IRA Products and SIMPLE Plans

Transcription

1 IRA Products and SIMPLE Plans This Document Will Help You Prepare To Take The Online Examination A Center for Continuing Education 707 Whitlock Ave, SW, Suite C-27 Marietta, GA Fax:

2 IRA Products and SIMPLE Plans

3 Published by Erland Education Services (formerly Erland Financial Education Services). About the Author Erland Education Services is a provider of financial continuing education curriculum for financial professionals, which began operations in The company s curriculum is written and researched using a variety of current, reliable sources. The proprietor and curriculum author, Peggy Erland, has a background including thirty-two years as a licensed agent, seven years as a licensed securities representative, four years as a dean of training for a na0tionwide firm, and six years managing insurance and securities sales support units. Her experience includes curriculum development, individualized and group training, training evaluation, technical manual creation, and research and documentation of thousands of technical sales issues. No part of these courses may be reproduced, transmitted in any form or by any means, electronic or mechanical, for any purpose, without the express permission of Erland Education Services. Although great effort has been made to ensure this publication contains accurate, timely information, it is provided with the understanding that the author is not engaged in rendering legal, accounting, tax, or other professional service. If professional advice is required, the services of a competent legal advisor should be sought. Copyright Erland Education Services (formerly Erland Financial Education Services) 2008, 2009, 2010, 2011, 2012, 2013, 2014, 2015, 2016, 2017, 2018

4 Table of Contents CHAPTER ONE: AN INTRODUCTION TO RETIREMENT SAVINGS... 1 LEARNING OBJECTIVES:... 1 RETIREMENT TODAY... 1 RETIREMENT INCOME... 1 Personal Savings... 1 Social Security... 2 Qualified Retirement Plans... 3 RETIREMENT SAVINGS FACTORS... 4 Life Expectancy... 4 Inflation... 4 Risk... 4 Health Care Costs... 5 Rule of Thumb... 5 CHAPTER ONE STUDY QUESTIONS... 6 Answers to Chapter One Study Questions... 7 CHAPTER TWO: AN INTRODUCTION TO TRADITIONAL IRAS... 8 LEARNING OBJECTIVES... 8 WHAT IS A TRADITIONAL IRA?... 8 ELIGIBILITY REQUIREMENTS FOR A TRADITIONAL IRA... 9 TYPES OF TRADITIONAL IRAS... 9 Individual Retirement Account... 9 Individual Retirement Annuity Simplified Employee Pension Employer and Employee Association Trust Account TRANSFERS Trustee-to-Trustee Transfers Rollovers Transfers Due to a Divorce IRA INVESTMENTS CHAPTER TWO STUDY QUESTIONS Answers to Chapter Two Study Questions CHAPTER THREE: CONTRIBUTION RULES OF TRADITIONAL IRAS LEARNING OBJECTIVES CONTRIBUTION LIMITS General Contribution Limit Catch-Up Contributions Spousal Limit Contributions Above or Below Limits Commissions and Fees Qualified Reservist Repayments CONTRIBUTION DEADLINES CHAPTER THREE STUDY QUESTIONS IRA Products and SIMPLE Plans i

5 Answers to Chapter Three Study Questions CHAPTER FOUR: DEDUCTING TRADITIONAL IRA CONTRIBUTIONS LEARNING OBJECTIVES DEDUCTING CONTRIBUTIONS Full Deduction Spousal Deduction Commissions and Fees EMPLOYER PLAN DEDUCTIONS Defined Contributions Plans Defined Benefit Plans Plans That Are Not Employer Plans Deduction Phaseout NONDEDUCTIBLE CONTRIBUTIONS CHAPTER FOUR STUDY QUESTIONS Answers to Chapter Four Study Questions CHAPTER FIVE: DISTRIBUTION RULES OF TRADITIONAL IRAS LEARNING OBJECTIVES MINIMUM DISTRIBUTIONS Distribution Period Life Expectancy Beneficiaries EARLY DISTRIBUTIONS Exceptions TAXABILITY OF DISTRIBUTIONS Fully and Partly Taxable Special Tax Situations CHAPTER FIVE STUDY QUESTIONS Answers to Chapter Five Study Questions CHAPTER SIX: TRADITIONAL IRA TRANSFERS AND ROLLOVERS LEARNING OBJECTIVES TRUSTEE-TO-TRUSTEE TRANSFERS Recharacterizations ROLLOVERS TO A TRADITIONAL IRA ROLLOVERS FROM A TRADITIONAL IRA Rollover from One Traditional IRA to Another Rollover from an Employer s Plan ROLLOVER TIME LIMITS TRANSFERS INCIDENT TO A DIVORCE Changing Names Direct Transfer AUTOMATIC ROLLOVERS AND SAFE HARBOR IRAS CHAPTER SIX STUDY QUESTIONS Answers to Chapter Six Study Questions IRA Products and SIMPLE Plans ii

6 CHAPTER SEVEN: ROTH IRAS LEARNING OBJECTIVES WHAT IS A ROTH IRA? ROTH IRA ELIGIBILITY RULES ROTH IRA CONTRIBUTION RULES CONVERSIONS AND ROLLOVERS Conversions Rollover from Another Roth IRA ROTH IRA DISTRIBUTION RULES Qualified Distributions Non-Qualified Distributions Minimum Distributions CHAPTER SEVEN STUDY QUESTIONS Answers to Chapter Seven Study Questions CHAPTER EIGHT: IRA PRODUCTS LEARNING OBJECTIVES CERTIFICATES OF DEPOSIT MUTUAL FUNDS Stocks Bonds Loads Fees Money Market Mutual Funds ANNUITIES Fixed Annuities Variable Annuities SELF-DIRECTED IRAS CHAPTER EIGHT STUDY QUESTIONS Answers to Chapter Eight Study Questions CHAPTER NINE: TRADITIONAL IRAS VS. ROTH IRAS LEARNING OBJECTIVES ELIGIBILITY Traditional IRA Roth IRA CONTRIBUTIONS Traditional IRA Roth IRA DISTRIBUTIONS Traditional IRA Roth IRA TAXES ROTH IRA CONVERSIONS Conversion Tax Age at Conversion Tax Benefits Tax Bracket IRA Products and SIMPLE Plans iii

7 IRA as an Inheritance CHAPTER NINE STUDY QUESTIONS Answers to Chapter Nine Study Questions CHAPTER TEN: SIMPLE IRAS LEARNING OBJECTIVES WHAT IS A SIMPLE PLAN? EMPLOYER RULES FOR ESTABLISHING A SIMPLE IRA PLAN Employee Limit Qualified Plan Account Requirements Notification Requirements EMPLOYEE ELIGIBILITY RULES Compensation CHAPTER TEN STUDY QUESTIONS Answers to Chapter Ten Study Questions CHAPTER ELEVEN: SIMPLE IRA CONTRIBUTIONS AND DISTRIBUTIONS LEARNING OBJECTIVES SIMPLE IRA EMPLOYEE CONTRIBUTIONS Salary Reduction Contributions Catch-up Contributions SIMPLE IRA EMPLOYER CONTRIBUTIONS Employer Matching Contributions Nonelective Contributions SIMPLE IRA CONTRIBUTION DEDUCTIONS SIMPLE IRA DISTRIBUTIONS CHAPTER ELEVEN STUDY QUESTIONS Answers to Chapter Eleven Study Questions CHAPTER TWELVE: SEP-IRAS LEARNING OBJECTIVES WHAT IS A SEP-IRA? ELIGIBILITY REQUIREMENTS Employers Eligible Employees ESTABLISHING A SEP Formal Written Agreement Specific SEP Information SEP-IRA for Each Employee TAX CREDIT FOR STARTUP COSTS CHAPTER TWELVE STUDY QUESTIONS Answers to Chapter Twelve Study Questions CHAPTER THIRTEEN: SEP- IRA CONTRIBUTIONS AND DISTRIBUTIONS LEARNING OBJECTIVES SEP-IRA CONTRIBUTIONS Contribution Limits Excess Contributions IRA Products and SIMPLE Plans iv

8 DEDUCTING CONTRIBUTIONS Self-Employed Individuals Excess Contribution Carryover Timing SEP DISTRIBUTIONS CHAPTER THIRTEEN STUDY QUESTIONS Answers to Chapter Thirteen Study Questions CHAPTER FOURTEEN: SARSEPS LEARNING OBJECTIVE WHAT IS A SARSEP? SARSEP ELIGIBILITY REQUIREMENTS SARSEP ADP Test ELECTIVE DEFERRAL LIMITS Catch-up Contributions Overall Limit ELECTIVE DEFERRALS AND TAXES Excess Deferrals and Contributions CHAPTER FOURTEEN STUDY QUESTIONS Answers to Chapter Fourteen Study Questions CHAPTER FIFTEEN: SAVER S TAX CREDIT LEARNING OBJECTIVES WHAT IS THE SAVER S CREDIT? SAVER S CREDIT INDIVIDUAL ELIGIBILITY REQUIREMENTS Birth date Full-Time Student Tax Exemption Adjusted Gross Income ELIGIBLE CONTRIBUTIONS Reducing Eligible Contributions SPOUSAL DISTRIBUTIONS CHAPTER FIFTEEN STUDY QUESTIONS Answers to Chapter Fifteen Study Questions IRA Products and SIMPLE Plans v

9 Chapter One: An Introduction to Retirement Savings Learning Objectives: Upon completion of this Chapter, the student will be able to: Indicate the relative level of personal savings rate in the US as compared to other nations Calculate retirement savings needed based on a generally recognized rule of thumb Identify the average amount of post-retirement income that comes from Social Security Recognize full Social Security retirement age by year of birth State the original purpose of Social Security Saving for retirement is an important concern for us all. This chapter discusses this critical topic, including trends in retirement savings, the components of retirement savings and key factors in determining how much to save. Retirement Today It is expected that in the next 20 years, 74 million workers will be retiring. The twentieth century has seen an increase in the prevalence of retirement among both men and women. This has chiefly been the result of more income earned by modern Americans, who today earn an average income that is equal to approximately eight times the income of Americans who lived a hundred years ago. Retirement is no longer a luxury that only the rich can afford, thanks to this increased affluence and, for now at least, the safety-net of Social Security. The nature of retirement has also changed in modern times. No longer is retirement confined to a few short years at the end of an individual s life. Nor are retirees expected to be dependent upon children, as in the past. Rather, it is common for them to spend an extended amount of time in post-working years, often striving to continue to live as independently as possible. Retirement Income Personal Savings The rate of personal savings in the United States in 2017 fluctuated between 4.1 and 2.5%. This rate had dropped to almost zero in the months following the economic plunge we saw in Many are encouraged that the savings rate has increased, but there are still very real IRA Products and SIMPLE Plans 1

10 concerns stemming from the fact that most Americans are not saving enough to pay for their retirement years. Europeans have a personal savings rate that is double that of the average American, while the Japanese save at a rate triple this amount. The lack of savings in America means that retirement goals are becoming increasingly unreachable. Modern Americans are having to work longer in order to afford to retire and may also experience a reduction in their quality of life during retirement. Personal savings are not the only source of retirement funds, however. Other sources include Social Security and qualified retirement plans. For 61 percent of elderly beneficiaries, Social Security provides the majority of their cash income. For 33 percent of them, it provides 90 percent or more of their income. For someone who worked all of his or her adult life at average earnings and retires at age 65 in 2016, Social Security benefits replace about 39 percent of past earnings. This replacement rate will slip to about 36 percent for a medium earner retiring at 65 in the future, chiefly because the full retirement age, which has already risen to 66, will climb to 67 over the period (Policy Basics: Top Ten Facts About Social Security, Center on Budget and Policy Priorities, August 12, 2016). Social Security Although we can expect modest Social Security benefits for some time to come, the individual s responsibility for personal retirement savings remains and is expected to remain for decades. President Franklin D. Roosevelt advocated Social Security in the United States in the 1930s in reaction to the devastation of the Great Depression. Officially created in 1935 through the passage of the Social Security Act, it was originally meant to be a means to provide benefits for poor, elderly Americans. However, miscalculations of population growth and longevity in the United States at its creation has led to a system that is unable to provide for all the needs of forthcoming retirees. The first of the 74 million-strong Baby Boomer generation began retiring in The exodus of retirees from the workforce may strain the Social Security System to the extent that full benefits will not be able to be paid to later generations without a significant structural overhaul. By some estimates, if no changes to the system are made, the Social Security trust funds will run out of money by If it runs out of funds, it will have to rely on current tax revenue only, which the Trustees of the Social Security Administration state will pay only about ¾ of required benefits through In order for payments to continue after that time, benefits will have to be reduced by 37%. Despite these problems, Social Security will probably remain in effect far into the future, but is likely to be subject to significant change in coming years. Social Security benefits are based on how much an individual puts into the system and at what point he or she begins receiving benefits. Benefits are divided into the following three categories: IRA Products and SIMPLE Plans 2

11 Retirement Income These benefits are assessed on the average of the 35 years of highest earned wages. Lower benefits are provided when individuals have worked less than 35 years. Retirement benefits are distributed once an individual reaches full retirement age. This age is dependent on an individual s birth year. The following table outlines the specifications related to year of birth and retirement age: Year of Birth Full Retirement Age 1937 or earlier and 2 months and 4 months and 6 months and 8 months and 10 months and 2 months and 4 months and 6 months and 8 months and 10 months 1960 or later 67 Disability These payments are provided to those individuals who have not yet retired, but who have been disabled for over one year and are unable to work in any employment. The Social Security Disability Program is facing its trust fund depletion by the end of It is expected disability benefits will be reduced unless a tax increase or reforms are implemented. Survivor Survivor benefits are distributed to a surviving spouse at full retirement age. They may also be distributed at a reduced benefit at age 60. Children under 18 and dependent parents over 62 may also receive these benefits. Qualified Retirement Plans Today, nearly 20% of postretirement income comes from qualified retirement plan assets. Qualified plan assets are those assets in employer-sponsored retirement plans on which taxes have not yet been paid. They are found in such investments as pensions, 401(k)s and Individual Retirement Accounts (IRAs). Qualified plans come in two employer-sponsored forms: defined benefit and defined contribution plans. Defined benefit plans provide a stated benefit, while defined contribution plans allow an individual to decide when and how much plan income to withdraw on the basis of the performance of the plan assets. IRA Products and SIMPLE Plans 3

12 Retirement Savings Factors How much retirement savings will an individual need? There are several factors to consider when considering this important question. Life Expectancy One crucial retirement savings factor is life expectancy. Life expectancy has increased dramatically in recent years, so much so that many Americans can now expect to live nearly a third of their lives in retirement. Knowing how much longer one is expected to live provides a good estimate of the amount of retirement savings needed. The following table presents the average life expectancy of men and women in a format of expected years left to live: Age Life Expectancy Inflation When saving for retirement, inflation must always be considered. Prices for goods and services will not remain static, thus a dollar saved today for retirement will not stretch as far in 10, 20 or 30 years when it is used. Inflation fluctuates greatly from year to year and month to month. According to the website, U.S. Inflation Calculator, the inflation rate was 2.5% in 2006, 4.1% in 2007, 0.1% in 2008, 2.7% in 2009, 1.5% in 2010, 3.0% in 2011, 1.7% in 2012, 1.5% in 2013, 0.8% in 2014, 0.7% in 2015, 1.6% in 2016, and was 2.1% in ( For many years, the U.S. inflation rate averaged 3%. In late 2017, the Federal Reserve Board of Governors began increasing key interest rates, and many experts believe the inflation rate will also slowly climb. Risk Retirement saving must also take into account various risks that affect the money saved. Such risks include: Market Risk Retirement funds invested in the stock and bond market are subject to market fluctuation risk. Business Risk Corporations such as Enron and Lehman Bros. have created headlines as they collapsed, taking their employees retirement stock plans along with them. Any business, industry or sector is subject to a certain amount of inherent risk of failure or downside, and the return on the stocks and bonds they issue are affected by this risk. Interest Rate Risk Interest rates affect the value of bonds and bond mutual funds. When interest rates rise, the value of these instruments fall. IRA Products and SIMPLE Plans 4

13 It is important that when a retirement savings plan is devised, the individual seek professional advice to help make sure money in the plan is diversified among different types of savings and investments. Having a diversified retirement savings plan can help protect against large losses, since the types of investments and savings are subject to different types of financial risks. Health Care Costs Health care costs are a necessary expense in retirement years, and the increase in these costs must be considered when saving for retirement. For instance, as of December 2015, health spending was 17.5% of GDP in This is especially significant since the inflation rate was about.7%. For older retiring couples, it is estimated that $200,000 to $300,000 in savings is necessary just to pay for basic medical coverage during the retirement years. Rule of Thumb Most financial experts have a standard rule of thumb for the amount of money needed for every year an individual spends in full retirement: 70% to 80% of pre-retirement annual income Experts expect that certain expenses will be reduced during retirement years. For example, the costs of commuting, parking, eating meals out during working hours and keeping up a working wardrobe go away when an individual no longer works. In addition, it is expected that certain long-term expenses will have disappeared by retirement, such as the mortgage payment. However, every situation is different, so this 70% to 80% rule of thumb may or may not apply in any specific individual s life. Again, it is wise for individuals to seek professional advice when planning for retirement, for help in thinking through what expenses they are likely to have during their retirement years, and to help them develop a plan for paying off items while they are working so that they don t have to pay them during their fixed income years. IRA Products and SIMPLE Plans 5

14 Chapter One Study Questions 1. In the United States, Social Security was created in reaction to which crisis? a. The Civil War b. The Great Depression c. The Cold War d. The Vietnam War 2. Compared to 20 years ago, health care costs in the United States can be most accurately described as being: a. In a state in decline b. In a state of marginal growth c. In a state of significant growth d. In a static state 3. Cynthia s annual pre-retirement income is $200,000. How much will she need for retirement annually, according to the rule of thumb? a. $100,000 to $120,000 b. $140,000 to $160,000 c. $200,000 to $220,000 d. $240,000 to $260, Frank is getting ready to retire and is studying the state of Social Security. The most accurate statement of what he has discovered is that Social Security s percentage of Frank s needed retirement income is and the Frank s responsibility for retirement savings is. a. Increasing; increasing b. Decreasing; decreasing c. Increasing; decreasing d. Decreasing; increasing IRA Products and SIMPLE Plans 6

15 Answers to Chapter One Study Questions 1. b. Social Security was created in reaction to the Great Depression. 2. c. Health care costs have been significantly increasing over the past twenty years. 3. b. The experts rule of thumb for needed retirement income is 70% to 80% of pre-retirement income, which is $140,000($200,000 x.70) to $160,000 ($200,000 x.80). This is only a rule of thumb, however, some people will continue to have large fixed payments after retirement, such as a mortgage, or may have large medical bills due to a chronic condition. An individual s situation should be discussed with a professional for help in determining how much money to set aside for retirement. 4. d. As our life expectancy increases and as health care costs increase, Social Security is becoming a smaller and smaller percentage of needed retirement income for the average individual. IRA Products and SIMPLE Plans 7

16 Chapter Two: An Introduction to Traditional IRAs Learning Objectives Upon completion of this chapter, the student will be able to: Name sources of taxable compensation for IRA purposes Describe eligibility rules of Traditional IRAs Express tax consequences of trustee-to-trustee transfers The first type of individual retirement account plan to be created was that of the traditional IRA. In this chapter, traditional IRA plans are introduced. Their eligibility requirements, types of plans, ways to transfer them, and basic IRA investments are all explained. What is a Traditional IRA? In 1974, President Ford signed the Employee Retirement Income Security Act (ERISA) into law. The Act s purpose was to safeguard and improve the retirement security of Americans by creating standards for employee benefit plans. ERISA also created the first Individual Retirement Account (IRA). This IRA would come to be known as a traditional IRA. It was originally created to serve two functions: 1. To provide a tax-deferred savings vehicle through private organizations for workers without employer-sponsored retirement coverage 2. To protect employer-sponsored retirement plan assets by allowing rollovers of those assets into IRAs at retirement or upon a job change IRAs were incredibly popular from the start. In 1975 alone, the very first year IRAs were available, $1.4 billion in contributions were made to IRAs in the United States. In 2017, IRAs made up over one-third of the U.S. retirement market and they held $8.4 trillion in assets. These figures reflect amounts for all IRA types. (ICI Research Perspective Key Findings, The Role of IRAs in US Households Saving for Retirement, 2017, December 2017, ) Various types of IRAs were created following the conception of the traditional IRA. An employer-based IRA known as the Simplified Employee Pensions (SEP) IRA was created in Universal IRAs were created in This type of plan eased eligibility requirements for participants, but it was discontinued in Congress created the Savings Incentive Match Plan for Employees (SIMPLE) IRA, an account for small businesses, in The most recent creation in the line of IRAs is the Roth IRA. It was formed in 1997 as an account for after-tax retirement contributions. This chapter will specifically address traditional IRAs. IRA Products and SIMPLE Plans 8

17 Eligibility Requirements for a Traditional IRA An individual may establish and make contributions to a traditional IRA if he (or his spouse, if a joint return is filed) received taxable compensation during the year. He must also be under 70 ½ years old. If each spouse in a marriage receives taxable compensation and is under 70 ½ years old, both spouses may set up an individual IRA. They may not both participate in the same IRA, however. Taxable compensation includes: earned wages and salaries, commissions, income earned in self-employment, alimony payments, and nontaxable combat pay (applicable to members of the U.S. Armed Forces). This definition does not include: earnings and profit from property (i.e. rental income, interest income), or income from pensions or annuities, or deferred compensation, or Any amounts that are excluded from income (including foreign earned income or housing costs) An individual covered by any other retirement plan may still establish a traditional IRA. However, he may not be allowed to deduct all of his contributions if he (or his spouse) is covered by an employer retirement plan. Types of Traditional IRAs Different types of IRAs may be established with diverse organizations. These include banks, mutual fund companies, or life insurance companies. An IRA may also be established through a stockbroker. A traditional IRA could be an individual retirement account, an individual retirement annuity, part of a simplified employee pension, or part of an employer or employee association trust account. Individual Retirement Account An individual retirement account is a trust or custodial account established for the exclusive benefit of a plan owner or beneficiaries. It is subject to the following requirements: Trustee or custodian must be a: o Bank; or o Federally insured credit union; or o Savings and loan association; or o Any other entity approved by the IRS to act as trustee or custodian Trustee or custodian usually cannot accept contributions over the deductible amount for the year Contributions (not including rollover contributions) must be in cash IRA Products and SIMPLE Plans 9

18 Plan owners must have nonforfeitable rights to the assets in the account at all times (this means that the money in the account may not be used as security for a loan or other such purpose) Assets in the account may not be used to buy life insurance, and generally may not be combined with other property Distributions must begin by April 1 of the year after the plan owner turns 70 ½ Individual Retirement Annuity An individual retirement annuity is established when an annuity or endowment contract is purchased from a life insurance company. An annuity contract is designed to pay the contract owner at specific intervals, while an endowment contract is designed to pay the contract owner a lump sum after a specified period of time. An individual retirement annuity may only be issued in a plan owner s name. Either the plan owner or his surviving beneficiaries are required to receive the benefits from the annuity. Individual retirement annuities are subject to the following requirements: The plan owner s entire contract interest must be nonforfeitable The contract must stipulate that no portion of the annuity may not be transferred to any other person All contracts issued after November 6, 1978 are required to have flexible premiums that allow payment changes in the case of any compensation alteration Contributions may not be more than the deductible amount for an IRA for the year. Any refunded premiums must be used to pay future premiums or to purchase more benefits before the end of the calendar year after the year in which the refund was received. Distributions must begin by April 1 of the year after the plan owner turns 70 ½ Simplified Employee Pension Simplified Employee Pensions (SEPs) are written arrangements under which an employer is allowed to make deductible contributions to a traditional IRA for an employee. Distributions from SEP-IRAs are usually subject to the withdrawal and tax rules that apply to traditional IRAs. SEP-IRAs will be discussed in detail in a later chapter. Employer and Employee Association Trust Account A trust account may be established by an employer, labor union, or other employee association to provide individual retirement accounts for employees or members. The same requirements to which individual retirement accounts are subject apply to these types of accounts. IRA Products and SIMPLE Plans 10

19 Transfers A primary feature of traditional IRAs is their ability to transfer assets in a tax-advantaged manner. Assets may be transferred from other retirement programs to a traditional IRA tax-free. Transfers come in the following forms: Trustee-to-trustee transfers Rollovers Transfers due to a divorce Trustee-to-Trustee Transfers A trustee-to-trustee transfer is a transfer of funds in a traditional IRA from one trustee directly to another. This is done either at the IRA owner s request, or the request of the trustee. This kind of transaction is tax-free because there is no distribution to the owner. This type of transfer is also known as a direct rollover. Rollovers A tax-free distribution of cash or other assets from one retirement plan to another is called a rollover. Rollover contributions are those contributions made from the first retirement plan to the second. Numerous plan assets may be rolled over into a traditional IRA, including assets from: Another traditional IRA An employer s qualified retirement plan A government deferred compensation plan A tax-sheltered annuity plan Conversely, a distribution from a traditional IRA may be rolled over into a qualified plan. Such plans include: A Federal Thrift Savings Fund A government deferred compensation plan A tax-sheltered annuity plan Transfers Due to a Divorce Interest in a traditional IRA could be transferred from an individual s spouse (or former spouse) by a divorce. The interest, starting from the date of the transfer, is then treated as the individual s IRA. This transfer is also tax-free. The two most commonly used methods of transfer due to a divorce are (1) changing the name on the IRA, and (2) making a direct transfer of the assets in the IRA. Transfers will be discussed in more detail in a later chapter IRA Products and SIMPLE Plans 11

20 IRA Investments The investment options of a traditional IRA are numerous; in fact, there are relatively few that are not permitted. Some common investments include: Stocks Stocks are a category of securities that indicates ownership in a corporation, and come in two main forms: common and preferred. Common stock generally allows the stockowner to have a vote in shareholders meetings. Common stock owners also receive dividends. Preferred stock owners are usually not allowed to have voting rights, but they do have a higher claim on assets and earnings than do common stock owners. Bonds Bonds are a kind of debt investment. An individual investing in a bond is loaning money to an entity that is borrowing those funds for a definite period at a fixed rate. The entity promises an interest rate, and guarantees when the loaned funds will be returned. Categories of bonds include corporate bonds, municipal bonds, and U.S. Treasury bonds. Mutual funds Mutual funds are investment vehicles that are made up of a collection of funds from numerous investors. The funds are collected for the purpose of investing in securities, and are managed by money managers. These managers invest the capital from the mutual fund and try to create capital gains and income. Money market funds Money market funds are investment vehicles that attempt to earn interest for shareholders while also generally maintaining a $1 net asset value per share (i.e., attempting not to have a negative share value). These kinds of funds are offered by mutual funds, brokerage firms, and banks. These kinds of funds are considered low-risk and low-return. Real Estate Real estate may include individually owned rental and vacation properties as well as investment vehicles such as real estate investment trusts. The risk of real estate as an investment depends on the type of property owned and how income is being generated from the property. An individual, wholly owned rental property in a stable real estate market is relatively low risk. A real estate investment trust made up of commercial properties in a city where commercial occupancy is volatile may be high risk. An IRA holder can purchase real estate investments that reflect the risk and return of virtually every facet of the risk spectrum. IRA Products and SIMPLE Plans 12

21 Chapter Two Study Questions 1. Eileen is 60 years old and earns income from an annuity. She is not eligible to make contributions to a traditional IRA. Which of the following is the most likely reason? a. She is too old to make contributions b. She is too young to make contributions c. She does not earn any taxable compensation d. She is not eligible for Social Security 2. Joe is the owner of a traditional IRA that is established with an Individual Retirement Account. Trish is the owner of a traditional IRA that is established with an Individual Retirement Annuity. Which one of the following requirements is solely applicable to Trish s IRA? a. Plan owners must have nonforfeitable rights b. Distributions must begin by April 1 of the year after the plan owner turns 70½ c. All contracts issued after November 6, 1978 are required to have flexible premiums that allow payment changes in the case of any compensation alteration d. Contributions must be in cash 3. Which of the following types of IRAs was discontinued in 1987? a. SEP-IRA b. Traditional IRA c. Universal IRA d. Roth IRA 4. Frank moves his assets in his traditional IRA into another traditional IRA via a rollover. What percentage of the assets will be taxed under this transfer? a. 0% b. 10% c. 20% d. 50% 5. Fanny sets up a traditional IRA as an individual retirement annuity. It could have been funded with: a. An annuity, only b. Either an annuity or an endowment contract c. An endowment contract, only d. Either an annuity, endowment contract, or mutual fund IRA Products and SIMPLE Plans 13

22 Answers to Chapter Two Study Questions 1. c. Of the options given, Eileen must not have earned taxable compensation. She is 60, and neither too young nor too old to make an IRA contribution. Being or not being eligible for Social Security does not impact the ability to make an IRA contribution. 2. c. Individual Retirement Annuities are required to allow flexible payment amounts. 3. c. Universal IRAs were discontinued in a. When IRA funds are moved through a rollover, the transaction is not taxable. 5. b. Individual retirement annuities can accept funds as an annuity or an endowment contract IRA Products and SIMPLE Plans 14

23 Chapter Three: Contribution Rules of Traditional IRAs Learning Objectives Upon completion of this chapter, the student will be able to: Recall Traditional IRA contribution maximums by age and marital status Calculate tax penalties for excess Traditional IRA contributions The contribution limits of traditional IRAs are explained in this chapter. There are special contribution amounts allowed for those age fifty and over. Contributions to these plans must be made by a specified date in order for the contributions to be deductible for a tax year. In addition, there may be tax penalties if excess contributions are made. Contribution Limits The contribution limits for Traditional IRAs vary based on age. General Contribution Limit The traditional IRA is subject to certain contribution rules. The general contribution limit sets forth the maximum that an individual is allowed to contribute to the IRA per year. In 2018, the general contribution limit is the lesser of $5,500 ($6,500 for those older than 50) or the total amount of an individual s taxable compensation for the year. The traditional IRA general contribution amount has increased in recent years: Tax Year < Age 50 Age $3,000 $3, $4,000 $4, $4,000 $5, $4,000 $5, $5,000 $6, $5,000 $6, $5,000 $6, $5,000 $6, $5,000 $6, $5,500 $6,500 Under the law, the maximum contribution amount rises with inflation after The contribution amounts did not increase for 2010, 2011 or In 2013, these amounts were increased by $500. They were unchanged for 2014 through Some individuals own more than one traditional IRA. In this instance, the general contribution limit applies to the total amount of contributions made to all traditional IRAs on the owner s behalf over the entire year. IRA Products and SIMPLE Plans 15

24 If an individual owns an individual retirement annuity, the general contribution limit also applies. The annuity or endowment contract will be disqualified if this limit is exceeded. Catch-Up Contributions As noted in the preceding section, those individuals aged 50 and over are allowed to contribute more to traditional IRAs than younger individuals. This is thanks to the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of Among other things, this Act allowed for changes in the laws relating to IRAs, and provided for increases in the contribution limits. The catch-up contribution it created was devised as a savings incentive for older Americans who had not had the same opportunities as younger Americans to save for retirement in earlier years. Spousal Limit If an individual files a joint tax return, and his taxable compensation is less than that of his spouse, then a certain limit applies to the amount he may contribute to his own traditional IRA. In 2018, this amount is the lesser of $5,500 ($6,500 for those older than 50) or the total compensation includible in the gross income of both spouses. The latter amount is reduced by two amounts: the annual IRA contribution of the higher-earning spouse and any contributions made to a Roth IRA (this will be discussed in a later chapter) on behalf of the higher-earning spouse. The total combined contributions that can be made in 2018 to an individual s traditional IRA and his spouse s IRA can be as much as: $11,000, if both spouses are under age 50 $12,000, if one spouse is under age 50 $13,000, if both spouses are age 50 or older Example: Mark is a 24 year-old, full-time med school student who does not earn any taxable income. He marries Lisa, a 23 year-old dental hygienist who has a taxable compensation of $35,000 in one year. She and Mark file a joint tax return. This means that each of them may contribute $5,500 (totaling $11,000 as a combined contribution) to a traditional IRA. This is possible because Mark can add Lisa s compensation (reduced by the amount of her IRA contribution) to his own compensation to figure his maximum contribution limit. Contributions Above or Below Limits If an individual contributes less than the maximum annual amount allowable to a traditional IRA during a certain year, he is prohibited from contributing more to the IRA to make up the difference after the due date of his tax return for that year. Example: Gloria is 39 years old. She earns $40,000 in Although she may contribute $5,500 in 2017, she only contributes $2,500. After April 17, 2018 (which is the tax due date for 2017 returns), Gloria may not make up the difference between her actual contribution for 2017 and her limit for that year. She also may not contribute $3,000 more than the contribution limit for any future year. The maximum contribution amount that applies to any contribution year must be made from January 1 of that year through the tax filing date of the following year only. IRA Products and SIMPLE Plans 16

25 Excess contributions are those contributions that exceed applicable contribution limits. If excess contributions are made to a traditional IRA but are not withdrawn by the date a tax return for the year is due, a 6% tax will generally be levied. This tax must be paid each year on excess amounts that remain in a traditional IRA at the end of the tax year. Note that the tax is not allowed to exceed 6% of the combined value of all an individual s IRAs at the end of a tax year. However, if an individual contributes more than the maximum annual amount allowable to his traditional IRA, he may apply the excess contribution to a later year. Note that this is only possible if the contributions for that later year are less than the maximum allowed for that year. However, the tax on the excess contribution still applies. Commissions and Fees It is important to note that brokers commissions that are paid in connection with a traditional IRA are subject to contribution limits. However, trustee s administrative fees are not subject to these limits. For example, if an IRA is opened in which mutual funds are used as an investment and the broker charges $100 for the product, the IRA contribution amount for an individual under 50 may not be $5,600 in The contribution limit is still $5,500. Qualified Reservist Repayments Members of reserve components who were ordered or called to active duty after September 11, 2001 may be allowed to repay amounts to an IRA that are equal to any qualified reservist distributions they receive. Reserve component refers to the: Army National Guard of the United States, Army Reserve, Naval Reserve, Marine Corps Reserve, Air National Guard of the United States, Air Force Reserve, Coast Guard Reserve, or Reserve Corps of the Public Health Service These repayment contributions may be made even if they would cause the total contributions to the IRA to exceed the general contribution limit. An individual is considered to have received a qualified reservist distribution if all of the following requirements are met: An individual is ordered or called to active duty after September 11, 2001 and before December 31 of the year for which the IRA contribution is being made An individual is ordered or called to active duty for a period of more than 179 days, or for an indefinite period, because of membership of a reserve component The distribution is from an IRA IRA Products and SIMPLE Plans 17

26 The distribution was not made any earlier than the date of the order or call to active duty and was not made any later than the close of the active duty period Contribution Deadlines Contributions may be made to a traditional IRA as soon as it is established. They must be in the form of money; this means cash, check, or money order. Contributions may not be property. But, certain property may be allowed to be transferred or rolled over from one retirement plan to another retirement plan. Contributions may be made to a traditional IRA for every year that an individual receives compensation and has not reached age 70½. Contributions may not be made in any year when an individual does not work, unless alimony or nontaxable combat pay is received, or a joint tax return is filed with a spouse who has compensation. Even if contributions are not made during a certain year, amounts contributed in past years remain in the IRA. Contributions for a particular year can be made to a traditional IRA at any time during the year, or by the due date for filing the tax return for that year (excluding extensions). IRA Products and SIMPLE Plans 18

27 Chapter Three Study Questions 1. Karen is 49 years old. What is the maximum she may contribute to a traditional IRA in 2018? a. $5,500 b. $3,000 c. $4,000 d. $6, Michael is 61 years old. He owns two different traditional IRAs. What is the maximum he may contribute to both traditional IRAs (in total) in 2018? a. $5,500 b. $6,500 c. $11,000 d. $13, Samantha contributes $1,000 over the general traditional IRA contribution limit that applies to her. The contribution is withdrawn by the date her tax return for the year is due. How much will she owe as a tax for the excess contribution? a. $0 b. $60 c. $100 d. $ Paul makes a contribution to his traditional IRA that is not in the form of a transfer or rollover. The contribution may be in any of the following forms, except: a. Cash b. Check c. Money order d. Stock certificate IRA Products and SIMPLE Plans 19

28 Answers to Chapter Three Study Questions 1. a. The maximum traditional IRA contribution amount for people under 50 in 2018 is $ b. The maximum traditional IRA contribution amount for people fifty and over in 2018 is $ a. Since she withdrew the excess contribution prior to her tax due date, no tax is due on the excess contribution. 4. d. IRA contributions must be in cash, which means, cash, checks and money orders, but not stock certificates. IRA Products and SIMPLE Plans 20

29 Chapter Four: Deducting Traditional IRA Contributions Learning Objectives Upon completion of this chapter, the student will be able to: Calculate annual deductible traditional IRA contributions based on compensation, agent and AGI Identify types of defined contribution plans Generally distinguish between defined contribution plan and defined benefit plan Traditional IRA contributions are deductible in certain circumstances. The amount of the deduction is dependent upon whether the owner or spouse is covered by an employer retirement plan and on income levels. This chapter describes the rules applicable to the taxdeductibility of traditional IRA contributions. Deducting Contributions Full Deduction One valuable feature of traditional IRAs is the deductibility of contributions. An individual is generally allowed to deduct the lesser of: The general contributions limit ($5,500 for those under 50; $6,500 for those 50 and older), or 100% of the individual s compensation Spousal Deduction If a married couple with unequal compensation files a joint tax return, deduction limits apply to any contributions made to a traditional IRA. For the spouse earning the smaller amount of compensation, the deduction is the lesser of: The general deduction amount ($5,500 for those under 50; $6,500 for those 50 and older); or The total compensation that is includible in the gross income of both spouses for the year, as reduced by the following amounts: o The IRA deduction of the greater-earning spouse for the year o Any designated nondeductible contribution for the year made on behalf of the greater-earning spouse o Any contributions for the year to a Roth IRA on behalf of the greater-earning spouse Commissions and Fees Administrative fees charged for trustees that are billed separately and are paid in connection with a traditional IRA are not deductible as contributions. Brokers commissions are seen as part of IRA contributions, however, and may be deducted. IRA Products and SIMPLE Plans 21

30 Employer Plan Deductions Certain rules apply to contributions made by individuals who are also covered by an employer-sponsored retirement plan in addition to contributing to a traditional IRA. If an individual (or his or her spouse) was covered by an employer retirement plan for any part of the year, the contribution amount may not be allowed to be deducted, or may only be allowed to be partially deducted. This depends upon income and filing status. Defined Contributions Plans Employer-sponsored retirement plans include defined contribution plans and defined benefit plans. Defined contribution plans are those that provide a separate account for each individual covered, and define exactly the amount that will be contributed. The total amount contributed to a participant s account (and any earnings and losses on those contributions) determine the level of benefits provided for the participant. Examples of defined contribution plans include: Profit sharing plans Stock bonus plans Money purchase pensions plans IRAs 401(k) plans Defined Benefit Plans Defined benefit plans spell out the level of benefits that each participant is given. The administrator of the plan calculates the amount needed to provide the promised benefits and also those amounts that must be contributed to the plan. Defined benefit plans include pension plans and annuity plans. An individual is seen as being covered by a defined benefit plan if he is eligible to participate in that plan for the plan year, even if the individual: Declined to participate in the defined benefit plan, Did not make a required contribution, or Did not perform the minimum service required to accumulate a benefit for the year Plans That Are Not Employer Plans Certain plans are not classified as employer plans for traditional IRA deduction purposes. Individuals in any of the following situations are not covered by an employer retirement plan under traditional IRA rules: Those individuals covered under Social Security or railroad retirement coverage Those individuals receiving benefits solely from a previous employer s retirement plan Those individuals who are U.S. Reservists, and who participate in a plan solely because of membership of a reserve unit, if: o The plan participated in is established for employees by the U.S., a state or political subdivision of a state, or an instrumentality of either; and o No more than 90 days on active duty during the year were served (not including duty for training) Those individuals who are volunteer firefighters, and who participate in a plan solely because of that status, if: IRA Products and SIMPLE Plans 22

31 Deduction Phaseout o The plan participated in is established for employees by the U.S., a state or political subdivision of a state, or an instrumentality of either; and o Retirement benefits accrued at the beginning of the year will not provide more than $1,800 a year at retirement If an individual (or his or her spouse) was covered by an employer retirement plan, depending on his income and filing status, he may only be entitled to a partial contribution deduction, or possibly no deduction at all. The IRA deduction will be reduced (or phased out ) when his income exceeds a certain amount, and is eliminated upon reaching a specified higher amount. In order to determine deduction phaseout, an individual must determine his modified adjusted gross income (AGI) and filing status. Modified AGI is an individual s gross income (gross income is income before standard or itemized deductions are claimed), as adjusted by certain allowable deductions. In 2018, if an individual is covered by an employer retirement plan, then the deduction will not be reduced unless his modified AGI is: More than $63,000 to $73,000 (single individual or head of household) More than $101,000 to $121,000 married couple filing jointly; or qualifying widow(er)) Less than $10,000 (married individual filing separately) Note that for those individuals filing as single individual or head of household, no deduction may be taken if modified AGI exceeds $73,000. For individuals who are part of a married couple filing jointly, or a qualifying widower, no deduction may be taken in if modified AGI exceeds $121,000. For those married individuals filing separately, deductions are not allowed if modified AGI exceeds $10,000. Nondeductible Contributions Nondeductible contributions are those contributions that exceed the limit for IRA deductions, but are under the total permitted contribution limit. Example: Felicity is 30 years old and is a married individual filing separately from her spouse. In 2018, she was covered by an employer retirement plan. Her salary is $82,312, and her modified AGI is $71,400. She is not allowed to deduct a $5,500 contribution she makes to her traditional IRA for tax purposes. Therefore, this contribution is considered a nondeductible contribution. IRA Products and SIMPLE Plans 23

32 Chapter Four Study Questions 1. Kaitlyn is 52 years old, single filing individually, and makes contributions to a traditional IRA. If her annual compensation is $27,000, what is the maximum she may deduct for those contributions per year? a. $3,000 b. $5,500 c. $6,500 d. $8, Dave s employer-sponsored retirement plan is a defined contribution plan. The plan could be any of the following, except: a. A traditional IRA b. A 401(k) c. A profit sharing plan d. A pension plan 3. Christine files her taxes as a single individual. She makes contributions to a traditional IRA. If she is also covered by an employer retirement plan, and her AGI is $65,000, the deductions for contributions to his IRA: a. Are allowed and not phased out b. Are phased out c. Are fully deductible d. Are considered excess contributions 4. Ben makes contributions to a traditional IRA. For IRA deduction purposes, in which of the following situations is he considered to be covered by an employer-sponsored retirement plan? a. He is covered under Social Security b. He receives benefits from a previous employer s plan in addition to benefits form a current employer s plan c. The only reason he participates in an employer-sponsored plan is because is a qualified reservist d. The only reason he participates in an employer-sponsored plan is because he is a volunteer firefighter IRA Products and SIMPLE Plans 24

33 Answers to Chapter Four Study Questions 1. c. The maximum deductible contribution for Kaitlyn, who is 50 or over and has compensation of $27,000, is $6, d. Defined contribution plans may be 401(k), money purchase, profit sharing or stock bonus plans, but not pension plans. 3. b. As a single taxpayer, at her AGI of $65,000, her deductible IRA contributions are being phased out. 4. b. For IRA deduction purposes, he is considered to be covered by an employer plan because he receives benefits from a previous employer s plan in addition to benefits form a current employer s plan. Being covered by Social Security is not being covered by an employer plan, and participation by volunteer firefighters and qualified reservists are not considered to be covered by employer plans. IRA Products and SIMPLE Plans 25

34 Chapter Five: Distribution Rules of Traditional IRAs Learning Objectives Upon completion of this chapter, the student will be able to: Recognize required IRA minimum distribution methods Compute required minimum distribution amounts based on distribution period and life expectancy There are minimum distributions that must be made from traditional IRAs when the owner reaches age 70 ½. The minimum distribution rules as well as the taxation of early distributions are explained in this chapter. Minimum Distributions Funds may not be kept in a traditional IRA for an indefinite period. Rather, distributions must begin by April 1 of the year following the year in which an IRA owner turns 70 ½ or be subject to a hefty 50% tax. These distributions are subject to certain minimum distribution requirements, which govern how much an individual must distribute from his IRA on an annual basis. The required minimum distribution for each year is calculated by dividing the balance of the IRA as of December 31 of the preceding year by the applicable distribution period or life expectancy. Distribution Period The distribution period is the maximum number of years over which an IRA owner is allowed to take distributions from an IRA. The following is an excerpt of a table published by the IRS used to determine the distribution period of individuals of a certain age: Age Distribution Period Example: Jean is the owner of a traditional IRA. The balance in her IRA at the end of 2016 is $200,000. She turns 80 years old in Her distribution period is 18.7, therefore, her required minimum distribution for 2017 is: $10, ($200,000 / 18.7). IRA Products and SIMPLE Plans 26

35 Life Expectancy Life expectancy may also be used to calculate the required minimum distribution: Age Life Expectancy Example: Gerry is the owner of a traditional IRA. The balance in his IRA at the end of 2016 is $200,000. He turns 80 years old in His life expectancy is 10.2 years, therefore, his required minimum distribution for 2017 is: $19, ($200,000 / 10.2). Life expectancy is calculated differently for those IRA owners whose sole beneficiary spouse is more than 10 years younger. In this case, the life expectancy used is the joint life and last survivor expectancy from another table published by the IRS: Ages Example: David is the owner of a traditional IRA. His wife, Elaine, is the sole beneficiary of his IRA, and is 11 years younger than him. The balance in his IRA at the end of 2016 is $200,000. David turns 86 in 2017 and Elaine turns 74. David s joint and last survivor expectancy is 15.2 years, therefore his required minimum distribution for 2017 is: $13, ($200,000 / 15.2). Beneficiaries If the sole beneficiary of a traditional IRA is a surviving spouse, then he or she may decide to either be treated as the beneficiary or the owner of the account. If ownership status is chosen, the spouse determines the required minimum distribution (if applicable) as if he or she were the owner beginning with the year in which this ownership status is assumed. It should be noted, however, that if the spouse becomes the owner in the year the deceased spouse died, then he or she may take the deceased owner s required minimum distribution for that year. If a traditional IRA owner dies on or after the required distribution beginning date, the designated beneficiary usually must base the required minimum distributions on the longer of either his single life expectancy, or the owner s life expectancy. However, if the traditional IRA Products and SIMPLE Plans 27

36 IRA owner died before the required distribution beginning date, the designated beneficiary bases the required minimum distribution on his or her single life expectancy only. Required minimum distributions for traditional IRA beneficiaries are determined differently if the beneficiary is an individual or not (such as if the beneficiary were a trust or an estate). If the beneficiary is an individual, the IRA account balance is divided by the appropriate life expectancy. Example: Megan s father died in She is the designated beneficiary of his traditional IRA. She is 53 years old in Her life expectancy that year is The IRA is worth $100,000 at the end of Therefore, her required minimum distribution for 2017 is $3,185 ($100,000/31.4). If the beneficiary is not an individual, and the traditional IRA owner died on or after the required minimum distribution beginning date, the distributions are determined by dividing the account balance at the end of the year by the appropriate life expectancy for the IRA owner in the year of his or her death. Example: The owner of a traditional IRA died in 2018 at age 90. His traditional IRA went to his estate as beneficiary. His life expectancy for 2018 is 9.0 years. The IRA is worth $200,000 at the end of 2018, therefore, the required minimum distribution is $25,000 ($200,000 / 8.0). Note that the owner s life expectancy was reduced by one to determine the account balance for the year following his death. It is important to note that a special rule could apply to beneficiary distributions: In certain situations, beneficiaries who are individuals may be required to take the entire balance of the IRA by the end of the 5 th year after the year of the owner s death. This rule could also apply to beneficiaries who are not individuals as well. This requirement could apply if a traditional IRA owner died before the required minimum distribution beginning date. Early Distributions Early distributions are generally defined to be those amounts distributed from a traditional IRA account (or annuity) before the owner reaches age 59 ½. They are also amounts received when retirement bonds are cashed in before that same age. If distributions are taken when a traditional IRA owner reaches age 59½, a 10% additional tax on the distribution of any assets in the IRA applies. Exceptions Certain exceptions apply to the early distribution penalty rule. If an individual is in one of the following situations, he generally will not have to pay the 10% additional tax: Medical Expenses The additional 10% tax is not levied if an individual has unreimbursed medical expenses that are more than 7.5% of his adjusted gross income. IRA Products and SIMPLE Plans 28

37 Medical Insurance If the early distributions are not more than the cost of an individual s medical insurance, then the additional tax does not apply. This applies to medical insurance for the individual, his spouse, and his dependents, and is subject to all of the following conditions: The individual lost his job The individual received unemployment compensation paid under federal or state law for 12 consecutive weeks because of a lost job The distributions were received either during the year the unemployment compensation was received, or the year following The distributions are received no later than 60 days after reemployment Disability If an individual can provide proof that he cannot do any substantial gainful activity because of a physical or mental disability, he will not be required to pay the early withdrawal tax. A physician is required to confirm that the disability is expected to result in death or be of a long, continued, and indefinite length. Beneficiary of Deceased IRA Owner The 10% tax will not be applied to the distribution of assets from a traditional IRA if the owner dies before reaching age 59½. Distributions as an Annuity If distributions are made from a traditional IRA that are part of a series of substantially equal payments over an individual s life or life expectancy (or over the lives or joint life expectancies of that individual and his beneficiary), no early distribution tax will be required, no matter when the distributions are made. This applies as long as an IRS-approved distribution method is used, and at least one distribution is made annually. Higher Education Expenses If an individual uses early distribution to pay expenses for higher education for either himself, a spouse, children or grandchildren, the 10% tax will not apply, as long as the amount is not more than the qualified higher education expenses. These expenses include tuition, fees, books, supplies, room and board, and the like. First Home The 10% tax is waived if an individual takes a distribution of no more than $10,000 to buy, build, or rebuild a first home. Distribution due to IRS Levy Distributions made because a qualified plan is subject to an IRS levy are not subject to the 10% additional tax. Qualified 2016 Disaster Distributions Due to provisions in the Disaster Tax Relief and Airport and Airway Extension Act of 2017, distributions from traditional IRA and other qualified retirement plans made by persons in areas designated as disaster areas may take up to $100,000 in distributions without being subject to the additional 10% tax. IRA Products and SIMPLE Plans 29

38 The Act allows qualified hurricane distributions to be made as an exception to the additional 10% tax. A qualified hurricane distribution" is any distribution from an eligible retirement plan, as defined in Code Sec. 402(c)(8)(B) (which includes IRAs), made: On or after Aug. 23, 2017, and before Jan. 1, 2019, to an individual whose principal place of abode on Aug. 23, 2017, is located in the Hurricane Harvey disaster area and who has sustained an economic loss by reason of Hurricane Harvey; On or after Sept. 4, 2017, and before Jan. 1, 2019, to an individual whose principal place of abode on Sept. 4, 2017, is located in the Hurricane Irma disaster area and who has sustained an economic loss by reason of Hurricane Irma; and On or after Sept. 16, 2017, and before Jan. 1, 2019, to an individual whose principal place of abode on Sept. 16, 2017, is located in the Hurricane Maria disaster area and who has sustained an economic loss by reason of Hurricane Maria. The amount distributed may be recontributed to the retirement plan at any time over a 3-year period beginning on the day after the distribution was received. Taxpayers may spread out any income inclusion resulting from qualified hurricane distribution withdrawals over a 3- year period, beginning with the year that any amount is required to be included. Taxability of Distributions Distributions made from a traditional IRA are generally taxable in the year they are received. This is true even for distributions made without an IRA owner s consent from a state agency acting as the receiver of a failed financial institution. Certain exceptions to the taxability of distributions in the year in which they are received apply, including: Rollovers Qualified charitable distributions (distributions made directly by the trustee of an IRA to an eligible organization) Tax-free withdrawals of contributions (contributions withdrawn by the due date of a tax return, under certain conditions) The return of nondeductible contributions Fully and Partly Taxable Distributions from a traditional IRA could be fully or partly taxable depending on whether or not any nondeductible contributions were made to the IRA. Distributions are fully taxable when received if only deductible contributions were made. However, if nondeductible contributions are made, then the IRA owner receives a cost basis (i.e. investment in the contract) that equals the amount of those nondeductible contributions. This means that the nondeductible contributions will not be taxed when they are distributed, but are seen as a return of the investment in the IRA. It should be noted that only the nondeductible portion of any distributions is tax-free. If nondeductible contributions are made, then distributions consist of both nondeductible contributions and deductible contributions. Until all of the nondeductible contributions have been distributed, each distribution is partly taxable and partly nontaxable. IRA Products and SIMPLE Plans 30

39 Special Tax Situations Certain distributions are subject to special tax rules. For instance, if a traditional IRA owner directs the trustee or custodian of his account to use the amount in the account to buy an annuity contract, no taxes will be levied when the owner receives the annuity contract. However, when payments are received under the contract, taxes will be charged. Also, if the owner of a traditional IRA cashes in retirement bonds, he will be taxed on the entire amount received. If the bonds are not cashed in before the owner reaches age 70 ½, he will be required to pay taxes on the entire value of the bonds at that time. IRA Products and SIMPLE Plans 31

40 Chapter Five Study Questions 1. Katie is the owner of a traditional IRA. The balance in her IRA at the end of 2017 is $100,000. She turns 80 years old in If her distribution period is 18.7, then her required minimum distribution for 2018 is: a. $2, b. $5, c. $13, d. $18, Bill is the owner of a traditional IRA. His wife, Jamie, is the sole beneficiary of his IRA. If Bill turns 86 in 2018, and the applicable joint and last survivor life expectancy is 15.2, how old is Felicity? Joint and Last Survivor Life Expectancy Ages a. 72 years old b. 74 years old c. 79 years old d. 82 years old 3. Carolyn is the beneficiary of a traditional IRA. The owner of the IRA died before the required minimum distribution beginning date. On what must Carolyn base the required minimum distributions from the traditional IRA? a. Her single life expectancy, only b. The IRA owner s life expectancy, only c. The longer of either her single life expectancy or the IRA owner s life expectancy d. The shorter of either her single life expectancy or the IRA owner s life expectancy IRA Products and SIMPLE Plans 32

41 4. The owner of a traditional IRA died in 2017 at age 90. His traditional IRA went to his estate as beneficiary. His life expectancy for 2017 is 9.0. If the IRA is worth $100,000 at the end of 2017, then the required minimum distribution is: a. $10, b. $11, c. $12, d. $14, Molly received early distributions from her traditional IRA because she was younger than: a. 47 years old b. 59 ½ years old c. 65 years old d. 70 ½ years old IRA Products and SIMPLE Plans 33

42 Answers to Chapter Five Study Questions 1. b. $100,000 divided by 18.7 is $5, b is the box that corresponds to ages 86 and 74: Joint and Last Survivor Life Expectancy Ages a. As a single beneficiary on the IRA when the IRA holder died prior to making required minimum distributions, the distributions must be made based on her single life expectancy 4. c. The life expectancy is reduced by one year when the distribution is after the death of the IRA holder, and $100,000 divided by 8 years is $12, b. Early distributions are those taken before the IRA holder is 59 ½. IRA Products and SIMPLE Plans 34

43 Chapter Six: Traditional IRA Transfers and Rollovers Learning Objectives Upon completion of this chapter, the student will be able to: Summarize IRA rollover and transfer rules Explain IRA recharacterization rules Recall from Chapter Two that IRA transfers come in three forms: trustee-to-trustee transfers, rollovers, and transfers incident to divorce. This chapter explains these transfer forms in more detail. Trustee-to-Trustee Transfers A trustee-to-trustee transfer is a transfer of funds in a traditional IRA from one trustee directly to another. This is done either at the IRA owner s request, or the request of the trustee. This kind of transaction is tax-free because there is no distribution to the owner. Recharacterizations Contributions made to one type of IRA may be able to be treated as having been made to a different type of IRA. This is referred to as recharacterizing the contribution and is done by having the contribution transferred from the first IRA to the second IRA in a trustee-to-trustee transfer. The contribution may be treated as having been made originally to the second IRA instead of the first IRA only if it is made by the due date for an individual s tax return for the year during which the contribution was made. For example, Samantha made a $4000 contribution to a traditional IRA in February She decided she really wanted the contribution to be made to a Roth IRA, and treated as a Roth IRA contribution. She filled out appropriate paperwork with the traditional IRA trustee to move the funds directly to a Roth IRA in July Samantha successfully recharacterized the $4000 contribution as a Roth IRA contribution. Trustee-to-trustee transfers occur when money from one IRA or qualified retirement plan is sent directly from the existing plan to another IRA or qualified plan. For example, an IRA holder may have his IRA in a bank CD sent directly to a mutual fund company s IRA program. The IRA holder never receives the funds in a trustee-to-trustee transfer; the transaction is handled directly between the plans. If an individual has his contribution recharacterized, he must do all of the following: Include any net income allocable to the contribution in the transfer. This may be a negative amount if there was a loss. Report the recharacterization on the tax return for the year in which the contribution was made. IRA Products and SIMPLE Plans 35

44 Treat the contribution as having been made to the second IRA on the date that it was made to the first IRA. Contributions made to the first IRA may not be deducted. Any net income transferred with the recharacterized contribution is seen as being earned in the second IRA. In order to recharacterize a contribution, the trustee of the first IRA and the trustee of the second IRA must be notified (only one notification is necessary if both IRAs are maintained by the same trustee). The notifications must be made by the date of transfer. The notification must include: The type and amount of the contribution to the first IRA that is to be recharacterized The date on which the contribution was made to the first IRA, as well as the year for which it was made A direction to the trustee of the first IRA to transfer (in a trustee-to-trustee transfer) the amount of the contribution and any net income allocable to the contribution to the trustee of the second IRA The name of the trustees of both the first IRA and the second IRA Any additional information needed to make the transfer Rollovers to a Traditional IRA Rollovers are a tax-free distribution of cash or other assets from one retirement plan to another. Rollover contributions are those contributions made from the first retirement plan to the second. Plan assets may be rolled over into a traditional IRA, including assets from: Another traditional IRA An employer s qualified retirement plan A deferred compensation plan of state and local governments A tax-sheltered annuity plan Note that rollover contributions cannot be deducted for tax purposes. Rollovers from a Traditional IRA Distributions from a traditional IRA may be rolled over into a qualified retirement plan. Such plans include: Other IRAs Qualified Trusts A Federal Thrift Savings Fund A deferred compensation plan of state and local governments A tax-sheltered annuity plan Usually, when basis (i.e. a non-deductible contribution) is in an IRA, any distribution is considered to include both nontaxable and taxable amounts, in proportion to the amount of the basis to the total value of the IRA. If this rule were applied to rollover situations, the nontaxable portion of a distribution could not be rolled over. But a special rule applies to IRA Products and SIMPLE Plans 36

45 distributions that are rolled over into an eligible retirement plan (other than an IRA) from a traditional IRA. This rule treats the distributions as including only otherwise taxable amounts if the amount left in the IRAs or the amount that is not rolled over is at least equal to the basis in the traditional IRA. This allows the amount in a traditional IRA that may be rolled over to an eligible retirement plan to be as large as possible. Rollover from One Traditional IRA to Another All of the assets from one traditional IRA may be withdrawn and reinvested in the same or another traditional IRA tax free, as long as the reinvestment occurs within 60 days. Recall that this amount may not be deducted. If a rollover is made from one traditional IRA to another, the rollover is only tax free if the property that is reinvested is the same property that was originally distributed. Partial rollovers are also allowed. Assets may be withdrawn from a traditional IRA and part of those assets may be rolled over tax free, while the rest of the assets may be retained. This amount, however, will generally be taxable, and may be subject to the 10% early withdrawal additional tax. Rollover from an Employer s Plan Eligible rollover distributions from an employer-sponsored retirement plan may be rolled over into a traditional IRA. Eligible rollover distributions are generally any distribution of all or part of the balance credited to an employee in a qualified retirement plan. However, the following are not considered eligible rollover distributions: A required minimum distribution A hardship distribution A series of substantially equal periodic distributions that are paid at least once a year over: o The employee s lifetime or life expectancy o The employee and the employee s beneficiary s lifetimes or life expectancies o A period of 10 years or more Corrective distributions of excess contributions or deferrals, and income allocable to the excess, or of excess annual additions and allocable gains A loan treated as a distribution because it does not satisfy certain requirements when it is made or later (unless the employee s accrued benefits are reduced to repay the loan) Dividends on employer securities The cost of life insurance If an eligible rollover distribution is paid directly to an employee, an employer is generally required to withhold 20% of it, even if the employee plans to roll the distribution into a traditional IRA. This can be avoided if the employee chooses the direct rollover option, or if: The distribution and all previous eligible rollover distributions the employee received during the tax year from the same plan equals less than $200 The distribution is only employer securities, plus cash of $200 or less in lieu of fractional shares IRA Products and SIMPLE Plans 37

46 For example, John has $34,000 in a 401(k) plan. He leaves his employment to join another firm. If he has his $34, (k) plan distributed to him, and then places the funds in an IRA in 60 days, his prior employer must withhold $6800 of the proceeds for taxes. If John makes the rollover within the 60 days, the 20% withheld is claimed on his next tax income return, and he will receive it back, or it will reduce his overall tax liability. If instead John had the money directly rolled from the employer 401(k) plan to an IRA, no amount has to be withheld, and John avoids the paperwork hassles of reporting the withheld amount on his tax returns. Note that the 1-year time limit between rollovers does not apply to rollover distributions from an employer plan. Rollover Time Limits Generally, rollover contributions must be made no more than 60 days after a distribution from an IRA or employer plan is received. If the contributions are made after the 60-day period, then those amounts will not qualify for tax-free treatment. The 60-day requirement could be waived in certain situations. Some of those situations include casualty, disaster, or other events that are beyond the reasonable control of the individual involved. There is an automatic waiver that applies only if all of the following conditions are met: The financial institution receives the rollover funds before the end of the 60-day rollover period All of the procedures for depositing the funds into an eligible retirement plan (as set by the financial institution) were followed The funds were not deposited into an eligible retirement plan with the rollover period only because of an error made by the financial institution The funds are deposited into an eligible retirement plan no more than 1 year from the beginning of the rollover period The rollover would have been valid if the financial institution had deposited the funds as charged There is also a waiting period between rollovers. If a tax-free rollover of any part of a distribution from a traditional IRA is made, an individual is generally not allowed to make another tax-free rollover of a later distribution from that same IRA with a 1-year period. The 1-year period does not begin on the date the assets are rolled over into the IRA; rather, it begins on the date the IRA distribution is received. An exception to this 1-year rule applies only if all of the following requirements are met: 1. The distribution was made from a failed financial institution by the Federal Deposit Insurance Corporation as its receiver 2. It was not initiated by the custodial institution or the depositor 3. It was made because the custodial institution is insolvent and the receiver is unable to find a buyer for the institution IRA Products and SIMPLE Plans 38

47 Transfers Incident to a Divorce Interest in a traditional IRA could be transferred from an individual s spouse (or former spouse) by a divorce. The interest, starting from the date of the transfer, is then treated as the individual s IRA. This transfer is also tax-free. The two most commonly used methods of transfers due to a divorce are changing the name on the IRA, and making a direct transfer of the assets in the IRA. Changing Names Assets may be transferred by changing the name of the IRA from an individual s name, to the name of his spouse (or former spouse). This is done only if all the assets from the IRA are to be transferred. Direct Transfer Under a direct transfer, the trustee of the traditional IRA is directed to transfer only the assets affected directly to the trustee of a new or existing traditional IRA that is set up in the name of an individual s spouse (or former spouse). If his spouse (or former spouse) is allowed to keep the portion of the IRA assets belonging to that spouse in the individual s existing IRA, then the trustee may be directed to transfer the assets the individual is permitted to keep directly into a new or existing traditional IRA set up in his name. The name of the IRA that contains the spouse s portion of the assets would then be changed to reflect the change in ownership. Automatic Rollovers and Safe Harbor IRAs Before the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) was passed, qualified retirement plans were allowed to make immediate cash out distributions to participants who terminated employment with the company that maintained the plan. These cash out distributions could be made without the plan participant s consent, if that participant s vested accrued benefit was not more than $5,000. But EGTRRA amended the Internal Revenue Code of 1986 to require that the plan administrator must (without direction from the participant as to the distribution) automatically rollover the mandatory distribution to an IRA if the mandatory distribution amount is greater than $1,000, but less than or equal to $5,000. The plan administrator is also required to notify the plan participant in writing that the distribution might be transferred to another individual retirement plan without cost or penalty. The IRA receiving the mandatory distribution is known as a safe harbor IRA. IRA Products and SIMPLE Plans 39

48 Chapter Six Study Questions 1. Ken has his 2018 IRA contributions recharacterized. When must the recharacterization have been accomplished by? a. The due date for Ken s 2017 tax return b. The due date for Ken s 2018 tax return c. Before January 1, 2017 d. Before January 1, Mark and his wife Sharon get a divorce. Sharon s interest in Mark s traditional IRA is transferred to another IRA. The interest left in the IRA, starting from the date of the transfer, is then treated as Mark s IRA. If the interest left in the traditional IRA is $100,000, and the amount transferred out of the IRA is $50,000, then the transfer will be subject to a tax of: a. $0 b. $1,000 c. $5,000 d. $10, Madeleine has $46,000 in a traditional IRA. $1,000 of this amount is from a nondeductible contribution made one year when she had income much higher than she normally has. How much can Madeleine rollover from her IRA into a SIMPLE Plan with her new employer as a non-taxable distribution? a. $0 b. $1,000 c. $45,000 d. $46, Eligible rollover distributions of $100,000 from Jordan s employer-sponsored retirement plan are rolled over into a traditional IRA. If the eligible rollover distributions were paid directly to Jordan, his employer will most likely be required to withhold: a. $0 b. $10,000 c. $20,000 d. $50, If a qualified retirement plan makes a mandatory distribution to a safe-harbor IRA for a participant who terminated employment with the company that maintained the plan, then the mandatory distribution amount must not be less than: a. $1,000 b. $3,000 c. $5,000 d. $6,000 IRA Products and SIMPLE Plans 40

49 Answers to Chapter Six Study Questions 1. a. In order to recharacterize IRA contributions, the recharacterization must be done by the tax due date for the tax year for which the contribution was made, in this case, the tax due date for 2018 taxes. 2. a. This transaction is not taxable. 3. c. The deductible contributions and earnings may be rolled over, which amounts to $45, c. When a distribution is made from an employer plan to an employee, even if the amount is rolled into an IRA, there is a requirement that 20% of the distribution be withheld. $100,000 x 20% = $20,000 5.a. A safe harbor IRA must be used when the employer has no direction from the participant and the amount in the employer plan is not less than $1000 and not more than $5000. IRA Products and SIMPLE Plans 41

50 Chapter Seven: Roth IRAs Learning Objectives Upon completion of this chapter, the student will be able to: Recognize Roth IRA eligibility rules Compute the date on which a qualified Roth IRA distribution could be made Select Roth contribution maximums based on AGI and tax filing status Calculate the maximum annual Roth contribution when traditional IRA contributions are also made This chapter introduces the Roth IRA. These IRAs may provide even greater tax benefits to the holder than traditional IRAs. The eligibility, contribution and distributions rules of Roth IRAs are all detailed in this chapter. What is a Roth IRA? The Roth IRA is named for a retired Republican senator named William V. Roth. Senator Roth was instrumental in the enactment of legislation that authorized this new type of IRA under the Tax Payer Relief Act of The passage of this Act stimulated new interest in IRAs, which had lagged since 1986 when Congress reversed the deductibility of IRAs for many people. A Roth IRA is subject to many of the same rules that govern traditional IRAs. However, unlike traditional IRAs, contributions cannot be deducted, but are made from after-tax dollars. And, qualified distributions are tax-free, rather than being taxable in the year in which they are received. In addition, contributions may be made to a Roth IRA after age 70 ½ and amounts may be left in a Roth IRA for as long as an individual is alive. Roth IRA Eligibility Rules In 2018, individuals can contribute to a Roth IRA, but have reduced contribution amounts, if they have a modified AGI of: At least $189,000 and $199,000 (married individual filing jointly or qualifying widow(er)) At least $120,000 to $135,000 (single individual, head of household, or married individual filing separately who did not live with a spouse any time during the year) More than $0 but not less than $10,000 (married individual filing separately who lived with a spouse at any time during the year) IRA Products and SIMPLE Plans 42

51 Individuals with modified AGI at the following levels may not contribute to Roth IRAs for 2018: $199,000 or more (married individual filing jointly or qualifying widow(er)) $135,000 or more (single individual, head of household, or married individual filing separately who did not live with a spouse any time during the year) $10,000 or more (married individual filing separately who lived with a spouse at any time of the year) Roth IRA Contribution Rules Roth IRA contribution limits are similar to those of traditional IRAs. In 2018, the general contribution limit is the lesser of $5,500 or an individual s taxable compensation for the year. For those individuals 50 and older, the general contribution limit is the maximum of $6,500 or the individual s taxable compensation for the year. In some situations, contributions are made to both Roth IRAs and traditional IRAs for the same individual. If this occurs, the contribution limit for the Roth IRA is generally the same as the limit that would apply if contributions were only being made to that Roth IRA, and then reduced by contributions to all other IRAs for the year. This means that in 2017, the contribution limit is the lesser of $5,500 (or $6,500 for those 50 and older) minus all contributions for the year to all other IRAs or taxable compensation minus all contributions for the year to all other IRAs. For example, Freida is 38, earns $40,000 and makes a $2500 contribution to a traditional IRA plan in The largest contribution she may make to a Roth IRA in 2018 is $3000 ($5,500 maximum contribution, less the $2500 contribution she made to the traditional IRA). Recall that catch-up contributions may be made for an additional $3,000 if an individual participated in a 401(k) plan and the sponsoring employer filed for bankruptcy. This special contribution applies to Roth IRAs as well as traditional IRAs. Any excess contributions to a Roth IRA are subject to the same 6% tax as excess contributions made to a traditional IRA. For Roth IRAs, excess contributions equal the total of: All amounts contributed for the tax year to a Roth IRA (other than amounts properly rolled over or converted, as described in a later section) that are greater than the contribution limit for the year, and Any excess contributions for the preceding year, minus the total of: o Distributions from any Roth IRAs for the year, plus o The contribution limit for the year minus the contributions to all IRAs for the year Conversions and Rollovers Conversions A traditional IRA may be converted into a Roth IRA. This conversion is always treated as a rollover. Most of the rules applicable to traditional IRA rollovers apply; however, the 1-year waiting period does not apply. IRA Products and SIMPLE Plans 43

52 Conversions may be made in three different ways: Rollover Distributions may be received from a traditional IRA and rolled over into a Roth IRA. This must be done within 60 days of the distribution, however. Trustee-to-Trustee Transfer A trustee of a traditional IRA may be directed to transfer an amount from that IRA to the trustee of a Roth IRA. Same Trustee Transfer The trustee of a traditional IRA may also be directed to transfer an amount from a traditional IRA to a Roth IRA, even if he is the trustee of both IRAs. It is important to note that prior to 2009, amounts from certain retirement plans were not allowed to be rolled over into a Roth IRA. However, due to certain rule changes, rollover amounts are allowed from all of the following plans: Qualified pension, profit-sharing or stock bonus plans (this includes 401(k) plans) Annuity plans Tax-sheltered annuity plans Government deferred compensation plans IRAs Taxation of Conversions That Are Not Recharacterizations If the amount from the traditional IRA converted to a Roth IRA may not be recharacterized as a Roth IRA contribution because the contribution to the traditional IRA was made in the same tax year, the amount contributed from the traditional IRA will be seen as a regular contribution to the Roth IRA and subject to tax consequences of both Roth IRAs and traditional IRAs, including that: A 6% tax every year that applies to any excess contribution not withdrawn from the Roth IRA The traditional IRA distributions must be included in gross income The 10% early distribution tax may apply to distributions that don t meet the specified IRA early distribution exemption requirements In order to avoid a taxable conversion, the amount converted from the traditional IRA to the Roth IRA must be moved back into a traditional IRA by the due date for the tax return for the year during which the conversion to the Roth IRA was made. Rollover from Another Roth IRA Assets from one Roth IRA may be withdrawn on a tax-free basis if they are contributed to another Roth IRA in 60 days. However, a rollover from a Roth IRA to an employer retirement plan is prohibited; a rollover is only allowed to be made to another designated Roth account or Roth IRA. IRA Products and SIMPLE Plans 44

53 Roth IRA Distribution Rules Qualified Distributions Distributions from Roth IRAs are not included in gross income for tax purposes. This is due to the fact that the contributions made to Roth IRAs are made from after-tax dollars. Distributions are not included in gross income that are qualified or are a return of regular contributions from a Roth IRA. A 10% penalty may have to be paid on distributions that are not qualified. A qualified distribution is any distribution from a Roth IRA that meets certain requirements: It is made after a 5-year period that begins with the first taxable year for which a contribution was made to a Roth IRA The distribution is made: o On or after an individual turns 59 ½, or o Because of a disability, or o To a beneficiary or an estate after the IRA owner s death, or o For the purchase of a first home (assuming the purchase meets applicable rules) Non-Qualified Distributions If distributions that are not qualified are received from a Roth IRA, part of those distributions may be taxable. There is a specific order in which contributions and earnings are considered to be distributed from a Roth IRA. The order is: 1. Regular contributions 2. Conversion contributions, on a first-in-first-out basis. These conversion are generally taken from the earliest years first, and are taken into account in the following manner: a. Taxable portion first (this is the amount required to be included in gross income because of conversion) b. Nontaxable portion 3. Earnings on contributions (Rollovers from contributions from other Roth IRAs are disregarded for the purpose of ordering.) To determine the taxable amounts distributed, distributions and contributions, they must all be grouped and added in the following manner: Add together all distributions during the year from all Roth IRAs Add together all regular contributions made for the year. Add this to the total undistributed regular contributions made in prior years. Add together all conversion contributions made during the year. Add any recharacterized contributions that end up in a Roth IRA in the appropriate contribution group for the year in which the original contribution would have been taken into account if it had been made directly to the Roth IRA. IRA Products and SIMPLE Plans 45

54 Any recharacterized contributions that end up in an IRA other than a Roth IRA must be disregarded for the purpose of grouping both contributions and distributions. Any amount withdrawn to correct an excess contribution must also be disregarded for this same purpose. Minimum Distributions Unlike traditional IRAs, minimum distribution rules do not apply to Roth IRAs while the IRA owner is alive. However, after the death of the owner, some of the minimum distribution rules that apply also apply to a Roth IRA. In this situation, minimum distribution rules apply as though the Roth IRA owner died before his or her required beginning distribution date. IRA Products and SIMPLE Plans 46

55 Chapter Seven Study Questions 1. Laura s tax filing status is married filing jointly. In 2018, her AGI is $155,000. She may: a. Make full contributions to a Roth IRA b. Make phased-out contributions to a Roth IRA c. May not make contributions to a Roth IRA d. May only make rollover contributions to a Roth IRA 2. Jennifer is 55 years old and makes contributions to both a Roth IRA and a traditional IRA. In 2018, if her taxable compensation is equal to $35,000, she files individually, and all contributions she made for the year to the traditional IRA equal $1,000, the most she may contribute to her Roth IRA for that year is: a. $2,500 b. $5,500 c. $7,000 d. $10, Wilma sets up a Roth IRA in June. If she takes distributions from her IRA in December of 2018, they will be subject to a tax of: a. 0% b. 6% c. 10% d. 25% 4. Jake withdraws assets from his Roth IRA and deposits them into another Roth IRA. In order for the withdrawal to be tax-free, within how many days must he have deposited the assets into the second Roth account? a. Within 30 days b. Within 45 days c. Within 60 days d. Within 90 days IRA Products and SIMPLE Plans 47

56 Answers to Chapter Seven Study Questions 1. a. At this level of modified AGI, Laura may make a contribution for the maximum allowable amount in b. A 55 year old with this level of compensation may make a total of $6500 in IRA contributions in a. Since the distribution is five years after the Roth IRA was opened, there is no tax. 4. c. Rollovers must be completed in 60 days IRA Products and SIMPLE Plans 48

57 Chapter Eight: IRA Products Learning Objectives Upon completion of this chapter, the student will be able to: Identify IRA investment products by their features Distinguish between annuity product types by their characteristics Recognize mutual fund features important to an IRA participant The funds invested in IRAs can be used to purchase many different products. This chapter discusses some of the most common IRA investment choices. Certificates of Deposit Certificates of Deposit (or CDs) are savings certificates issued by banks that entitle the bearer to receive interest. They have a specific fixed interest rate, and have restrictions on withdrawing funds on demand. CDs are insured by the FDIC up to certain amounts, and so the risk of losing an investment is very low. Low risk also means that growth potential is relatively low as well. CDs are found in a multitude of terms (maturities). These generally stretch from as short a period as one month up to five or ten years. The amount required to open a CD also varies, from $50 up to $10,000. Usually, CDs are not subject to an administrative fee. But penalties for early withdrawals are heavy if a CD is closed or liquidated before it reaches maturity. This charge is typically from 3 to 6 months of interest. It should be noted that some banks waive withdrawal charges on regular IRA CD withdrawals for those customers over age 59 ½. Mutual Funds Mutual funds are investment vehicles that are made up of a collection of funds from numerous investors. The funds are collected for the purpose of investing in securities, and are purchased for a specific fund objective. Mutual funds are managed by money managers, who invest the capital from the mutual fund and try to create capital gains and income. One of the biggest advantages of mutual funds is diversification, which means that many different securities make up the collection of investments. Diversification allows the risks of aggressive, high growth investments in mutual funds to be offset by stable, low risk funds. Mutual fund securities include stocks and bonds: Stocks Stocks are a category of securities that indicates ownership in a corporation, and come in two main forms: common and preferred. Common stock generally allows the stockowner to have IRA Products and SIMPLE Plans 49

58 a vote in shareholders meetings. Common stock owners also receive dividends. Preferred stock owners are usually not allowed to have voting rights, but they do have a higher claim on assets and earnings than common stock owners. Bonds Bonds are a kind of debt investment. An individual investing in a bond is loaning money to an entity that is borrowing those funds for a definite period at a fixed rate. The entity promises an interest rate, and guarantees the date when the loaned funds will be returned. Categories of bonds include corporate bonds, municipal bonds, and U.S. Treasury bonds. Loads Mutual funds come either as load funds or no load funds. A load is a fee that is charged to pay commissions for distributors and sellers of a fund. Funds that are loaded may make a sales charge that is a front or back-end charge. Other loaded funds may distribute the charge over a specific period of time. These sales charges may be as small as 1% or as large as 9% of the amount invested, although most charges fall around 4 5%. Fees In addition to loads, mutual funds have other fees attached to them. These include yearly management fees, which are charged for the life of any fund chosen. Administrative charges and taxes are also charged to mutual fund investors. Administration duties may include tax reporting, issuing statements and executing transactions. Fees related to these duties are usually from $10 to $25 annually. Some mutual funds charge a fee against the assets in the fund for administration rather than a separate administrative charge to each mutual fund account holder. Money Market Mutual Funds Money market funds are special kinds of mutual funds. They are investment vehicles that attempt to earn interest for shareholders while also generally maintaining $1 net value asset per share. These kinds of funds are considered low-risk and low-return. Annuities Annuities are products that pay a return and that are issued by insurance companies. They are tax-deferred contracts which offer payouts that may either be immediate or deferred, and offer returns that may be either fixed or variable. Fixed Annuities With fixed annuities, a sum of money is given to an insurance company in exchange for a promised, fixed return for a certain period of time. Immediate fixed annuities have payments that begin immediately, while deferred fixed annuities have payments that begin at a date of the annuity purchaser s choice. However, once the payments begin, they do not change. Annuitization Payments When a fixed annuity begins making annuitization payments, the owner has two basic choices for the term of the payment stream. The first choice is a fixed period of time. The IRA Products and SIMPLE Plans 50

59 second choice the owner has is to annuitize for life, which means that payments will begin and continue until the annuitant s death. There are many variations of fixed term payment streams. The individual can choose from, generally, a minimum of a five-year payment period, up through 20 years or more. Annuitization payments may also be made in combinations of fixed periods and life, for example, there are 20 year certain and life annuities. When this type of annuitization selection is made, if the annuitant lives for more than 20 years, the payments will continue through the annuitant s lifetime. But, if the annuitant dies before twenty years are up, the payments will continue to a beneficiary until the end of the twenty-year period. Guarantees The primary benefit of a fixed annuity as an IRA vehicle is that these insurance products are considered to be among the most conservative and safe in the arena of IRA investments. Insurance companies, which are subject to strict financial guidelines by the states that regulate them, guarantee the returns of fixed annuities and also guarantee to make the annuitization payments as the annuity contract specifies. Many retirees find these to be stable, effective products from which to receive retirement savings income. Variable Annuities Variable annuities use sub-account unit investment options, which are pools of securities with a specific investment goal, similar to mutual funds. These sub-account units may incur value fluctuations, and have risks, return potential and a suggested investment time-frame that relate to the account s investment goal and policies. Variable annuities may allow for very aggressive investments, and also have more conservative options, such as government bond accounts. The investments in a variable annuity, like those in a fixed annuity, grow taxdeferred. Annuitization Variable annuities include similar annuitization options to fixed annuities. In addition to the fixed annuitization options, variable annuities allow variable annuitization, where payments from the product may vary based on the fluctuations in the subaccounts underlying the annuity. Under a variable annuitization option, the owner can choose to have a certain amount of units from the subaccounts disbursed on a periodic basis. The unit values of the accounts vary based on the performance of the investments within them. Therefore, the payments made to the owner can vary from period to period. Variable annuities are preferred by retirees who are willing to take on more risk, with the hope of better returns, than those who prefer the secure, stable return of fixed annuities. Self-Directed IRAs Certain kinds of investment products may only be used with a special kind of IRA: a selfdirected IRA. This kind of IRA allows the investor to include in one IRA plan a variety of investments. Often, when an IRA is opened with a bank or mutual fund, only that particular bank s CDs or that particular mutual fund company s funds may be utilized in the IRA. Selfdirected IRAs give the owner much more flexibility in making investment choices, and have IRA Products and SIMPLE Plans 51

60 the benefits of the owner receiving one statement and having one servicing contact for the various needs that come up in the holding of an IRA. Under self-directed IRAs, any of the following types of investment products may be purchased: Individual stocks Individual bonds CDs Annuities Mutual funds Real estate Self-directed IRAs can be a flexible choice for the right IRA holder. However, if the IRA holder is not going to utilize several products in the self-directed IRA, it may be better to open a non-self-directed account. The fees associated with the administration of self-directed IRAs tend to be much greater than those charged by a bank (which may be zero), a mutual fund company or an insurance company. IRA Products and SIMPLE Plans 52

61 Chapter Eight Study Questions 1. Nancy is using an investment vehicle that attempts to earn interest for shareholders while also generally maintaining $1 net value asset per share as a product to fund her IRA. Nancy is using a: a. CD b. Money market mutual fund c. Variable annuity d. Fixed annuity 2. The mutual fund that Ted uses as a product for his IRA is a load fund. If he invested $1,000 in the fund, the load charge is most likely about: a. $4 b. $40 c. $100 d. $ Frank uses an annuity as a product for his IRA. If he annuitizes the payments as a 20 year certain and life annuity and he dies 10 years after the annuitization begins, the annuity payments: a. Will continue to a beneficiary for 1 more year b. Will continue to a beneficiary for 10 more years c. Will continue to the beneficiary for 20 more years d. Will stop 4. Jonas is a retiree who would like a secure, stable return. Marianne is a retiree who would like to take on more risk than Jonas, with the hope of better returns. According to their preferences: a. Both Jonas and Marianne will use fixed annuities b. Both Jonas and Marianne will use variable annuities c. Jonas will use a fixed annuity, while Marianne will use a variable annuity d. Jonas will use a variable annuity, while Marianne will use a fixed annuity 5. Angela opens a self-directed IRA. The fees associated with the administration of her IRA will most likely be those charged by a bank or an insurance company. a. much greater than b. relatively equal c. slightly less than d. much less than IRA Products and SIMPLE Plans 53

62 Answers to Chapter Eight Study Questions 1. b. Money market funds are the only one of the options given that meets this definition. 2. b. Mutual funds may have a load of 4%. 3. b. A 20 year and life annuity will make payments for a minimum of 20 years. If the annuitant dies during the 20-year period, the payments will continue to a beneficiary for the remainder of the period. If the annuitant lives past the 20-year period, the payments will continue for the remainder of the annuitant s life. 4. c. Fixed annuities provide a more secure, stable return than do variable annuities. Variable annuities contain more risk, but offer the opportunity for higher returns. 5. a. Self-directed IRAs tend to charge much more than insurance companies and banks do for their IRA plans. IRA Products and SIMPLE Plans 54

63 Chapter Nine: Traditional IRAs vs. Roth IRAs Learning Objectives Upon completion of this chapter, the student will be able to: Predict the most advantageous IRA conversion circumstance based on age of the participant at conversion Predict the most advantageous IRA conversion circumstance based on tax bracket of the participant at conversion This chapter compares and contrasts traditional and Roth IRAs. Their eligibility, contribution and distribution rules and their taxation rules are all reviewed. Also described are the rules surrounding converting a traditional IRA to a Roth IRA. Eligibility Traditional IRA Traditional IRAs are available to almost all individuals, regardless of income level. The only restriction on this is if an individual is also covered by an employer retirement plan. Roth IRA Roth IRAs are available only to individuals of a certain income level, dependent upon filing status (married individual filing joint or qualifying widow(er); single individual, head of household, or married individual filing separately who did not live with a spouse any time during the year; married individual filing separately who lived with a spouse at any time during the year). Contributions Traditional IRA The general contribution limit for traditional IRAs in 2018 is $5,500 ($6,500 for those 50 and older). Depending on income level, contributions are tax deductible. Roth IRA The general contribution limit for Roth IRAS in 2018 is also $5,500 ($6,500 for those 50 and older). Contributions are not tax deductible. Distributions Traditional IRA Taxable distributions from traditional IRAs may begin when an individual turns 59 ½. They are required by age 70 ½. A 10% additional tax is generally levied against early withdrawals, and a 50% tax is generally levied against late withdrawals. IRA Products and SIMPLE Plans 55

64 Roth IRA Assets must be left in a Roth IRA for at least five years and the owner must generally be at least 59 ½ before qualified distributions may be taken tax-free. A 10% additional tax is generally levied against early withdrawals. There is no mandatory distribution age, however. Taxes The main differences between traditional and Roth IRAs are the tax ramifications of each. If an individual chooses to invest in a traditional IRA, he will be receiving an immediate tax break, which in turn lowers adjusted gross income. The money invested in the traditional IRA also grows on a tax-deferred basis. However, when the money (including capital gains) is eventually distributed, it will be taxed as ordinary income. It is important to note that tax rates on ordinary income are higher than the rates for capital gains. However, with Roth IRAs, money is invested as after-tax dollars and receives tax-free accumulation and tax-free qualified distributions. So although an immediate tax deduction is lost, all the money invested will be distributed without losing any portion to the IRS. Roth IRA Conversions As noted earlier, existing traditional IRAs may be converted into a Roth IRA. The advantage to such a conversion would be the avoidance of taxes at a retirement withdrawal. However, many factors come into play when determining whether or not such a conversion is really advantageous for a particular individual. Conversion Tax When a traditional IRA is converted to a Roth IRA, income taxes are levied on any earnings and pretax contributions in the traditional IRA. Funds in the IRA should not be used to pay the conversion tax. If they are withdrawn before the IRA owner is 59 ½, a 10% early withdrawal tax will generally be applied. Also, by removing money from the account, the amount remaining for compounding of earnings purposes in the Roth IRA will be reduced. For example, Greta has $23,400 in a traditional IRA. All the contributions to the traditional IRA were deductible contributions. She converts the traditional IRA to a Roth IRA. She must claim the amount converted as taxable income on her income tax return. Age at Conversion A conversion is generally more beneficial for younger individuals. This is due to the fact that the older an individual is, the less time he will have to make up lost assets due to the conversion tax. Also, younger individuals are likely to have less in a traditional IRA, making the conversion tax smaller than it would be for an older person with more assets in the IRA. Tax Benefits A Roth IRA conversion could force a traditional IRA owner into a higher tax bracket, because of the IRA amount being included in his income. This in turn could disqualify him from other tax benefits (such as college tuition tax credits). IRA Products and SIMPLE Plans 56

65 Tax Bracket Another important factor to consider is an individual s tax bracket. If the tax bracket that one falls into in retirement is the same or higher than the tax bracket he is in when he contributes to his IRA, the more advantageous tax choice would be a Roth IRA. However, if an individual will be in a lower tax bracket in retirement, a traditional IRA would provide the tax advantage. This is due to the fact that income tax is paid on a Roth IRA conversion at an individual s current tax rate, rather than his rate at retirement. IRA as an Inheritance If an individual plans to leave his IRA to his heirs, then a Roth IRA conversion could be a very advantageous choice. One reason for this is that Roth IRAs have no minimum withdrawal requirements. With traditional IRAs, however, the owner must begin taking withdrawals no later than the year after he turns 70 ½. This means that there is less time for the money to compound without paying taxes, which in turn means that heirs will receive less. Also, by converting to a Roth IRA, an individual s taxable estate will be reduced by the amount of conversion tax he pays, thereby reducing estate taxes for heirs. IRA Products and SIMPLE Plans 57

66 Chapter Nine Study Questions 1. Sarah is trying to decide whether or not converting her traditional IRA to a Roth IRA is the most fiscally wise choice based on tax advantage. If she is planning on being in a higher tax bracket at retirement, the option that would provide the best tax advantage is: a. Keeping her assets in his traditional IRA b. Converting her traditional IRA to a Roth IRA immediately c. Converting her traditional IRA to a Roth IRA just before retirement d. Both options would provide an equal tax advantage 2. Kim is 28 when she converts her traditional IRA to a Roth IRA. Frank is 65 when he converts his traditional IRA into a Roth IRA. Based on age alone, will the conversion have been more beneficial for Kim or Frank? a. The conversion will have been more beneficial for Kim b. The conversion will have been more beneficial for Frank c. The conversion would have been just as beneficial for Kim as it would have been for Frank d. The conversion would not have been beneficial for either Kim nor Frank 3. Sam is 35 years old when he sets up his traditional IRA. Lisa is also 35 years old when she sets up her Roth IRA. Assuming they are not covered by employer plans and make the same income amount, Sam is able to make IRA contributions of Lisa. a. the same amount as b. a greater amount than c. a slightly smaller amount than d. a much smaller amount than 4. Leah has $20,200 in a traditional IRA. All the contributions to the traditional IRA were deductible contributions. She converted the traditional IRA to a Roth IRA in How much of the converted amount must she claim as taxable income on her income tax return? a. $0 b. $10,100 c. $18,500 d. $20, Phil sets up a traditional IRA. Hannah sets up a Roth IRA. All of the following regulations that apply to Phil s IRA also apply to Hannah s, except: a. Taxable distributions may begin when an individual turns 59 ½ b. Taxable distributions are required by age 70½ c. A 10% additional tax is generally levied against early withdrawals d. Contributions are subject to a general limit IRA Products and SIMPLE Plans 58

67 Answers to Chapter Nine Study Questions 1. c. Since she is in a lower tax bracket now than she will be at retirement, she will save taxes by converting the traditional IRA to a Roth IRA now. 2. a. Since Kim is younger, she will have more time for earnings to accumulate tax-free by converting her traditional IRA to a Roth IRA than will a 65 year old. 3. a. Since both these individuals are under 50, they are subject to the same maximum IRA contribution amounts. 4. d. Since all of the contributions were deductible, they are all taxable upon conversion. (Taxpayers may file amended tax forms for prior tax years if this conversion was not reported properly in the past.) 5. b. Roth IRAs do not require distributions at age 70 ½. IRA Products and SIMPLE Plans 59

68 Chapter Ten: SIMPLE IRAs Learning Objectives Upon completion of this chapter, the student will be able to: Recall SIMPLE IRA employer rules Recognize SIMPLE IRA employee rules Describe SIMPLE IRA self-employed participant rules SIMPLE IRA plans are a special type of IRA for employers. This chapter explains their structure and their eligibility rules. What is a SIMPLE Plan? A savings incentive match plan (SIMPLE plan) is a type of employer-sponsored retirement plan. It provides an employer (this includes self-employed individuals) and employees with a simplified way to provide for retirement. Under this kind of plan, eligible employees may contribute part of their pre-tax compensation to the plan, deferring taxation until amounts in the IRA are distributed. Employees may choose to make salary reduction contributions to the plan (rather than just receiving the amounts as a portion of regular pay) and employers make matching or nonelective contributions. SIMPLE plans may be set up as SIMPLE IRA plans, or as part of a 401(k) plan. This chapter will focus of SIMPLE plans set up as IRAs. Employer Rules for Establishing a SIMPLE IRA Plan Employee Limit An employer may set up a SIMPLE IRA plan only if he has 100 or fewer employees who received $5,000 or more in compensation for the preceding year. The employee-count must include all employees employed at any time during the preceding year, whether or not they were eligible to participate in the plan. This includes employees who are self-employed who received earned income, as well as leased employees. Leased employees are those employees who are not common-law employees, but who do all of the following: Provide services under an agreement between the employer and a leasing organization Perform services for the employer substantially full time for at least 1 year Perform services under the employer s primary direction or control A grace period applies to employers who do not meet the 100-employee limit under certain conditions. It applies if the employer has maintained the SIMPLE IRA plan for at least 1 year, but has ceased to meet the employee limit in a later year. In this situation, the employer will be treated as meeting the employee-limit for the 2 years immediately following the year in which the employer last meet the limit. A slightly different rule applies if the employer fails IRA Products and SIMPLE Plans 60

69 to meet the employee limit due to an acquisition, disposition, or the like. The employer will be eligible for the grace period only if: Coverage has not significantly changed under the plan during the grace period The plan would have continued to qualify after the transaction if the original employer had remained a separate employer Qualified Plan An employer must also have no other qualified retirement plan than a SIMPLE IRA to which he makes contributions, or to which benefits accumulate. This applies to any year beginning with the year a SIMPLE IRA plan goes into effect. However, qualified plans maintained for collective bargaining employees are allowed in addition to a SIMPLE IRA plan. Account Requirements SIMPLE IRAs can be set up so that employee contributions are deposited into either individual retirement accounts or annuities. An employer must set up a SIMPLE IRA for each eligible employee. This must be done before the first date a contributions is required to be deposited into an employee s IRA. Notification Requirements All employers who establish a SIMPLE IRA plan is subject to certain employee notification requirements. These include providing the following information: The employee s opportunity to make or change a salary reduction choice under the SIMPLE IRA plan The employer s choice to make either matching contributions or nonelective contributions A summary description given by the financial institution Written notice that an employee s balance may be transferred without cost or penalty if an employer uses a designated financial institution This information must be provided before the beginning of the election period. This is usually the 60-day period immediately before January 1 of a calendar year. The dates will be modified for those employers who establish a SIMPLE IRA plan in mid-year, or if the election period falls before the first day an employee becomes eligible to participate in the SIMPLE IRA plan. Longer election periods may be provided to permit employees to enter into salary reduction agreements or modify prior agreements. For instance, a 90-day election period may be provided by a SIMPLE IRA plan, instead of the 60-day period. Also, a SIMPLE IRA plan may provide quarterly election periods during the first 30 days before each calendar year, in addition to the 60-day period. Note, however, that establishing shorter or fewer election periods is prohibited. Employee Eligibility Rules Employees eligible under a SIMPLE IRA plan are those who have received at least $5,000 in compensation during any 2 years preceding the current year. They must also be reasonably IRA Products and SIMPLE Plans 61

70 expected to receive at least $5,000 during the current year. It should be noted that less (but not more) restrictive eligibility requirements may be imposed by an employer. This is accomplished by eliminating or reducing the prior year compensation requirements, eliminating or reducing the current year compensation requirements, or reducing or eliminating requirements for both. For example, an employer may require annual compensation of $2,000 during any preceding year as an eligibility requirement for his SIMPLE IRA plan. However, an employer may not require annual compensation of $6,000 during any preceding year as an eligibility requirement for his SIMPLE IRA plan, because this is a more restrictive eligibility requirement under IRS rules. Certain employees are excluded from eligibility under a SIMPLE IRA plan. These include: Union Employees These employees are covered by a union agreement. Their retirement benefits were bargained for in good faith by both the SIMPLE plan employer and the employees union. Nonresident Aliens These nonresident alien employees must have received no U.S. source wages, salaries, or other personal services compensation from a SIMPLE plan employer. Example: An employer establishes a SIMPLE IRA plan for tax year In order to participate in the plan, employees must have received at least $5,000 in compensation during any two years before They must also be reasonably expected to receive at least $5,000 in Cynthia has been working for the employer since She has earned the following annual compensation: Year Compensation 2012 $3, $5, $5, $5, $5,000 Cynthia earned at least $5,000 in two years preceding She also received a salary increase in 2017, and so is expected to earn at least $7,000 in Therefore, she is eligible for her employer s SIMPLE IRA plan. Compensation Compensation for employment includes wages, tips and other employer compensation that are subject to federal income tax withholding. It also includes the sum paid for domestic service in a private home, local college club, or local chapter of a college fraternity or sorority. Employee salary reduction contributions made under SIMPLE plans are also considered compensation. Compensation for self-employed individuals are defined as net earnings from selfemployment before subtracting any contributions made to a SIMPLE IRA on the individual s IRA Products and SIMPLE Plans 62

71 behalf. Note that net earnings include any services performed while claiming exemption from self-employment tax as a member of a group conscientiously opposed to social security benefits. IRA Products and SIMPLE Plans 63

72 Chapter Ten Study Questions 1. Crystal owns her own business. In order to be eligible to set up a SIMPLE IRA, how many eligible employees must her business employ? a. 100 or fewer b. 70 or fewer c. 20 or fewer d. 1 or more 2. An employer establishes a SIMPLE IRA plan for tax year The eligibility requirements of the plan are the maximum an employer may set. Thomas has been working for the employer since He has earned the following annual compensation: Year Compensation 2012 $6, $3, $5, $5, $5,000 In 2017, Thomas is expected to earn $6,000. Under his employer s SIMPLE plan, he will be considered: a. Ineligible for coverage b. Eligible for coverage c. Eligible for coverage only if he is not a leased employee d. Eligible for coverage only if he is not a highly compensated employee 3. Mike is the owner of a business that employs 12 employees. He maintains a qualified plan. He may not establish a SIMPLE IRA plan unless the qualified plan he already has is: a. A 401(k) plan b. A SEP plan c. A plan maintained for collective bargaining employees d. A plan maintained for leased employees 4. A grace period applies to an employer who does not meet the employee-limit for a SIMPLE plan in 2016 but had met the employee-limit in past years. In this situation, the employer will be treated as meeting the employee-limit: a. Until the middle of 2018 b. In 2017 only c. Through 2016 and 2017 d. In 2017, 2018, 2019 IRA Products and SIMPLE Plans 64

73 5. An employer sets up a SIMPLE Plan. He must provide certain notification to his employees before the beginning of the election period. He may establish an election period of any of the following lengths, except: a. An election period of 30 days b. An election period of 60 days c. An election period of 90 days d. An election period of 120 days IRA Products and SIMPLE Plans 65

74 Answers to Chapter Ten Study Questions 1. a. SIMPLE Plans require that employers have 100 or fewer eligible employees. 2. b. Employees eligible under a SIMPLE IRA plan are those who have received at least $5,000 in compensation during any 2 years preceding the current year. 3. c. An employer may not establish a SIMPLE Plan if it has another employer retirement plan in place, unless it is a plan maintained for collective bargaining employees only. 4. c. The SIMPLE Plan grace period applies if the employer has maintained the SIMPLE IRA plan for at least 1 year, but has ceased to meet the employee limit in a later year. In this situation, the employer will be treated as meeting the employee-limit for the 2 years immediately following the year in which the employer last met the limit. 5. a. A SIMPLE IRA plan must provide at least a 60-day election period before the beginning of the plan period. IRA Products and SIMPLE Plans 66

75 Chapter Eleven: SIMPLE IRA Contributions and Distributions Learning Objectives Upon completion of this chapter, the student will be able to: Calculate contribution amounts for employers to SIMPLE IRA plans Choose the correct tax penalty applicable to early SIMPLE IRA plan withdrawals Calculate contribution amounts for employees to SIMPLE IRA plans SIMPLE IRA contribution and distribution requirements are the subject of this chapter. These plans allow both employee and employer contributions, and have required distribution rules similar to those of traditional IRAs. SIMPLE IRA Employee Contributions SIMPLE IRA plan contributions consist of salary reduction contributions and employer contributions. Salary Reduction Contributions A salary reduction contribution is a contribution that an employee chooses to have an employer make on his behalf. In 2018, salary reduction contributions are limited to $12,500. These contributions are expressed as a percentage of an employee s compensation, unless an employer allows an employee to express the contributions as a specific dollar amount. An employer may not place any restrictions on the contribution amount, unless it is to comply with the approved limit of $12,500. An employee could participate in another employer plan during the year and receive elective salary reductions or deferred compensation under that plan. In this case, the salary reduction contributions under a SIMPLE IRA Plan are also considered elective deferrals that count toward the overall annual limit on exclusion of salary reduction contributions and other elective deferrals. In 2018, this limit is $18,500. Salary reduction contributions must be made to a SIMPLE IRA within 30 days after the end of the month in which the amounts contributed would otherwise have been payable to the employee. Catch-up Contributions Employees age 50 or older are allowed to make catch-up contributions under a SIMPLE IRA plan. In 2018, the catch-up contribution limit is $3,000. Catch-up contributions are not considered salary reduction contributions unless they exceed the $12,500 limit. Note, however, that an employee making catch-up contributions may not exceed the lesser of the following amounts in one year: IRA Products and SIMPLE Plans 67

76 The catch-up contribution limit The excess of the employee s compensation above the salary reduction contributions that are not catch-up contributions SIMPLE IRA Employer Contributions In addition to employee contributions, an employer may make either matching contributions or nonelective contributions. Employer Matching Contributions An employer is usually required to match an employee s salary reduction contributions (unless he makes nonelective contributions) on a dollar-for-dollar basis of up to 3% of an employee s compensation. An employer may choose to make a matching contribution of less than 3%, however, it must be at least 1%. An employer may not choose a percentage less than 3% for more than 2 years during a 5-year period. Employer matching contributions must be made by the date an employer must file his federal income tax return for the year. Example: Ellen s employer establishes a SIMPLE IRA plan, in which she is a participant. Her compensation was $31,200 ($600 a week). Ellen chooses to contribute $90 a week (15% of her weekly pay) as salary reduction contributions to her SIMPLE IRA. For the year, Ellen s contributions were $4,680, which is under the $12,500 limit. Under Ellen s plan, her employer was required to make matching contributions equal to her salary reductions, but not more than 3% of her compensation for the year. So, Ellen s employer s matching contribution was limited to $936 (3% of $31,200). The total amount of the contributions to Ellen s SIMPLE IRA plan for the year was $5,616. Now assume that Ellen s annual compensation was $420,000. She decides to have 2.7% of her weekly pay contributed to her SIMPLE IRA as salary reduction contributions. For the year, Ellen s contributions were $12,500, which is equal to the salary contribution limit. Ellen s employer is not required to make a matching contribution of 3% of her salary, because the amount ($12,600) exceeds the contribution limit. Rather, her employer s matching contribution was limited to $12,500. So the total amount of the contributions to Ellen s SIMPLE IRA plan for the year was $25,000. Nonelective Contributions An employer may choose to make nonelective contributions instead of matching contributions. Nonelective contributions may be made of 2% of compensation for each eligible employee. If an employer chooses to make nonelective contributions, he must make them regardless of whether the employee chooses to make salary reduction contributions. A maximum of $275,000 of an employee s compensation may be used to calculate the nonelective contribution amount. Employer nonelective contributions must be made by the date an employer must file his federal income tax return for the year. IRA Products and SIMPLE Plans 68

77 Example: George s employer establishes a SIMPLE IRA plan, in which he is a participant. His compensation was $39,000 ($750 a week). George chooses to contribute $105 a week (14% of his weekly pay) as salary reduction contributions to his SIMPLE IRA. For the year, George s contributions were $5,460, which is under the $12,500 limit. Under George s plan, his employer chooses to make nonelective contributions, instead of matching contributions. His employers nonelective contributions are limited to 2% of George s compensation ($780). So the total contributions made on George s behalf for the year equaled $6,240. SIMPLE IRA Contribution Deductions An employer may deduct his contributions to a SIMPLE IRA plan. Employees under the plan may also exclude these contributions from their gross income. Contributions to SIMPLE IRA plans are not subject to federal income tax withholding, although salary reduction contributions are subject to: Social Security taxes Medicare taxes Federal Unemployment (FUTA) taxes Employer matching and nonelective contributions are not subject to these taxes. SIMPLE IRA Distributions The distributions from SIMPLE IRAs are usually subject to the same rules as traditional IRAs, and are includible in income for the year in which they were received. Rollovers from one SIMPLE IRA to another may be made tax-free. Rollovers from one SIMPLE IRA to a non- SIMPLE IRA may only be made after a 2-year participation in the SIMPLE IRA plan, however. The 10% additional tax generally applies withdrawals before age 59 ½ from SIMPLE IRA plans. An additional tax is levied under early withdrawal circumstances as well. If funds from a SIMPLE plan are withdrawn within 2 years of the start of participation, a 25% additional tax applies. IRA Products and SIMPLE Plans 69

78 Chapter Eleven Study Questions 1. Douglas is covered under his employer s SIMPLE plan. He also participates in another employer plan during the year and receives elective salary reductions under that plan. In 2018, the overall annual limit on exclusion of salary reduction contributions and other elective deferrals that Douglas is subject to is: a. $7,000 b. $9,200 c. $12,500 d. $18, Tabitha s employer establishes a SIMPLE IRA plan, which she is a participant of. Her compensation was $40,000. Under Tabitha s plan, her employer chooses to make nonelective contributions. Her employers nonelective contributions are limited to: a. $800 b. $1,000 c. $2,600 d. $6, Dan s employer establishes a SIMPLE IRA plan, in which he is a participant. His compensation was $40,000. Dan chooses to contribute $100 a week as salary reduction contributions to his SIMPLE IRA. For the year, Dan s contributions were $5,200. Under Dan s plan, his employer was required to make matching contributions equal to his salary reductions, but not more than the maximum allowable percentage of his compensation for the year. So, Dan s employer s matching contribution is limited to: a. $800 b. $1,200 c. $3,600 d. $5, An employer sets up a SIMPLE Plan. Under the plan, which of the following contributions are subject to taxes for Social Security? a. Salary reduction contributions, only b. Employer matching contributions, only c. Employer nonelective contributions, only d. Employer matching and nonelective contributions, only IRA Products and SIMPLE Plans 70

79 5. Jenny makes a rollover from one SIMPLE IRA to a non-simple IRA. How many years must she have participated in the SIMPLE IRA in order to allow this rollover? a. 1 year b. 2 years c. 3 years d. 5 years IRA Products and SIMPLE Plans 71

80 Answers to Chapter Eleven Study Questions 1. d. In 2018, the overall annual limit on exclusion of salary reduction contributions and other elective deferrals is $18, a. Nonelective contributions are limited to 2% of the employee s eligible compensation. $40,000 x 2% = $ b. Employers match salary deduction contributions in SIMPLE Plans, so the employer would match Dan s contributions of $ a. The employee s salary reduction contributions are subject to Social Security taxation. 5. b. A rollover is allowed from a SIMPLE plan after the employee has participated in the plan for two years. IRA Products and SIMPLE Plans 72

81 Chapter Twelve: SEP-IRAs Learning Objectives Upon completion of this chapter, the student will be able to: Evaluate eligibility for SEP plans based on years worked, age and compensation Computer the tax credit for a SEP based on start-up costs Recognize factors that cause ineligibility for a SEP Plan employer tax credit Another type of IRA plan for businesses is the SEP-IRA. This chapter introduces these plans, and discusses their structure, eligibility and establishment requirements. What is a SEP-IRA? A simplified employee pension (SEP) is another type of employer-sponsored retirement plan. It allows an employer (including self-employed individuals) to make tax-deductible contributions on behalf of eligible employees. Employees make tax-free contributions to their SEP plans, deferring taxation until the amounts in the plan are distributed. A SEP plan is established first as a traditional IRA. An employer deposits SEP contributions into the IRA (which is owned and controlled by an individual employee) via the financial institution where the SEP-IRA is maintained. Some institutions require that the IRA be classified as a SEP-IRA, rather than a traditional IRA, before contributions will be accepted. Other institutions allow SEP contributions to be deposited to the traditional IRA, regardless of how the IRA is classified. Because of the fact that a SEP plan uses a traditional IRA as a funding instrument, all contributions made to the SEP Plan become traditional IRA assets, and thus are subject to many of the same rules as traditional IRAS. Eligibility Requirements Employers In contrast to a SIMPLE IRA, a SEP-IRA may be established by an employer with one or more employees, including the business owner. Eligible employers include: Sole proprietorships Partnerships Corporations Nonprofit organizations IRA Products and SIMPLE Plans 73

82 Individual employees are not allowed to establish a SEP plan. Rather, eligible individual employees establish a traditional IRA. Then, an employer deposits SEP contributions into that IRA. Eligible Employees Employees must meet certain requirements in order to be considered eligible for a SEP-IRA plan. These requirements include that the employee: Be at least 21 years old Has worked for the employer during at least 3 of the last 5 years Has received at least $600 from the employer The employees excluded from eligibility under a SEP-IRA plan are the same as those excluded under a SIMPLE IRA plan. They include: Union Employees These employees are covered by a union agreement. Their retirement benefits were bargained for in good faith by both the SEP plan employer and the employees union. Nonresident Aliens These nonresident alien employees must have received no U.S. source wages, salaries, or other personal services compensation from a SEP plan employer. Example: A corporation establishes a SEP plan. David worked for the corporation in 2014, 2015 and In 2014 and 2017 he only worked for the corporation for a total of three weeks. However, since David is over 21 years old and received $1,000 from the corporation in 2017, he is eligible for the SEP plan. Establishing a SEP A SEP is established using three basic steps: executing a formal written agreement to provide benefits to all eligible employees, giving each eligible employee specific SEP information, and establishing a SEP-IRA by or for each eligible employee. A SEP plan may be established for a year as late as the due date of an employer s tax return for that year. Formal Written Agreement A formal written agreement must be executed to provide benefits to all eligible employees under a SEP plan. This can be accomplished by adopting an IRS model SEP using Form SEP. In this case, prior IRS approval or determination letter is not needed and an employer will usually not have to file annual retirement plan information returns with the IRS and the Department of Labor. However, there are certain instances when a Form 5305-SEP cannot be used: The employer currently maintains any other qualified retirement plan. Note that this does not prevent the employer from maintaining another SEP. The employer has any eligible employees for whom IRAs have not been established. The employer used the services of a leased employee. IRA Products and SIMPLE Plans 74

83 The employer is a member of any of the following (unless all eligible employees of all the members of these groups, trades or businesses also participate under the SEP): o Certain affiliated service groups o Certain controlled groups of corporations o Certain trades or businesses under common control The employer does not pay the cost of the contributions to the SEP. Specific SEP Information An employer must give a copy of Form 5305-SEP to each eligible employee, along with its instructions and other information listed in the Form. Until this information is given, a SEP plan is not considered to have been established. SEP-IRA for Each Employee Before a SEP plan can be established, a SEP-IRA must be set up by or for each eligible employee under the plan. These IRAs may be set up with banks, insurance companies, or other qualified financial institutions. The SEP contributions will be sent to these institutions. Tax Credit for Startup Costs An employer who sets up a SEP plan may be able to claim a tax credit as part of the ordinary and necessary costs of starting that plan. This credit equals 50% of the cost to set up and administer the plan, in addition to education the employees about the plan. The credit will cover up to a maximum of $500 each year for the first 3 years of the plan. It can be claimed in the tax year before the tax year in which the SEP plan becomes effective. In order for the credit to be applied, an employer must have had 100 or fewer employees who received at least $5,000 in compensation for the preceding year. At least one non-highly compensated employee must be a participant of the plan as well. The employees covered by the plan usually cannot be substantially the same employees for whom contributions were made or benefits accrued under a plan in the 3-tax-year period immediately before the first year to which the credit applies. This rule applies to plans under any of the following employers: The employer of the current SEP-plan A member of a controlled group that includes the employer of the current SEP-plan A predecessor of either of the preceding two individuals The tax credit is part of the general business credit, and if it cannot be used in the current tax year, then it can be carried back or forward to other tax years. Note, however, that the part of the general business credit that is attributable to the SEP plan startup cost credit may not be carried back to a tax year beginning before January 1, Also, startup costs equal to the credit claimed for a tax year may not be deducted, but an employer may choose to not claim the allowable credit for a tax year. This plan s startup tax credit may also be used when starting a SIMPLE plan, or a qualified plan. IRA Products and SIMPLE Plans 75

84 Chapter Twelve Study Questions 1. Patricia s employer establishes a SEP plan. What is this plan first established as? a. A universal IRA b. A SIMPLE IRA c. A traditional IRA d. An annuity 2. A corporation establishes a SEP plan in Jeremy worked for the corporation in 2015 and In 2015 and 2017 he only worked for the corporation for a total of three weeks. Jeremy is 25 years old and received $1,000 from the corporation in Why is he ineligible for the SEP plan? a. Because he only worked for the corporation for two different years b. Because he only worked for the corporation for a total of three weeks c. Because he is only 25 years old d. Because he only received $1,000 from the corporation in An employer who sets up a SEP plan claims a tax credit as part of the ordinary and necessary costs of starting that plan. If the cost to set up and administer the plan was $500 in 2017 for that year, the credit will cover: a. $100 b. $250 c. $375 d. $ An employer who is a corporation sets up a SEP plan but cannot claim a tax credit as part of the ordinary and necessary costs of starting that plan. The employer had 90 employees who received at least $5,000 in compensation for the preceding year. There were no nonhighly compensated employees who were participants of the plan. Why is the employer ineligible for the SEP plan credit? a. Because the employer was a corporation b. Because the employer employed 90 employees c. Because the employer s employees received at least $5,000 in compensation for the preceding year d. Because no non-highly compensated employees were participants in the plan IRA Products and SIMPLE Plans 76

85 Answers to Chapter Twelve Study Questions 1. c. A SEP is a form of IRA, and requires the establishment of a traditional IRA for each participant. 2. a. Employees must meet certain requirements in order to be considered eligible for a SEP- IRA plan. These requirements include that the employee: Be at least 21 years old Has worked for the employer during at least 3 of the last 5 years Has received at least $600 from the employer in d. The tax credit covers up to a maximum of $500 each year for the first 3 years of the plan. 4. d. In order to qualify for the SEP cost tax credit, at least one highly compensated employee must participate in the plan. IRA Products and SIMPLE Plans 77

86 Chapter Thirteen: SEP- IRA Contributions and Distributions Learning Objectives Upon completion of this chapter, the student will be able to: State rules applicable to employee rights to SEP amounts Know basic SEP-IRA contribution and distribution rules Identify highly compensated employees by annual compensation levels The contribution and distribution rules of SEP-IRAs are explained in this chapter. The deductibility rules of contributions for employees, employers and the self-employed are also described. SEP-IRA Contributions An employer may contribute a limited amount of money to employees SEP-IRAs each year. A self-employed individual may also contribute money to his own SEP-IRA. Contributions do not have to be made every year. However, when contributions are made, they must be based on a written allocation formula and must not discriminate in favor of highly compensated employees. Highly compensated employees are those employees who: Owned over 5% of the interest in the participating business at any time during the year, or the preceding year Received compensation from the employer of more than $120,000, and (if the employer chooses) was in the top 20% of employees, as ranked by compensation amounts. When an employer contributes, he must contribute to the SEP-IRAs of all plan participants who performed personal services during the year for which the contributions are being made. This applies even to the employees who died or terminated employment before the contributions are made. Contribution Limits In 2018, contributions an employer makes for a common-law-employee s SEP-IRA may not exceed the lesser of 25% of the employee s compensation, or $55,000. Generally, compensation does not include employer contributions to the SEP. When determining the contribution limit for an employee, any compensation over $275,000 (in 2018) may not be considered. The annual limits on employer contributions also apply to contributions made to an employer s own SEP-IRA; he may not contribute more than 20% of his net earnings, however. Example: Jeff is eligible for his employer s SEP plan. He earns $275,000 in compensation in Twenty-five percent of his $275,000 is equal to $68,750, which exceeds the contribution limit. Therefore, the most that may be contributed to his SEP-IRA in 2018 is $55,000. IRA Products and SIMPLE Plans 78

87 If an employer contributes to a defined contribution plan, certain additional contribution limits apply. In 2018, annual additions to an account are limited to the lesser of $55,000 or 100% of an employee s compensation. All contributions to defined contribution plans must be added when this limit is being calculated. For this limit, a SEP is considered a defined contribution plan; therefore the contributions to the SEP must be added to contributions of other defined contribution plans. Excess Contributions Excess contributions made to SEP-IRAs are treated in much the same manner as excess contributions made to traditional IRAs. They are included in an employee s income for the year, and are seen as contributions by the employee to his SEP-IRA. Deducting Contributions An employer can generally deduct contributions made to an employee s SEP-IRA. Selfemployed individuals may only deduct contributions made to their own SEP-IRAs. In 2016, the most that may be deducted for contributions that are not elective deferrals is the lesser of employer contributions (including excess contribution carryovers) or 25% of the compensation (limited for each employee to $275,000) paid to an employee. This amount cannot exceed $55,000. Self-Employed Individuals Self-employed individuals who contribute to their own SEP-IRAs must use a special computation to determine the maximum deduction amount for contributions. Compensation is calculated as net earnings from self-employment (gross income from a trade or business), which includes these deductions: Deduction for ½ of the individual s self-employment tax Deduction for contributions to the individual s SEP-IRA Deduction for contributions made to a self-employed individual s SEP-IRA and that individual s net earnings are co-dependent. Because of this, the deduction for contributions are calculated by reducing the contribution rate called for in the individual s SEP plan. Excess Contribution Carryover If SEP contributions are made that exceed the deduction limit, they may be carried over and deducted in later years. But the carryover is subject to the deduction limit for that year when combined with the contribution for that year. A 10% tax may be applied for excess contributions to a SEP. Timing The tax year in which a SEP is maintained determines when contributions made to a SEP may be deducted. For instance, if the SEP is maintained on a calendar year basis, the yearly contributions on a tax return are deducted for the year within which the calendar year ends. But if the tax return is filed and the SEP is maintained on a fiscal year or short tax year, then contributions made for that year are deducted on the tax return for that year. IRA Products and SIMPLE Plans 79

88 SEP Distributions An employer may not prohibit distributions made from an employee s SEP-IRA. In addition, an employer is not allowed to set conditions on an account that require an employee to refrain from making distributions from the account. SEP-IRA distributions are subject to the same rules and penalties as traditional IRAs. IRA Products and SIMPLE Plans 80

89 Chapter Thirteen Study Questions 1. Melissa is an employer who establishes a SEP plan. She may prohibit her employees from taking distributions from their individual SEP-IRAs: a. At any time b. Once every six months c. Once annually d. At no time 2. James receives $125,000 in compensation from his employer in 2018 and is in the top 20% of earners in the company. Under the SEP contribution rules, James is considered to be what type of employee? a. Low-income employee b. Marginal employee c. Highly compensated employee d. Fringe employee 3. Fred is eligible for his employer s SEP plan. He earns $120,000 in compensation in What is the most that may be contributed to his SEP-IRA in 2018? a. $30,000 b. $49,000 c. $50,000 d. $60, An employer who has established a SEP plan makes contributions to his own SEP-IRA. If his net earnings in 2018 are $200,000, he may not contribute more than: a. $20,000 b. $40,000 c. $49,000 d. $51, Max is self-employed and contributes to his own SEP-IRAs. When determining the maximum deduction amount for contributions, his compensation is calculated as net earnings from self-employment which includes a deduction for what fraction of his selfemployment tax? a. 1/4 b. 1/3 c. 1/2 d. 3/8 IRA Products and SIMPLE Plans 81

90 Answers to Chapter Thirteen Study Questions 1. d. Each employee owns his or her own SEP-IRA, and the employer cannot prohibit distributions from these IRAs. 2. c. Highly compensated employees are those employees who: Owned over 5% of the interest in the participating business at any time during the year, or the preceding year Received compensation from the employer of more than $120,000, and (if the employer chooses) was in the top 20% of employees, as ranked by compensation amounts. 3. a. The maximum amount is 25% of eligible compensation, limited by the cap of $55, % x $120,000 = $30, b. The employer s contributions are limited to 20% of net earnings. $200,000 x 20% = $40, c. Compensation is calculated as net earnings from self-employment (gross income from a trade or business), which includes these deductions: Deduction for ½ of the individual s self-employment tax Deduction for contributions to the individual s SEP-IRA IRA Products and SIMPLE Plans 82

91 Chapter Fourteen: SARSEPs Learning Objective Upon completion of this chapter, the student will be able to: Recognize SARSEP contribution maximum based on age and compensation Explain the SARSEP ADP test Another type of IRA plan for business use the SARSEP is explored in this course. This plan is no longer allowed to be newly established, but existing plans may continue to be active as long as eligibility rules are met. This chapter describes the structure, eligibility and deferral rules of these plans. What is a SARSEP? A SARSEP is a salary-deferral SEP that is used to enable eligible employees to make salarydeferral contributions to a SEP-IRA. Under these arrangements, employees choose to have their employer contribute a part of their pay to a SEP-IRA, rather than receive it in cash. This contribution is made on a tax-deferred basis; therefore it is referred to as an elective deferral contribution. After 1996, employers are no longer allowed to establish SARSEPS. But participants (including those employees hired after 1996) of a SARSEP plan set up prior to 1997 may continue to have their employers contribute part of their pay to the active plan. SARSEP Eligibility Requirements An employer and eligible employees may utilize a SARSEP established before 1997 only if all of the following requirements are carried out: At least 50% of the employer s eligible employee s choose to make elective deferrals The employer has 25 or fewer eligible employees at any time during the preceding year The elective deferrals of highly compensated employees meet the SARSEP ADP test SARSEP ADP Test The SARSEP ADP test requires that the amount deferred each year by every eligible highly compensated employee as a percentage of pay (the deferral percentage) must not exceed 125% of the average deferral percentage (ADP) of all non-highly compensated eligible employees. IRA Products and SIMPLE Plans 83