth IRAs and Roth 401(k)s
6. Roth IRAs Are Exempt from RMD
hile traditional IRA owners must take required minimum distributions (“RMD”) when the account owner reaches age 70 1/2, Roth IRAs are exempt from RMD rules. That’s a great perk and allows you to keep your money invested as long as possible.
7. Roth 401(k)s Must Take RMD
Roth 401(k) designated accounts are subject to RMD. This is a confusing rule since Roth IRAs are NOT subject to RMD. Such is the tax code. How can you avoid this? Simply roll your Roth 401(k) funds over to a Roth IRA when you reach 70 1/2.
8. Distributions of Contributions Are Always Tax-Free
Distributions of contributions to a Roth IRA are always tax-free. Regardless of age, you can always take a distribution of your Roth IRA contributions without penalty or tax.
9. Distributions of Roth IRA Earnings
In order to take a tax-free distribution from a Roth IRA, you must be age 59 1/2 or older and you must have had a Roth IRA for five years or longer. As long as those two criteria are met, all amounts (contributions and earnings) may be distributed from a Roth IRA tax free. If your funds in the Roth IRA are from a conversion, then you must have converted the funds at least 5 years ago and must be 59 1/2 or older in order to take a tax-free distribution.
10. Delay Roth Distributions
Roth retirement accounts are the most tax efficient way to earn income in the U.S. As a result, it is best to distribute and use other funds and assets that are at your disposal before using the funds built up in your Roth account as those funds aren’t as tax efficient while invested.
by Mat Sorensen | Mar 12, 2018 | News
Solo 401(k) plans have grown significantly and are often used by self-directed investors. Solo 401(k)s are an excellent tool for self employed persons to maximize contributions in their own business or self-employment just like large companies who offer plans for their employees. The basic rules for solo 401(k)s are that you must be self-employed and that you must have a no other employees other than the business owner and family. As happens with many good things, this is starting to get over-sold and we are seeing common problems arise with persons who create them on-line or with the assistance of someone who has no credentials or experience outside of creating a catchy website. Here are a few things to watch out for.
Top Three Mistakes in Solo 401(k) Plans
1. Failure to Update/Amend– Pursuant to Revenue Procedure 2007-44, 401(k) plans shall be amended and restated every six years to conform with current law. The company who provided your plan document, usually what is called a pre-approved plan document for solo 401(k)’s, should be providing you with these updates so that your plan stays in compliance with the amendment cycles established by the IRS. Failure to properly update the plan can result in significant penalties and revocation of tax status.
2. Using an LLC With Rental Income as The Employer/Company – Solo 401(k)s must be established by an employer company. Unlike IRAs, where any individual may establish an account, a 401(k) may only be established by a company and is a benefit for its employees. For example, a solo 401(k) for a self-employed real estate agent with no other employees is created for the real estate agent who is the sole employee/owner. For many self-employed persons who have no other employees, this type of 401(k) is an excellent retirement plan too.
Unfortunately, the solo 401(k) is being oversold and over promoted to real estate investors who only own rentals. We have seen many promoters (operating out of a basement somewhere) who state that you can establish a solo 401(k) with your LLC that owns rental real estate. After all, they say, the LLC is a company and you are the only owner. Therefore this company can establish a solo 401(k). This is only partly true. The LLC that owns rental properties is not a proper entity in which to establish a solo 401(k) since the LLC receives “rental income” and since the owners of the LLC are not considered “employees” receiving wages or earned income that may be contributed to a retirement account. Rental income cannot be contributed to a retirement account and as a result the owner of the LLC is not an employee or person receiving earned income that qualifies to have a solo 401(k) account. All 401(k)s, solo 401(k)s included, must be established by a company for the benefit of its employees with wages or earned income. See IRS Publication 560. As a result, we recommend that clients use companies where there is wage income (e.g. s-corps) or self-employment income that creates earned income on schedule C be used to establish a solo 401(k). While an LLC may be used to adopt a solo 401(k), that would only be the case if the LLC receives ordinary income for its owner that is then claimed on schedule C of the owner’s tax return.
3. Failing to File Form 5500-EZ – In general, 401(k)s are required to file a return called from 5500. Solo 401(k)s, however, have some exemptions to the 5500 filing requirement but there are many situations where a solo 401(k) is still required to file an annual form 5500-EZ return. The first instance where a 5500-EZ tax return is required is when the solo 401(k) has over $250,000 in assets. The second instance is when the plan is terminated. Regardless of assets, a form 5500 must still be filed at termination.
Our law firm has experience in creating solo 401(k)s that can be self-trustee’d and self-directed and we also assist our clients with annual maintenance, plan amendments, and required annual 5500-EZ filings. Contact us at the law firm to learn more information about our services.
by Mat Sorensen | Feb 12, 2018 | News
Self-Directed IRA investors should be aware of the following IRA tax reporting responsibilities. Some of these items are completed by your custodian and others are the IRA owner’s sole responsibility. Here’s a quick summary of what should be reported to the IRS each year for your self-directed IRA.
IRA Custodian Files
Your IRA Custodian will file the following forms to the IRS annually:
| IRS FORM |
PURPOSE |
WHAT DOES IT REPORT |
|
|
|
| Form 5498 |
Filed to the IRS by your custodian. No taxes are due or paid as a result of Form 5498. |
IRA contributions, Roth conversions, the account’s fair market value as of 12/31/17, and required minimum distributions taken.
|
| Form 1099-R |
Filed to the IRS by your custodian to report any distributions or Roth conversions. The amounts distributed or converted are generally subject to tax and are claimed on your personal tax return. |
IRA distributions for the year, Roth IRA conversions, and also rollovers that are not direct IRA trustee-to-IRA trustee. |
IRA Owner’s Responsibility
Depending on your self-directed IRA investments, you may be required to file the following tax return(s) with the IRS for your IRA’s investments/income:
| IRS FORM |
DOES MY IRA NEED TO FILE THIS? |
DUE DATE |
|
|
|
| 1065 Partnership Tax Return |
If your IRA is an owner in an LLC, LP, or other partnership, then the Partnership should file a 1065 Tax Return for the company to the IRS and should issue a K-1 to your IRA for its share of income or loss. Make sure the accountant preparing the company return knows to use your custodian’s tax ID for your IRA’s K-1’s and not your personal SSN (or your IRAs Tax ID if it has one for UBIT 990-T tax return purposes). If your IRA owns an LLC 100%, then it is disregarded for tax purposes (single-member LLC) and the LLC does not need to file a tax return to the IRS. |
March 15th, 6-month extension available |
| 990-T IRA Tax Return (UBIT) |
If your IRA incurs Unrelated Business Income Tax (UBIT), then it is required to file a tax return. The IRA files a tax return and any taxes due are paid from the IRA. Most self-directed IRAs don’t need to file a 990-T for their IRA, but you may be required to file for your IRA if your IRA obtained a non-recourse loan to buy a property (UDFI tax), or if your IRA participates in non-passive real estate investments such as: Construction, development, or on-going short-term flips. You may also have UBIT if your IRA has received income from an active trade or business such as a being a partner in an LLC that sells goods and services (C-Corp dividends exempt). Rental real estate income (no debt leverage), interest income, capital gain income, and dividend income are exempt from UBIT tax. |
April 15th, 6 -month extension available |
Most Frequently Asked Questions
Below are my most frequently asked questions related to your IRA’s tax reporting responsibilities:
Q: My IRA is a member in an LLC with other investors. What should I tell the accountant preparing the tax return about reporting profit/loss for my IRA?
A: Let your accountant know that the IRA should receive the K-1 (e.g. ABC Trust Company FBO John Doe IRA) and that they should use the Tax-ID/EIN of your custodian and not your personal SSN. Contact your custodian to obtain their Tax-ID/EIN. Most custodians are familiar with this process, so it should be readily available. If your IRA has a Tax-ID/EIN because you file a 990-T for Unrelated Business Income Tax then you can provide that Tax-ID/EIN.
Q: Why do I need to provide an annual valuation to my custodian for the LLC (or other company) my IRA owns?
A: Your IRA custodian must report your IRA’s fair market value as of the end of the year (as of 12/31/17) to the IRS on Form 5498 and in order to do this they must have an accurate record of the value of your IRA’s investments. If your IRA owns an LLC, they need to know the value of that LLC. For example, let’s say you have an IRA that owns an LLC 100% and that this LLC owns a rental property, and that it also has a bank account with some cash. If the value of the rental property at the end of the year was $150,000, and if the cash in the LLC bank account is $15,000, then the value of the LLC at the end of the year is $165,000.
Q: I have a property owned by my IRA and I obtained a non-recourse loan to purchase the property. Does my IRA need to file a 990-T tax return?
A: Probably. A 990-T tax return is required if your IRA has income subject to UBIT tax. There is a tax called UDFI tax (Unrelated Debt Financed Income) that is triggered when your IRA uses debt to acquire an asset. Essentially, what the IRS does in this situation is they make you apportion the percent of your investment that is the IRA’s cash (tax favorable treatment) and the portion that is debt (subject to UDFI/UBIT tax) and your IRA ends up paying taxes on the profits that are generated from the debt as this is non-retirement plan money. If you have rental income for the year, then you can use expenses to offset this income. However, if you have $1,000 or more of gross income subject to UBIT, then you should file a 990-T tax return. In addition, if you have losses for the year, you may want to file 990-T to claim those losses as they can carry-forward to be used to offset future gains (e.g. sale of the property).
Q: How do I file a 990-T tax return for my IRA?
A: This is filed by your IRA and is not part of your personal tax return. If tax is due, you will need to send the completed tax form to your IRA Custodian along with an instruction to pay the tax due and your custodian will pay the taxes owed from the IRA to the IRS. Your IRA must obtain its own Tax ID to file Form 990-T. Your IRA custodian does not file this form or report UBIT tax to the IRS for your IRA. This is the IRA owner’s responsibility. Our law firm prepares and files 990-T tax returns for our self-directed IRA and 401(k) clients. Contact us at the law firm if you need assistance.
Sadly, not many professionals are familiar with the rules and tax procedures for self-directed IRAs, so it is important to seek out those attorneys, accountants, and CPAs who can help you understand your self-directed IRA tax reporting obligations. Our law firm routinely advises clients and their accountants on the rules and procedures that I have summarized in this article and we can also prepare and file your 990-T tax return.
by Mat Sorensen | Jan 23, 2018 | Investing
For most American workers and business owners, the first vehicle to save and invest in is your 401(k). The tax benefits and the typical company matching that offers free company money make a 401(k) a great place to save and invest for the long-haul. But what if you’ve maxed out your 401(k) contributions? What else can you do?
Here are the three options you should consider that provide significant tax and financial benefits:
1. Back-Door Roth IRA
This is a really cool option that many clients utilize every year. (I do too.) First, you may be thinking that you can’t do a Roth IRA because your income is too high or because you already maxed out your 401(k). WRONG: It is still possible to do a Roth IRA, but you just have to know the back-door route. The reason it’s called a back-door Roth IRA is because you make a non-deductible traditional IRA contribution (up to $5,500 annual limit, $6,500 if 50 or older). Then, after the non-deductible traditional IRA contribution is made, you then convert the funds to Roth. There is no income limit on Roth conversions, and since you didn’t take a deduction on the non-deductible traditional IRA contribution, there is no tax due on the conversion to Roth. And now, voila, you have $5,500 in your Roth IRA. That’s the back-door route.
There is a road block though for some who already have funds already in traditional IRAs. The Roth conversion ordering rules state that you must first convert your pre-tax traditional IRA funds, which you got a deduction for and now pay tax when you convert, before you are able to convert the non-deductible traditional IRA funds. So, if you have pre-tax traditional IRA funds and you want to do the back-door Roth IRA, you have two options:
- First, convert those pre-tax traditional IRA dollars to Roth and pay the taxes on the conversion.
- Second, if your 401(k) allows, you can roll those pre-tax traditional IRA dollars into your 401(k). If you don’t have a traditional IRA, you’re on easy street and only need to do the two-step process of making the non-deductible traditional IRA contribution and then convert it to Roth.
You have until April 15th of each year to do this for the prior tax year. Additionally, while the GOP tax-reform restricted Roth re-characterizations, Roth conversions and the back-door Roth IRA route were unaffected. For more detail on the back-door Roth IRA, check out my prior article here.
2. Health Savings Account (HSA)
If you have a high-deductible health insurance plan, you can make contributions to your HSA up until April 15th of each year for the prior tax year. Why make an HSA contribution? Because you get a tax deduction for doing it, and because that money comes out of your HSA tax-free for your medical, dental, or drug costs. You can contribute and get a deduction, above the line, of up to $3,400 if you’re single or for up to $6,750 for family. We all have these out-of-pockets costs, and this is the most efficient way to spend those dollars (from an account you got a tax deduction for putting money into). If you didn’t have a high deductible HSA-qualifying plan by December 1st of the prior year, then the HSA won’t work.
Any amounts you don’t spend on medical can be invested in the account and grow tax-free for your future medical or long-term care. Health savings accounts can also be invested and self-directed into real estate, LLCs, private companies, crypto-currency or other alternative assets. We’ve helped many clients invest these tax-favored funds using a self-directed HSA.
For more details on health savings accounts, check out my partner Mark’s article here.
3. Cash Balance Plan or Defined Benefit Plan
If you’re self-employed you may consider establishing a cash balance plan or a defined benefit plan (aka “pension”), where you can possibly contribute hundreds of thousands of dollars each year. The amount of your contribution depends on your income, age, and the age and number of employees you may have. A cash balance plan or defined benefit plan/pension will cost you ten thousand dollars or more in fees to establish, and is far more expensive to maintain and administer. But, if you have the income, it’s a valuable option to consider. For more details on cash balance plans, check out Randy Luebke’s article here.
by Mat Sorensen | Dec 12, 2017 | Investing
Bitcoin, Ethereum, Litecoin, and other cryptocurrencies have seen dramatic price increases this year. Have you thought about cashing in? Are you wondering how will you be taxed?
Cryptocurrency is a Capital Asset
The IRS has clearly stated that cryptocurrency (aka virtual currency) is a capital asset like property. And therefore, the buying and selling of it for profit results in short-term capital gain if held for under one year, and long-term capital gain if held for over a year. Short-term capital gain rates are based on your regular income tax bracket, while the long-term capital gains rate is 15-20%, depending on income level. IRS Notice 2014-21.
So, for example, let’s say I bought 10 Bitcoin in June 2017 for $25,000 US dollars when the price of Bitcoin was approximately $2,500. I decide that in December 2017 that I would like to sell my Bitcoin. The price is now approximately $16,500 per Bitcoin, so my holdings are now worth $165,000. As a result, my $25,000 investment has generated a taxable profit of $140,000. Since I owned the Bitcoin for less than one year, the income will be short-term capital gain income and I will pay at my regular federal rate.
If I instead held the cryptocurrency until July 2018, then I would have long-term capital gain and would be paying tax at a much lesser rate.
Any realized gain from the cryptocurrency profit is taxable. This is the case if you exchanged Bitcoin for other cryptocurrency, or for goods or services. In this instance, you take the value of the Bitcoin in US dollars at the time of the exchange for other property and treat whatever gain you have when that Bitcoin was exchanged (at the value of the other property) as your taxable gain. Let’s say you bought 10 Bitcoin in 2015 for $250 per Bitcoin for a total purchase price of $2,500. You decide to exchange one Bitcoin, valued at $16,500 in December 2017, for 17 Ethereum valued at approximately $500 per Ethereum. Your gain on the Bitcoin being exchanged is the value of the Ethereum, $16,500, minus the cost of the Bitcoin, $250, for a long-term capital gain of $16,250.
Mining Cryptocurrency
Cryptocurrency mining is the process of using servers and other computers to verify the blockchain and transactions that are the backbone of the cryptocurrency. This IRS has stated that income from cryptocurrency mining, whether received in dollars or cryptocurrency, is taxable as regular income. Consequently, if you have engaged in the cryptocurrency mining business or are otherwise self-employed doing cryptocurrency mining then the income you received is taxable at your ordinary income rates and it will also be subject to self-employment tax.
Retirement Accounts and Cryptocurrency
Retirement accounts such as IRAs and 401(k) can own Bitcoin and other cryptocurrency. This requires a self-directed IRA or 401(k) and some careful structuring. For a more detailed discussion on this topic, check out my prior article and video here. When gains are made from the sale of cryptocurrency, whether for US dollars or other cryptocurrency, there is no tax owed on the gain. And, if you use a Roth IRA or Roth 401(k), there will be zero tax owed when you pull the funds out at retirement. For traditional IRAs and 401(k)s you pay tax when you withdraw the funds at retirement and these distributions, as is the case for all traditional IRA or 401(k) distributions, are subject to tax at your ordinary income tax rate at the time of distribution.
If your self-directed IRA or 401(k) is invested into cryptocurrency mining, as opposed to holding cryptocurrency for investment, then the income from such mining activities will likely cause unrelated business income tax.
I’m routinely asked questions about what taxes and rules apply when a distribution occurs from a retirement account. Here are the top ten rules you should know about distributions from retirement accounts:
