SIE Chapter 12

Taxation of Roth IRA

Distributions from a Roth IRA are completely tax-free, including the growth, if they meet two tests: 1. Distributions are made after the five-year period that began with the first tax year in which a Roth was established. 2. Distributions are made after reaching age 59 ½

Separate account

The investment account of an insurance company where the owner of a variable annuity contract's premiums are invested in order to generate market-based return

Tax deferred accounts

401k, Pension, Traditional IRA

401(k) plans

401(k) plans have become the most popular and prevalent type of employer-sponsored retirement plan in the US. They are a type of defined contribution plan that allows each eligible employee the option of deferring a portion of her salary into the plan instead of receiving current pay in cash

1035 Exchange

A 1035 exchange allows an investor to transfer from one variable annuity to another with no tax consequences. Note that surrender charges may still apply.

Non qualified corporate retirement plan

A corporate plan that does not meet the guidelines of ERISA and therefore only allows for after-tax contributions The earnings in the plan grow tax-deferred, and when distributions are taken, only the growth is taxed as ordinary income ◆Flexibility to choose which employees participate ◆Flexibility to structure the plan so that it offers greater reward to the most valuable executives ◆Avoidance of nondiscrimination tests (because they are not ERISA-covered) ◆No limits on the amount of income that can be contributed non-deductible or after-tax

Employee Retirement Income Security Act (ERISA)

In order for a corporate plan to be qualified and receive these tax benefits, it must meet ERISA requirements. The landmark Employee Retirement Income Security Act (ERISA)was passed by Congress in 1974 to strengthen the retirement security of private-sector American workers. ERISA does not apply to plans for public workers or government employees; it applies to private, employer-sponsored plans only.

IRA Rollovers

Individuals can move their IRA investments from one plan provider to another (e.g. Fidelity to Wells Fargo). This is referred to as a rollover and must be completed within 60 days to avoid potential tax liabilities and early withdrawal penalties.

Can investment income be contributed to an IRA?

No - Only earned income can be contributed to an IRA. Investment income, such as capital gains, dividends, interest, and pension income, cannot be contributed. If an individual's sole income is investment income, that person cannot contribute to an IRA.

Tax free accounts

Roth, 529, Coverdell, ABLE

Coverdell Education Savings Account

Similar to 529 plans, a Coverdell is another tax-advantaged investment account to save for education. The tax treatment is identical to that of a 529 plan. However, 529 plans are the much more popular of the two plans as a Coverdell has a much lower maximum contribution limit: $2,000 per year per child. Additionally, a Coverdell can be opened for any student who is under the age of 18, but the assets must be withdrawn or transferred by the time the student reaches the age of 30.

General Versus Separate Account

The general account of the insurance company seeks to provide a fixed return by investing customer premiums into conservative investment options, such as Treasury securities and high grade corporate bonds. The separate account of the insurance company seeks to provide a variable return by investing in a wider range of securities including equities and mutual funds.

What does tax deferred mean?

The manner in which retirement accounts and other tax-advantaged accounts grow, meaning no taxation on the capital gains, dividends, or interest income that is generated each year until the funds are distributed from the plan

Variable Annuity Payouts

The payouts received by an investor from their variable annuity will fluctuate each month based on the performance of their separate account.

Variable annuities

market performance. Because of this, they are resistant to inflation and provide the possibility of greater returns. Variable annuities do this by allowing the contract owner to invest in the insurance company's separate account in a broad range of professionally managed investment options, typically mutual funds. Contract owners may choose investments that offer different levels of risk and potential growth. The value of a variable annuity will vary, depending on the performance of the investment options that were chosen.

SEP IRA

A Simplified Employee Pension (SEP-IRA) is a type of employer-sponsored retirement plan that is typically offered by small businesses because it is inexpensive to set up and maintain. Contributions are made in the name of each participant directly into his individual retirement account, or IRA (discussed shortly). SEP-IRAs are at the option of the employer, never required. However, the same percentage contribution must be made for all eligible employees.

Spousal IRA

A contribution of up to $6,000 per year may be made by a working spouse to a spousal IRA account in the non-working spouse's name.

Qualified Corporate Retirement Plans

A corporate plan that meets the guidelines of ERISA and therefore allows for pre-tax contributions This means that money is invested into the plan before taxes are paid on those funds. This cash is then invested into any number of eligible securities and those investments will grow tax-deferred Distributions are taxable at ordinary income, never as capital gains

Individual Retirement Account (IRA)

A retirement account that can be opened by an individual with earned income separate from the retirement plans offered by their company

SEP-IRA

A simplified employee pension (SEP-IRA) is a type of employer sponsored retirement plan that is typically offered by small businesses because it is inexpensive to set up and maintain. Instead of companies having to establish a new plan, a SEP-IRA allows the company to contribute directly to each employee's IRA. Take note that only the employer, not the employee, can contribute to a SEP-IRA.

Surrender Charges

A surrender charge is a fee paid by an investor to the insurance company if the investor withdraws their capital prior to annuitization.

403(b) Plans

A tax-sheltered annuity, also known as a 403(b) plan, is a retirement plan used by employees of public schools and non-profits. Similar to a 401(k), it allows individuals to make pre-tax (tax-deductible) contributions. The investments in the plan grow tax-deferred and all distributions from the plan are taxed as ordinary income.

Roth IRA (post-tax/ tax-free)

Contributions to a Roth IRA are always made with after-tax dollars. The earnings in the plan grow and accumulate tax-free and qualified distributions from a Roth are tax-free. To be qualified, distributions must be made after reaching age 59 ½ and the money must have been in the plan for at least five years.

Are annuities registered securities?

Variable are - Because investors take on the investment risk in variable annuities, variable annuities are considered securities and must be registered with the SEC and sold with a prospectus. The prospectus contains important information about the annuity contract, including fees and charges, investment options, death benefits, and annuity payout options.

Accumulation Units

When an individual invests money into a variable annuity, the dollars invested into the insurance company's separate account purchase accumulation units. Each unit represents an interest in the underlying subaccount. The value of each unit will fluctuate based on the value of the securities in the portfolio. Therefore, both the number of accumulation units will vary (the number will increase as the individual invests more money) as will the value of each unit.

ERISA retirement plans must

be non discriminatory and have a vesting schedule (which specifies when participants have ownership rights to employer contributions)

Three traditional IRA contribution scenarios

1. An individual can have a tax-deductible (pre-tax) IRA if they are not eligible to participate in a corporate plan. For example, the individual's employer does not offer them 2. An individual can have a tax-deductible (pre-tax) IRA if they are eligible for a corporate plan, but make below a certain amount of income (the exact numbers are not important for the exam). 3. An individual can have a non-deductible (after-tax) IRA if they are eligible for a corporate plan and make over a certain amount of income (the exact numbers are not important for the exam).

Roth 401(k) accounts

401(k) plans have been allowed to add a Roth account feature. Technically, a Roth 401(k) is an optional Roth account, which may be offered by the employer, to which each participant may choose to contribute in addition to their regular 401(k) contributions. The Roth account works like a Roth IRA inside the plan. Only employee contributions go in the Roth account; employer match contributions are made to the regular 401(k) account

457(b) Plans

457(b) plans are participant-directed, ERISA, deferred compensation plans sponsored by state or local government entities, as well as tax-exempt 501(c) organizations. In virtually all respects, they work the same as 401(k) and 403(b) plans, with the same tax treatment and contribution limits

529 Plan

A 529 plan is a tax-advantaged to save for education. Contributions to the plan are made with after-tax dollars. The earnings in the plan grow and accumulate tax-free and distributions for qualified education (e.g. tuition and books) are completely tax-free at the federal level. Technically, because 529 plans are offered by states, the maximum amount that can be contributed will vary state to state. Additionally, there is no age limit on the beneficiary of a 529 plan. All states provide a program disclosure document, which includes a description of their plans.In addition to savings plans, some states and educational institutions have established pre-paid tuition plans which allow for the prepayment of future tuition at one or more designated colleges, often limited to designated public colleges within the state.

Guaranteed Investment Contract (GIC)

A GIC is an insurance contract that function like a time deposit. An investor agrees to deposit cash with the insurance company for a fixed period and in return the insurance company provides them with a guaranteed rate of interest as well as the return of principal.

Simple IRA

A Savings Inventive Match Plan for Employees (SIMPLE) is a type of employer sponsored retirement plan available to small businesses. It can only be used by companies that have 100 employees or less.

Keogh plans

Keogh plans, also referred to as HR-10 plans, are qualified plans that allow self-employed individuals and owners of unincorporated businesses to contribute for retirement on behalf of themselves and their employees. Because of certain legislative changes, new Keogh plans are seldom set up, though many are still in existenc

Deferred vs. Immediate Annuity

Deferred annuities accumulate earnings until a future date when payments of income to the annuitant begin. A deferred annuity can be purchased with either a single premium or periodic payments. Immediate annuities begin payments shortly after the contract is issued (usually within one month to one year). The payment amount varies by the age of the individual, the contribution amounts, and the earnings applied to the purchase payments. A longer deferral period allows the annuity to accumulate more earnings, which increases the amount of the potential payout

Non-Qualified Retirement Plans - Credit Risk

Non-qualified corporate retirement plans carry credit risk if the employer is insolvent or files for bankruptcy. A non-qualified plan does not meet certain federal legal requirements under ERISA (the federal law). The ERISA criteria are not tested.

Perk of annuities

One of the main benefits of annuities is that, like retirement plans, the investments grow tax-deferred. This means that an investor will not pay taxes each year on the earnings or growth in the plan. The investor only pays taxes when he takes distributions.

Roth vs Traditional IRA

Similarities: ◆The dollar limits on annual contributions are the same—$6,000 plus a $1,000 catch-up for those age 50 and over. The contribution is limited to 100% of earned income. ◆Owners have discretion to invest assets in a variety of investment choices, and the prohibited transactions are the same as in traditional IRAs. ◆Earnings accumulate on a tax-deferred basis—i.e., without current tax consequence. Differences: ◆Roth IRA contributions are available only to taxpayers who have an income below a certain limit. Once a person's income exceeds the limit she can no longer contribute to the plan ◆Roth IRA contributions are always made with after-tax dollars (non-deductible). ◆Distributions from Roth IRAs are tax-free. ◆RMDs are never required from Roth IRAs during the account owner's lifetime.

IRA Contribution Limits

The maximum contribution to an IRA is the lesser of $6,000 (this was updated from $5,500 on January 1st , 2019) or 100% of the individual's earned income. Note, that only earned income (e.g. salary) can be contributed to an IRA. Investment income, such as capital gains or dividends, and income from a retirement plan (e.g. a pension plan) is not considered earned income and therefore cannot be contributed. Example: If an individual earns $3,000 from a part time job, $10,000 of investment income, and $40,000 of pension income, they can only contribute $3,000 to their IRA.

Traditional IRA (pre-tax/ tax-deferred)

Traditional IRA contributions are usually pre-tax, have tax-deferred earnings and growth, and all distributions are taxed as ordinary income. There is no minimum age, so even a child with compensation is allowed to contribute to a traditional IRA. The maximum contribution as of 2020 is the lesser of $6,000 or 100% of the individual's annual earned income, which includes wages, salary, and commissions. Described differently, an individual can contribute up to $6,000 of earned income to an IRA Individuals age 50 or over may add an annual catch-up contribution of $1,000 with a 6% penalty if used early

Variable Annuity Payout Options

When an investor annuitizes, they begin to receive payments from the insurance company. One factor that impacts their monthly payment is the payout option the investor has chosen. A life option or life annuity makes payments for the life of the investor, but no payments to their beneficiary upon death. In contrast, a joint and last survivor option guarantees payments over two lives. Once the investor dies, the insurance company will then make payments to the beneficiary until their death. Because the life option is expected to have a shorter duration and is therefore riskier to the investor, it makes higher monthly payments.

Early distribution 10% penalty exceptions

◆Disability of the account owner ◆Payment of education expenses for the account owner, her spouse, children, and grandchildren ◆First-time homebuyers (limited to $10,000) Medical expenses ◆Death of the account owner

Investments prohibited in IRAs

◆Fixed life insurance ◆Antiques and collectibles, other than certain US-issued gold and silver coins ◆Option positions, other than covered call-writing programs on listed options, and ◆Real estate

Defined contribution plan

A type of qualified plan, such as a 401(k), where retirement income is based on the amount of money contributed to the plan and the performance of those investments Because defined contribution plans meet ERISA guidelines, they are all qualified plans, meaning they enjoy tax-deductible contributions and tax-deferred growth, and all distributions are taxed as ordinary income

Defined benefit plan

A type of qualified plan, such as a pension plan, where the amount of income received at retirement is predetermined based on the employee's age, position, and tenure with the company all company con-tributions are deposited into a trust and professionally managed to produce investment returns that are designed to meet the required retirement benefits.

ABLE Accounts

An ABLE account is a tax-advantaged savings account for individuals with disabilities. It may be opened for persons with disabilities up to the age of 26. It allows for a donor to contribute after-tax dollars on behalf of an individual with disabilities. The earnings in the plan grow and accumulate tax-free and distributions for qualified disability expenses (e.g. education, housing, health care, transportation, etc.) are completely tax-free at the federaI level.

Roth IRA Eligibility

An individual is only eligible to contribute to a Roth IRA if their modified adjusted gross income is below a certain threshold. In 2020, the limit is $139,000 and this figure is adjusted annually for inflation. Focus on the concept rather than memorizing the specific threshold.

Roth IRA Early Withdrawals

An individual under age 59.5 with a valid exception (e.g. first-time home buyer, qualified education expenses, death, disability, and major medical expenses) can withdraw funds from a Roth IRA that they have had for less than five years without being subject to a 10% early withdrawal penalty. However, in this situation the individual will be taxed on the earnings.

How to establish a 529 plan

Any adult may set up and contribute to a 529 plan for a designated beneficiary. The designated beneficiary, typically a minor, does not have to be a relative of the contributor, but the beneficiary must be an existing child (i.e., not an unborn child). Additionally, there is no requirement to have earned income in the year of the contribution. All plan contributions are made with post-tax dollars, and maximum contributions vary by state

Tax-Advantaged Savings for Education and Individuals with Disabilities

As discussed previously, municipal fund securities are investment pools like mutual funds, but they are instead issued by a state or local government entity. Two types of municipal fund securities—ABLE accounts and 529 plans—have a tax-advantaged structure similar to those of the accounts and products discussed so far in this chapter. As with retirement investments and annuities, no annual taxation applies to the growth in these plans, mean-ing any capital gains, dividends, and interest income can be fully reinvested back into the funds without taxation. Instead, they provide certain tax benefits to help those saving for education as well as with expenses for those with disabilities

Catch-Up Contribution

If an individual is 50 or older, they can contribute an additional $1,000 to their IRA ($7,000 total).

Excess Contributions

If an investor makes an excess contribution (e.g. more than $6,000) to a Traditional or Roth IRA, they will be assessed a 6% tax penalty by the IRS.

Fixed Versus Variable Annuities

In a fixed annuity, the investor earns a guaranteed fixed return. The risk of negative performance of the investments is assumed by the insurance company. However, the investor still faces inflationary risk (the fixed return will not keep place with inflation). In a variable annuity, the investor earns a variable return based on the market performance of the investments they select within the insurance company's separate account. The investor bears the risk of any reduced payout (market risk).

Fixed annuities

Offer both guaranteed principal and a guaranteed fixed rate of interest for the term of the contract, which is managed through the insurance company's general account. They accumulate a stated amount of interest and guarantee that a certain amount of income will be paid. With a fixed annuity "what you see is what you get"—there is no variability to the investment returns or payment

Pre vs post tax

Pre-tax deductions reduce the amount of income that the employee has to pay taxes on. You will withhold post-tax deductions from employee wages after you withhold taxes. Post-tax deductions have no effect on an employee's taxable income

Profit sharing plans

Profit-sharing plans are a type of defined contribution plan that gives employers the flexibility to vary the level of annual contributions each year based on the company's profits. The same percentage of compensation generally must be contributed for all eligible employees. Typically, these plans are combined with 401(k)s, allowing for both an employee deferral contribution as well as a company contribution based on profits

Tax free vs tax deferred

Tax deferral: Income contributed or earned in these accounts is not taxed in the year in which it is earned Tax free: Taxes must be paid on the contributed income the year in which it is earned, but once in the account, it is tax free

Required Minimum Distributions (RMD)

The owner of a traditional IRA is required to begin taking distributions from the account by April 1st of the year following their turning 70 ½. The amount they are required to withdraw is referred to as the RMD and is calculated based on the owner's account value and life expectancy. For Roth IRAs, because there is no age limit for making contributions, RMDs are not required from a Roth IRA until death of the account owner. Note that beginning in 2020, the Secure Act has raised the RMD age from 70 ½ to 72.

Annuitization

The second phase of the annuity is annuitization, where the investor can begin taking income from the plan. As with IRAs, distributions can begin at age 59 ½ with early with-drawals subject to a 10% penalty on the earnings. The payouts received by an investor from her variable annuity will fluctuate each month based on the performance of her separate account.

Non-deductible/after-tax and examples

the company sets money aside for the future use of key employees. As long as employees have no current ownership or control of assets, they do not pay current income tax. Typically, tax is owed by the employee and companies take tax deductions when plan benefits are distributed. Payroll deduction plans and deferred compensation plans