HS 355 Managing the Retirement Income Plan

What is the deadline for the conversion to a Roth Account?

It must be converted by the last day of the tax year, 12/31. If you take a withdrawal on 12/31 and roll that into a Roth IRA within the 60 day window it counts for the 12/31 date. The easiest way is to redesignate the account and then the date is clear.

What are the implications of a QLAC?

It's not certain how the market will react to them. There are only a few on the market and it may take time for the consumer to understand them.

What is recharacterization?

It's reversing the conversion to a Roth Account.

What is an example of the IRD rules?

Joe dies with a $12 million estate and $2 million in an IRA. The $2 million IRA is included in the estate and assume that $300,000 of estate taxes are paid as a result of the IRA. Assume that Sally withdrawals all of the $2 million at once from the IRA. She'll pay taxes on the $2 million but receives a deduction for the $300,000 already paid paying taxes on $1.7 million.

What is the actuarial equivalent of the standard form (life annuity)?

Joint and survivor

What is the normal form (required form of payment) for distribution of a qualified plan?

Joint and survivor for a married participant. Qualified retirement plans are required to pay out benefits to married participants in the form of a qualified joint and survivor annuity unless both the participant and the spouse waive it. The plan must state this rule. Since most elect a lump sum, this is typically waived.

What is the standard form of payment for distribution of a qualified plan?

Life annuity

What defined-benefit distribution option do most people elect?

Lump sum. The lump sum option is based on the actuarial factor stated in the plan but Code Sec 417 provides overriding interest rates when companies determine lump sum values.

What is important with the timing and form of payment with cash balance plans?

Many large companies have turned their defined-benefit plans into cash balance plans. These are basically defined-benefit plans guaranteed by the PBGC subject to minimum funding requirements and providing a promised benefit. From the participant's perspective it's a defined-contribution plan where the benefit grows with annual contributions tied to compensation. The return is stated and conservative, it's predictable like a defined-benefit plan. There isn't a lot an older worker can do as with a defined-benefit plan. If they work an additional year it helps that year but not previous years.

Should a defined-contribution participant elect an annuity?

Many plans don't offer an annuity. If they do you may be able to get a better annuity outside the plan.

What are the tax consequences for rollovers?

Most distributions from employer tax advantaged plans and IRAs can be rolled into another tax advantaged plan without any consequences.

Can you receive early retirement benefits with defined-benefit plans and what is the impact of early retirement?

Most do offer early retirement benefits at a certain age and typically a certain number of years of employment. Since plan benefits are still tied to average monthly comp and years of service, it can have a significant impact on benefits. Since these are annuities, retiring before normal retirement age will reduce the monthly amount because the payout is longer. Some companies may offer subsidized benefits for early retirement, however it could still reduce the amount due to years of service.

Where can benefits be rolled over to?

Most into an IRA. They can also be rolled into an employer tax qualified plan, 401(b), or government 457(b) plan.

What are the tax consequences on periodic distributions?

Most won't withdrawal all at once, distributions are stretched out over to minimize taxes and to enjoy additional tax-deferred growth. When they're taken over time, law provides for a methodology for getting a prorated deduction of the estate taxes.

What are the advantages of choosing a charitable remainder trust as the beneficiary?

No income taxes at the time of death. Beneficiaries can receive lifetime income; the beneficiary pays tax on the distributions. The beneficiary doesn't pay income tax on the remainder interest left to the charity. The decedent receives a deduction for estate tax purposes on the remainder interest that is going to the charity.

Are there age limits for a conversion to a Roth Account?

No. Prior to 59 1/2 there's no 72(t) penalty however if any distributions are taken they could be subject to the penalty if the withdrawals occur within 5 years of he conversion and still under age 59 1/2.

What are the regulations for products used in a QLAC?

Only a deferred income annuity can be used. A single or joint life annuity is used with a defined beneficiary. The only allowable benefit is a lump sum return of premium death benefit payable to heirs. The return of premium feature was added in as some thought people wouldn't buy them without it.

Is there a way to avoid the aggregation rule when converting IRAs to Roth Accounts?

Only the IRAs must be aggregated. If someone has multiple IRAs and they have a qualified plan or 403(b), if allowed in the plan they could roll over the IRA into the qualified plans and that would take it out of the calculation.

Why is there a required notice about the right to make a direct rollover?

Plans are required to tell participants and is an additional decision faced for the participant. Since this avoids the 20% mandatory tax withholding requirement and ensures the participant doesn't violate the 60 day rule, this is critical. Two IRS notices are typically used for traditional plans and Roth accounts.

How are retirement withdrawals of after tax contributions taxed?

Pre 1987 contributions can be withdrawn anytime without tax consequences. Post 1986 are subject to prorata recovery rules where the after tax portion of the account is accounted for. Account balance of $10,000, $2,000 is post 1986 and $500 is investment earnings on the $2,000. An in-service distribution of $1,000 is taken. The exclusion ratio is $2,000/$2,500 = 80%. $1,000 x 80% = $800 income tax free, tax is due on the $200.

What are the QLAC requirements?

Premiums paid can't exceed the lesser of $125,000 or 25% of the account balance. If the amounts exceed the requirements, as long as their paid back in the next calendar year it will remain a QLAC. Individual IRAs can be aggregated, spouses can't so each can purchase their own. The start dates must be specified, beginning not later than the first day of the month after turning 85.

What are the contribution rules for employee after tax contributions in a qualified plan?

Prior to 1987 everyone could make a 10% after tax contribution, and those who were business owners or highly compensated employees did. After 1987 nondiscrimination rules had to be followed and they counted under the maximum contribution limit. After 1986 these were mostly seen in large company 401(k)s as most lower income employees would rather contribute on an after tax basis because withdrawals are typically more accessible.

What can a participant or beneficiary convert?

Qualified plans (if allowed), 401(b)s, 457(b)s

What are some NUA traps?

Rolling the distribution into an IRA, the NUA is lost. This must be considered when performing a rollover.

How are Roth IRA and Roth Accounts taxed?

Simple, they grow tax free so if distributions are qualified, they aren't included as income.

Does the spouse have the same benefits in a defined-contribution plan as they do with a defined-benefit plan?

Since these are profit sharing or 401(k) plans, many are exempt from qualified joint and survivor annuity rules. Most plans today offer lump sum and installment payments so they can avoid the spousal paperwork

Can a defined-contribution participant retire at any time?

Some plans require the participant to work 1,000 hours and/or be employed on the last day of the plan year.

What is the Sec. 72(t) penalty tax?

The 10% penalty tax that is accessed along with the income tax from a withdrawal prior to age 59 1/2 from a qualified plan. Applies to IRAs, SEPs, SIMPLEs, qualified plans, and 403(b) annuities. Taxable withdrawals on earnings from a Roth IRA are included. 50 year old with $50,000 Roth IRA with $30,000 in contributions withdrawals $35,000. The $30,000 is return of contribution. Unless an exception to 72(t) applies the $5,000 is taxed and subject to the penalty.

How is life insurance taxed when it has been purchased on the life of the participant?

The Table 2001 amounts that have been taxed can be recovered tax free if the policy is distributed as part of the retirement plan. This isn't available to self-employed individuals.

What are rollovers of after tax contributions taxed?

The after tax contributions can be rolled over into an IRA however they will be subject to the prorata recovery rules. The better choice is to roll over all but the after tax contributions, now the after tax contributions have been rolled over tax free. $10,000 account balance, $2,000 is post 1986. $8,000 is rolled over and the $2,000 is now taken tax free.

How is life insurance taxed in a qualified plan if as part of a death benefit?

The beneficiary pays tax only on the cash value of the policy. Because the participant paid tax on the term portion of the contract the face amount minus the cash value is tax free. The cash value is also reduced by the Table 2001 amounts. Participant dies has a contract with a face value of $100,000, a cash value of $20,000 and $4,000 of accumulated cost basis. The beneficiary receives the $100,000. The pure life insurance portion is $100,000 - $20,000 = $80,000 is tax free. The cash value of $20,000 is taxable but that's reduced by the $4,000 table 2001 amount so only $16,000 is taxable.

What is the deadline for recharacterization?

The due date of the tax return plus extensions. Earnings or losses must be considered and you can't cherry pick specific assets. A way to pick specific assets to recharacterize is to set up multiple Roth IRA conversions with different assets in each Roth IRA to retain control over which assets are recharacterized.

What are qualified distributions from a Roth IRA and Roth Account?

The first question is at the time of distribution more than 5 years must have passed. The 5 year rule starts at the beginning of the year that the contribution is made. A person's first contribution to a Roth is 2/2015 for they year 2014. The 5 year clock starts 1/1/14 and ends 12/31/08. Any contribution after satisfies the 5 year rule. Then, one of 4 triggering events; 59 1/2, death, disability, or first time home buyer.

What about exceptions from the penalty for IRAs, SEPs, and SIMPLEs?

The following are exempt: A $10,000 first time home buyers exception, paying for higher education expenses (in the year the expenses occur), Health insurance premiums for the unemployed.

How will working more affect defined-benefit plans?

The monthly benefit is calculated based on a benefit percentage multiplied by the final monthly average compensation multiplied by years of service. So an individual with 30 years of service, a 1% formula for each year of service, and $10,000 average monthly compensation with have 1% x $10,000 = 100 x 30 = $3,000. If that person works an additional year this could have a significant impact. 31 years of service, 1% formula, $10,500 average monthly compensation will have 1% x $10,500 = 105 x 31 = $3,255.

What is the Net Unrealized Appreciation (NUA) tax rule?

The opportunity to have the appreciation of employer stock taxed at capital gain rates when the stock is sold. This applies to lump sum distributions from 401(k)s, ESOPs, and profit sharing plans. The entire balance must be paid out within one taxable year and after age 59 1/2, separates from service, or dies.

What happens to the penalty tax if I'm 55 or older, with a qualified plan, and separate from service?

The penalty tax does not apply.

Who's responsible for identifying the NUA amount?

The plan administrator. Usually done with the average basis for all shares and is reported on form 1099R.

What happens to the benefit if a defined-benefit plan is converted to a cash balance plan?

The plan's accrued benefit is usually an opening balance tied to the accrued benefit that was earned under the defined-benefit plan. Going forward the plan grows with contributions and interest credits. Unless an older worker who is grandfathered, the worker can't have the impact on benefits as with a defined-benefit plan. If grandfathered, the plans may provide larger contribution credits or stay on the defined-benefit plan.

What if a charity is one of several beneficiaries?

The shortest life expectancy is used, or if they all are nonperson charities, the ability to spread the distribution over the life expectancy of the other beneficiaries is lost. This is only a problem if the charity is still the beneficiary on 9/30 following the death of the participant (this is the determination date for beneficiaries). Solve this by paying out the benefit before 9/30.

What are cash balance arrangements?

These operate under law as defined-benefit plans subject to the same rules. From the participant's perspective it looks like a defined-contribution plan because the plan is stated as an account balance. Lumps sums distributions are allowed and most elect this. If the participant elects a lump sum, it is calculated using rates from Sec 417. When deciding to take a distribution be sure to look at plan documents because some plans may require a full year to received interest and contribution credits.

What are the benefits of the QLAC?

They bring credit to annuities into the retirement portfolio making them a viable retirement solution. This makes annuities more affordable for the average consumer by using their 401(k)s and IRAs. The help to: Manage longevity risk, frailty risk (simple financial management), market risk (replenishing income later in retirement), long term care risk by providing more resources at the time they're more likely needed.

How is life insurance treated in a qualified plan?

They can provide benefits as long as the benefit is incidental. Plans such as 403(b)s, SEPs, Simples, IRAs, and Roth IRAs can't hold life insurance.

Do defined-benefit plans have a years of service cap?

They can. Some may limit to 30 years of service. However working longer can still increase the payout because there will be a shorter payout period from the annuity.

What are some common tax issues with tax deferred retirement plans?

They're taxed at ordinary income and since it's taxed to the recipient the plan participant or IRA owner can't avoid taxes by gifting or divesting themselves of the benefit. After death distributions are taxed to the beneficiary, although there may be a deduction for any estate tax paid.

Explain the higher education exception to 72(t).

This allows up to the amount for higher education expenses for the taxpayer, spouse, child, and grandchild at an eligible institution. Higher education expenses include tuition, books, feed, supplies, equipment, and room and board if the student is enrolled half time.

What happens if a participant works past retirement in a defined-contribution plan?

This could be a benefit for the participant. Age discrimination laws require the employer to make contributions for older workers. If they're working past 70 1/2 they may be able to defer RMDs until they retire allowing the benefit to grow tax free.

What is the impact of a late career change for a defined-contribution plan?

This doesn't have a negative impact like the defined-benefit plan does. If the new employer has a defined contribution plan, the employee could benefit by a larger benefit over a short period of time.

Why would 72(t) exceptions be available in IRAs?

To encourage people to participate and contribute more and provide flexibility.

What plans can be converted to Roth Accounts?

Traditional IRAs, and SEPs, SIMPLEs (after 2 years)

What if I work past normal retirement age with a defined-benefit plan?

Unless the plan has a cap on service it will increase the years worked. It can impact retirement by 3 ways; years of service, higher compensation, and an actuarial increase for a shorter payout period.

If I begin substantially periodic equal payments, how long must they last?

Until either age 59 1/2 or 5 years, whichever is longer. Once this is reached the payments can stop, increase, or decrease. You can switch to the RMD method once without penalty. This typically lowers the amount taken (good for accounts that have experienced poor investment results).

Can the definition of compensation in the plan impact the payout?

Yes. The plan could limit to base pay or it could be as comprehensive as all taxable income plus nontaxable salary deferral contributions. If it is the latter, an older worker would benefit by working overtime, earning bonuses, or finding other ways to increase their income.

What about conversions to a Roth Account after age 70 1/2?

You can't convert the RMDs so if you are going to convert the amount must be reduced by the RMD amount.

What is the tax consequence if I have multiple IRAs to convert to a Roth Account?

You must find the cost basis which required aggregating the IRAs. If there is no cost basis the entire amount is taxed. A $23,000 IRA that includes $18,000 of nondeductible contributions that the participant wants to convert. There is also a fully taxable $100,000 rollover IRA. Find the tax free portion of the conversion: The amount converted ($23,000) x $18,000 (cost basis) / the value of all the accounts $123,000 = $3,366 is tax free. Tax would be owed on $19,634.

How is the conversion to the Roth Account taxed?

You must pay income taxes on the conversion however there is no 72(t) penalty. The tax is accessed on the fair market value of the account on the day the conversion is executed.

Explain the first time home buyer exception to 72(t).

$10,000 available. The distribution must be made 120 days to pay for qualified acquisition costs of the principal residence. This can be the individual, spouse, child, grandchild, or other ancestor of the individual or spouse. First time means that no ownership interest in a principal residence in the 2 years prior to acquisition.

What are the tax consequences for Roth accounts?

401(k)s, 403(b)s, and 457(b) plans are allowed, but not required, to give participants the election to make all or a portion of their contributions after-tax, in exchange for tax free treatment of qualified withdrawals. Roth accounts can be rolled into Roth IRAs or qualified plans that allow Roth accounts.

What is an eligible educational institution?

Any college, university, vocational school, or other postsecondary school eligible to participate in student aid programs through the Department of Education.

How is NUA calculated?

At the time of distribution the participant pays tax on the cost basis, the value of the stock when it was allocated to the account. The difference between the cost basis and the current market price is the NUA. This amount is taxed at long term capital gains when the stock is sold. 62 yo who takes a lump sum distribution from a 401(k). The current market value is $700,000 of which $500,000 is cash and $200,000 is company stock that was worth $50,000 when it was allocated to the account. They can roll the $500,000 into an IRA, $50,000 is taxed at ordinary income rates, and $150,000 is NUA which is taxed as long term capital gains.

How will additional work affect benefits in a defined-contribution plan?

Contributions grow over time with contributions and investment experience. It's harder to manipulate benefits with short term changes in income because more earnings mean a larger contribution for the current year, but it won't impact prior years. This might be more important for the account balance if the account isn't needed for sometime.

What about converted Roth IRAs and Sec 72(t)?

Generally only taxable withdrawals are subject to the penalty, however with a converted Roth IRA it's subject to the penalty tax.

What are the tax consequences for QDROs?

IRAs can be split without without tax consequences.

What are the tax consequences for Net Unrealized Appreciation (NUA)?

If a lump sum distribution is taken and has a distribution in kind of employee stock, there is a special tax treatment. The difference between the current value and the value when it was allocated is called the NUA.

With a defined-benefit plan what happens if a person changes jobs late in their career?

If the employee goes from an employer with a defined benefit-plan to a defined-contribution plan, this could have a negative impact. The employee could lose the last years where they're earning more and increasing years of service to a plan that has contributions that are more ratable and they may not rate favorably due to being a new employee. This could also happen if an employer decides to change thier plan to a defined-contribution or cash balance plan however most plans grandfather older workers.

Are there any reasons not to take a lump sum in a defined-benefit plan?

If the participant required an annuity, you typically get a larger payout inside the plan than taking the lump sum and purchasing an annuity outside the plan. If the plan has cost of living increases, those would be lost. Some plans provide ad hoc increases, those would be lost. Depending on the interest rate environment you could receive a lower amount.

When would someone want to do a recharacterization?

If too much has been converted, there has been a reduction in market value, or not enough cash to pay the taxes.

What are additional taxes with tax deferred retirement plans?

If under 591/2 a 10% penalty is also applied unless eligible for one of many exceptions, this can be complicated. The 3.8% unearned income Medicare contribution tax of 2013 is applied. this applies to investment income after a threshold is exceeded. Income from IRAs, qualified plans, and Roth IRAs aren't considered investment income, but they are included in adjusted gross income which determines whether the threshold is exceeded. Withdrawals can also increase Medicare Part B premiums or how much of Social Security is taxed.

What can be rolled over for a Roth Account?

In 401(k)s, 403(b)s, and 457(b) plans there may be a Roth option to exchange a tax deduction for a tax exempt withdrawal. Roth accounts can't be rolled into an IRA, but can be rolled into a Roth IRA.

How do you avoid the 72(t) penalty tax with Substantially Equal Periodic Payments (SEPP)?

In a year if the SEPP is modified, any tax along with penalties are due. For those involuntarily retired, they may return back to work and they may be planning to return to work. They should divide the IRA into two, taking the SEPP covering basic expenses from one and leaving the other for emergencies rather than being stuck with a large withdrawal for 5 years or age 59 1/2. For a younger person the period might be long as they need to leave it until 59 1/2. This will be a small payment because of the life expectancy.

What are the tax consequences for a death beneficiary?

Income taxes are deferred until distrubtions are made. They're taxed as ordinary income but is treated as income in respect to a decedent (IRD). Under IRD rules, the beneficiary receives deduction for any estate taxes paid.

What are the tax consequences for grandfathered tax treatment?

Individuals born before 1.1.36 can take lump sum with a special tax treatment. However, this would be lower due to RMDs and the distribution must be small to count for the special tax treatment.

What are qualified longevity annuity contracts (QLACs)?

A new regulation in 2012 says that you can use a portion of your 401(k) or IRA to purchase a defined income annuity that begins at 85.

How do you recover the cost basis with an IRA?

All IRAs must be aggregated. If a withdrawal is taken from an IRA that has nondeductible contributions, all IRAs must be counted. You multiply the distribution by a fraction. The numerator is the remaining nondeductible contribution and the denominator is the value of the account prior to the distribution.

How do you avoid the 72(t) penalty tax with death benefits?

All distributions to beneficiaries, even nonperson beneficiaries, regardless of age, are not subject to the tax. As long as the name remains in the participant, the same applies to the spouse. Spouses have the ability to roll over in their names and most do for the RMD benefit. If the spouse is under 59 1/2 at the time of the rollover, future distributions are not eligible for the exception. Leave the account in the name of the decedent until the spouse is 59 1/2 to avoid this.

What are the tax consequences for HSA tax free transfers?

An IRA owner can elect a one time transfer of funds tax-free from an IRA to an HSA account. However HSAs are only available to those with a high deductible medical plan.

What did the Pension Protection Act of 2006 do to interest rates required under Code Sec 417?

Beginning in 2008-2011 it changed the rates from following the 30 year Treasury Bonds to a rate based on investment grade corporate bonds. Since this is typically a higher rate, the reduced the capital requirements for plans and reduced the payout amount to participants.

How do you avoid the 72(t) penalty tax with disability benefits?

Distributions for a disability are exempt if the recipient is unable to engage in any substantial gainful activity. Proof must be furnished per IRS guidelines.

Who can roll over a benefit?

During the lifetime only the participant unless there's a QDRO, then the ex-spouse. After death, a spouse has the benefit of rolling into their own plan. A non-spousal beneficiary can only elect into an inherited IRA. If paid directly to the beneficiary it's taxable.

What are the advantages of leaving a tax-advantaged plan to a charity?

Eliminates taxes on the distribution as well as eliminates the value from the estate.

What are the exceptions to the 60 day rollover rule?

Error on part of an institution. A IRA private letter ruling is requested by the participant under some circumstances.

What factors have the most impact on a defined-contribution plan?

Investment experience has the single most impact on a plan. Fees can also have an impact on a plan.

What is a deemed distribution?

It is a case where a distribution is taxed prematurely. For example, a person defaulting on a loan may not have the means to pay the loan back in full when separating from the company. Certain IRA distributions are deemed distributions; engaging in a prohibited transaction, pledging the IRA as collateral, assigning the IRA to another person.

What if someone has a lot of assets in tax deferred savings with a NUA?

It would be a good way to get money outside the plan and diversify tax. This could provide opportunities for gifting and other estate planning objectives.

What are the two rule changes of 2012?

One is the QLAC. The other allows employers who offer both a defined-benefit and 401(k) plan to let employees to us a single sum from their 401(k) to buy more lifetime income from their defined-benefit plan.

How can the definition of average compensation affect retirement decisions?

The benefit is tied to average monthly compensation and is typically the highest earning 3-5 years of compensation. For longer periods, 5 years rather than 3, reduces the average monthly amount it makes it harder to impact the amount on a short-term basis. This can also be tied to the last 5 years or the highest 3-5 years which makes it difficult for an older worker who is looking to cut back hours or work less. You should look for these limitation when deciding what to do. Military plans require a person to be in a pay grade for a certain amount of time for it to count towards retirement.

What can be rolled over for life insurance?

The cost of insurance, Table 2001 amounts aren't eligible for rollover. Can't be rolled into an IRA but can be rolled into other qualified plans.

What are the tax consequences for life insurance in a qualified plan?

The cost of the term portion is taxed each year to the participant. The amount is calculated using IRS Table 2001.

How do you avoid the 72(t) penalty tax with medical benefits?

The distribution must be less or equal to deductible medical expenses for the year. Only 10% in excess of AGI are allowable.

How do you execute a Roth Conversion?

The simplest way is to redesignate an IRA to a Roth IRA. You can do a trustee to trustee transfer from an IRA to a Roth IRA. A direct rollover from a qualified plan to a Roth IRA. Or you can take the withdrawal and roll it over into a Roth IRA within the 60 day window.

What about spouses and the penalty tax?

The spouse can elect to roll the death benefit into their own account and can no longer enjoy the benefit of being exempt. However, it the account stays in the name of the decedent the withdrawals with be eligible for the exception.

How is life insurance taxed if the participant doesn't want the policy?

The trustee can strip out the cash value (by borrowing) to reduce it to the accumulated Table 2001 costs and then distribute the contract and the cash. The participant then cancels the policy and recovers the tax free cost basis. The cash can then be rolled into an IRA.

Defined-Contribution plans

The trustee purchases the annuity inside the plan. In most cases there is better annuity pricing inside the plan because of institutional pricing.

What are the tax consequences for charitable beneficiary?

There are no income tax consequences.

How do lump sum amounts react to interest rates?

When interest rates are low the amounts are higher. When rates are high, the rates are lower.

When doesn't the 20% mandatory tax withholding apply?

With SEPs and SIMPLEs. SIMPLEs can't be rolled into an IRA within 2 years of initial participation, however they can roll anytime between SIMPLEs.

Can Sec. 72(t) be avoided?

With some planning it may. You need to avoid unnecessary withdrawals with proper emergency fund planning. Diversify the portfolio by having cash funds outside the plan, a Roth IRA protects the contributions, and cash value life insurance can also help.

Is the participant in a defined-contribution plan allowed a rollover notice as with a defined-benefit plan?

Yes, the rules are the same.

Are there withdrawals that aren't penalized by 72(t)?

Yes, withdrawals due to a disability, deductibel medical expenses, early retirement through substantially equal periodic payments made over the recipient's lifetime, and account on death, distributions to the beneficiary are exempt. Hardship withdrawals aren't addressed.

Are partial conversions allowed to a Roth Account?

You can convert any amount or the entire account. A partial conversion allows you to control the tax consequence of the conversion.