ACCT 345 Chapter 13
Is a taxpayer who contributed to a traditional IRA able to convert the funds to a Roth IRA?
Yes, taxpayers can convert deductible contributions made to a traditional IRA into a Roth IRA. They can do this by having the funds directly transferred from the traditional to the Roth IRA (taxpayer does not receive a distribution of the funds) or the taxpayer can roll over the funds from the traditional IRA to the Roth IRA by receiving a distribution from the traditional IRA and then contributing the funds to the Roth IRA within 60 days of receiving the contribution. With either a direct transfer or a rollover, the entire amount taken from the traditional IRA is taxed at ordinary rates. A direct transfer is not subject to the 10% early distribution penalty because the funds are not distributed. In the case of a rollover, the distribution amount is not subject to the 10% penalty so long as the taxpayer contributes the full amount taken out of the traditional IRA to a Roth IRA within 60 days of taking it out of the traditional IRA. Any amount not rolled into the Roth IRA is generally subject to the 10% early distribution penalty if the taxpayer is not 59 ½ years of age at the time of the distribution.
Explain the nontax similarities and differences between qualified defined contribution plans and nonqualified deferred compensation plans from an employee's perspective.
1.The two types of plans are similar in that they invest (or defer receiving) compensation for a future return. However, the future return is frequently based on deemed, rather than actual, investment choices and the employee becomes an unsecured creditor of the employer. If the employer doesn't have the funds, the employee may not receive benefit from a nonqualified plan. Because the funds in a defined contribution plan are set aside for the taxpayer in a separate account outside the control or ownership of the employer, the employee is not an unsecured creditor of the company.
Describe the minimum distribution requirements for defined benefit plans.
An employee must receive distributions by the later of April 1 of the year after the year in which the employee turns 72 or when she actually retires, if later. While the requirement necessitates that she receive a distribution for the year in which she turns 72, she can defer receipt of the first payment until April 1 of the year after which she turns 72.
How are defined benefit plans different from defined contribution plans? How are they similar?
As the name suggests, defined benefit plans spell out the specific benefit the employee will receive on retirement. In contrast, defined contribution plans specify the maximum annual contributions that employers and employees may contribute to the plan. Defined benefit plans are funded by the employer while defined contribution plans are funded by the employee. Both plans are generally classified as employer-provided qualified retirement plans and have similar rules for vesting (although the vesting rules are slightly more favorable for defined contribution plans than defined benefit plans) and required distributions.
Cami (age 52 and married) was recently laid off as part of her employer's reduction in force program. Cami's annual AGI was usually around $50,000. Shortly after Cami's employment was terminated, her employer distributed the balance of her employer-sponsored 401(k) account to her. What could Cami do to avoid being assessed the 10 percent early distribution penalty?
Cami could "roll over" (contribute) the full 401(k) proceeds to an individually managed retirement plan such as an IRA or a Roth IRA. Because she is under age 55, if she does not roll over the proceeds, she will be taxed on the full distribution amount and she will be required to pay a 10% penalty on the full proceeds.
Are these requirements typically an item of concern for taxpayers?
Distribution requirements for defined benefit plans are rarely a concern, since the plans are typically structured to avoid them.
What are reasons why companies provide nonqualified deferred compensation plans for certain employees?
Employers may provide nonqualified deferred compensation as part of a compensation package to attract prospective executives and other employees. They may provide plans because they can earn more on the deferred compensation than they are required to pay to employees. They may also provide plans to make highly compensated employees whole in terms of matching contributions to qualified retirement plans (because employers may not be able to contribute the full matching percentage to the highly compensated employees due to tax law limitations on contributions).
What are the nontax advantages and disadvantages of defined benefit plans relative to defined contribution plans?
For an employee the advantage of a defined benefit plan is knowing what the payout will be at retirement given a certain amount of years of service. Thus, a defined benefit plan shifts investment risk (the risk of how an investment will perform) to the employer. However, if the employer is not able to fund or pay for the benefits, the employee may not ever receive the retirement benefits from a defined benefit plan. Many of the disadvantages of defined benefit plans are faced by the employer. Employers are required to fund (pay for) the plans. The contributions required to fund a plan are dependent upon actuarial and management estimates. This process can become very cumbersome and expensive for the employer. Also, because the employer is required to provide a certain benefit for the employee, the employer must bear the investment risk. Many employers are now moving towards defined contribution plans due to the significant nontax advantages. Employers are not required to make costly estimates to fund a contribution plan—they simply make the contribution they have committed to make. Also, employers do not bear the investment risk of the investments. For defined contribution plans, employees generally have some direction over the way in which contributions are invested and also reap all the benefits of positive market conditions or good investments. But employees also bear the investment risk associated with defined contribution plans.
Describe the circumstances in which it would be more favorable for a taxpayer to contribute to a traditional IRA rather than a Roth IRA, and vice-versa.
In general, a traditional IRA will typically provide a better after-tax rate of return when tax rates are expected to decline in the future. A Roth IRA will generally provide a better after-tax rate of return when tax rates are expected to increase in the future. If the tax rates are expected to remain the same, the after-tax rate of return will be the same for both types of IRAs.
Compare the minimum distribution requirements for traditional IRAs to those of Roth IRAs.
In regards to traditional IRAs, taxpayers are subject to the same minimum distribution requirements as traditional 401(k) plans. They must begin receiving distribution by the later of April 1 of the year after the year in which the taxpayer turns 72 or when she retires. The minimum amount of the distribution is determined by using a table provided in the Treasury Regulations and is based upon the taxpayer's age and account balance. Taxpayers are not ever required to receive minimum distributions from Roth IRAs.
What nontax factor(s) should an employee consider when deciding whether and to what extent to participate in an employer's 401(k) plan?
Nontax factors to be considered in the decision to participate in an employer's 401(k) plan include any matching programs the employer may have in place, when an employee may need funds distributed, and how funds contributed to the 401(k) will be invested.
How are qualified distributions from Roth IRAs taxed? How are nonqualified distributions taxed?
Qualified distributions from a Roth IRA are not taxable. Nonqualified distributions are taxed to the extent that they are made from the earnings of the account. Nonqualified distributions of account earnings are also subject to a 10 percent penalty unless the taxpayer is at least 59 ½ years of age at the time of distribution. Contributions to a Roth IRA are from after-tax dollars (non-deductible) and can always be recovered tax free. Nonqualified distributions are considered to first come from contributions and then earnings.
Explain the tax similarities and differences between qualified defined contribution plans and nonqualified deferred compensation plans from an employer's perspective.
Similarities Employers: Employers deduct amounts they pay for qualified and nonqualified plans. Both plans provide deferred compensation or benefits to the employee. Dissimilarities Employers: Nonqualified plans are not subject to the same restrictive requirements pertaining to qualified plans, so employers may discriminate in terms of who they allow to participate in the plan. In fact, employers generally restrict participation in nonqualified plans to more highly compensated employees. Also, employers are not required to "fund" nonqualified plans. That is, employers are not required to formally set aside and accumulate funds specifically to pay the deferred compensation obligation when it comes due. Rather, employers typically retain funds deferred by employees under the plan, use the funds for business operations, and pay the deferred compensation out of their general funds when it comes due.
Explain when a taxpayer will be subject to the 10 percent penalty when receiving distributions from a Roth IRA.
Taxpayers who receive a distribution of earnings from a Roth IRA are subject to the 10% penalty on the earnings unless the taxpayer is 59 ½ years of age at the time of the distribution or the taxpayer meets one of the other exceptions provided in §72(t)(2). Nonqualified distributions are any distributions from the Roth IRA if the taxpayer has not had the Roth IRA account open for at least five years. If the Roth account has been open for five years, all distributions other than distributions (1) made on or after the date the taxpayer reaches 59 ½ years of age, (2) made to a beneficiary (or to the estate of the taxpayer) on or after the death of the taxpayer, (3) attributable to the taxpayer being disabled, or (4) used to pay qualified acquisition costs for first-time homebuyers (limited to $10,000) are considered to be disqualified distributions.
Describe the annual limitation on employer and employee contributions to traditional 401(k) and Roth 401(k) plans.
The combined contributions made by an employer and employee to an employee's 401(k) plan (Roth or traditional) is limited to the lesser of $57,000 or 100% of the employee's compensation for the year. In 2020, the employee's contribution is limited to $19,500 ($26,000 if age 50 by the end of the year). Thus, if an employee contributes $19,500 to her 401(k) plan (Roth or traditional), the employer's contribution to the employee's traditional 401(k) plan is limited to $37,500 ($57,000 - $19,500). If the employee and employer make the maximum contributions, taxpayers under 50 years of age could have $57,000 contributed to their accounts and taxpayers 50 years of age or older could have $63,500 contributed to their accounts. Employers may not contribute to an employee's Roth 401(k).
Compare and contrast the annual limitations on deductible contributions to SEP IRAs and individual 401(k) accounts for self-employed taxpayers.
The contribution limitation on a SEP IRA for 2020 is the lesser of $57,000 or 20% of Schedule C net income minus the deduction for half of self-employment taxes paid. The contribution limitation on individual 401(k) accounts is the lesser of $57,000 or 20% of Schedule C net income minus the deduction for half of self-employment taxes paid plus $19,500 (the employee's contribution). Taxpayers 50 years old and older may contribute an additional $6,500 "catch up" contribution above and beyond these limitations (the catch up is not available for SEP IRAs). Thus, taxpayers who are at least 50 years of age at the end of the year can contribute up to $63,500 to their individual 401(k) accounts. In any event, taxpayers are not allowed to contribute more than their net Schedule C income minus the deduction for self-employment taxes no matter their age at year end.
What is the maximum saver's credit available to taxpayers? What taxpayer characteristics are relevant to the determination?
The maximum saver's credit available to taxpayers is $1,000. It is calculated by multiplying the taxpayer's contribution, up to a maximum of $2,000, by the applicable percentage depending on the taxpayer's filing status and AGI. Also, the credit is restricted to individuals who are 18 years of age or older and who are not full-time students or claimed as dependents on another taxpayer's return. The saver's credit is nonrefundable.
What is the saver's credit, and who is eligible to receive it?
The saver's credit is a credit provided for an individual's elective contributions of up to $2,000 to any qualified retirement plan multiplied by a percentage provided by the IRS and dependent upon AGI. The credit is in addition to any deduction the taxpayer may have been able to take as a result of the contribution. The credit is only available for taxpayers who are 18 years of age or older, not full-time students during the year (full-time student during five calendar months during taxpayer's tax year), and not claimed as dependents on another taxpayer's return.
How is the saver's credit computed?
The saver's credit is calculated by multiplying the taxpayer's contribution (only up to $2,000) by an applicable percentage (10%, 20%, or 50%) provided by the IRS and based on the taxpayer's filing status and AGI. Also, the credit is restricted to individuals who are 18 years of age or older and who are not full-time students (full-time students during at least five calendar months during taxpayer's tax year) or claimed as dependents on another taxpayer's return.
What are the primary tax differences between traditional IRAs and Roth IRAs?
Traditional IRA contributions are deductible and distributions when received are taxable (assuming all deductible contributions, otherwise part of the traditional IRA distributions are taxable). Roth IRA contributions are not deductible and qualified distributions when received are not taxable. Minimum distributions are not required for Roth IRAs but they are required for traditional IRAs.
What types of retirement plans are available to self-employed taxpayers?
Two of the more common plans for the self-employed are the SEP IRA and individual (or "self-employed") 401(k). Other plans such as Simple IRA plans are also available to self-employed taxpayers although we don't discuss details of these plans in the chapter.
What does it mean if an employer "matches" employee contribution to 401(k) plans?
When an employer matches an employee's contribution, the employer contributes to the employee's plan based on how much the employee contributes. The matching policy is frequently described as a multiple of what the employee contributes to the plan. If, for example, an employee contributes $1,000 to a 401(k) plan, the employer may offer to match this contribution 2 to 1 for a $2,000 contribution from the employer. In this case, the employer and employee contributions sum to $3,000.