Understanding IRA and SIMPLE Plans

Transcription

1 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 UNDERSTANDING IRA AND SIMPLE PLANS 2

3 Published by Erland Education Services (formerly Erland Financial Education Services). 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. (formerly Erland Financial Education Services)

4 Table of Contents UNDERSTANDING IRA AND SIMPLE PLANS... 2 INTRODUCTION CHAPTER ONE: INTRODUCTION TO INDIVIDUAL RETIREMENT ACCOUNTS REGULAR INDIVIDUAL RETIREMENT ACCOUNTS THE ROTH IRA THE SIMPLE IRA SEP PLANS THE COVERDELL ESA THE MEDICAL IRA SUMMARY CHAPTER TWO: ELEMENTS OF RETIREMENT SAVINGS RETIREMENT SAVINGS Income Level Inflation EFFECT OF INFLATION ON PURCHASING POWER Savings Rate Life Expectancy Social Security Benefits Social Security s Future Social Security and Taxation CALCULATING NEEDED RETIREMENT INCOME SAMPLE RETIREMENT INCOME CALCULATION SUMMARY CHAPTER THREE: ADVANTAGES OF THE REGULAR IRA AVAILABILITY TAX-DEFERRAL TAX DEDUCTIBILITY FLEXIBILITY EASY TO COMBINE OR TRANSFER PROBATE AVOIDANCE SUMMARY CHAPTER FOUR: ELIGIBILITY AND CONTRIBUTION RULES OF THE REGULAR IRA ELIGIBILITY CONTRIBUTIONS Catch-Up Contributions On-Going Contributions IRA INVESTMENTS TYPES OF REGULAR IRAS Individual Retirement Accounts Individual Retirement Annuities SPOUSAL REGULAR IRAS DEDUCTIBILITY OF IRA CONTRIBUTIONS Active Participant Phase Out of Deductibility Active Participant Spouse Non-Deductible Contributions EXCESS CONTRIBUTIONS TO REGULAR IRAS Interest Earned on an Excess Contribution

5 IRA FEES SUMMARY APPENDIX TO CHAPTER FOUR - WORKSHEETS FOR SOCIAL SECURITY RECIPIENTS WHO CONTRIBUTE TO AN IRA CHAPTER FIVE: DISTRIBUTION RULES OF REGULAR IRAS DISTRIBUTIONS FROM REGULAR IRAS WITH NON-DEDUCTIBLE CONTRIBUTIONS Cost Basis Taxation of Earnings PREMATURE DISTRIBUTIONS Exceptions REQUIRED MINIMUM DISTRIBUTIONS Required Beginning Date Required Minimum Amount Distribution Methods Distributions Annuity Method Designated Beneficiary Calculating Required Minimum Distributions Distributions Greater Than the Minimum Distribution Amount Excess Accumulations PLEDGING A REGULAR IRA AS COLLATERAL DISTRIBUTIONS DUE TO THE DEATH OF THE REGULAR IRA HOLDER Death After Distributions Have Begun Death Before Distributions Have Begun Designated Beneficiary Named No Designated Beneficiary Determination of A Designated Beneficiary ESTATE TAXES AND THE IRA Estate Taxes and Naming A Spouse As Beneficiary Estate Tax and Distribution Methods Exceptions FORM 1099-R DEEMED IRAS SUMMARY CODE SECTION 72(T) 10-PERCENT ADDITIONAL TAX ON EARLY DISTRIBUTIONS FROM QUALIFIED RETIREMENT PLANS46 CHAPTER SIX: ROLLOVER AND TRANSFER RULES OF THE REGULAR IRA ROLLOVERS AND TRANSFERS FROM AN IRA TO AN IRA Trustee-to-Trustee Transfers IRA to IRA Rollovers Sixty-Day Rule One-Year Rule PARTIAL TRANSFERS AND ROLLOVERS ROLLOVERS AND DIRECT ROLLOVERS FROM QUALIFIED PLANS TO A REGULAR IRA Amount of Qualified Plan Rollovers and Direct Rollovers Direct Rollovers ROLLOVERS AND DIRECT ROLLOVERS FROM A QUALIFIED PLAN TO A QUALIFIED PLAN Conduit IRAs ROLLING PROPERTY OTHER THAN CASH INTO AN IRA ROLLOVERS AFTER REQUIRED DISTRIBUTIONS HAVE BEGUN TRANSFERS DUE TO DIVORCE Qualified Domestic Relations Order Rollover Rules For a Distribution Received Due to A Divorce SUMMARY SECTION CHAPTER SEVEN: ADVANTAGES OF THE ROTH IRA

6 TAX-FREE WITHDRAWALS TAX ADVANTAGE WITH A SHORT INVESTMENT HORIZON AVAILABILITY FLEXIBLE CONTRIBUTION FREQUENCY FLEXIBLE INVESTMENT OPTIONS CONTRIBUTIONS CAN CONTINUE NO MANDATED DISTRIBUTIONS PROBATE AVOIDANCE SUMMARY CHAPTER EIGHT: ELIGIBILITY AND CONTRIBUTION RULES OF THE ROTH IRA ELIGIBILITY CONTRIBUTIONS Roth IRA Investments Frequency of Contributions Contributions after Age 70 ½ Spousal Roth IRAs Excess Contributions SUMMARY CHAPTER NINE: DISTRIBUTION RULES OF THE ROTH IRA QUALIFIED DISTRIBUTIONS TAXATION OF NON-QUALIFIED DISTRIBUTIONS FROM A ROTH IRA REQUIRED BEGINNING DATE PLEDGING A ROTH IRA AS COLLATERAL ROTH IRA DISTRIBUTIONS AT DEATH ROTH IRA DISTRIBUTIONS DUE TO DIVORCE ROLLOVER RULES OF THE ROTH IRA ROLLOVERS FROM A ROTH IRA TO A ROTH IRA ROLLOVERS FROM A TRADITIONAL IRA TO A ROTH IRA QUALIFIED PLAN AFTER-TAX ROTH-IRA CONTRIBUTIONS Maximum Designated Roth Contribution Amounts Qualified Distributions from Designated Roth Accounts Rollovers from Designated Roth Accounts SUMMARY SEC. 408A. ROTH IRAS SEC. 402A. OPTIONAL TREATMENT OF ELECTIVE DEFERRALS AS ROTH CONTRIBUTIONS CHAPTER TEN: COMPARISON OF THE ROTH AND REGULAR IRAS FEATURES COMPARISON TAXATION COMPARISON % Tax Bracket Today and At Retirement % Tax Bracket Today and 15% At Retirement Distributes Half Her IRA at Age 50, Remainder at Age WHEN WILL A REGULAR IRA BE USED? Regular IRAs and Qualified Plan Distributions CHAPTER ELEVEN: THE COVERDELL ESA ACCUMULATING ASSETS FOR A COLLEGE EDUCATION Cost of A College Education ADVANTAGES OF THE COVERDELL ESA Tax-Free Withdrawals Availability Ability to Make Rollovers CONTRIBUTION AND ELIGIBILITY RULES OF THE COVERDELL ESA Eligibility

7 Contributions Qualified State Tuition Programs Coverdell ESA Investments Excess Contributions to Coverdell ESAs DISTRIBUTIONS FROM COVERDELL ESAS HOPE and Lifetime Learning Credits Additional Tax on Distributions Naming a New Beneficiary Distributions Due to Death Spousal Beneficiary Non-Spousal Beneficiary Distributions Due to Divorce ROLLOVERS FROM AN COVERDELL ESA TO AN COVERDELL ESA TERMINATION OF COVERDELL ESAS SUMMARY SEC EDUCATION INDIVIDUAL RETIREMENT ACCOUNTS CHAPTER TWELVE: FEATURES AND BENEFITS OF IRA PRODUCTS AND PLANS CERTIFICATES OF DEPOSIT Risk Maturities Calculation of RMD for Regular IRAs Fees MUTUAL FUNDS Diversification Types of Mutual Fund Securities Objectives Loads Fund Families Opening Requirements Calculation of RMD for Regular IRAs Fees Risk INDIVIDUAL STOCKS AND BONDS Self-Directed IRAs Fees Calculation of RMD for Regular IRAs FIXED ANNUITIES Interest Rate Risk and Conservation of Principal Surrender Charges Calculation of RMD for Regular IRAs Features EQUITY-INDEX ANNUITIES Risk and Return Guarantees Opportunity For Growth Guaranteed Minimum Return Calculation of RMD for Regular IRAs VARIABLE ANNUITIES Sub-Accounts Calculation of RMD for Regular IRAs Surrender Charges and Fees Stepped up Death Benefit Other Features SUMMARY

8 CHAPTER THIRTEEN: SEP PLANS SEP AND SAR-SEP ADVANTAGES Tax Deferral Ease of Establishment Flexibility Easy to Transfer and Combine Relative Low Cost Tax Deductibility ELIGIBILITY Excluded Employees CONTRIBUTIONS Excess Contributions SAR-SEP PLANS ELIGIBILITY CONTRIBUTIONS Elective Deferrals Excess Deferrals Highly Compensated Employee Elective Contributions Employer Contributions PLAN INVESTMENTS DISTRIBUTIONS Premature Distributions Distributions From A Sep With Non-Deductible Ira Contributions ROLLOVERS AND TRANSFERS POTENTIAL DISADVANTAGES OF SEP AND SAR-SEP PLANS Lack of Vesting and Loan Options CHAPTER FOURTEEN: SIMPLE PLANS SIMPLE PLAN ADVANTAGES Ease of Establishment Easy To Transfer and Combine Relative Low Cost Tax Deductibility ELIGIBILITY Excluded Employees CONTRIBUTIONS INVESTMENT OPTIONS DISTRIBUTIONS ROLLOVERS AND TRANSFERS POTENTIAL DISADVANTAGES OF SIMPLE PLANS SEC INDIVIDUAL RETIREMENT ACCOUNTS CHAPTER FIFTEEN: HOW IRAS COMPARE TO OTHER RETIREMENT SAVINGS PLANS REGULAR AND ROTH IRAS COMPARED TO SEP AND SIMPLE IRAS EXHIBIT COMPARISON OF REGULAR AND ROTH IRAS TO SIMPLE PLANS SELF- EMPLOYED PLANS (KEOGH PLANS) Contributions Eligibility Vesting Investment Options Tax Deductibility Distributions Advantages Disadvantages

9 EXHIBIT 15.3 COMPARISON OF REGULAR AND ROTH IRAS TO KEOGH (SELF EMPLOYED) PLANS K PLANS Contributions Investment Options Vesting Distributions Advantages Disadvantages EXHIBIT 15.4 COMPARISON OF A REGULAR AND ROTH IRA TO 401K PLANS EXHIBIT 15.5 COMPARISON OF A REGULAR AND ROTH IRA TO QUALIFIED RETIREMENT VEHICLES NON-QUALIFIED ANNUITIES Premature Distributions Distributions Taxation at Withdrawal Exchanges Advantages EXHIBIT 15.7 COMPARISON OF A REGULAR IRA TO A NON-QUALIFIED ANNUITY Disadvantages SUMMARY CHAPTER FOURTEEN: HEALTH IRAS ELIGIBILITY AND CONTRIBUTION RULES OF MSAS Eligibility High Deductible Health Plans Other Health Insurance Contributions Maximum Contributions Deductibility of Contributions Spousal Rules MSA Investments Excess Contributions Employer Plans DISTRIBUTION RULES OF MSA ACCOUNTS Additional Tax on Distributions Medical Expense Deduction Distributions Due to Death Spousal Beneficiary Non-Spousal Beneficiary Distributions Due to Divorce ROLLOVER RULES OF THE MSA Tax Filing HEALTH SAVINGS ACCOUNTS Eligibility Rules of HSAs High Deductible Health Plan Establishing An HSA HSA Contributions Last Month Rule Catch-Up Contributions Spousal Rules Deductibility of HSA Plan Contributions Timing of Contributions Excess Contributions Distributions from HSAs Distributions after Death Rollovers to HSAs FSA Plans and HSAs

10 SUMMARY CODE SECTION 220. MEDICAL SAVINGS ACCOUNTS CODE SEC HEALTH SAVINGS ACCOUNTS GLOSSARY SOURCES

11 INTRODUCTION The IRA now has several forms - the traditional or regular IRA, the SIMPLE and SEP IRAs, the Roth IRA, the Coverdell ESA, the Health Savings Account (which evolved from a plan first called a Medical IRA ) and a special category of IRA called a Deemed IRA. All of these IRA types are retirement savings vehicles except the Coverdell ESA, which is an education savings vehicle. All provide tax advantages to encourage Americans to save. This course begins by introducing the types of IRAs. Then, the retirement savings IRAs will be discussed. The element of retirement savings begins this section, followed by a detailed look at traditional IRAs. The Roth IRA is then examined, with a thorough look at its eligibility, contribution, distribution and rollover rules. The Coverdell ESA and the Health Savings Account plans are also covered in detail. The IRA options Congress has created provide the financial professional with the privilege of offering a valuable service to his or her customers: introducing them to tax-advantaged savings vehicles. This course will give a strong foundation to the financial professional willing to assist his or her customers in utilizing these programs. 11

12 CHAPTER ONE: INTRODUCTION TO INDIVIDUAL RETIREMENT ACCOUNTS Regular IRAs SIMPLE IRAs SEP IRAs Roth IRAs Coverdell ESAs Medical Savings Accounts The need to accumulate savings is a very real one for most Americans. Congress has created several types of savings vehicles to help individuals meet this need: the Individual Retirement Account, the Roth IRA, the SIMPLE Plan and it s predecessors, the SEP Plans, and the Coverdell ESA. The Roth and Coverdell ESA types became available beginning in 1998 and were created by The Taxpayer Relief Act of The first type, which will often be referred to in this manual as the traditional or regular IRA, has been available in some form since The SIMPLE Plan became available in The Medical savings accounts became available in 1997, and its current form, the Health Savings Account, became available in REGULAR INDIVIDUAL RETIREMENT ACCOUNTS The regular IRA allows annual contributions to be made by individuals to individually held accounts or plans. The earnings in these plans are not taxed annually; rather, earnings are taxed when they are withdrawn. Earnings in an IRA are therefore tax-deferred. The impact of tax-deferral on earnings can be significant. The impact on return increases the more money is contributed to the tax-deferred plan and the longer the money remains tax-deferred. A contribution to traditional IRAs may be tax-deductible in the year the contribution is made as well. These legislated tax advantages are meant to encourage individuals to save for retirement. Withdrawals from regular IRAs must be made beginning no later than April 15 of the year following the year in which the IRA holder reaches age 70 ½. An additional 10% tax applies to most withdrawals of earnings prior to age 59 ½. THE ROTH IRA The key differences between a Roth IRA and a traditional IRA is that contributions to a Roth IRA are never tax-deductible and withdrawals are generally free from income taxation. Contributions may also continue to be made after age 70 ½ to a Roth IRA if the individual is still working. Distributions do not have to be made beginning after age 70 ½, as they do in a traditional IRA. The Roth IRA is a streamlined version of the traditional IRA, without many of the cumbersome rules associated with the traditional IRA. THE SIMPLE IRA The SIMPLE IRA plan is a retirement plan which allows both employer and employee contributions. It is designed for small businesses; it may not be established by employers with more than 100 employees earning more than $5000 in compensation. 12

13 It s distribution rules are similar to those of regular IRAs, although the tax on withdrawals during the first two years of participation is higher than those of regular IRAs. SEP PLANS SEP plans are also IRA plans for small businesses. No new Salary Reduction SEP plans (SARSEPs) may be established after December 31, 1996 (Congress replaced them with SIMPLE plans.) However, SARSEP plans which are already in place may continue to be contributed to. Because of this provision, this manual will include information on SARSEP plans. Regular SEP plans may still be established. SEP plans include a few more eligibility restrictions than do SIMPLE plans. THE COVERDELL ESA The Coverdell ESA, previously known as the Education IRA, is not really an individual retirement account, but rather is an education savings vehicle. It was called an IRA because it shares many of the rules of the traditional and Roth IRAs. An individual may place up to $2000 per beneficiary annually in an Coverdell ESA, generally until the beneficiary reaches age 18. Under specified conditions, withdrawals from Coverdell ESAs are income tax free. These conditions include that the withdrawal is made to pay for a beneficiary s qualified education expenses, and that they are made prior to the beneficiary s age thirty. THE MEDICAL IRA The Medical IRA, or medical savings account is used in conjunction with a high-deductible health insurance plan. A high-deductible health insurance plan is purchased, and contributions are made to a medical savings account to pay for those expenses the health plan does not cover. The contributions are either deductible to the medical savings account holder or are not included in gross income if made by another person or entity for the account holder. The contributions in medical savings accounts grow tax-deferred, and if used for certain medical expenses, are withdrawn tax-free. The current version of medical savings accounts are called Health Savings Accounts. SUMMARY IRAs are vehicles which provide a federal income tax incentive to save. Traditionally, this tax incentive was limited to retirement savings. Recent legislation has expanded tax advantages to include education and medical savings as well. 13

14 CHAPTER TWO: ELEMENTS OF RETIREMENT SAVINGS Most people will live beyond their working years, and will need income from savings for this retirement period. But, relatively few are putting enough money aside for retirement. This chapter discusses why it is important to save for retirement and what factors should be considered to determine the amount of retirement funds to accumulate. RETIREMENT SAVINGS To determine the retirement savings need for any individual, several elements are involved: current income level, expected expenses during retirement years, inflation, current savings and life expectancy. Taxation issues impact each of these elements. Income Level Financial experts generally agree that a comfortable retirement requires income equal to seventy to eighty percent of pre-retirement income. Many people estimate their retirement income needs as being much lower than this amount. The tendency is to overestimate the reduction in expenses attributable to earning a living, such as commuting expenses and clothing, and underestimate both those expenses related to a retirement lifestyle, such as travel, and those expenses unfortunately related to aging, such as medical expenses. By using a rule of thumb seventy or eighty percent of today s expense levels, most people will have a reasonable estimation of retirement needs without having to guess about the future. Inflation The inflation rate has varied over the years, with a 7.2% average during the seventies, an approximately 3.5% average from 1985 through 2000, and a 2.2% rate in In 2009, the inflation rate was -.4% in 2010 was 1.6%. For the year 2014, the annual inflation rate was 0.8%, the lowest increase since For many years, the U.S. inflation rate averaged 3%. The impact of inflation cannot be forgotten in the determination of retirement income amount. Inflation decreases the purchasing power of today s dollars for future purchases. For example, if a three percent inflation rate occurs over the next twelve months, and we assume every product and service will be affected equally by this inflation rate, then a loaf of bread that costs one dollar today will cost $1.03 in twelve months, and an apartment that rents for $900 per month today will rent for $927 in twelve months. If the annual three percent inflation rate occurs over a period of ten years, then by the end of the tenth year, the loaf of bread will cost $1.35 and the apartment rent will be $1214 per month. 14

15 EFFECT OF INFLATION ON PURCHASING POWER END OF YEAR BREAD RENTAL EXPENSE Current $1.00 $900 1 $1.03 $927 2 $1.06 $956 3 $1.09 $985 4 $1.13 $ $1.16 $ $1.20 $ $1.23 $ $1.27 $ $1.31 $ $1.35 $1214 Exhibit 2.1 Assumes 3% inflation rate. The impact of inflation can be reduced through an increase in after tax-income. For example, if inflation were at three percent and an individual s after-tax income grew by five percent, the effect of inflation on this individual s situation would be to reduce his income increase by three percent in terms of purchasing power. His five percent income increase will purchase an approximate additional two percent in goods and services, after taking into account inflation In the same way inflation impacts purchasing power for bread and an apartment, inflation impacts the amount of retirement income to be saved. More of today s dollars must be saved to purchase future goods and services because inflation erodes the value of the dollar over time. For the individual on a fixed income, or planning toward a fixed income, inflation is more significant than for the income earner, since the individual on a fixed income may not have significant income increases to offset inflation. Savings Rate The rate of personal savings in the United States in January 2015 was 5.5%. This rate had dropped to almost zero in the months following the economic plunge we saw in Financial experts recommend saving at least 10% each month, even more as one nears retirement. But, the average American is saving much less than this. Assume a forty year old is planning to retire at age 65 and saves 5.5% of his $60,000 annual income. This $3300 ($275 a month) receives an average return of 5% for 25 years. He will have saved about $163,750 at age 65. If the inflation rate is 3% over this time, this savings will have a spending value of only about $77,000. If the inflation rate is only 1.5% over this 25 year span, this savings will have a spending value of about $111,000. Unfortunately, a total of $77,000 to $111,000 will not meet the retirement savings needs of many people. Life Expectancy How long is retirement income needed? According to the U.S. Government, women reaching age 65 could expect to live 20.3 more years on average, and men could expect to live an additional 17.7 years. (U.S. Department of Health and Human Services, Health, 2013, 15

16 Table 17.) Government projections indicate that life expectancy will continue to increase. When working with a client, these figures may be used as a starting point to determine how long the client may need retirement income. Some clients will want to use a longer life expectancy horizon because there is a history of long life in their family, or because they would like to be conservative in their retirement income need planning. Using a longer life expectancy when determining retirement savings needs means that an individual will strive to save more for retirement than if a shorter life expectancy were used. Social Security Benefits Despite the now well-known problems with the Social Security system, many people believe Social Security will meet retirement income needs. However, Social Security provides far less retirement income than the recommended seventy percent of current income benchmark. It is currently designed to replace about 24% of pre-retirement pay. The average retired worker receiving Social Security benefits in 2015 receives $1328 per month, or $15,936 annually. Social Security cannot be relied upon to provide sufficient income during retirement. Social Security s Future For the younger client, the question of whether social security benefits will even be available is not unthinkable. By some estimates, if no changes to the system are made, the Social Security trust funds will run out of money by If so, 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 Congress continues to discuss methods of saving Social Security or dramatically revamping its rules so that some sort of benefits may be provided to retirees in years to come. However, those planning for retirement should take into consideration that the future of the Social Security system is in question. Social Security and Taxation Whether Social Security benefits are here to stay at its current levels is arguable. However, taxation of Social Security benefits is currently a fact. Social Security benefits are taxable under the following circumstances: If a single taxpayer s modified adjusted gross income ( modified agi ) added to one-half of social security benefits received during a tax year is greater than $25,000 and up to $34,000 (Threshold I), then up to fifty percent of social security benefits received during the tax year may be included in gross income and are therefore taxable. If modified agi plus one-half of social security benefits received exceed $34,000 (Threshold II), up to 85% of social security benefits may be included in gross income. A married taxpayer filing jointly is subject to a Threshold I of greater than $32,000 and up to $44,000 and a Threshold II of greater than $44,000. Modified agi is equal to adjusted gross income (disregarding any foreign income and savings bonds exclusions) plus any nontaxable interest income received or accrued during the tax year. 16

17 In addition to Social Security benefit taxation, Social Security FICA taxes must be paid as well. Currently, the FICA rate is 15.4%, but it is projected by some experts to be 20-27% by the year 2020, and % by The bottom line regarding Social Security and retirement planning is that Social Security will not provide sufficient retirement income for most individuals and the related FICA and benefit taxation further reduce its overall contribution to retirement savings. CALCULATING NEEDED RETIREMENT INCOME Bringing the elements of projected retirement income level, inflation, savings life expectancy and tax rate together, the amount of needed retirement savings can be derived. Today, a variety of software programs are available which will assist in computing desired retirement income and monthly or annual savings needed. The more sophisticated software packages will estimate projected social security income, pension plan income, and growth of individual investment accounts, taking into account the tax consequences of each. Retirement worksheets are also available from various investment providers to assist in determining retirement savings and income needs. Whether a worksheet or software package is used, most calculations include all or some of the following elements: 17

18 SAMPLE RETIREMENT INCOME CALCULATION Step One Step Two Step Three Determine the desired retirement income Current income (annual or monthly) multiplied by 70 or 80 percent equals Desired Retirement Income Determine expected retirement income from other sources (Social Security, pension plans) Expected pension plan benefits plus Expected Social Security benefits equals Expected Retirement Income Determine additional retirement income needed. Desired Retirement Income minus Expected Retirement Income equals Additional Retirement Income Needed. Step Four Adjust (increase) income needed due to inflation. Step Five Step Six Step Seven Step Eight Multiply inflation adjusted income needed by life expectancy to determine Total Retirement Savings Needed. Determine future value of current savings based on an assumed rate and adjusted for inflation. Determine additional retirement savings needed. Inflation adjusted retirement savings minus Inflated adjusted future value of current savings equals Retirement Savings Needed. Determine monthly or annual income to contribute until retirement to accumulate retirement savings needed. 18

19 The table below shows the result of starting a retirement savings program at different ages for a worker earning $80,000 annually, having a savings rate of 5.5%, which is $376 monthly or $4512 annually, and earning a return of 5%. The assumed inflation rate for the period is 2%. Exhibit 2.3 Age Savings Begins Retirement Age Retirement Savings at 65 Inflation Adjusted Savings at $559,700 $253, $307,800 $170, $153,200 $103, $58,300 $47,800 This simple table points out some important information:! The amount of savings required for retirement is well above the average 5.5% Americans are currently saving on an annual basis.! The earlier savings start the better; starting to save ten years later approximately doubles the savings amount needed for the same retirement income.! Monthly savings may seem much easier to plan toward than a large annual commitment. SUMMARY Most Americans dramatically underestimate the amount of retirement income they will require to live comfortably. Social Security benefits will not by themselves provide adequate retirement income. Inflation must be taken into consideration when determining retirement needs. Savings for retirement need to begin as early as possible for maximum growth potential. 19

20 CHAPTER THREE: ADVANTAGES OF THE REGULAR IRA This chapter begins a detailed discussion of the regular or traditional IRA. This IRA has several significant advantages as a retirement vehicle. AVAILABILITY Many workers are not offered a way by their employers to save for retirement, e.g., through a qualified retirement plan. However, anyone earning compensation and under the age of seventy and one-half may contribute to a traditional IRA. TAX-DEFERRAL Many retirement vehicles, including IRAs, have the advantage of being tax-deferred: pre-tax accumulations are not taxable as current income until withdrawn. Tax-deferral can have a significant impact on savings growth. Taxable investments generate a statement Income must be reported and tax paid on the income annually. The effect of this taxation is to reduce the effective rate of return on the investment. For example, a product earning taxable rate of 8% purchased by an investor in a 25% tax bracket is equivalent to an after-tax rate of only 6%. This after-tax yield is derived by applying the following formula: taxable rate x (1-tax bracket) Exhibit Tax Brackets Tax Bracket Married, Filing Jointly Single 10% $0 $18,450 $0 - $9,225 15% Over $18,450 - $74,900 Over $9,225 - $37,450 25% Over $74,900 - $151,200 Over $37,450 - $90,750 28% Over $151,200 - $230,450 Over $90,750 - $189,300 33% Over $230,450 - $411,500 Over $189,300 - $411,500 35% Over $411,500 - $464,850 Over $411,500 - $413, % Over $464,850 Over $413,200 20

21 Assume a thirty year old contributes $5,500 a year to a regular IRA until age 65, and the IRA earns 5% annually. The IRA owner is in a 25% tax bracket. Below is a comparison of the growth in the IRA to the growth in a taxable investment. Year Tax- Deferred After Tax Accumulations Accumulations 5 $31,190 $30, $121,790 $110, $269,360 $225, $509,750 $392,840 Exhibit 3.1. TAX DEDUCTIBILITY Despite recent tax law changes, up to 87% of working Americans may take a partial or total income tax deduction for regular IRA contributions. Deducting contributions reduces the amount of income tax due for the tax year the contribution was made. For example, assume a single individual has taxable income of $38,000 and is in a 25% federal tax bracket. If he or she contributes $5500 to an IRA this year, his or her tax liability will be reduced by $1250 ($5500 contribution multiplied by 25% marginal tax bracket). FLEXIBILITY Contributions to a traditional IRA are flexible. Once the IRA is opened, annual contributions do not have to continue, but may be made as the owner decides. Investment options are flexible as well. Regular IRA moneys may be placed in bank certificates of deposit, fixed and variable annuities, mutual funds, individual securities - just about anything other than life insurance and certain collectibles. EASY TO COMBINE OR TRANSFER Regular IRA funds may be moved via trustee-to-trustee rules at any time, or once every twelve months via an IRA rollover and retain tax-deferral. Qualified pension plan distributions may also be rolled directly into a regular IRA and retain tax-deferral. Many clients approaching retirement want to combine IRA and pension plan distributions so that they may enjoy the ease of receiving one statement and one income check. Ease of transfer is also important as investment needs change. A younger IRA contributor may place IRA moneys in an aggressive stock fund early on with the plan to move the funds to more conservative instruments as retirement approaches. PROBATE AVOIDANCE An IRA may be structured to avoid probate. If a beneficiary is named for the IRA, death distributions will be made directly to that beneficiary without going through the publicity, delay and expense of probate. 21

22 SUMMARY Traditional IRAs have many advantages, making them an attractive, flexible retirement savings vehicle for many working Americans. 22

23 CHAPTER FOUR: ELIGIBILITY AND CONTRIBUTION RULES OF THE REGULAR IRA ELIGIBILITY Any individual may contribute to a regular IRA who: a) has not reached age seventy and one-half during the tax year for which the contribution is made, and b) has compensation. Compensation includes wages, salaries, tips, commissions, fees, bonuses, and taxable alimony and separate maintenance payments. Compensation does not include deferred compensation received or social security or railroad retirement income. Disability income is also not included in compensation for the purpose of calculating IRA contribution eligibility. Other items not included in compensation are rental income, interest income, dividend income, pension or annuity income, and foreign earned income. CONTRIBUTIONS In years 2002 through 2004, an individual could generally contribute up to $3000 or one hundred percent of compensation earned in a tax year, whichever is smaller, to a regular IRA. This amount was increased to $4,000 in years 2005 through 2007 and to $5,000 in 2008 through This contribution amount is $5,500 for 2013 through For example, if 45-year old Mr. Johnson earned $25,000 in compensation for the year, he could contribute up to $5500 to an IRA in If 18-year old Ms. Daniels earned $2700 in compensation in 2015 her maximum regular IRA contribution would be $2700, or one hundred percent of her compensation. Catch-Up Contributions Beginning in 2002, older individuals are able to make additional catch-up contributions to their regular IRAs. Individuals who have reached age 50 before the end of the tax year wereable to contribute an additional $500 annually to their regular IRAs in years 2002 through 2005, and an additional $1,000 annually in the year 2006 and thereafter. For example, if 51-year old Mrs. Takashi earned $40,000 in 2015, she could contribute up to $6500 to her traditional IRA ($5500 regular contribution, plus $1000 catch-up contribution). On-Going Contributions Once a regular IRA is established, there is no requirement that future contributions be made. Contributions may be made each tax year, monthly during the tax year, every other year, or never again. Additional Individual Retirement Accounts may be opened and maintained as well. There is no requirement that only one regular IRA may exist per IRA owner. 23

24 Contributions to a regular IRA must be in cash. Once established as an IRA, the IRA moneys may be used to purchase any of a variety of investments, such as mutual funds, certificates of deposit, individual stocks or bonds, real estate, annuities, or any other investment other than life insurance and most collectibles. IRA INVESTMENTS Collectibles. In 1982, legislation included in the Tax Equity Fiscal Responsibility Act, or TEFRA, mandated that collectibles could not be purchased through an IRA. Collectibles include items such as art, rugs, antiques, gems, stamps and coins. The Tax Reform Act of 1986, TRA 86, modified this legislation to state that certain US gold and silver coins could be purchased in a traditional IRA. The Taxpayer Relief Act of 1997 added platinum coins and gold, silver, platinum and palladium bullion which meets certain specifications to the list of acceptable collectibles. None of these coins or types of bullion are now prohibited from use as an IRA investment. Life Insurance. Life insurance cannot be purchased through a traditional IRA. prohibition does not include tax-deferred annuities, however, whether fixed or variable. This TYPES OF REGULAR IRAS Two types of regular IRA plans are currently allowed under IRS regulations: the Individual Retirement Account and an Individual Retirement Annuity. Individual Retirement Accounts An Individual Retirement Account must be an account opened through a written trust or a custodial account. The IRS allows banks, federally insured credit unions, other financial institutions and other corporations to act as trustee or custodian for IRA agreements, assuming the institutions meet IRS requirements. These requirements include continuity of life, established location, fiduciary experience, fitness to handle retirement funds, ability to administer fiduciary powers and adequate net worth. The Individual Retirement Account administered by these entities must meet the following requirements: a) The trustee or custodian cannot accept contributions, other than rollover contributions, over the maximum IRA contribution ($5500 for 2015) for a tax year. b) Contributions, other than rollover contributions, must be in cash. c) The IRA holder must have a nonforfeitable right to the amount in the account at all times. d) The account cannot invest in life insurance nor most collectibles. e) Distributions must generally be made by April 1 of the year following the year in which the IRA holder reaches age seventy and one-half. f) The assets in the account cannot be commingled with other property, except in a common trust fund or common investment fund. 24

25 Individual Retirement Annuities An Individual Retirement Annuity is an annuity contract issued through a life insurance company. The annuity must meet the following requirements: a) The IRA holder must be named as owner and only the IRA holder or beneficiary or beneficiaries may receive payments or benefits from the annuity. b) The annuity cannot be transferable. c) Contracts issued after November 6, 1978, cannot require a fixed premium payment. d) Contributions, other than rollover contributions, cannot exceed the maximum IRA contribution for a tax year ($5500 for 2015). e) Distributions must generally begin by April 1 of the year following the year in which the IRA holder reaches age seventy and one-half. SPOUSAL REGULAR IRAS A deductible contribution may be made by an individual under special IRA rules even if the individual has not earned compensation during the tax year. The requirements of this rule are: a) the amount of compensation, if any, includible in the individual s gross income is less than the amount of compensation includible in the gross income of the individual s spouse, and b) the individual files a joint return for the taxable year. As long as these requirements are met, the maximum contribution that may be made for this individual is the lesser of: the maximum annual contribution amount ($5500 in 2015, plus any catch-up contribution, for example), or the sum of the compensation includible in the individual s gross income for the tax year, plus the compensation includible in the gross income of the individual s spouse for the tax year reduced by the amount allowed as a deduction to the spouse for a contribution to the spouse s own IRA for that tax year. For example, in 2015, Mr. Smith, age 66, has retired and has no compensation. His wife, Mrs. Smith, age 62, is working and earned $37,000 in includible compensation. A maximum of $6500 can be contributed to each of the Smith s IRAs ($5500 IRA contribution maximum plus $1000 catch-up contribution for individuals 50 and over). Or, for example, in 2015, Mr. Jones, age 48, earned $10,000. His wife, Mrs. Jones, age 49, earned no compensation. If Mr. Jones contributes $5500 to his IRA, A maximum of $4500 may be contributed to Mrs. Jones IRA - total includable compensation for the couple is $10,000, less $5500 contribution to Mr. Jones IRA, leaves $4500 which may be contributed to Mrs. Jones IRA. Although this IRA funding structure is commonly called a Spousal IRA, each IRA is individually owned. 25

26 DEDUCTIBILITY OF IRA CONTRIBUTIONS TRA 86 changed the rules regarding the deductibility of IRA contributions. Prior to this legislation, anyone eligible to contribute to an IRA could deduct the full amount of the contribution for income tax purposes. After this legislation took effect however, in order to determine whether an IRA contribution is deductible in full or in part, one must look at several factors. These factors include: 1. Whether or not the IRA owner or his or her spouse is covered by an employer retirement plan (is an active participant in a qualified plan). 2. The IRA owner s income level. 3. The IRA owner s filing status. Active Participant If an individual is an active participant in a qualified employer retirement plan, the allowable deductible amount of his or her regular IRA contributions is limited, based on adjusted gross income and filing status. The definition of an active participant varies depending upon what type of qualified plan is in effect. One of the easiest methods of determining active participant status is to check the employer generated W-2, Statement of Earnings. Employers are required to report whether the employee is covered by the qualified plan by marking the pension plan box on the W-2. If the pension plan box is checked, any contribution made by the employee to an IRA is subject to the deductibility limits. Phase Out of Deductibility If neither an individual or spouse is covered by an employer plan, then the full eligible regular IRA contributions made may be deducted for income tax purposes, regardless of income level. Active Participant Spouse If one spouse is an active participant and the other is not, deductibility for the non-active participant is phased out only if the couple s combined adjusted gross income is between $183,000 and $193,000. If both are active participants, then deductibility for both when filing jointly is phased out between $98,000 and $118,000. Non-Deductible Contributions Although a regular IRA holder s IRA contributions may be subject to limited deductibility, non-deductible contributions may be made. The maximum IRA contribution limits of the smaller of $5500 (2015) or 100% of compensation, apply to all contributions to an IRA, whether deductible or non-deductible. Non-deductible contributions grow tax-deferred. The earnings attributable to nondeductible contributions are not subject to income taxation until withdrawn. If nondeductible contributions are made to an IRA, the taxpayer must report them on his or her tax return when filed. 26

27 EXCESS CONTRIBUTIONS TO REGULAR IRAS An excess contribution is a contribution to a regular IRA greater than the maximum contribution amount, e.g. greater than the smaller of $5500 or 100% of compensation in years 2013 through Excess contributions are subject to a 6% tax if not withdrawn before the date the IRA owner s tax return is due. The tax is assessed each year the excess contribution and attributable earnings remain in the IRA. If the excess contribution, along with any earnings attributable to the excess contribution, are withdrawn within the mandated time frame, the excess contribution tax does not apply. Interest Earned on an Excess Contribution The interest earned on the excess contribution, whether withdrawn from the IRA or not, must be included in gross income for the tax year in which it was earned. The withdrawal of interest may be subject to the tax on premature distributions if the IRA holder is under age 59 ½, as discussed under Premature Distributions later in this manual. For example, 45 year-old Ms. Masterson contributed $6000 to her IRA in 2015 ($500 too much). She noticed the error prior to filing her taxes in April She contacted her IRA trustee to notify the trustee of the error. The trustee withdrew the $500 and accumulated interest of $5. No tax on the excess contribution was due since it was withdrawn prior to April 15, 2016, her tax due date. If instead she had contacted her IRA trustee in May of 2016, a tax of $30 would have been assessed on the excess contribution and a tax of $.30 would have been due on $5 of interest. IRA FEES IRA Trustees may charge a fee to the IRA holder for the duties performed as trustee, e.g. tax reporting, issuing annual account statements, making distributions, etc. If this fee is separately billed and paid to the trustee rather than being taken from the IRA contribution, this fee is not considered part of the IRA contribution. The trustee fee in this case may be considered an itemized deduction for income tax purposes. For example, an IRA holder contributed $5500 to an IRA. Each year a trustee administration fee of $25 is billed to the IRA holder, who writes a check and pays the trustee. The $25 annual fee is not considered part of the IRA contribution. The IRA holder may list the $25 as an itemized deduction for income tax purposes. Exhibit 4.1 Effect of Modified AGI on Deduction if a Taxpayer is Covered by a Retirement Plan at Work AND taxpayer modified adjusted IF taxpayer filing status is... gross income (modified AGI) is... THEN taxpayer can take... $61,000 or less A full deduction Single or Head of Household More than $61,000 but less than $71,000 A partial deduction $71,000 or more No deduction Married filing jointly or qualifying widow(er) $98,000 or less A full deduction More than $98,000 but less than A partial deduction 27

28 Married filing separately $118,000 $118,000 or more No deduction Less than $10,000 A partial deduction $10,000 or more No deduction Effect of Modified AGI on Deduction if a Taxpayer is NOT Covered by a Retirement Plan at Work AND taxpayer modified adjusted IF taxpayer filing status is... gross income (modified AGI) is... THEN taxpayer can take... Single, Head of Household or A full deduction Any amount qualifying widow(er) Married filing jointly or A full deduction separately with a spouse who IS NOT covered by a retirement plan Any amount at work $183,000 or less A full deduction Married filing jointly with a More than $183,000 but less than A partial deduction spouse who IS covered by a $193,000 retirement plan at work $193,000 or more No deduction Married filing separately with a Less than $10,000 A partial deduction spouse who IS covered by a $10,000 or more No deduction retirement plan at work (From IRS Publication 590-A) SUMMARY An individual may contribute to a traditional IRA $5500 in years 2013 through 2015, or one hundred percent of compensation earned within a tax year, whichever amount is greater, to a regular or traditional IRA. Individuals who reach age 50 during the tax year or who are older may make an additional $1,000 catch up contribution. Two types of regular IRA plans are available: an Individual Retirement Account and an Individual Retirement Annuity. A spouse earning compensation may fund an IRA for his or her non-earner spouse. The maximum contribution available for spousal IRAs is the same as the maximum annual contribution level applicable for the year. Neither spouse s IRA can receive more than this maximum annual contribution. Deductibility of IRA contributions is based upon whether the IRA holder or spouse is an active participant, his or her filing status and adjusted gross income. Non-deductible contributions may be made to a regular IRA, subject to maximum IRA contribution limits. 28

29 APPENDIX TO CHAPTER FOUR - WORKSHEETS FOR SOCIAL SECURITY RECIPIENTS WHO CONTRIBUTE TO AN IRA (From IRS Publication 590-A, 2015 Returns) If you receive social security benefits, have taxable compensation, contribute to your IRA and are covered (or considered covered) by an employer retirement plan, complete the following worksheets. Use Worksheet 1 to figure your modified adjusted gross income. This amount is needed in the computation of your IRA deduction, if any, which is figured using Worksheet 2. The IRA deduction figured using Worksheet 2 is entered on your tax return. Worksheet 1 Computation of Modified AGI (For use only by taxpayers who receive social security benefits) Filing Status Check only one box: A. Married filing a joint return. B. Single, Head of Household, Qualifying Widow(er) or Married filing separately and lived apart from your spouse during the entire year C. Married filing separately and lived with your spouse at any time during the year. 1) Adjusted gross income (AGI) from Form 1040 (not taking into account any social security benefits from Form SSA-1099, RRB-1099, any deduction for contributions to a traditional IRA, any student loan interest deduction, or any exclusion of interest from savings bonds to be reported on Form 8815) 2) Enter the amount in Box 5 of all Forms SSA-1099 and Forms RRB ) Enter one half of line 2 4) Enter the amount of any foreign earned income exclusion, foreign housing exclusion, U.S. possessions income exclusion, exclusion of income from Puerto Rico you claimed as a bona fide resident of Puerto Rico, or exclusion of employer-paid adoption expenses 5) Enter the amount of any tax-exempt interest reported on line 8b of Form 1040 or 1040A 6) Add lines 1,3,4 and 5 7) Enter the amount listed below for your filing status $32,000 if you checked box A above. $25,000 if you checked box B above. $-0- if you checked box C above. 8) Subtract line 7 from line 6. If zero or less, enter 0 on this line 9) If line 8 is zero, STOP HERE. None of your social security benefits are taxable. If line 8 is more than 0, enter the amount listed below for your filing status. $12,000 if you checked box A above. 29

30 $ 9,000 if you checked box B above. $ - 0- if you checked box C above. 10) Subtract line 9 from line 8. If zero or less, enter -0-11) Enter the smaller of line 8 or line 9 12) Enter one half of line 11 13) Enter the smaller of line 3 or line 12 14) Multiply line 10 by.85. If line 10 is zero, enter -0-15) Add lines 13 and 14 16) Multiply line 2 by.85 17) Taxable benefits to be included in Modified AGI for IRA deduction purposes. Enter the smaller of line 15 or line ) Enter the amount of any employer-paid adoption expenses exclusion and any foreign earned income exclusion and foreign housing exclusion or deduction that your claimed. 19) Modified AGI for determining your reduced IRA deduction add lines 1, 17 and 18. Enter here and on line 2 of Worksheet 2, next Worksheet 2 Computation of IRA Deduction (For use only by taxpayers who receive social security benefits) If your filing status is And your modified AGI is over: Enter on line 1 below: Married-joint return or qualifying widow(er) $98,000 $118,000 Married-joint return (You are not covered by an $183,000* $193,000 employer plan but your spouse is) Single, or Head of household $61,000 $71,000 Married filing separately $ -0- $10,000 *If your modified AGI is not over this amount, you can take an IRA deduction for your contribution of up to the lesser of $5,500 ($6,500 if you are 50 or older) or your taxable compensation. Skip this worksheet and proceed to Worksheet 3 and enter your IRA deduction on line 2 of Worksheet 3. ** If you did not live with your spouse at any time during the year, consider your filing status as single. Note: If you were married and you or your spouse worked and you both contributed to IRAs, figure the deduction for each of you separately. 1. Enter the applicable amount from above 2. Enter your modified AGI from Worksheet 1, line 19 30

31 Note: If line 2 is equal to or more than the amount on line 1, stop here; you IRA contributions are not deductible. Proceed to Worksheet Subtract line 2 from line Multiply line 3 by the percentage below that applies to you. If the result is not a multiple of $10, round it to the next highest multiple of $10. (For example $ is rounded to $620). However, if the result is less than $200, enter $ Married filing jointly or qualifying widow(er) and you are covered by an employer plan, multiply line 3 by 27.5% (.275) (by 32.5% (.325) if you are 50 or older - All others multiply line 3 by 55% (by.55) (by 65% (.65) if you are age 50 or older 5. Enter your compensation minus any deductions on Form 1040, line 27 (one-half of self-employment tax) and line 28 (self-employed SEP, SIMPLE, and qualified plans). (If you are the lower income spouse, include your spouse s compensation reduced by his or her IRA deduction and any contributions to Roth IRAs.) 6. Enter contributions you made, or plan to make, to your traditional IRA for 2015, but do not enter more than $5,500 ($6,500 if you are age 50 or older) 7. Deduction. Compare lines 4, 5, and 6. Enter the smallest amount here (or a smaller amount if you choose). Enter this amount on the Form 1040 or 1040A line for your IRA. (If the amount on line 6 is more than the amount on line 7, complete line 8.) 8. Nondeductible contributions. Subtract line 7 from line 5 or 6, whichever is smaller. Enter the result here and on line 1 of your Form 8606, Nondeductible IRAs 31

32 Worksheet 3 Computation of Taxable Social Security Benefits (For use by taxpayers who receive social security benefits and take an IRA deduction) Filing Status Check only one box: A. Married filing a joint return. B. Single, Head of Household, Qualifying Widow(er) or Married filing separately and lived apart from your spouse during the entire year Married filing separately and lived with your spouse at any time during the year. 1. Adjusted gross income (AGI) from Form 1040 or Form 1040A (not taking into account any IRA deduction, any student loan interest deduction, any tuition and fees deduction, any domestic production activities deduction, any social security benefits from Form SSA-1099 or RBB-1099, or any exclusion of interest from savings bonds to be reported on Form 8815) 2) Deduction(s) from line 7 of Worksheet 2 3) Subtract line 2 from line 1 4) Enter amount in Box 5 of all Forms SSA-1099 and Forms RRB ) Enter one half of line 4 6) Enter the amount of any foreign earned income exclusion, foreign housing exclusion, exclusion of income from U.S. possessions, exclusion of income from Puerto Rico you claimed as a bona fide resident of Puerto Rico, or exclusion of employer-paid adoption expenses. 7) Enter the amount of any tax-exempt interest reported on line 8b of Form 1040 or 1040A 8) Add lines 3, 5, 6 and 7 9) Enter the amount listed below for your filing status $32,000 if you checked box A above $25,000 if you checked box B above $ -0- if you checked box C above 10) Subtract line 9 form line 8. If zero or less, enter 0 on this line. 11) If line 10 is zero, STOP HERE. None of your social security benefits are taxable. If line 10 is more than 0, enter the amount listed below for your filing status. $12,000 if you checked box A above. $ 9,000 if you checked box B above. $ - 0- if you checked box C above. 12) Subtract line 11 from line 10. If zero or less, enter -0-13) Enter the smaller of line 10 or 11 14) Enter one half of line 13 15) Enter the smaller of line 5 or line 14 16) Multiply line 12 by.85. If line 12 is zero, enter -0-32

33 17) Add lines 15 and 16 18) Multiply line 4 by.85 19) Taxable social security benefits. Enter the smaller of line 17 or line 18 33

34 CHAPTER FIVE: DISTRIBUTION RULES OF REGULAR IRAS Regular IRA funds grow tax deferred until they are withdrawn, or distributed, unless they are placed in another IRA through a rollover or transfer. This chapter focuses on distributions that are not rolled or transferred to another IRA. DISTRIBUTIONS FROM REGULAR IRAS WITH NON-DEDUCTIBLE CONTRIBUTIONS Deductible contributions are included in income for tax purposes in the year they are received. Special rules apply to traditional IRAs that include non-deductible contributions. When distributions are made from an IRA with non-deductible contributions, the portion of the distribution attributable to non-deductible contributions will be considered a return of investment in the account, or as cost basis, and therefore will not be taxed. Cost Basis Generally, cost basis is equivalent to the amount invested in property. Amounts over cost basis are considered gain and at some point are taxable as gains. Return of investment is normally not a taxable event, since the invested amount has normally been taxed sometime in the past. In the case of a regular IRA, however, investment and cost basis are not necessarily synonymous. The investment in this type of IRA may include both deductible and nondeductible contributions. Since deductible contributions are, as the name implies, deducted from gross income for tax purposes, deductible contributions are not considered as part of the cost basis in an IRA. Therefore, deductible contributions are taxable when withdrawn, and non-deductible contributions, which are part of an IRA s cost basis, are not. To determine the taxable and non-taxable portions of the distribution, the ratio of nondeductible contributions to the total value of the IRA is applied to each distribution. For example, assume Mr. Jones has never taken an IRA distribution. He has made a total of $10,000 in non-deductible contributions to his IRA. His IRA balance is now $100,000. To determine the percent of each distribution which is non-taxable, divide the non-deductible contribution amount by the total value of the IRA: $10,000 / $100,000 = 10% If he distributes $20,000, $2000 of the distribution would be non-taxable: $20,000 x 10% = $2000. Mr. Jones now has $8000 of non-deductible contributions remaining in his IRA. The following year, his IRA value has grown to $84,800. He makes another distribution of $20,000. The non-taxable portion of the distribution is now calculated using the $8000 of nondeductible contributions within the IRA and the total value of $84,800: $8000 / $84,800 = 9.43% 34

35 $20,000 x 9.43% = $1886 $1886 is the non-taxable portion of the distribution. Of course, Mr. Jones should consult a tax professional to ensure accurate calculation of the non-taxable amount of his distribution. Taxation of Earnings Notice that only the amount of non-deductible contributions withdrawn are non-taxable. The earnings, or gain, on the non-deductible contributions are taxed when withdrawn. The earnings have not yet been taxed, just as deductible contributions and the earnings on deductible contributions have not been taxed. Therefore, these items are all taxable when withdrawn. PREMATURE DISTRIBUTIONS IRA moneys distributed prior to the IRA holder s age 59 ½ are considered premature distributions. Generally, premature distributions are subject to an additional IRS tax of 10% applied to the entire distribution. Exceptions There are exceptions to the tax on premature distributions. The exceptions are: a) Disability. Disability is strictly defined by the IRS. Generally, a physician must determine that an IRA holder has a condition that will last for a contiguous period of at least twelve months under which he or she cannot do any substantial gainful activity because of his or her physical or mental condition. b) Death IRA distributions made to beneficiaries due to the death of the IRA holder are not subject to the additional 10% tax. c) Payments which are part of a series of substantially equal payments which are made over the IRA holder s lifetime. These payments may also be made over the IRA holder and a designated beneficiary s lifetime. At least one payment must be made annually. The payments may not be modified until the IRA holder reaches age 59 ½, or at least five years from the first payment, whichever is greater. If the payments are modified prior to this time period, the entire amount distributed will become subject to the additional 10% tax, unless the modification in payments was due to disability or death of the IRA holder. d) Distributions for certain medical expenses. Distributions less than or equal to the amount allowable as a medical deduction for income tax purposes for amounts paid during the year for medical care. Currently the allowable medical deduction amount are amounts in excess of 7 ½% of adjusted gross income. e) Distributions to unemployed individuals for health insurance premiums. To qualify under this exception to the premature distribution tax, the IRA holder must have separated from employment and must have received unemployment compensation for twelve consecutive weeks, or, if self-employed, would have received unemployment compensation if he or she were not selfemployed. The distribution must be made either during the tax year the participant received the unemployment compensation or in the succeeding tax year. If the distribution is made after the IRA holder has been re-employed for at least sixty days, it will not qualify under this exception. f) Distributions for certain higher education expenses. 35

36 Distributions that do not exceed qualified higher education expenses of the taxpayer are not subject to premature distribution tax. Qualified higher education expenses means qualified higher education expenses for education furnished to (i)the taxpayer (ii)the taxpayer s spouse, or (iii) any child or grandchild of the taxpayer or the taxpayer s spouse, at an eligible education institution (IRC Section 72(t)(7)) g) Distributions for certain first-time homebuyer expenses. Distributions which are made by the IRA holder for qualified acquisition costs for a principal residence of a first-time homebuyer for the IRA holder, the IRA holder s spouse, or the child, grandchild or ancestor of the IRA holder or the IRA holder s spouse. (Note: This exception has many specific conditions and rules. IRC Section 72(t)(8) which explains this exception is highlighted on the next page.) 36

37 Exhibit 5.1 IRC Section 72(t)(8) (8) Qualified first-time homebuyer distributions (A)In general. The term qualified first-time homebuyer distribution means any payment or distribution received by an individual to the extent such payment or distribution is used by the individual before the close of the 120 th day after the day on which such payment or distribution is received to pay qualified acquisition costs with respect to a principal residence of a first-time homebuyer who is such individual, the spouse of such individual, or any child, grandchild, or ancestor of such individual or the individual s spouse. (B) Lifetime dollar limitation. The aggregate amount of payments or distributions received by an individual which may be treated as qualified first-time homebuyer distributions for any taxable year shall not exceed the excess (if any) of (i) $10,000, over (ii) the aggregate amounts treated as qualified first-time homebuyer distributions with respect to such individual for all prior taxable years. (C)Qualified acquisition costs. For purposes of this paragraph, the term qualified acquisition costs means the costs of acquiring, constructing, or reconstructing a residence. Such term includes any usual or reasonable settlement, financing or other closing costs. (D)First-time homebuyer; other definitions. For purposes of this paragraph (i)first-time homebuyer. The term first-time homebuyer means any individual if (I) such individual (and if married, such individual s spouse) had no present ownership in a principal residence during the 2-year period ending on the date of acquisition of the principal residence to which this paragraph applies, and (II) subsection (h) or (k) of subsection 1034 (as in effect on the day before the date of the enactment of this paragraph) did not suspend the running of any period of time specified in section 1034 (as so in effect) with respect to such individual on the day before the date the distribution is applied pursuant to paragraph (A). (ii)principal residence. The term principal residence has the same meaning as when used in section 121. (iii) Date of acquisition. The term date of acquisition means the date (I)on which a binding contract to acquire the principal residence to which subparagraph (A) applies is entered into, or (II) on which construction or reconstruction of such a principal residence is commenced. (E)Special rule where delay in acquisition. If any distribution from any individual retirement plan fails to meet the requirements of subparagraph (A) solely by reason of a delay or cancellation of the purchase or construction of the residence, the amount of the distribution may be contributed to an individual retirement plan as provided in section 408(d)(3)(A)(i) (determined by substituting 120 days for 60 days in such section),except that (i)section 408(d)(3)(B) shall not be applied to such contribution and (ii)such amount shall not be taken into account in determining whether section 408(d)(3)(B) applies to any other amount. Notes: Section 72(t)(8)(D)(i)(II) Sections 1034(h) and (k) apply to members of the armed forces and individuals with a tax home outside the U.S.Section 72(t)(8)(E) Section 408(3) regulates IRA to IRA rollovers (discussed in detail in Chapter Six). Under the circumstances described in section 72(t)(8)(E), the distribution may be rolled into an IRA to avoid current taxation. Section 72(t)(8)(E) Section 408(d)(3)(B) deals with spousal distributions from a qualified plan rolled to an IRA. These rules will not apply to distributions which fall under section 72(t)(8)(E). 37

38 The portion of a premature distribution attributable to non-deductible contributions is not subject to the tax on premature distributions. For example, assume an IRA holder is 45 and has made $2000 in non-deductible contributions to his IRA now worth $10,000. He takes a full, lump-sum distribution of his IRA funds. Eight thousand dollars of the distribution would be subject to the 10% premature distribution tax and $2000 would not be taxed as a premature distribution. REQUIRED MINIMUM DISTRIBUTIONS If a regular IRA is held until the owner reaches age 70 ½, the IRA is subject to distribution rules. Regulations require that the distributions must meet certain minimum amount requirements and must be made within certain time frames. The rules surrounding these distributions are known as the required minimum distribution rules Required Beginning Date Required minimum distributions from regular IRAs must begin by April 1 of the year following the year in which the IRA holder reaches age 70 ½. This date is the required beginning date for required minimum distributions. The regulations give the IRA holder a little extra time, three months and one day, to make his or her first distribution. All distributions following must be made by December 31. If an IRA holder opts to wait until April 1 of the year following the year in which he or she reaches seventy and one-half to make the first distribution, a second distribution must be made by December 31 of that same year. The first distribution is the distribution required because the owner has reached age seventy and one-half, the second is the distribution required for the calendar year following age seventy and one-half. The calculation is based on the balance in the IRA as of December 31 of the year prior to the year in which the distribution is made. For example, Mrs. Anderson reaches age 70 ½ in August On April 1, 2016, she takes her first distribution. The distribution is calculated based on the value of her IRA as of December 31, By December 31, 2016, she takes her second distribution, based on the IRA value on December 31, Each year following, she must take a distribution by December 31 of that year, based on the IRA value on December 31 of the prior year. Required Minimum Amount Each distribution must meet a required minimum amount. Generally, the amount in the IRA must be distributed over the joint life expectancies of the IRA owner and designated beneficiary. The required minimum amount is calculated based on the total in all regular IRAs owned by the IRA holder. The distribution may be made from any one, or a combination of the regular IRAs, as long as the minimum amount is distributed. 38

39 Distribution Methods Prior to 2001, the regular IRA owner had to choose what IRS approved method would be used to calculate the required minimum distribution, or RMD, including whether the minimum distribution would be calculated over the owner s life expectancy or the joint life expectancies of the owner and designated beneficiary. Determining the RMD method was an important decision for the IRA owner. Each method came with its own advantages and disadvantages, limitations and features. In 2001, the IRS introduced new RMD calculation rules. Under current rules, the minimum distribution amount is generally calculated using the joint life expectancy of the IRA holder and an individual exactly 10 years younger. The IRS provides the appropriate life expectancy number within the IRS Minimum Distribution Incidental Benefit Divisor Table, which is published in IRS Publication 590-B for each respective tax year. The current rules allow only one alternative method, which is used only when a spousal beneficiary is named who is more than ten years younger than the IRA holder. Distributions Under the rules in effect for 2001 and forward, the IRA holder calculates required minimum distributions based on a distribution period using the IRA holder s age and an IRS life expectancy table. The life expectancy table used by all IRA holder s, except those who have a spousal beneficiary more than ten years younger than the IRA holder, assumes that the IRA holder has a beneficiary who is exactly ten years younger than the IRA holder. This table is called the Table for Determining Applicable Divisor for MDIB (Minimum Distribution Incidental Benefit). The table used if a spousal beneficiary is over ten years younger than the IRA holder is called Table II, Joint and Last Survivor Expectancy. Annuity Method IRA distribution rules allow the use of an annuity payment method to meet the RMD rules. The annuity must meet the RMD rules, use the appropriate life expectancy tables, and must extend over the joint life expectancy of the IRA holder and a designated beneficiary. Generally, the purchase of an annuity wherein payments are at least equal to those based on a reasonable interest rate and a reasonable life expectancy table meet the RMD rules. As long as the insurance company issuing the contract follows IRS standards for reasonable rates and mortality tables, the purchase of most life annuities and some period certain annuities will satisfy RMD rules. Annuity Rules After The Death Of The IRA Holder Generally, required minimum distribution payments to a designated beneficiary must begin by the end of the calendar year following the calendar year in which the participant died. If a non-spousal beneficiary is named, or if the spouse is not the only beneficiary, to calculate the distribution payment, the life expectancy is reduced by one (1) each following year. If the spouse is the only designated beneficiary, life expectancy is determined based on the spouse s age each year. 39

40 If there is no designated beneficiary for required minimum distribution purposes, the payments may continue to be paid over the remaining life expectancy of the participant as determined in the year of death. The life expectancy is reduced by one (1) each subsequent year. Changing Annuity Payments An annuity is an irrevocable contract. This means that once the contract is in force, payments must continue under the provisions of the contract. The annuity owner cannot stop the payments nor change the payments. The advantage of this feature for the IRA holder is that once the annuity is purchased, he or she no longer has to worry about annually calculating required minimum distributions. The disadvantage is that if income needs increase, the IRA holder cannot increase payments from an income annuity. Annuity Withdrawals vs. Annuity Income Payments Withdrawals can be made from deferred annuities to meet required minimum distributions. Deferred annuities are annuities that have not begun to pay annuity income through an irrevocable annuity income contract. Withdrawals from an annuity contract are treated like withdrawals from any other IRA product, such as a CD or mutual fund: they must meet the requirements of the required minimum distribution rules. Designated Beneficiary A designated beneficiary is not determined until the end of the calendar year following the year the IRA holder died. Therefore, beneficiaries may be changed during the IRA holder s lifetime, and the RMD calculation is not affected. Calculating Required Minimum Distributions Even though the calculation of required minimum distributions has been greatly simplified, the IRA owner should seek professional tax advice for assistance in this calculation. The tax advisor may work with the IRA plan trustee to ensure the IRA owner s distributions are calculated correctly. Some trustees or custodians will guarantee the calculation of distributions in certain circumstances. Common restrictions to these guarantees include items such as the IRA must be placed with that trustee prior to or at the time of the first distribution and the beneficiary designation must be a spouse. Distributions Greater Than the Minimum Distribution Amount When amounts greater than the minimum distribution are taken, no credit is given toward future years distributions. For example, assume Mr. Johnston s required distribution is $3600. He decides to take $5000. He cannot use the additional $1400 distributed this year as a credit against next year s distribution. He must take at least the required minimum each year. Excess Accumulations If the IRA participant does not make the required minimum distribution, he or she is subject to an excise tax of fifty percent of the amount not distributed, or the excess accumulation. 40

41 For example, if Mr. Edward s required distribution were $2500 and he took only $1000, the $1500 not distributed - the excess accumulation - would be subject to a fifty percent tax of $750. PLEDGING A REGULAR IRA AS COLLATERAL If a regular IRA is pledged as collateral for a loan, the amount pledged is treated as a distribution, and must be included as such in gross income for the tax year in which the account was pledged. If the pledged IRA is owned by an individual under 59 ½, the additional ten percent premature distribution tax will apply to the amount pledged as well. DISTRIBUTIONS DUE TO THE DEATH OF THE REGULAR IRA HOLDER The rules applying to distributions due to the death of a regular IRA holder differ based on whether distributions from the IRA have begun, or whether distributions have not begun. Death After Distributions Have Begun Generally, after an IRA holder dies, the remaining IRA amounts must be distributed over a period no longer than the single life expectancy of the oldest designated beneficiary, determined as of the calendar year following the participant s death. If the spouse is the only designated beneficiary, the remaining IRA amounts must be distributed over a period no longer than the life expectancy of the surviving spouse. The spouse s life expectancy is reduced by one (1) each subsequent year to determine the distribution amount. Upon the spouse s death, the distributions continue based on this schedule. Death Before Distributions Have Begun If the IRA holder dies before the required beginning date, there are different rules which apply depending upon whether a designated beneficiary has been made, or no designated beneficiary has been named. Designated Beneficiary Named If a designated beneficiary has been named, distributions must be made over the lifetime of the designated beneficiary. This rule applies whether the designated beneficiary is a spouse or non-spouse. No Designated Beneficiary If no beneficiary is named, or if the named beneficiary is not an individual or a permissible trust, the regular IRA is treated as having no designated beneficiary for the purposes of determining post death distribution requirements. A permissible trust is one valid under state law, is irrevocable, and lists identifiable beneficiaries. If such a trust is named as beneficiary, the individuals named within the trust as beneficiaries are considered the IRA s designated beneficiaries. 41

42 If an IRA holder dies without naming a designated beneficiary and IRA distributions have not begun, the entire balance in the IRA must be distributed by December 31 of the calendar year that contains the fifth anniversary of the date of the owner s death. For example, Mrs. Adams named her estate as the beneficiary of her regular IRA. Her estate is not an individual, nor a permissible trust, so her IRA is treated as having no designated beneficiary. If she passed away in February 2015 the executor of her estate must instruct the IRA trustee to distribute the IRA in full by December 31, Determination of A Designated Beneficiary As mentioned, under the new rules, a beneficiary is not determined, for the purposes of calculating required minimum distributions, until the death of the IRA holder. The beneficiary is determined by December 31 of the calendar year following the year of the participant s death. Generally, the beneficiary named by the IRA holder during life and who was the beneficiary in effect at the date of death of the IRA holder will be determined as the designated beneficiary by December 31 of the calendar year following the IRA holder s death, unless the beneficiary is eliminated by disclaimer or other event. ESTATE TAXES AND THE IRA The entire value or a portion of an IRA is normally includible in the estate of the IRA holder upon the death of the IRA holder. Property includible in an estate is subject to federal estate taxation. Generally, any property which the deceased property holder had an interest in, or in which he or she had ownership rights, is includible in his or her gross estate. The amount of the IRA value which is includible in the deceased s IRA holder s estate (the decedent) is based on the value of the IRA on the date of death, who is named as the beneficiary, and the type of payment method the beneficiary will receive from the IRA. Estate Taxes and Naming A Spouse As Beneficiary If a spouse is named as beneficiary on an IRA, the value of the IRA may qualify for the unlimited marital deduction, which is a deduction of property transferred to a surviving spouse from the gross estate value. Any estate property qualifying for the unlimited marital deduction is free from estate taxation upon the death of the property holder. For example, assume a $250,000 IRA is owned by Mr. Applebaum at his death. His wife is named as the only IRA beneficiary. At his death, the $250,000 is passed onto his wife and the value is not included in Mr. Applebaum s taxable estate because the unlimited marital deduction is applied. If a spouse is named as beneficiary along with other beneficiaries, only the amount of the IRA value passed onto the spouse will qualify for the unlimited marital deduction. Assume Mr. Applebaum had named his wife and two children as beneficiaries, and each beneficiary was to receive an equal share of the IRA value. At Mr. Applebaum s death, Mrs. Applebaum receives one-third of the $250,000 IRA, or $83,333. The children receive the remaining $166,667. Mrs. Applebaum s portion, $83,333 is deducted from the gross estate value due to the unlimited marital deduction, but the children s portion, $166,667 is includible in Mr. 42

43 Applebaum s estate, and depending upon the value of other estate property and other deductions and credits to the estate, may incur estate tax. Estate Tax and Distribution Methods If a regular IRA has started distribution before the IRA holder s death, the method of distribution may affect how the IRA is valued at death. The value of property owned at death is the value which is included in the decedent s estate. If a life income annuity, with no installment refund or cash refund option, was selected as the distribution option of the IRA holder, the IRA is considered to have no value at the time of the IRA holder s death, since the payments cease at his death. Therefore, there is no IRA property to include in the decedent s estate. If the life annuity still had value, e.g. was a period certain and life and the decedent died prior to the period certain end, or was a joint life annuity and the joint annuitant was still surviving, or was a life annuity with an installment or cash refund, the remaining value in the annuity is includible in the IRA holder s estate. As discussed above, if the remaining value is payable to the surviving spouse, the amount payable to the spouse will qualify for the unlimited marital deduction. If a non-annuity distribution method was selected, generally the value of the IRA at death is includible in the estate, as described above. Exceptions The estate tax exclusion rules include a provision that any amount of the IRA value attributable to non-deductible contributions does not qualify for the exclusion. In addition, if the distribution method selected does not extend for the life of the beneficiary, or for at least thirty six months after the decedent s death, the estate tax exclusion will not apply. FORM 1099-R Form 1099-R is a form used by IRA plan administrators and trustees to report to the participant the reason for an IRA plan distribution. Knowing why a distribution was made will help the participant to report the distribution properly to the IRS, and to know whether taxes must be paid. The number codes used on Form 1099-R are: 1 Early (premature) distribution, no known exception. 2 Early (premature) distribution, exception applies. 3 Disability. 4 Death. 5 Prohibited transaction. 6 Section 1035 exchange (a tax-free exchange of life insurance, annuity, or endowment contracts). 7 Normal distribution 8 Excess contributions plus earnings /excess deferrals (and/or earnings) taxable in the current tax year. 9 PS-58 costs (premiums paid by a trustee or custodian for current insurance protection, taxable to you currently). 43

44 The letter codes used on the form are: A May be eligible for 5 or10-year tax options. B May be eligible for death benefit exclusion. C May be eligible for both A and B. D Excess contributions plus earnings/ excess deferrals taxable in E Excess annual additions under section 415. F Charitable gift annuity. G Direct rollover to IRA. H Direct rollover to qualified plan or tax-sheltered annuity. L Loans treated as distributions. P Excess contributions plus earnings/ excess deferrals taxable in S Early distributions from a SIMPLE IRA in first 2 years, no known exception. DEEMED IRAS After 2002, a qualified plan that includes a separate account or annuity that meets the requirements for a regular IRA or Roth IRA may be deemed an IRA. This means that certain rules applying only to qualified plans will not apply to deemed IRAs. Instead they will be treated for tax purposes as IRAs. In order to be considered a deemed IRA, the employer plan must elect to allow employees to make voluntary contributions to the separate account or annuity, and the separate account or annuity must generally meet the requirements under Section 408 for IRAs. Deemed IRAs do not have to meet the requirement that normally applies to IRAs that their funds not be commingled with other property, however. Contributions to deemed IRAs are considered contributions to IRAs, not as contributions to qualified plans. So, if the deemed IRA is a regular IRA, the contribution rules, including the maximum contribution amount limits and the ability to deduct contributions if the participant is under certain adjusted gross income levels, apply. If a Roth IRA, the Roth IRA rules apply (for more about Roth IRA plans, see Chapters Eight and Nine). As IRA plans, deemed IRAs also are not subject to the reporting requirements under ERISA to which qualified plans are subject. Deemed IRAs are also exempt from rules related to vesting, eligibility, participation and so forth under ERISA. SUMMARY Non-deductible contributions are not taxable when withdrawn. The ratio of nondeductible contributions to the total IRA value is applied to each distribution. IRA distributions made prior to the IRA holder s age 59 ½ are subject to a 10% additional tax on premature distributions. There are exceptions to this tax. Required minimum distributions must begin by April 1 of the year following the year the IRA owner turns 70 ½. The method for meeting RMD rules generally requires using the IRA holder s age and life expectancy from an IRS table. Excess accumulations are subject to a 50% excise tax. 44

45 If an IRA is pledged as collateral, the amount pledged is considered a distribution and taxed accordingly. Qualified plans may now include deemed IRA accounts that are generally treated for tax purposes like regular IRAs. 45

46 CODE SECTION 72(T) 10-PERCENT ADDITIONAL TAX ON EARLY DISTRIBUTIONS FROM QUALIFIED RETIREMENT PLANS (1) Imposition of additional tax If any taxpayer receives any amount from a qualified retirement plan (as defined in section 4974(c)), the taxpayer's tax under this chapter for the taxable year in which such amount is received shall be increased by an amount equal to 10 percent of the portion of such amount which is includible in gross income. (2) Subsection not to apply to certain distributions Except as provided in paragraphs (3) and (4), paragraph (1) shall not apply to any of the following distributions: (A) In general Distributions which are-- (i) made on or after the date on which the employee attains age 59 ½, (ii) made to a beneficiary (or to the estate of the employee) on or after the death of the employee, (iii) attributable to the employee's being disabled within the meaning of subsection (m)(7), (iv) part of a series of substantially equal periodic payments (not less frequently than annually) made for the life (or life expectancy) of the employee or the joint lives (or joint life expectancies) of such employee and his designated beneficiary, (v) made to an employee after separation from service after attainment of age 55, or (vi) dividends paid with respect to stock of a corporation which are described in section 404(k). (B) Medical expenses Distributions made to the employee (other than distributions described in subparagraph (A), (C) or (D)) to the extent such distributions do not exceed the amount allowable as a deduction under section 213 to the employee for amounts paid during the taxable year for medical care (determined without regard to whether the employee itemizes deductions for such taxable year). (C) Payments to alternate payees pursuant to qualified domestic relations orders Any distribution to an alternate payee pursuant to a qualified domestic relations order (within the meaning of section 414(p)(1)). (D) Distributions to unemployed individuals for health insurance premiums (i) In general. Distributions from an individual retirement plan to an individual after separation from employment (I) if such individual has received unemployment compensation for 12 consecutive weeks under any Federal or State unemployment compensation law by reason of such separation, (II) if such distributions are made during any taxable year during which such unemployment compensation is paid or the succeeding taxable year, and (III) to the extent such distributions do not exceed the amount paid during the taxable year for insurance described in section 213(d)(1)(D) with respect to the individual and the individual s spouse and dependents (as defined in section 152) (ii) Distributions after reemployment. Clause (I) shall not apply to any distribution made after the individual has been employed for at least 60 days after the separation from employment to which clause (i) applies. 46

47 (iii) Self-employed individuals. To the extent provided in regulations, a self-employed individual shall be treated as meeting the requirements of clause (i)(i) if, under Federal or State law, the individual would have received unemployment compensation but for the fact the individual was self-employed. (E)Distributions from individual retirement plans for higher education expenses. Distributions to an individual from an individual retirement plan to the extent such distributions do not exceed the qualified higher education expenses (as defined in paragraph (7) of the taxpayer for the taxable year. Distributions shall not be taken into account under the preceding sentence is such distributions are described in subparagraph (A), (C), or (D) or to extent paragraph (1) does not apply to such distributions by reason of subparagraph (B). (F) Distributions for certain plans for first home purchases. Distributions to an individual from an individual retirement plan which are qualified first-time homebuyer distributions (as defined in paragraph (8)). Distributions shall not be taken into account under the preceding sentence if such distributions are described in subparagraph (A),(C), (D), or (E) or to the extent paragraph (1) does not apply to such distributions by reason of subparagraph (B). (3) Limitations (A) Certain exceptions not to apply to individual retirement plans Subparagraphs (A)(v), and (C) of paragraph (2) shall not apply to distributions from an individual retirement plan. (B) Periodic payments under qualified plans must begin after separation Paragraph (2)(A)(iv) shall not apply to any amount paid from a trust described in section 401(a) which is exempt from tax under section 501(a) or from a contract described in section 72(e)(5)(D)(ii) unless the series of payments begins after the employee separates from service. (4) Change in substantially equal payments (A) In general. If-- (i) paragraph (1) does not apply to a distribution by reason of paragraph (2)(A)(iv), and (ii) the series of payments under such paragraph are subsequently modified (other than by reason of death or disability)-- (I) before the close of the 5-year period beginning with the date of the first payment and after the employee attains age 59\1/2\, or (II) before the employee attains age 59\1/2\,the taxpayer's tax for the 1st taxable year in which such modification occurs shall be increased by an amount, determined under regulations, equal to the tax which (but for paragraph (2)(A)(iv)) would have been imposed, plus interest for the deferral period. (B) Deferral period For purposes of this paragraph, the term ``deferral period'' means the period beginning with the taxable year in which (without regard to paragraph (2)(A)(iv)) the distribution would have been includible in gross income and ending with the taxable year in which the modification described in subparagraph (A) occurs. (5) Employee For purposes of this subsection, the term ``employee'' includes any participant, and in the case of an individual retirement plan, the individual for whose benefit such plan was established. (6) Special rules for simple retirement accounts. In the case of any amount received from a simple retirement account (within the meaning of section 408(p)) during the 2-year period beginning on the date such individual first participated in any 47

48 qualified salary reduction arrangement maintained by the individual s employer under section 408(p)(2), paragraph (1) shall be applied by substituting 25 percent for 10 percent. (7) Qualified higher education expenses. (A) In general. The term qualified higher education expense means qualified higher education expenses (as defined in section 529(e)(3) for education furnished to (i)the taxpayer, (ii) the taxpayer s spouse, or (iii) any child (as defined in section 151(c)(3)) or grandchild of the taxpayer or the taxpayer s spouse, at an eligible educational institution (as defined in section 529 (e)(5) (B) Coordination with other benefits. The amount of qualified higher education expenses for any taxable year shall be reduced as provided in section 25A(g)(2). (8) See Exhibit 5.1 in this chapter. 48

49 CHAPTER SIX: ROLLOVER AND TRANSFER RULES OF THE REGULAR IRA ROLLOVERS AND TRANSFERS FROM AN IRA TO AN IRA Rollovers and transfers are allowable methods of moving IRA funds from one product or investment to another without incurring tax consequences. An IRA holder does not have to leave his or her IRA assets in the same IRA plan with the same IRA trustee forever to avoid current taxation. For example, the IRA owner may initially open a bank certificate of deposit and then later move the IRA funds to a mutual fund IRA or an Individual Retirement Annuity. Trustee-to-Trustee Transfers A trustee-to-trustee transfer is the term applied when IRA moneys are moved directly from one IRA trustee to another IRA trustee, or from one IRA plan to another IRA plan. The IRA owner directs the current trustee, through written instruction, to release his or her IRA funds to a new IRA trustee. The number of transfers which may be made from one regular IRA to another is unlimited under current regulation. The IRA owner may complete a trustee-to-trustee transfer at any time. The IRA plan, however, may impose fees or penalties if the IRA funds are moved to another plan within a specified time frame, or moved at all. IRA to IRA Rollovers Rollovers occur when IRA funds are distributed to the IRA owner, who then places the funds into another IRA plan or into another eligible retirement plan. The ability to roll IRA plan funds to an eligible retirement plan was created under the Economic Growth and Tax Relief Reconciliation Act of An eligible retirement plan is an IRA plan, an IRA Annuity, a qualified plan (such as a 401(k) plan), a Section 403(b) plan and a Section 457 plan. Prior to 2002, regular IRAs could only be rolled into qualified plans under limited circumstances. In order to avoid taxation on a rollover distribution, the rollover must be done in a manner which conforms to certain rules: Sixty-Day Rule A rollover must be completed by the sixtieth day from the date the distribution was received. This means that the new IRA trustee must record the IRA moneys as received by the sixtieth day. For example, if Mrs. Roberts received an IRA distribution on May 1, she would need to place the IRA funds into another IRA or eligible retirement plan by June 29, sixty days from May 1, to avoid being taxed on the distribution. If she failed to do so, the portion of the distribution not attributable to non-deductible contributions will be includible as income to Mrs. Roberts, 49

50 and, if she is under 59 ½, the 10% tax on premature withdrawals would also apply to the distribution. The Secretary of the Treasury has the authority to waive the sixty-day rule if the failure to waive such requirement would be against equity or good conscience, including cases of casualty, disaster, or other events beyond the reasonable control of the individual subject to such requirement (House Report H.R. 10). Examples of circumstances that may cause the Secretary to waive the sixty-day rule include casualty, disaster, military service in a combat zone, and errors committed by a financial institution. One-Year Rule Only one rollover may be made from an IRA to another IRA (or IRAs) within a one-year period. Note this one-year period is not a calendar year, but twelve months from the date the distribution was received. One Rollover Per Plan If an IRA owner has more than one IRA, the one-year rule applies to each IRA plan individually. For example, if Mr. Hansen has an IRA at ABC bank through trustee D and one with XYZ mutual fund company through trustee E, these are considered separate IRA plans and both could be rolled over in the same one year period, should Mr. Hansen desire. However, if Mr. Hansen has several IRA certificate of deposit accounts, or CDs, with ABC bank, the IRA accounts may be separate IRA plans, or they may all be accounts within one IRA plan. Mr. Hansen should check with the IRA trustee at ABC bank to determine if each IRA CD is a separate plan or not. If each CD is considered part of one IRA plan, Mr. Hansen could only make one allowable rollover from one of these CDs to another IRA plan within a one year period. Of course, he could move any or all of the IRA CDs at any time via a trustee-to-trustee transfer. As a further example, suppose Mr. Fredericks has five CD IRA accounts with ABC Bank and five with TUV Bank. He decides to consolidate all his IRAs into one Individual Retirement Annuity. Mr. Fredericks contacts ABC Bank and finds each IRA CD is considered a separate IRA plan. The CDs from ABC Bank may each be rolled into his new Individual Retirement Annuity. However, when he contacts TUV Bank, he finds that his five IRA CDs are each considered accounts within one IRA plan. Therefore, as each CD matures, he submits trusteeto-trustee paperwork to TUV bank to transfer the CDs into his annuity. PARTIAL TRANSFERS AND ROLLOVERS The IRA holder may rollover or transfer a partial distribution from an IRA. Any amount distributed from an IRA but not rolled over or transferred is subject to taxation, including any applicable tax on premature distributions or excess distributions. The IRA holder may also rollover or transfer the proceeds from one IRA into one or more IRAs or other eligible retirement plans. 50

51 For example, Mrs. Sanders has a $50,000 IRA. She wants to invest $25,000 of this IRA to a mutual fund IRA. She instructs her current IRA trustee to transfer $25,000 of her IRA to the mutual fund company. The remaining $25,000 stays in her existing IRA account. If the rollover funds are placed in a non-ira account anytime during the sixty-day period prior to the rollover being completed, the earnings on the funds while in the non-ira account may not be rolled over. These earnings are taxed as regular interest or dividend income in the tax year they are earned. ROLLOVERS AND DIRECT ROLLOVERS FROM QUALIFIED PLANS TO A REGULAR IRA. Taxable distributions from a qualified plan may be rolled over into a regular IRA. Excluded from the amount of a taxable distribution which may be rolled over are required distributions, payments which are a series of substantially equal payments over the life or life expectancies of the IRA holder, and payments which are a part of a specified distribution of ten years or more. Amount of Qualified Plan Rollovers and Direct Rollovers. Taxable distributions prior to and through December 31, 1992, had to comprise at least 50% of the balance in the employees qualified plan to be eligible for rollover treatment. Currently, any distribution from a qualified plan can be rolled over to a regular IRA, as long as the distribution is not made up of the excluded items listed in the paragraph above and the distribution is not made up of property which cannot be invested in an IRA, such as life insurance. Direct Rollovers Taxable distributions from qualified plans after December 31, 1992, are governed by the direct rollover or direct transfer rules. These rules state that if the employee instructs the qualified plan administrator to distribute the qualified plan moneys directly to the employee, the plan administrator is required to withhold 20% of the distribution for income tax purposes. This 20% withholding is mandatory even if the employee places the distribution in a traditional IRA as a rollover within sixty days. To avoid the 20% withholding, the qualified plan distribution must be directly rolled or directly transferred to the IRA trustee. The employee instructs the plan administrator in writing to transfer the qualified plan moneys to an IRA plan. If the employee takes receipt of the qualified plan distribution, (which is now reduced by 20%) and then rolls over the amount he or she received, the 20% withheld and therefore not rolled over will be considered a taxable distribution. If the employee is under 59 ½, the amount not rolled over will also be subject to the 10% premature distribution tax. To avoid the taxation of the 20% withheld, the employee must come up with an amount equal to the withheld amount and roll this amount along with the qualified plan distribution. If the employee does roll the full distribution amount, including an amount equal to the 20% withheld, he may be eligible to receive a tax refund. The withheld amount is reported as federal income tax withheld and may cause an overpayment of taxes for that year. 51

52 For example, assume a retiring employee has $80,000 in his qualified plan account. The amount he receives after withholding is $64,000. Sixteen thousand was withheld and paid by the qualified plan to the IRS for income tax purposes on behalf of the employee. To avoid being taxed on the $16,000 withheld, the employee would need to come up with $16,000 from some other source and roll it into an IRA along with the $64,000 received from the qualified plan. The maximum amount of a rollover from a qualified plan cannot exceed the amount of the taxable distribution made. In some cases, qualified plans will include both before tax and after tax contributions. Only the portion of a qualified plan distribution attributable to before tax contributions and tax-deferred earnings is considered a taxable distribution. ROLLOVERS AND DIRECT ROLLOVERS FROM A QUALIFIED PLAN TO A QUALIFIED PLAN Conduit IRAs Prior to the Economic Growth and Tax Relief Reconciliation Act of 2001, the only way that IRA funds could be rolled into a qualified plan was if the money that originally funded the IRA was from a qualified plan. A distribution from a qualified plan could be placed in a regular IRA and then later moved to a qualified plan. This type of IRA was often referred to as a conduit IRA, since the money was placed in the IRA temporarily until it is moved to a qualified plan. In order to have been able to move qualified money that had been placed in a conduit IRA to a new qualified plan, no commingling of IRA funds could occur. Commingling referred to mixing qualified plan distributions with IRAs accepting new contributions or with IRAs rolled over from other sources. The qualified money placed in a conduit IRA had to remain separate from all other IRA moneys in order to be able to place it into a qualified plan. After 2001, amounts from any IRA that would be considered taxable distributions were they not rolled over may be rolled into a qualified plan. This is true regardless of the source of funds from the IRA. The limitations of using only money in a conduit IRA that has not been commingled no longer apply. However, only IRA money that has not been commingled qualifies for special averaging. ROLLING PROPERTY OTHER THAN CASH INTO AN IRA Although contributions to IRAs must be in cash, rollovers may be in cash or property. To qualify as a rollover in this case, the same property must be rolled over from the IRA or Qualified Plan to the IRA. Or, the property may be sold and the cash proceeds may be rolled over to the IRA. However, since IRAs cannot invest in most collectibles or life insurance, these two types of property cannot be rolled into an IRA. For example, Ms. Abernathy received 1300 shares of XYZ stock as part of her qualified plan distribution. These stock shares may either be converted to cash and rolled into an IRA, or can be transferred as stock into an IRA plan which will accept shares of stock. 52

53 ROLLOVERS AFTER REQUIRED DISTRIBUTIONS HAVE BEGUN Rollovers may be made after required distributions have begun from an IRA, but the required distribution must be made prior to rollover completion. Required minimum distributions may not be rolled over. For example, Mr. Hanes is 75 and decides to move some of his IRA funds valued at $75,000 from DEF mutual funds to RST mutual funds. His required minimum distribution for the current year is $6000. The maximum rollover allowable for Mr. Hanes is $69,000: $75,000 less his $6000 required minimum distribution. TRANSFERS DUE TO DIVORCE If a regular IRA or retirement plan is distributed due to a divorce, the receiving spouse may be able to roll the proceeds over into his or her own IRA. IRA proceeds received due to a divorce can be rolled over by the receiving spouse if: 1. The distribution is made to the credit of the receiving spouse. 2. The distribution is made according to a Qualified Domestic Relations Order (QDRO). 3. The same property received in the distribution, if any, is rolled over. The rollover must be made to an IRA. If the money was from a qualified plan, it could not be rolled or transferred to another qualified plan. The Economic Growth and Tax Relief Reconciliation Act of 2001 allows required minimum distributions to be delayed up to 18 months while a court order s status as a QDRO is being determined. Qualified Domestic Relations Order A qualified domestic relations order (QDRO) is a judgment, decree or order that is created under the domestic relations law of a state and relates to the provision of child support, alimony payments, or marital property rights to a spouse, former spouse, child or other dependent. Generally, a QDRO provides that an alternate payee will receive all or a portion of a distribution from a qualified plan or IRA. A QDRO must be structured under the following requirements: Only a spouse, child or other dependent may be an alternate payee. The QDRO must be made under a state s domestic relations or community property laws. The QDRO must relate to the child support, alimony, or property rights to a spouse, former spouse, child or other dependent. The QDRO must create, recognize or assign the right to all or part of a participant s plan benefits to the alternate payee. The QDRO must clearly specify each alternate payee, the percentage or amount payable to the payee, the number or time frame of payments to be made, and identify each qualified or IRA plan to which the QDRO applies. 53

54 The IRS published sample language for inclusion in a QDRO in order to enable those involved in distributions due to divorce to determine whether a QDRO exists that meets IRS regulations. This sample language is available in Internal Revenue Bulletin Rollover Rules For a Distribution Received Due to A Divorce The receiving spouse may roll the distribution to his or her own IRA. Since the IRA is his or her own, the required beginning date for distributions is based on the new IRA holder s age, not the original qualified plan or IRA participant s age. If the receiving spouse does not roll all of the plan proceeds, the amount not rolled over is taxable, but is not subject to the premature distribution tax if the receiving spouse is under 59 ½. If the distribution is made from a qualified plan, the direct rollover rules apply. In other words, if the distribution is not made directly from the plan to the receiving IRA holder s IRA, the plan administrator is required to withhold 20% of the distribution. SUMMARY Rollover and transfer rules can be quite complex. Key points to remember are: A rollover from an IRA plan can only be done once in a twelve-month period. Transfers may be done as frequently as the IRA owner desires, although the IRA plan may impose penalties for withdrawals. A transfer is not subject to mandatory 20% withholding. Some distributions may not be rolled over. These would include required minimum distributions, return of excess contributions, payments which are part of a series of substantially equal payments over the life expectancy of the IRA holder or the joint life expectancies of the IRA owner and designated beneficiary, and payments which are a part of a specified distribution of ten years or more. Rollovers from an IRA may be made to an eligible retirement plan, including IRA plans, IRA annuities, qualified plans, 403(b) plans and 457 plans. Rollovers to IRAs may be in cash or property. Rollovers may be made from distributions under a Qualified Domestic Relations Order. 54

55 SECTION 402 (as updated by the Economic Growth and Tax Relief Reconciliation Act of 2001) (c) Rules applicable to rollovers from exempt trusts (1) Exclusion from income If-- (A) any portion of the balance to the credit of an employee in a qualified trust is paid to the employee in an eligible rollover distribution, (B) the distributee transfers any portion of the property received in such distribution to an eligible retirement plan, and (C) in the case of a distribution of property other than money, the amount so transferred consists of the property distributed, then such distribution (to the extent so transferred) shall not be includible in gross income for the taxable year in which paid. (2) Maximum amount which may be rolled over In the case of any eligible rollover distribution, the maximum amount transferred to which paragraph (1) applies shall not exceed the portion of such distribution which is includible in gross income (determined without regard to paragraph (1)). The preceding sentence shall not apply to such distribution to the extent (A) such portion is transferred in a direct trustee-to-trustee transfer to a qualified trust which is part of a plan which is a defined contribution plan and which agrees to separately account for amounts so transferred, including separately accounting for the portion of such distribution which is includible in gross income and the portion of such distribution which is not so includible, or (B) such portion is transferred to an eligible retirement plan described in clause (i) or (ii) of paragraph (8)(B). (3) Transfer must be made within 60 days of receipt (A) In general. Except as provided in subparagraph (B), paragraph (1) shall not apply to any transfer of a distribution made after the 60th day following the day on which the (B) distributee received the property distributed. Hardship exception. The Secretary may waive the 60-day requirement under subparagraph (A) where the failure to waive such requirement would be against equity or good conscience, including casualty, disaster, or other events beyond the reasonable control of the individual subject to such requirement. (4) Eligible rollover distribution For purposes of this subsection, the term ``eligible rollover distribution'' means any distribution to an employee of all or any portion of the balance to the credit of the employee in a qualified trust; except that such term shall not include-- (A) any distribution which is one of a series of substantially equal periodic payments (not less frequently than annually) made-- (i) for the life (or life expectancy) of the employee or the joint lives (or joint life expectancies) of the employee and the employee's designated beneficiary, or (ii) for a specified period of 10 years or more, and (B) any distribution to the extent such distribution is required under section 401(a)(9). (C) any distribution which is made upon hardship of the employee. (5) Transfer treated as rollover contribution under section

56 For purposes of this title, a transfer to an eligible retirement plan described in clause (i) or (ii) of paragraph (8)(B) resulting in any portion of a distribution being excluded from gross income under paragraph (1) shall be treated as a rollover contribution described in section 408(d)(3). (6) Sales of distributed property For purposes of this subsection-- (A) Transfer of proceeds from sale of distributed property treated as transfer of distributed property The transfer of an amount equal to any portion of the proceeds from the sale of property received in the distribution shall be treated as the transfer of property received in the distribution. (B) Proceeds attributable to increase in value The excess of fair market value of property on sale over its fair market value on distribution shall be treated as property received in the distribution. (C) Designation where amount of distribution exceeds rollover contribution In any case where part or all of the distribution consists of property other than money-- (i) the portion of the money or other property which is to be treated as attributable to amounts not included in gross income, and (ii) the portion of the money or other property which is to be treated as included in the rollover contribution, shall be determined on a ratable basis unless the taxpayer designates otherwise. Any designation under this subparagraph for a taxable year shall be made not later than the time prescribed by law for filing the return for such taxable year (including extensions thereof). Any such designation, once made, shall be irrevocable. (D) Nonrecognition of gain or loss No gain or loss shall be recognized on any sale described in subparagraph (A) to the extent that an amount equal to the proceeds is transferred pursuant to paragraph (1). (7) Special rule for frozen deposits (A) In general The 60-day period described in paragraph (3) shall not--(i) include any period during which the amount transferred to the employee is a frozen deposit, or(ii) end earlier than 10 days after such amount ceases to be a frozen deposit. (B) Frozen deposits For purposes of this subparagraph, the term ``frozen deposit'' means any deposit which may not be withdrawn because of-- (i) the bankruptcy or insolvency of any financial institution, or (ii) any requirement imposed by the State in which such institution is located by reason of the bankruptcy or insolvency (or threat thereof) of 1 or more financial institutions in such State. A deposit shall not be treated as a frozen deposit unless on at least 1 day during the 60- day period described in paragraph (3) (without regard to this paragraph) such deposit is described in the preceding sentence. (8) Definitions For purposes of this subsection-- (A) Qualified trust The term ``qualified trust'' means an employees' trust described in section 401(a) which is exempt from tax under section 501(a). 56

57 (B) Eligible retirement plan The term ``eligible retirement plan'' means (i) an individual retirement account described in section 408(a), (ii) an individual retirement annuity described in section 408(b) (other than an endowment contract), (iii) a qualified trust, and (iv) an annuity plan described in section 403(a). (v) an eligible deferred compensation plan described in section 457(b) which is maintained by an eligible employer described in section 403(b). If any portion of an eligible rollover distribution is attributable to payments or distributions from a designated Roth account (as defined in section 402A), an eligible retirement plan with respect to such portion shall include only another designated Roth account and a Roth IRA. (9) Rollover where spouse receives distribution after death of employee If any distribution attributable to an employee is paid to the spouse of the employee after the employee's death, the preceding provisions of this subsection shall apply to such distribution in the same manner as if the spouse were the employee; except that a trust or plan described in clause (iii) or (iv) of paragraph (8)(B) shall not be treated as an eligible retirement plan with respect to such distribution. (d) Taxability of beneficiary of certain foreign situs trusts. For purposes of subsections (a), (b), and (c), a stock pension or profit-sharing trust which would qualify for exemption from tax under section 501(a) except for the fact that it is a trust created or organized outside the United States shall be treated as if it were a trust exempt from tax under section 501(a). (e) Other rules applicable to exempt trusts (1) Alternate payees (A) Alternate payee treated as distributee For purposes of subsection (a) and section 72, an alternate payee who is the spouse or former spouse of the participant shall be treated as the distributee of any distribution or payment made to the alternate payee under a qualified domestic relations order (as defined in section 414(p)). (B) Rollovers If any amount is paid or distributed to an alternate payee who is the spouse or former spouse of the participant by reason of any qualified domestic relations order (within the meaning of section 414(p)), subsection (c) shall apply to such distribution in the same manner as if such alternate payee were the employee. (2) Distributions by United States to nonresident aliens The amount includible under subsection (a) in the gross income of a nonresident alien with respect to a distribution made by the United States in respect of services performed by an employee of the United States shall not exceed an amount which bears the same ratio to the amount includible in gross income without regard to this paragraph as (A) the aggregate basic pay paid by the United States to such employee for such services, reduced by the amount of such basic pay which was not includible in gross income by reason of being from sources without the United States, bears to (B) the aggregate basic pay paid by the United States to such employee for such services. In the case of distributions under the civil service retirement laws, the term ``basic pay'' shall have the meaning provided in section 8331(3) of title 5, United States Code. 57

58 (3) Cash or deferred arrangements For purposes of this title, contributions made by an employer on behalf of an employee to a trust which is a part of a qualified cash or deferred arrangement (as defined in section 401(k)(2)) or which is part of a salary reduction agreement under section 403(b) shall not be treated as distributed or made available to the employee nor as contributions made to the trust by the employee merely because the arrangement includes provisions under which the employee has an election whether the contribution will be made to the trust or received by the employee in cash. (4) Net unrealized appreciation (A) Amounts attributable to employee contributions For purposes of subsection (a) and section 72, in the case of a distribution other than a lump sum distribution, the amount actually distributed to any distributee from a trust described in subsection (a) shall not include any net unrealized appreciation in securities of the employer corporation attributable to amounts contributed by the employee (other than deductible employee contributions within the meaning of section 72(o)(5)). This subparagraph shall not apply to a distribution to which subsection (c) applies. (B) Amounts attributable to employer contributions For purposes of subsection (a) and section 72, in the case of any lump sum distribution which includes securities of the employer corporation, there shall be excluded from gross income the net unrealized appreciation attributable to that part of the distribution which consists of securities of the employer corporation. In accordance with rules prescribed by the Secretary, a taxpayer may elect, on the return of tax on which a lump sum distribution is required to be included, not to have this subparagraph apply to such distribution. (C) Determination of amounts and adjustments For purposes of subparagraphs (A) and (B), net unrealized appreciation and the resulting adjustments to basis shall be determined in accordance with regulations prescribed by the Secretary. (D) Lump sum distribution For purposes of this paragraph (i) In general. The term lump sum distribution means the distribution or payment within one taxable year of the recipient of the balance to the credit of an employee which becomes payable to the recipient-- (I) on account of the employee s death (II) after the employee attains age 59 ½, (III) on account of the employee s separation from service, or (IV) after the employee has become disabled (within the meaning of section 72(m)(7)), from a trust which forms a part of a plan described in section 401(a) and which is exempt from tax under section 501 or from a plan described in section 403(a). Subclause (III) of this clause shall be applied only with respect to an individual who is an employee without regard to section 401(c)(1), and subclause (IV) shall be applied only with respect to an employee within the meaning of section 401(c)(1). For purposes of this clause, a distribution to two or more trusts shall be treated as a distribution to one recipient. For purposes of this paragraph, the balance to the credit of the employee does not include the accumulated deductible employee contributions under the plan (within the meaning of section 72(o)(5). 58

59 (ii) Aggregation of certain trusts and plans. For purposes of determining the balance to the credit of an employee under clause (i) (I) all trusts which are part of a plan shall be treated as a single trust, all pension plans maintained by the employer shall be treated as a single plan, all profit-sharing plans maintained by the employer shall be treated as a single plan, and all stock bonus plans maintained by the employer shall be treated as a single plan, and (II) trusts which are not qualified trusts under section 401(a) and annuity contracts which do not satisfy the requirements of 404(a)(2) shall not be taken into account. (iii) Community property laws. The provisions of this paragraph shall be applied without regard to community property laws. (iv) Amounts subject to penalty. This paragraph shall not apply to amounts described in subparagraph (A) of section 72(m)(5) to the extent that section 72(m)(5) applies to such amounts. (v) Balance to credit of employees not to include amounts payable under qualified domestic relations order. For purposes of this paragraph, the balance to the credit of an employee shall not include any amount payable to an alternate payee under a qualified domestic relations order (within the meaning of section 414(p)). (vi) Transfers to cost-of-living arrangement not treated as a distribution. For purposes of this paragraph, the balance to the credit of an employee under a defined contribution plan shall not include any amount transferred from such defined contribution plan to a qualified cost-of-living arrangement (within the meaning of section 415(k)(2)) under a defined benefit plan. (vii) Lump-sum distributions of alternate payees. If any distribution or payment of the balance to the credit of an employee would be treated as a lump-sum distribution, then, for purposes of this paragraph, the payment under a qualified domestic relations order (within the meaning of section 414(p)) of the balance to the credit of an alternate payee who is the spouse or former spouse of the employee shall be treated as a lump-sum distribution. For purposes of this clause, the balance to the credit of the alternate payee shall not include any amount payable to the employee. (E) Definitions relating to securities For purposes of this paragraph-- (i) Securities The term ``securities'' means only shares of stock and bonds or debentures issued by a corporation with interest coupons or in registered form. (ii) Securities of the employer The term ``securities of the employer corporation'' includes securities of a parent or subsidiary corporation (as defined in subsections (e) and (f) of section 424) of the employer corporation. (5) Repealed (6) Direct trustee-to-trustee transfers Any amount transferred in a direct trustee-to-trustee transfer in accordance with section 401(a)(31) shall not be includible in gross income for the taxable year of such transfer. (f) Written explanation to recipients of distributions eligible for rollover treatment (1) In general 59

60 The plan administrator of any plan shall, within a reasonable period of time before making an eligible rollover distribution from an eligible retirement plan, provide a written explanation to the recipient-- (A) of the provisions under which the recipient may have the distribution directly transferred to another eligible retirement plan and that the automatic distribution by direct transfer applies to certain distributions in accordance with section 401(a)(31)(B), (B) of the provision which requires the withholding of tax on the distribution if it is not directly transferred to an eligible retirement plan, (C) of the provisions under which the distribution will not be subject to tax if transferred to an eligible retirement plan within 60 days after the date on which the recipient received the distribution, and (D) if applicable, of the provisions of subsections (d) and (e) of this section. (E) of the provisions under which distributions from the eligible retirement plan receiving the distribution may be subject to restrictions and tax consequences which are different from those applicable to distributions from the plan making such distribution. (2) Definitions For purposes of this subsection-- (A) Eligible rollover distribution The term ``eligible rollover distribution'' has the same meaning as when used in subsection (c) of this section or paragraph (4) of section 403(a), subparagraph (A) of section 403(b)(8), or subparagraph (A( ) of section 457(e)(16). (B) Eligible retirement plan The term ``eligible retirement plan'' has the meaning given such term by subsection (c)(8)(b). (g) Limitation on exclusion for elective deferrals. (1) In general. (A) Limitation. Notwithstanding subsections (e)(3) and (h)(1)(b), the elective deferrals of any individual for any taxable year shall be included in such individual s gross income to the extent the amount of such deferrals for the taxable year exceeds the applicable dollar amount. The preceding sentence shall not apply the portion of such excess as does not exceed the designated Roth contributions of the individual for the taxable year. (B) Applicable dollar amount. For purposes of subparagraph (A), the applicable dollar amount shall be the amount determined in accordance with the following table: For taxable years beginning in calendar year: The applicable dollar amount: $11, $12, $13, $14, or thereafter.. $15,000 60

61 CHAPTER SEVEN: ADVANTAGES OF THE ROTH IRA ROTH IRAs! FEATURING Tax-Free Withdrawals! Beginning in 1998, a new Individual Retirement Account became available: the Roth IRA. It is named after a Congressmen who was a key player in the crafting of IRA legislation. Congress created this IRA version to provide an incentive for people to save for retirement which did not include the constraints and many of the penalties of the traditional IRA. The Roth IRA has several advantages as a savings vehicle: TAX-FREE WITHDRAWALS Qualified distributions from Roth IRAs are free from taxation. For example, a person in a 28% tax bracket who places $5500 annually in a Roth IRA for ten years and earns a 10% return over that time would accumulate $95,095, after taxes. Assuming a qualified distribution from the Roth IRA were made, the tax liability attributable to that distribution would be zero. If instead that same $5500 were placed in a regular IRA, the IRA account would grow to $110,687 after ten years, assuming all the contributions are deductible. A qualified distribution of the entire taxable portion of the IRA, $55,687, could cause a tax liability of over $15,592, bringing the after tax balance of the regular IRA to about $95,095, if the person was still in a 28% tax bracket. TAX ADVANTAGE WITH A SHORT INVESTMENT HORIZON The Roth IRA allows tax-free qualified distributions in as little as five years, regardless of the age of the Roth IRA holder. This is in direct contrast to the traditional IRA, which requires most withdrawals to be made after age 59 ½ to avoid a tax penalty. AVAILABILITY As an individual savings plan, the Roth IRA is available to a large portion of the working population, as well as to non-working spouses. FLEXIBLE CONTRIBUTION FREQUENCY Like the regular IRA, contributions do not have to be made annually. FLEXIBLE INVESTMENT OPTIONS Roth IRA contributions may be made to the same spectrum of investment products as the traditional IRA. CONTRIBUTIONS CAN CONTINUE Roth IRA contributions do not have to stop at age 70 ½ in all situations, as they must under regular IRA rules. 61

62 NO MANDATED DISTRIBUTIONS Roth IRA distributions also do not have to be made after age 70½, as they must be from traditional IRAs. PROBATE AVOIDANCE Like the regular IRA, Roth IRAs can be structured to avoid probate. In most cases, the named beneficiary can receive plan proceeds directly from the plan administrator or trustee. SUMMARY Roth IRAs are truly a special savings tool. They provide a less complicated retirement vehicle for the individual with excellent tax advantages. The prospect of tax-free withdrawals and the ability to use the funds prior to age 59 ½ without tax penalty in certain circumstances make the Roth IRA a retirement option to seriously consider. 62

63 CHAPTER EIGHT: ELIGIBILITY AND CONTRIBUTION RULES OF THE ROTH IRA ELIGIBILITY An individual who earns compensation may generally contribute to a Roth IRA. Compensation is defined as wages, tips, salaries, commissions, fees, bonuses, and taxable alimony and separate maintenance payments. Deferred compensation received, social security or railroad retirement income, disability income and other unearned income is not considered compensation for the purposes of determining eligibility to contribute to a Roth IRA. Eligibility to contribute to a Roth IRA phases out for persons with adjusted gross income over a certain level. Eligibility phases out for joint filers with adjusted gross income between $183,000 and $193,000 and for individuals with adjusted gross income between $116,000 and $131,000 (see Exhibit 8.1) CONTRIBUTIONS In years 2013 through 2015, the maximum dollar contribution is $5,500. The total of all IRA contributions may not exceed this limit. If an individual has made an IRA contribution to a traditional IRA for a tax year, his or her allowable Roth IRA contribution is reduced by the amount of contributions to the regular IRA. For example, Mrs. Perez, a 40-year old earning $35,000 in 2015, makes a $2000 deductible traditional IRA contribution in May The maximum Roth IRA contribution she may make in 2015 is $3500. This rule applies to regular IRAs as well. If instead Mrs. Perez had made a total of $4000 in contributions to a Roth IRA in 2015, a maximum of $1500 could be made to a regular IRA in this tax year. 63

64 Exhibit 8.1 Effect of Modified AGI on Roth IRA Contribution If taxpayer has taxable compensation and taxpayer AND taxpayer modified AGI filing status is is Less than $183,000 THEN Taxpayer can contribute up to $5500 ($6500 if 50 or older) Married filing jointly or qualified widow(er) Married filing separately and taxpayer lived with spouse any time during the year Single, head of household or married filing separately and taxpayer did not live with spouse any time during the year From IRS Publication 590-A At least $183,000 but less than $193,000 $193,000 or more zero More than zero but less than $10,000 $10,000 or more Less than $116,000 At least $116,000 but less than $131,000 $131,000 or more Amount allowed to be contributed is reduced Taxpayer cannot contribute to a Roth IRA Taxpayer can contribute up to $5500 ($6500 if 50 or older) Amount allowed to be contributed is reduced Taxpayer cannot contribute to a Roth IRA Taxpayer can contribute up to $5500 ($6500 if 50 or older) Amount allowed to be contributed is reduced Taxpayer cannot contribute to a Roth IRA 64

65 As with regular IRAs, individuals who have reached age fifty during the tax year, or who are older, may make additional catch-up contributions to their Roth IRA. In years 2006 and thereafter, the additional catch-up contribution amount is $1,000. Contributions to Roth IRAs are never tax-deductible. Rather, they are generally free from taxation at distribution. This important aspect of Roth IRAs is discussed in the next chapter. Roth IRA Investments Like a traditional IRA, certain investments may not be used to hold Roth IRA moneys. Life insurance and most collectibles are prohibited. Collectibles that may be utilized are certain gold, silver and platinum coins, and certain gold, silver, platinum or palladium bullion. Available IRA vehicles include, but are not limited to, mutual funds, annuities, individual stocks, taxable bonds and certificates of deposit. Frequency of Contributions Unlike some qualified plans, Roth IRAs do not require contributions on an annual basis. A Roth IRA may be contributed to each year an individual meets its eligibility requirements, occasionally until the plan is liquidated, or on a one-time basis only. There is no requirement that any amount of contributions be made. Contributions after Age 70 ½ Contributions may continue to be made after age 70½ to Roth IRAs, as long as there is compensation. This is in contrast to traditional IRAs, which require contributions to end at this age, since required minimum distributions must be made. Spousal Roth IRAs Like traditional IRAs, a contribution of up to $11,000 (in 2015) or 100% of an individual and spouse s combined compensation, whichever is smaller, may be made to Roth IRAs for the couple. Each spouse is limited to a maximum $5500 (2015) maximum. Catch-up contributions rules apply to spousal Roth IRAs. Excess Contributions A six percent tax is applied to Roth IRA excess contributions. Excess contributions are generally contributions greater than the maximum annual contribution, plus any remaining excess contribution from prior years, less distributions from a Roth IRA. As long as an excess contribution is withdrawn by April 15 following the tax year to which the excess contribution applies, the six percent penalty will not be applied to the contribution. 65

66 SUMMARY An individual can generally contribute up to $5500 or 100% of compensation in 2013 through 2015, whichever is smaller, to a Roth IRA annually. Individuals with adjusted gross income above certain limits are phased-out of the ability to make Roth IRA contributions. Spousal Roth IRAs are available, and follow the same contribution limits as spousal traditional IRAs. 66

67 CHAPTER NINE: DISTRIBUTION RULES OF THE ROTH IRA The primary advantage of Roth IRAs lies in the way in which they are taxed upon distribution. Unlike traditional IRAs, which may be both taxdeductible and tax-deferred, Roth IRAs may be tax-free. After-tax contributions are used to fund a Roth IRA, and as long as a qualified distribution is taken, the distribution is completely free from federal taxation. QUALIFIED DISTRIBUTIONS As can be seen, an important term when discussing taxation of Roth IRA withdrawals is the term qualified distribution. As long as a withdrawal from a Roth IRA is considered a qualified distribution, it is received tax-free. IRC section 408A(d)(2) defines what is considered a qualified distribution: (2)Qualified distribution. For purposes of this subsection (A) In general. The term qualified distribution means any payment or distribution -- (i) made on or after the date on which the individual attains age 59 ½, (ii) made to a beneficiary (or to the estate of the individual) on or after the death of the individual, (iii) attributable to the individual s being disabled (within the meaning of section 72(m)(7), or (iv) which is a qualified first-time homebuyer distribution. (B) Certain distributions within 5 years. A payment or distribution shall not be treated as a qualified distribution under subparagraph (A) if (i) it is made within the 5-taxable year period beginning with the 1 st taxable year for which the individual made a contribution to a Roth IRA (or such individual s spouse made a contribution to a Roth IRA) established for such individual, or (ii) in the case of a payment or distribution properly allocable to a qualified rollover contribution from an individual retirement plan other than a Roth IRA (or income allocable thereto), it is made within the 5-taxable year period beginning with the taxable year in which the rollover contribution was made. In summary, a qualified distribution is one made after the first five tax years from the first contribution to a Roth IRA, and which is made either: a) after the individual reaches age 59½, or b) after the death of the individual, or c) because of the disability of the individual, or d) for payment of first-time homebuyer expenses. For example, assume Joe Brown, age 20, makes his first Roth IRA contribution on December 31, 2012, and makes additional $3000 contributions in June 2013 and February 2014, and additions $4000 contributions in August 2015, and May In January 2017, he buys his first home and withdraws $17,000 plus all earnings from his Roth IRA. This distribution 67

68 would be considered a qualified distribution, and would be considered tax-free. Note how the five-year period is calculated in this example: Year 1: 2012 Year 2: 2013 Year 3: 2014 Year 4: 2015 Year 5: 2016 Qualified distribution: January 2017 The withdrawal is made after five tax years, not five 365-day periods. If the qualified distribution rule required five 365-day periods, Joe could not withdraw his funds tax-free until after December 31, If a person waits until April 15 of the following year to make a Roth IRA contribution for the preceding tax year, the contribution would be considered to be made on the last day of the preceding tax year for the purposes of calculating the five-year period under qualified distribution rules. TAXATION OF NON-QUALIFIED DISTRIBUTIONS FROM A ROTH IRA Even if a distribution made from a Roth IRA is not a qualified distribution, it is taxed in a more favorable manner than are regular IRAs. Currently, the Roth IRA rules state that contributions are considered to be withdrawn before earnings. Traditional IRA rules, in contrast, state that withdrawals are considered to be comprised first of earnings. The taxation rules of the Roth IRA mean that it will normally make monetary sense to place funds in a Roth IRA rather than make a non-deductible traditional IRA contribution. The impact of the differing taxation treatments in this scenario depends on how the funds are distributed. If the entire amount is distributed at once, or the entire amount within one tax year, there is no difference in the amount of tax due. If, however, an amount equal to the amount contributed is distributed over more than one tax year, the difference in tax treatment has an impact on the tax amount due. The regular non-deductible IRA contribution earnings will be taxed before those of the Roth IRA earnings would be. REQUIRED BEGINNING DATE Unlike traditional IRAs, there is no mandated distribution beginning date under Roth IRA rules. Contributions can remain in the Roth IRA up until the individual s death. No required minimum distributions need be made. PLEDGING A ROTH IRA AS COLLATERAL As with a regular IRA, if a Roth IRA is pledged as collateral, the amount pledged is treated as a distribution, and taxed as one. ROTH IRA DISTRIBUTIONS AT DEATH Since Roth IRAs are not subject to minimum distribution rules, the rules applying to traditional IRAs that have begun minimum distributions prior to the owner s death do not 68

69 have any applicability to Roth IRAs. However, the IRA rules that apply to beneficiaries who may continue IRAs after the death of the IRA holder do apply to Roth IRAs. Therefore, a spouse can continue a Roth IRA at the death of the original Roth IRA holder if the spouse was named as designated beneficiary. A non-spouse beneficiary must receive the distribution within five years after the death of the Roth IRA holder, or may take the distribution over the beneficiary s life or life expectancy if the beneficiary starts the distribution no later than one year after the date of the Roth IRA holder s death. ROTH IRA DISTRIBUTIONS DUE TO DIVORCE Distributions from a Roth IRA due to divorce are treated just as those from regular IRAs. The receiving spouse may be able to transfer the proceeds to his or her own Roth IRA as long as the distribution meets the requirements of the tax code: 1. The distribution is made to the credit of the receiving spouse. 2. The distribution is made according to a Qualified Domestic Relations Order (QDRO). 3. The same property received in the distribution, if any, is rolled over. ROLLOVER RULES OF THE ROTH IRA Remember that rollovers are a method of moving moneys from one IRA plan to an eligible retirement plan without creating a taxable transaction, as was discussed in Chapter Six. A rollover is completed when a distribution is made from an IRA plan to the IRA holder and is placed in an eligible retirement plan within sixty days of the distribution. ROLLOVERS FROM A ROTH IRA TO A ROTH IRA Rollovers may be made from one Roth IRA to another Roth IRA. One rollover may be made from a plan each tax year. If more than one Roth IRA is held the rules allow for a distribution from each separate plan to be rolled to another Roth IRA. ROLLOVERS FROM A TRADITIONAL IRA TO A ROTH IRA Generally, when a distribution from a traditional IRA is rolled to a Roth IRA, the portion of the distribution attributable to earnings and to deductible contributions is includible in the gross income of the IRA holder in the year of distribution. For example, Jane Wright has a regular IRA to which she has made $12,000 in deductible contributions. The IRA includes $2000 in earnings. Normally, she would be taxed on distributions from this regular IRA when she begins taking distributions, e.g., at retirement. If, rather than keeping the amounts in the regular IRA, she distributes the entire amount and rolls it to a Roth IRA, she would have to include $14,000 in gross income for that tax year. When she begins taking distributions from this Roth IRA, she will not have any tax liability related to the distributions, as long as the distribution is a qualified distribution. QUALIFIED PLAN AFTER-TAX ROTH-IRA CONTRIBUTIONS The Economic Growth and Tax Relief Reconciliation Act of 2001 allowed certain qualified plans to treat elective deferrals made by employees as after-tax Roth IRA contributions. 401(k) and 403(b) plans may, after 2005, include a qualified Roth contribution program. If the employer includes this program, the employer must establish a designated Roth 69

70 account for each employee. The employee may then elect to make designated Roth contributions to their designated Roth account. A qualified Roth contribution program gives participants in qualified plans the ability to take advantage of the tax treatment applicable to Roth IRAs. Without such a program in place, distributions from 401(k) and 403(b) plans are taxed just like distributions from a regular IRA: generally taxable upon withdrawal. The distributions made from a designated Roth account will be taxed like Roth IRAs; distributions will generally be received tax-free. Maximum Designated Roth Contribution Amounts The maximum amount that an employee may elect to place in their designated Roth account is equal to the maximum elective deferral amount applicable to the qualified plan. In 2015, the maximum amount is $18,000. This amount is subject to adjustment for inflation. Qualified Distributions from Designated Roth Accounts Qualified distributions from a designated Roth account will not be includable in the employee s taxable income. Qualified distributions: must be made after five tax years beginning with the earlier of (1) the first tax year the individual made a designated Roth contribution to the employer plan currently covering the employee, or (2) the first tax year the individual made a designated Roth contribution to a previous employer plan, if a rollover from that plan established the designated Roth account for the employee under his or her current plan; and must be made on or after the date on which the employee reaches age 59 ½; or must be made to a beneficiary or the employee s estate on or after the death of the employee; or must be attributable to the employee s disability. Rollovers from Designated Roth Accounts Rollovers from designated Roth accounts will only be able to be made to another designated Roth account within an employer plan, or to a Roth IRA. The employee will not be able to roll these amounts to a qualified plan that does not include a qualified Roth contribution program, nor to a regular IRA. SUMMARY As long as a withdrawal from a Roth IRA is a qualified distribution, it is received income tax-free. Roth IRAs are not subject to the required minimum distribution rules to which regular IRAs are subject. Non-qualified Roth IRA distributions are taxed as though contributions are received before earnings. If a Roth IRA is pledged as collateral, the amount pledged is considered a distribution, and taxed accordingly. Rollovers may be made from a Roth IRA to a Roth IRA 70

71 Rollovers may be made from a regular IRA to a Roth IRA, but generally, deductible contributions and earnings of the regular IRA must be included in gross income in the tax year the rollover is made. 401(k) and 403(b) plans are able to establish qualified Roth contribution programs. 71

72 SEC. 408A. ROTH IRAS. (a) General rule. Except as provided in this section, a Roth IRA shall be treated for purposes of this title in the same manner as an individual retirement plan. (b) Roth IRA. For purposes of this title, the term Roth IRA means an individual retirement plan (as defined in section 7701(a)(37) which is designated (in such manner as the Secretary may prescribe) at the time of establishment of the plan as a Roth IRA. Such designations shall be made in such manner as the Secretary may prescribe. (c) Treatment of contributions. (1) No deduction allowed. No deduction shall be allowed under section 219 for a contribution to a Roth IRA. (2) Contribution limit. The aggregate amount of contributions for any taxable year to all Roth IRAs maintained for the benefit of an individual shall not exceed the excess (if any) of (A) the maximum amount allowable as a deduction under section 219 with respect to such individual for such taxable year (computed without regard to subsection (d)(1)or (g) of such section), over (B) the aggregate amount of contributions for such taxable year to all other individual retirement plans (other than Roth IRAs) maintained for the benefit of the individual. (3) Limits based on modified adjusted gross income. (A) Dollar limit. The amount determined under paragraph (2) for taxable year shall be reduced (but not below zero) by the amount which bears the same ratio to such amount as- - (i) the excess of-- (I) the taxpayer s adjusted gross income for such taxable year, over (II) the applicable dollar amount bears to (ii) $15,000 ($10,000 in the case of a joint return) The rules of subparagraphs (B) and (C) of section 219(g)(2) shall apply to any reduction under this subparagraph. (B) Rollover from IRA. A taxpayer shall not be allowed to make a qualified rollover to a Roth IRA from an individual retirement plan other than a Roth IRA during any taxable year if (i)the taxpayer s adjusted gross income for such taxable year exceeds $100,000, or (ii)the taxpayer is a married individual filing a separate return. C) Definitions. For purposes of this paragraph (i) adjusted gross income shall be determined in the same manner as under section 219(g)(3), except that any amount included in gross income under subsection(d)(3) shall not be taken into account and the deduction under section 219 shall be taken into account, and (ii) the applicable dollar amount is-- (I) in the case of a taxpayer filing a joint return, $150,000 (II) in the case of any other taxpayer (other than a married individual filing a separate return), $95,000 and (III) in the case of a married individual filing a separate return, zero. (D) Marital status. Section 219(g)(4) shall apply for purposes of this paragraph. (4)Contributions permitted after age 70½. Contributions to a Roth IRA may be made even 72

73 after the individual for whom the account is maintained has attained age 70 ½. (5)Mandatory distribution rules not to apply before death. Notwithstanding subsections (a)(6) and (b)(3) of section 408 (relating to required distributions), the following provisions shall not apply to any Roth IRA: (A)Section 401(a)(9)(A). (B)The incidental death benefit requirements of section 401(a). (6)Rollover contributions. (A)In general. No rollover contribution may be made to a Roth IRA unless it is a qualified rollover contribution. B)Coordination with limit. A qualified rollover contribution shall not be taken into account for purposes of paragraph (2). (7) Time when contributions made. For purposes of this section, the rule of Section 219(f)(3) shall apply. (d)distribution rules. For purposes of this title-- (1) General rules. (A) Exclusions from gross income. Any qualified distribution from a Roth IRA shall not be includible in gross income. (B) Non-qualified distributions. In applying section 72 to any distribution from a Roth IRA which is not a qualified distribution shall be treated as made from contributions to the Roth IRA to the extent that such distribution, when added to all previous distributions from the Roth IRA, does not exceed the aggregate amount of contributions to the Roth IRA. (2) Qualified distribution. For purposes of this sub-section-- (A) In general. The term qualified distribution means any payment or distribution (i) made on or after the date on which the individual attains age 59½, (ii) made to a beneficiary (or to the estate of the individual) on or after the death of the individual, (iii) attributable to the individual s being disabled (within the meaning of section 72(m)(7)), or (iv) which is a qualified special purpose distribution (B) Certain distributions within 5 years. A payment or distribution shall not be treated as a qualified distribution under subparagraph(a) if (i)it is made within the 5-taxable year period beginning with the 1st taxable year for which the individual made a contribution to a Roth IRA (or such individual s spouse made a contribution to a Roth IRA) established for such individual. or (ii)in the ease of a payment or distribution properly allocable (as determined in the manner prescribed by the Secretary) to a qualified rollover contribution other than a Roth IRA (or income allocable thereto), it is made within the 5-taxable year period beginning with the taxable year in which the rollover contribution was made. (3)Rollovers from an IRA other than a Roth IRA. (A)In general. Notwithstanding section 408(d)(3), in the case of any distribution to which this paragraph applies-- (i) there shall be included in gross income any amount which would be includible were it not part of a qualified rollover contribution, (ii) section 72(t) shall not apply, and (iii) in the case of a distribution before January 1, 1999, any amount required to be 73

74 included in gross income by reason of this paragraph shall be so included ratably over the 4-taxable year period beginning with the taxable year in which the payment or distribution is made. (B) Distributions to which paragraph applies. This paragraph shall apply to a distribution from an individual retirement plan (other than a Roth IRA) maintained for the benefit of an individual which is contributed to a Roth IRA maintained for the benefit of such individual in a qualified rollover contribution. (C) Conversions. The conversion of an individual retirement plan (other than a Roth IRA) to a Roth IRA shall be treated for purposes of this paragraph as a distribution to which this paragraph applies. (D) Conversion of Excess Contributions. If, no later than the due date for filing the return of tax for taxable year (without regard to extensions), an individual transfers, from an individual retirement plan (other than a Roth IRA), contributions for such taxable year (and any earnings allocable thereto) to a Roth IRA, no such amount shall be includible in gross income to the extent no deduction was allowed with respect to such amount. (E) Additional reporting requirements. Trustees of Roth IRAs, trustees of individual retirement plans, or both, whichever is appropriate, shall include such additional information in reports required under section 408(i) as the Secretary may require to ensure that amounts required to be included in gross income under subparagraph (A) are so included. (4) Coordination with individual retirement accounts. Section 408(d)(2) shall be applied separately with respect to Roth IRAs and other individual retirement plans. (5) Qualified special purpose distribution. For purposes of this section, the term qualified special purpose distribution means any distribution to which subparagraph (F) of section 72(t)(2) applies. (e) Qualified rollover contribution. For purposes of this section, the term qualified rollover contribution means a rollover contribution to a Roth IRA from another such account, or from an individual retirement 131an, but only if such rollover contribution meets the requirements of section 408(d)(3). Such term includes a rollover contribution described in section 402A(c)(3)(A). For purposes of section 408(d)(3)(B), there shall be disregarded any qualified rollover contribution from an individual retirement plan (other than a Roth IRA) to a Roth IRA. SEC. 402A. OPTIONAL TREATMENT OF ELECTIVE DEFERRALS AS ROTH CONTRIBUTIONS. (a) General rule. If an applicable retirement plan includes a qualified Roth contributions program-- (1) any designated Roth contribution made by an employee pursuant to the program shall be treated as an elective deferral for purposes of this chapter, except that such contribution shall not be excludable from gross income, and (2) such plan (and any arrangement which is part of such a plan) shall not be treated as failing to meet any requirement of this chapter solely by reason of including such program. (b) Qualified Roth contribution program. For purposes of this section-- (1) In general. The term qualified Rot contribution program means a program under which an employee may elect to make designated Roth contributions in lieu of all or a portion of elective deferrals the employee is otherwise eligible to make under the applicable retirement plan. (2) Separate accounting required. A program shall not be treated as a qualified Roth contribution program unless the applicable retirement plan (A) establishes separate accounts ( designated Roth accounts ) for the designated Roth contributions of each employee and any earnings properly allocable to the contributions, and 74

75 (B) maintains separate recordkeeping with respect to each account. (d) Definitions and rules relating to designated Roth contributions. For purposes of this section (1) Designated Roth contribution. The term designated Roth contribution: means any elective deferral which-- (A) is excludable from gross income of an employee without regard to this section, and (B) maintains separate recordkeeping with respect to each account. (2)Designation limits. The amount of elective deferrals which an employee may designate under paragraph (1) shall not exceed the excess (if any) of (A) the maximum amount of elective deferrals excludable from gross income of the employee for the taxable year (without regard to this section), over (B) the aggregate amount of elective deferrals of the employee for the taxable year which the employee does not designate under paragraph (1). (3) Rollover contributions. (A) In general. A rollover contribution of any payment or distribution from a designated Roth account which is otherwise allowable under this chapter may be made only if the contribution is to (i) another designated Roth account of the individual from whose account the payment or distribution was made, or (ii) a Roth IRA of such individual. (B) Coordination with limit. Any rollover contribution to a designated Roth account under subparagraph (A) shall not be taken into account for purposes of paragraph (1). (e) Distribution rules. For purposes of this title (1) Exclusion. Any qualified distribution from a designated Roth account shall not be includible in gross income. (2) Qualified distribution. For purposes of this subsection-- (A) In general. The term qualified distribution has the meaning given such term by section 408A(d)(2)(A) (without regard to clause (iv) thereof). (B) Distributions within nonexclusion period. A payment or distribution from a designated Roth account shall not be treated as a qualified distribution if such payment or distribution is made within the 5-taxable-year period beginning with the earlier of-- (i) the first taxable year for which the individual made a designated Roth contribution to any designated Roth account established for such individual under the same applicable retirement plan, or (ii) if a rollover contribution was made to such designated Roth account from a designated Roth account previously established for such individual under another applicable retirement plan, the first taxable year for which the individual made a designated Roth contribution to such previously established account. (C) Distributions of excess deferrals and contributions and earnings thereon. The term qualified distribution shall not include any distribution of any excess deferral under section 402(g)(2) or any excess contribution under section 401(k)(8), and any income on the excess deferral or contribution. (3) Treatment of distributions of certain excess deferrals. Notwithstanding section 72, if any excess deferral under section 402(g)(2) attributable to a designated Roth contribution is not distributed on or before the 1 st April 15 following the close of the taxable year in which such excess deferral is made, the amount of such excess deferral shall-- 75

76 (A) not be treated as investment in the contract, and (B) be included in gross income for the taxable year in which such excess is distributed. (4) Aggregation rules. Section 72 shall be applied separately with respect to distributions and payments from a designated Roth account and other distributions and payments from the plan. (f) Other definitions. For purposes of this section-- (1) Applicable retirement plan. The term applicable retirement plan means- (A) an employees trust described in section 401(a) which is exempt from tax under section 501(a), and (B) a plan under which amounts are contributed by an individual s employer for an annuity contract described in section 403(b). (2) Elective deferral. The term elective deferral means any elective deferral described in subparagraph (A) or (C) of section 402(g)(3). 76

77 CHAPTER TEN: COMPARISON OF THE ROTH AND REGULAR IRAS FEATURES COMPARISON A comparison of the features of regular and Roth IRAs is found in Exhibit Each of these features was covered in detail in preceding chapters. TAXATION COMPARISON As can be seen, there are many differences in the features of these two IRA types. But what is the significance of these differences to the individual? Perhaps the most important differences result in an impact on taxation. Assume a single individual, Angela Banding, age 35, wants to maximize her IRA contribution annually. We will look at three versions of this scenario. First, assume she is in the 15% tax bracket today and will be when she retires. Then, assume she is in the 25% tax bracket and will be in the 15% tax bracket when she retires. Finally, assume she distributes some of her retirement funds prior to age 59 ½ and the rest after age 59 ½. 15% Tax Bracket Today and At Retirement Assume Angela makes a $4000 contribution to a regular IRA for 30 years and earns 8% on the contributions during this time. She starts taking $22,000 annually starting at age 65, continuing until age 85. She continues to earn interest of 8% during this distribution period. She is in a 15% tax bracket today and assumes she will remain in a 15% tax bracket at retirement. Tax paid on compensation to yield $4000 contribution, years 1-30: $18,000 Tax deduction years 1-30: $18,000 Tax paid years 31-50: $63,000 Net Taxation: $63,000 Assume the same facts, but that the contributions are instead made to a Roth IRA. Tax paid on compensation to yield $4000 contribution, years 1-30: $18,000 Tax deduction years 1-30: $0 Tax paid years 31-50: $0 Net Taxation: $18,000 77

78 Exhibit 10.1 Comparison of Regular and Roth IRA Features Feature Regular IRA Roth IRA Eligibility Eligibility Phaseout Contribution Maximum All persons under 70 ½ who have compensation None to make contributions. Deductible contributions eligibility phased out based on agi. The smaller of $5500 ( ) or 100% of compensation, Catch-up contributions of $1000 in 2006 and thereafter. All persons who have compensation. Between agi of $183,000 to $193,000 for taxpayers married filing jointly. Between agi of $116,000 to $131,000 The smaller of $5500 ( ) or 100% of compensation, Catch-up contributions of $1000 in 2006 and thereafter. Contribution Maximum Age 70½ None Non-Earner Spouse IRA Taxation of Earnings While In IRA Mandatory Distributions Taxation of Distributions Minimum Holding Period Without Tax Penalty Yes, maximum of $5500 (increases using same schedule as non-spousal IRA) No taxation while earnings remain in IRA. Must begin the year following age 70½, prior to 59½, additional tax applies Deductible contributions and all earnings taxable when withdrawn. Unless an exception to premature distribution penalty, to age 59½. Yes, maximum of $5500 (increases using same schedule as nonspousal Roth IRA) No taxation while earnings remain in IRA. No mandatory distributions. If a qualified distribution, distributions are tax-free. If a nonqualified distribution, contributions are considered to be withdrawn first and are not taxable. Earnings within a qualified distribution are taxable. 5 years if a qualified distribution, or if due to death, disability or reaching age 59 ½. Prohibited Investments Life insurance, most collectibles Life insurance, most collectibles Rollovers Allowed Regular IRA to eligible retirement plan. Regular IRA to Roth IRA rollovers have current taxation ramifications. Roth IRA to Roth IRA 25% Tax Bracket Today and 15% At Retirement Assume the same facts as above, except that Angela is in a 25% tax bracket today and will be in a 15% tax bracket at retirement. First, assume the contributions are made to a regular IRA. 78

79 Tax paid on compensation to yield $4000 contribution, years 1-30: $30,000 Tax deduction years 1-30: $30,000 Tax paid years 31-50: $63,000 Net Taxation: $63,000 Assume the contributions are instead made to a Roth IRA. Tax paid on compensation to yield $4000 contribution, years 1-30: $30,000 Tax deduction years 1-30: $0 Tax paid years 31-50: $0 Net Taxation: $30,000 Distributes Half Her IRA at Age 50, Remainder at Age 65. Assume Angela is in a 15% tax bracket before and after retirement. She takes half her IRA as a distribution at age 50, and the remainder at age 65. She continues to contribute to the IRA until age 65. Regular IRA: Tax paid on compensation to yield $4000 contribution, years 1-30: $18,000 Tax deduction years 1-30: $18,000 Tax paid on distribution year 15: $14,662 (includes 10% premature distribution tax) Tax paid on distribution year 30: $45,501 Net Taxation: $60,163 Roth IRA: Tax paid on compensation to yield $4000 contribution, years 1-30: $18,000 Tax deduction years 1-30: 0 Tax paid on distribution year 15: 0 (distribution consists of all contributions) Tax paid on distribution year 30: 0 Net Taxation: $18,000 Net Taxation: $18,000 From these examples, it becomes apparent that the Roth IRA is more beneficial from a tax standpoint than the regular IRA when one compares contributing to either IRA from the establishment of the IRA and holds the IRA until after age 59 ½. And if contributions only are distributed prior to 59 ½, under current tax rules, the Roth IRA also comes out better from a tax standpoint than the regular IRA. What about converting from a regular IRA to a Roth IRA. For whom does this make financial sense? The important issue in this decision is that tax must be paid on any deductible contributions and earnings at the time of conversion. The tax must be paid in the year the conversion is completed. So the question becomes, will the overall tax burden be smaller by paying taxes today on the earnings and deductible contributions than if paid at retirement? 79

80 Assume Kevin Long is 45. He is now in the 25% tax bracket, but at the lower end, and so assumes he will be in the 15% tax bracket at retirement. He has contributed $2000 annually for ten years to his regular IRA, $1800 of which was deductible each year. The IRA has earned 10% over this period. What if he converts his regular IRA to a Roth IRA? Amount contributed: $20,000 Amount of deductible contributions: $18,000 Earnings: $15,000 Tax Due at Conversion: $8250 ($33,000 x 25%) If he holds the now Roth IRA until after 59½, or after five years and it is a qualified distribution, or distributes it due to death or disability, no more tax will be due. What if he does not convert to a Roth IRA? Rather, he starts making contributions to a Roth IRA at age 45, and leaves his regular IRA to earn 10% until age 65: Amount contributed: $20,000 Amount of deductible contributions: $18,000 Earnings: $15,000 Tax Due at Retirement: $36,800 (($18,000 deductible contributions + $227,337 earnings) x 15%) If Kevin were closer to retirement, or would be earning a lower rate on his IRA funds, the tax due in the second scenario may not be as significant. He also is not likely to pay the tax due at retirement in one lump sum, but will pay it over time as he receives income from the IRA. WHEN WILL A REGULAR IRA BE USED? Despite the way the Roth IRA s taxation pencils out as better from a tax standpoint than a Regular IRA in many circumstances, some individuals will still prefer to contribute to a regular IRA, particularly if they are eligible for a tax deduction. Such an individual tends to view the immediate tax-deduction of the regular-ira as a known tax benefit, and the prospect of tax-free withdrawals as an unknown. Retirement may be several years away, giving lots of time for tax rules to change. A common perspective of a person making this decision is that the government can take away anything the government has given. If the Roth IRA tax rules do change, the contributions already made may be given grandfathered tax treatment. This means that up until any tax change, contributions made would be taxed at distribution under the rules that applied to those contributions at the time they were made. It is hard to know what future legislation may do to either the Roth-IRA or the regular IRA rules. [Note: Some in the tax profession believe the taxation of non-qualified distributions is more likely to be changed than the tax-free treatment of qualified distributions. Congress has changed the taxation of withdrawals from tax-advantaged plans in the past. Annuity withdrawals were originally taxed as if contributions were withdrawn first, but were 80

81 changed to being taxed as though earnings are withdrawn first. The tax treatment of Roth non-qualified distributions is currently a unique advantage among tax-advantaged plans. ] Regular IRAs and Qualified Plan Distributions Regular IRAs will continue to be opened to accept qualified plan distributions. Qualified plan rollovers have historically made up a large portion of regular IRA savings, and will continue to do so. The financial professional will need to continue to have an understanding of the regular IRA along with Roth IRA rules to serve clients who are both saving for retirement and planning to distribute retirement income. 81

82 CHAPTER ELEVEN: THE COVERDELL ESA The Taxpayer Relief Act of 1997 created a new college savings vehicle - the Education IRA. Though the name of this vehicle included the term IRA, it is not a retirement savings plan. It is actually a trust created for the purpose of paying trust beneficiaries education expenses. In 2001, the name of the plan was changed to the Coverdell Education Savings Account, or the Coverdell ESA. Generally, this plan allows $2000 per beneficiary to be placed in the Coverdell ESA annually. The beneficiary receives the proceeds from the Coverdell ESA without income taxation as long as they are used to pay higher education expenses in the manner required by the Act. Coverdell ESAs were originally designed to pay for higher education expenses only. Under the Economic Growth and Tax Relief Reconciliation Act of 2001, they may also be used to pay for qualified elementary and secondary school expenses. ACCUMULATING ASSETS FOR A COLLEGE EDUCATION Saving for college is an important use of Coverdell ESAs. A college education is a requirement for many jobs, and if this trend continues, will be a requirement for even more jobs in the future. This is one reason so many parents and grandparents are concerned with putting away money for their children or grandchildren s college education. Another compelling reason is the earnings gap cited by the US Census Bureau between those who have a college degree and those who have only a high school diploma. The Census Bureau data states that in 2013, the following median amounts were earned by those 25 and over in a 12 month period, by level of education: Cost of A College Education Population 25 years and over with earnings $35,644 Less than high school graduate 19,652 High school graduate (includes equivalency) 27,528 Some college or associate s degree 33,702 Bachelor s degree 50,254 Graduate or professional degree 66,493 Source: U.S. Census Bureau, Year American Community Survey College expenses are increasing faster than the inflation rate. They are expected to increase at a pace of about seven percent annually. Both public and private school tuition are experiencing this staggering growth. Currently, a public, four-year, in-state college or university education costs about $8000 a year, including tuition, fees, room and board. Private universities have costs of about $18,000, with elite school expenses as high as $25,000 annually. 82

83 Using a figure of $10,000 annually, and a rate of increase of 7% annually, the table below shows the potential cost of a four year degree over the next twenty years. Exhibit Potential Increase in Annual College Expenses Today End of Year 1 End of Year 2 End of Year 3 End of Year 4 End of Year 5 End of Year 6 End of Year 7 End of Year 8 End of Year 9 End of Year 10 End of Year 11 End of Year 12 End of Year 13 End of Year 14 End of Year 15 End of Year 16 End of Year 17 End of Year 18 End of Year 19 End of Year 20 $10,000 $10,700 $11,449 $12,250 $13,108 $14,026 $15,007 $16,058 $17,182 $18,385 $19,672 $21,049 $22,522 $24,098 $25,785 $27,590 $29,522 $31,588 $33,799 $36,165 $38,697 These figures point out the importance of beginning a college savings program early so that savings have an opportunity to accumulate for this goal. The Coverdell ESA provides a taxadvantaged method to reach this end. ADVANTAGES OF THE COVERDELL ESA Tax-Free Withdrawals Coverdell ESAs eliminate the tax-bite from college savings. If $2000 is placed into an Coverdell ESA for 18 years, and the IRA earns 10%, the beneficiary will save over $9600 in income taxes, assuming a 15% tax rate, when compared to a taxable savings account. Availability The Coverdell ESA does not require that the contributor earn compensation, as the regular and Roth IRAs do. Although contributions are subject to eligibility limits based on adjusted gross income, they are available to a large segment of the population. Ability to Make Rollovers Rollovers may be made from an Coverdell ESA to another Coverdell ESA. Under certain conditions, they may even be rolled over to a different beneficiary s Coverdell ESA. 83

84 CONTRIBUTION AND ELIGIBILITY RULES OF THE COVERDELL ESA Eligibility Anyone can make a contribution to an Coverdell ESA who has an adjusted gross income under certain levels. The ability to make contributions phases out for single taxpayers at a modified adjusted gross income between $95,000 and $110,000. Contributions by taxpayers filing a joint return are phased out at a modified adjusted gross income between $190,000 and $220,000. These phase-out levels do not apply to corporations and other entities, only to individuals. Corporations and other entities may make contributions to Coverdell ESAs, regardless of their earnings or net income. Contributions Contributions to Coverdell ESAs must be made in cash, like contributions to other IRA products. They are limited to a maximum of $2000 per beneficiary, and must not generally be made to the trust for the benefit of a beneficiary who has reached age 18. However, this age 18 rule does not apply if the beneficiary has special needs. Qualified State Tuition Programs Prior to the Economic Growth and Tax Relief Reconciliation Act of 2001, if a contribution was made to a qualified state tuition program during a tax year for a beneficiary, no contribution could be made to an Coverdell ESA during that same tax year for that beneficiary. However, after 2001, this prohibition no longer applies. Contributions may be made to both Coverdell ESAs and Qualified State Tuition Programs in the same tax year. A qualified state tuition program provides a vehicle to accumulate college funds tax-free. It is a program established and maintained by a state, or an agency or instrumentality of a state, which allows a person to purchase tuition credits or certificates for a designated beneficiary, or to make cash contributions to an account that will be used to pay the qualified higher education of a beneficiary. In order to be considered a qualified state tuition program, several conditions must be met. For example, penalties for withdrawal of earnings: that are not used for qualified higher education expenses, or that are not withdrawn due to the death or disability of the beneficiary, or that are not withdrawn because of the receipt of certain scholarship money, must be part of the state tuition program rules. Qualified state tuition program distributions are generally received tax free if they are used for higher education expenses. Coverdell ESA Investments Coverdell ESA moneys may not be placed in life insurance. Excess Contributions to Coverdell ESAs A six percent excise tax is applied to excess contributions to Coverdell ESAs. Generally, an excess contribution is one exceeding the maximum Coverdell ESA contribution limit for the tax year. If the excess contribution is returned prior to the contributor s tax due date, it will not be charged the excise tax. 84

85 DISTRIBUTIONS FROM COVERDELL ESAS Like the Roth IRA, distributions from Coverdell ESAs are generally tax-free. Herein lies the great advantage of the tool. However, certain rules must be followed in order for an Coverdell ESA distribution to be tax-free. Tax-free distributions must generally be for the payment of qualified education expenses. Qualified education expenses include qualified elementary and secondary education expenses and qualified higher education expenses. Qualified higher education expenses are defined in IRC section 529 (e)(3): (3) Qualified higher education expenses. (A) In general. The term qualified higher education expenses means-- (i) tuition, fees, books, supplies, and equipment required for the enrollment or attendance of a designated beneficiary at an eligible educational institution; and (ii) expenses for special needs services in the case of a special needs beneficiary which are incurred in connection with such enrollment or attendance. (B) Room and board included for students under guaranteed plans who are at least half-time. Qualified elementary and secondary education expenses are defined in Code Section 530(b)(4). (A) In general. The term qualified elementary and secondary education expenses means (i) expenses for tuition, fees, academic tutoring, special needs services in the case of a special needs beneficiary, books, supplies, and other equipment which are incurred in connection with the enrollment or attendance of the designated beneficiary of the trust as an elementary or secondary school student at a public, private, or religious school. (ii) expenses for room and board, uniforms, transportation, and supplementary items and services (including extended day programs) which are required or provided by a public, private, or religious school in connection with such enrollment or attendance, and (iii) expenses for the purchase of any computer technology or equipment (as defined in section 170(e)(6)(F)(i) or Internet access and related services, if such technology equipment, or services are to be used by the beneficiary and the beneficiary s family during any of the years the beneficiary is in school. Clause (iii) shall not include expenses for computer software designed for sports, games, or hobbies unless the software is predominantly educational in nature. If a distribution exceeds qualified education expenses in a tax year, the earnings portion of the distribution is taxed. The taxable portion is determined using the following formula: (amount used for qualified education expenses / amount distributed ) x earnings in the distribution For example, assume Brad Holmes has qualified education expenses of $8000. A distribution of $10,000 is made from his Coverdell ESA. The earnings portion of the distribution is $2000. Calculating the taxable portion of this distribution is done as follows: 1. Determine the ratio of the qualified education expenses to the distribution: 85

86 $2000 / $8000 = Multiply the result by the earnings portion of the distribution: $2000 x.25 = $500 Five hundred dollars is the taxable portion of Brad s distribution. HOPE and Lifetime Learning Credits Prior to the passing of the Economic Growth and Tax Relief Reconciliation Act of 2001, if a distribution was made from an Coverdell ESA for a designated beneficiary in any tax year, neither a HOPE or Lifetime Learning Credit could be taken for the expenses of that beneficiary during the same tax year. After 2001, this prohibition is amended so that a HOPE or a Lifetime Learning Credit may be taken in the same year as an exclusion from income due to an Coverdell ESA distribution. Additional Tax on Distributions A 10% tax is imposed on certain distributions. The tax is imposed on the portion of the distribution includible in income. This 10% additional distribution tax is applied to any taxable distribution that is not: Due to the death of the designated beneficiary. To qualify under this exception, the distribution must be made to a beneficiary or the estate of the designated beneficiary. Due to the designated beneficiary s disability, or Due to certain scholarships, education assistance allowances or payments which are excludable from gross income under other laws of the US. Naming a New Beneficiary A new beneficiary may be named on an Coverdell ESA, as long as the new beneficiary is a member of the original designated beneficiary s family, or the spouse of the designated beneficiary. If a beneficiary were named which did not meet these requirements, the entire value of the Coverdell ESA is treated as a distribution, and the earnings are subject to the 10% additional tax on distributions. Distributions Due to Death Spousal Beneficiary If an Coverdell ESA is transferred to a surviving spouse at the death of the designated beneficiary, the transfer is not taxable. The surviving spouse can be treated as the Coverdell ESA designated beneficiary. Non-Spousal Beneficiary If a non-spouse receives the distribution upon the death of a designated beneficiary, the Coverdell ESA ceases to be considered an Coverdell ESA. The fair-market value of the IRA is included in the gross income of the non-spouse beneficiary in the tax year which includes the date of the Coverdell ESA designated beneficiary s death. 86

87 Distributions Due to Divorce Distributions from a Coverdell ESA under a divorce decree or separation agreement are not taxable. ROLLOVERS FROM AN COVERDELL ESA TO AN COVERDELL ESA Rollovers may be made from an Coverdell ESA to an Coverdell ESA if the rollover is made to an Coverdell ESA for the same designated beneficiary, or a member of the designated beneficiary s family, or the designated beneficiary s spouse. Like other IRA rollovers, the rollover must be completed within sixty days. TERMINATION OF COVERDELL ESAS Generally, a Coverdell ESA terminates when the designated beneficiary reaches age 30. Any remaining balance is taxable at this time, and the earnings are subject to the additional 10% tax. There is an exception to the age 30 Rule for beneficiaries who have special needs. Coverdell ESAs for beneficiaries with special needs may continue after the beneficiary s age 30, and will not be deemed distributed for tax purposes. SUMMARY Coverdell ESAs provide tax-free withdrawals for qualified education expenses. Eligibility to contribute to an Coverdell ESA phases out at certain adjusted gross income levels for individuals. The phase-out levels do not apply to corporations and other entities. The maximum amount that may be contributed for each beneficiary is $2000. Certain distributions are subject to an additional 10% tax. Rollovers may be made from Coverdell ESA to Coverdell ESA. Coverdell ESAs must generally terminate when the designated beneficiary reaches age 30. There is an exception for beneficiaries with special needs, however. 87

88 SEC EDUCATION INDIVIDUAL RETIREMENT ACCOUNTS. (a) General rule. An education individual retirement account shall be exempt from taxation under this subtitle. Notwithstanding the preceding sentence, the education individual retirement account shall be subject to the taxes imposed by section 511 (relating to imposition of tax on unrelated business income of charitable organizations). (b) Definitions and special rules. For purposes of this section (1) Education individual retirement account. The term education individual retirement account means a trust created or organized in the United States exclusively for the qualified higher education expenses of designated as an education individual retirement time at the time created or organized), but only if the written governing instrument creating the trust meets the following requirements: (A) No contribution will be accepted (i) unless it is in cash (ii) after the date on which such beneficiary attains age 18, or (iii) except in the case of rollover contributions, if such contribution would result in aggregate contributions for the taxable year exceeding $500. (B) The trustee is a bank (as defined in section 408(n)) or another person who demonstrates to the satisfaction of the Secretary that the manner in which that person will administer the trust will be consistent with the requirements of this section or who has so demonstrated with respect to any individual retirement plan. (C) No part of the trust assets will be invested in life insurance contracts. (D) The assets of the trust shall not be commingled with other property. except in a common trust fund for common investment fund. (E) Upon the death of the designated beneficiary, any balance to the credit of the beneficiary shall be distributed within 30 days after the date of death to the estate of such beneficiary. (2)Qualified education expenses (A) In general. The term qualified education expenses means (i) qualified higher education expenses ( as defined in section 529(e)(3)), and (ii) qualified elementary and secondary education expenses (as defined in paragraph (4)). (B) Qualified state tuition programs. Such term shall include any contribution to a qualified tuition program (as defined in section 529(b) on behalf of the designated beneficiary (as defined in section 529(e)(1)); but there shall be no increase in the investment in the contract for purposes of applying section 72 by reason of any portion of such contribution which is not includible in gross income by reason of subsection (d)(2). (3)Eligible educational institution. The term eligible educational institution has the meaning given such term by section 529(e)(5). (4) Qualified elementary and secondary education expenses. (A) In general. The term qualified elementary and secondary education expenses means (i) expenses for tuition, fees, academic tutoring, special needs services in the case of a special needs beneficiary, books, supplies, and other equipment which are incurred in connection with 88

89 the enrollment or attendance of the designated beneficiary of the trust as an elementary or secondary school student at a public, private, or religious school. (ii) expenses for room and board, uniforms, transportation, and supplementary items and services (including extended day programs) which are required or provided by a public, private, or religious school in connection with such enrollment or attendance, and (iii) expenses for the purchase of any computer technology or equipment (as defined in section 170(e)(6)(F)(i) or Internet access and related services, if such technology equipment, or services are to be used by the beneficiary and the beneficiary s family during any of the years the beneficiary is in school. Clause (iii) shall not include expenses for computer software designed for sports, games, or hobbies unless the software is predominantly educational in nature. (5) Time when contributions deemed made. An individual shall be deemed to have made a contribution to an education individual retirement account on the last day of the preceding taxable year if the contribution is made on account of such taxable year and is made not later than the time prescribed by law for filing the return for such taxable year (not including extensions thereof). (c) Reduction in permitted contributions based on adjusted gross income. (1) In general. The maximum amount which a contributor who is an individual, the maximum amount the contribution could otherwise make to an account under this section shall be reduced by an amount which bears the same ratio to such maximum amount as (A) the excess of- (i) the contributor's modified adjusted gross income for such taxable year, over (ii) $95,000 ($190,000 in the case of a joint return), bears to (B) $15,000 ($30,000 in the case of a joint return), (2) Modified adjusted gross income. For purposes of paragraph (1), the term modified gross income ' means the adjusted gross income of the taxpayer for the taxable year increased by any amount excluded from gross income under section 911, 931, or 933. (d) Tax Treatment of Distributions (1) In general. Any distribution shall be includible in the gross income of the distributee in the manner as provided in section 72(b). (2) Distributions for qualified higher education expenses.-- (A) In general. No amount shall be includible in gross income under paragraph (1) if the qualified higher education expenses of the designated beneficiary during the taxable year are not less than the aggregate distributions during the taxable year. (B) Distributions in excess of expenses. If such aggregate distributions exceed such expenses during the taxable year, the amount otherwise includible in gross income under paragraph (1)shall be reduced by the amount which bears the same ratio to the amount which would be includible in gross income under paragraph (1) (without regard to this subparagraph) as the qualified higher education expenses bear to such aggregate distributions. (C) Coordination with hope and lifetime learning credits and qualified tuition programs. For purposes of subparagraph (A) (i) Credit coordination. The total amount of qualified higher education expenses with respect to an individual for the taxable year shall be reduced-- (I) as provided in section 25A(g)(2), and (II) by the amount of such expenses which were taken into account in determining the credit allowed to the taxpayer or any other person under section 25A. 89

90 (ii) Coordination wit qualified tuition programs. If, with respect to an individual for any taxable year (I) the aggregate distributions during such year to which subparagraph (A) and section 529(c)(3)(B) apply, exceed (II) the total amount of qualified education expenses (after the application of clause (i) for such year, the taxpayer shall allocate such expenses among such distributions for purposes of determining the amount of the exclusion under subparagraph (A) and section 529(c)(3)(B). (D) Disallowance of excluded amounts as deduction, credit or exclusion. No deduction, credit, or exclusion shall be allowed to the taxpayer under any other section of this chapter for any qualified education expenses to the extent taken into account in determining the amount of the exclusion under this paragraph. (3)Special rules for applying estate and gift taxes with respect to account. Rules similar to the rules of paragraphs (2), (4), and (5) of section 529(c) shall apply for purposes of this section. (4)Additional tax for distributions not used for educational expenses.- (A) In general. The tax imposed by this chapter for any taxable year on any taxpayer who receives a payment or distribution from an education individual retirement account which is includible in gross income shall be increased by 10 percent of the amount which is so includible. (B)Exceptions. Subparagraph (A) shall not apply if the payment or distribution is- (i) made to a beneficiary (or to the estate of the designated beneficiary) on or after the death of the designated beneficiary, (ii) attributable to the designated beneficiary s being disabled (within the meaning of section 72(m)(7)), or (iii) made on account of a scholarship, allowance, or payment described in section 25A(g)(2) received by the account holder to the extent the amount of the payment or distribution does not exceed the amount of the scholarship, allowance, or payment. (C) Contributions returned before certain date. Subparagraph (A) shall not apply to the distribution of any contribution made during a taxable year on behalf of a designated beneficiary if- (i) such distribution is made before the first day of the sixth month of the taxable year following the taxable year, and (ii) such distribution is accompanied by the amount of net income attributable to such excess contribution. Any net income described in clause (ii) shall be included in gross income for the taxable year in which such excess contribution was made. (5) Rollover contributions. Paragraph (1) shall not apply to any amount paid or distributed from an education individual retirement account to the extent that the amount received is paid into another individual retirement for the benefit of the same beneficiary or a member of the family (within the meaning of 529(e)(2)) of such beneficiary not later than the 6oth day after the date of such payment or distribution during the 12-month period ending on the date of the payment of distribution. (6) Change in beneficiary. Any change in beneficiary of an education individual retirement account shall not be treated as a distribution for purposes of paragraph (1) if the new beneficiary is a member of the family (as so defined) of the old beneficiary. 90

91 (7) Special rules for death and divorce. Rules similar to the rules of paragraphs (7) and (8) of section 220(f) shall apply. (e)tax Treatment of Accounts. Rules similar to the rules of paragraphs (2) and (4) of section 408(e) shall apply to any education retirement account. (f)community Property Laws. This section shall be applied without regard to any community properly laws. (g)custodial accounts. For purposes of this section, a custodial account shall be treated as a trust if the assets of such account are held by a bank (as defined in section 408(n)) or another person who demonstrates, to the satisfaction of the Secretary, that manner in which he will administer the account will be consistent with the requirements of this section, and if the custodial account would, except for the fact that it is not a trust, constitute an account described in subsection (b)(1). For purposes of this title, in the case of a custodial account treated as a trust by reason of the preceding sentence, the custodial of such account shall be treated as the trustee thereof. (h) Reports. The trustee of an education individual retirement account shall make such reports regarding such account to the Secretary and to the beneficiary of the account with respect to contributions, distributions, such other matters as the Secretary may require. The reports required by this subsection shall be filed at such time and in such manner and furnished to such individuals at such time and in such manner as may be required. 91

92 CHAPTER TWELVE: FEATURES AND BENEFITS OF IRA PRODUCTS AND PLANS Individual Retirement Account funds may be used to purchase a variety of products. This chapter will discuss the features, benefits, advantages and disadvantages of some of these IRA investment choices. These vehicles will commonly be used for the regular IRA, Roth IRA and Coverdell ESA. CERTIFICATES OF DEPOSIT Risk. Bank Certificates of Deposit, or CDs, are one of the most conservative products which could be selected as an IRA vehicle. They are guaranteed by the FDIC up to certain limits and so the risk of losing any of the investment made in the IRA is generally considered negligible if it exists at all. This can be very attractive to people in their retirement years, who want to know that every cent invested will come back to them, and for whom significant opportunity for growth is secondary. Maturities Certificates of deposit come in a wide variety of terms or maturities. CD maturities range from thirty days to ten years. The amount required to open a CD varies, from as little as $50 to as much as $10,000. Some CDs allow additions. These are often variable rate CDs which can have a fluctuating interest rate. Or, the addition may extend the maturity of the CD. Calculation of RMD for Regular IRAs Many banks will provide the service of calculating required minimum distributions and may have the ability to automatically make distributions to the IRA owner. Distribution options are usually limited to the recalculation and non-recalculation methods. Fees. Although banks are charging more and more fees for services, there is often no fee for the administration of an IRA CD, and usually no more than a nominal fee, if any, for the service of calculating and distributing required minimum distributions. However, CDs do have a substantial penalty for early withdrawal if a CD is closed or liquidated prior to maturity. A typical withdrawal charge is three to six months interest, earned or unearned. Many banks waive withdrawal charges on regular IRA CD withdrawals for customers over 59 ½, however. Most CDs do allow withdrawal of interest during the CD term as well. The attraction of the low risk and stability of investment or principal is offset by the relatively low potential for growth. For the younger IRA customer, or the more aggressive investor of any age, a CD cannot meet the desire for potential high growth. 92

93 MUTUAL FUNDS Mutual funds are a very popular IRA vehicle. There are thousands of mutual funds, so virtually every investment option is available, from relatively stable, low risk bond funds to aggressive, high growth stock funds. Diversification Mutual funds are pools of securities purchased for a specific fund objective. The securities may be stocks or bonds, or short term "cash" instruments which are highly liquid. Individuals buy shares in these pooled funds. A key advantage of mutual funds is diversification. Diversification means that since many different securities make up the pool of investments, the risk of poor performance associated with any one of the securities is offset by the performance of other securities in the pool. Types of Mutual Fund Securities Stock securities, or equities, include, among other types, common stocks, preferred stocks, foreign stocks, stocks from small capital companies which represent potential high growth, or stocks from established larger companies which can represent high dividend potential. Bonds may be government issued or corporate issued. Bonds backed by the federal government are considered to have the lowest risk of default, and those from corporations with potential or existing credit problems are considered as having the highest risk. The returns on both stocks and bonds generally reflect their risk level, with the securities with the highest risk generally having the highest earnings or growth potential. Objectives. The investment objective of a mutual fund can include high income from dividends, growth from the increased value of shares, total return, which is the increase in share value from both dividends and growth, stable income, or stable share value, among many, many others. Groups of funds with similar investment objectives, e.g. aggressive growth, have generally accepted suggested investment time frames. A fund with conservative securities and an objective of stable share value will have a shorter suggested investment time frame than an aggressive stock fund whose shares could fluctuate greatly over time. The longer the investment time frame, the less impact any particular market upturn or downturn will have on the overall return of a mutual fund. Loads Mutual funds are either load or no load funds. A load is a sales charge which goes to pay commission to the distributors and sellers of the fund, e.g. a broker. Loaded funds may assess the sales charge as a front or back-end charge, or may distribute the charge over a specified period. Sales charges range from as little as one or two percent to eight or nine percent of the amount invested. Most sales charges are about four to four and one-half percent. In the case of a back end charge, if shares in the fund are liquidated prior to the end of a specified period, e.g. five years, a charge is levied against the amount withdrawn. Therefore, if the shares are held until after the specified period, the sales charge is avoided. 93

94 Fund Families If a mutual fund family is selected with a wide variety of fund options, an IRA investor could ostensibly remain within that mutual fund family for the entire life of his or her IRA. An advantage of staying within one family of funds when a different type of fund is desired is that sales charges are generally not invoked when transferring shares within the same family. Conversely, if a fund were purchased outside of the family, a new sales charge would be incurred, unless a no-load fund was selected. Opening Requirements Many mutual funds allow low monthly automatic investments, such as $50, which can make them attractive to the younger, small investor just beginning to save for retirement. Common, non-monthly opening requirements range from $1000 to $5000. Calculation of RMD for Regular IRAs A mutual fund IRA trustee will generally calculate and make required minimum distributions for an IRA holder. The distribution frequency may be annually or as often as monthly through systematic withdrawals. A systematic withdrawal is a scheduled withdrawal from a product. Some mutual funds charge for the calculation of RMDs at a rate from $10 to $20 per year. Fees The mutual fund IRA trustee will generally charge an annual fee for administration of the IRA. Administration duties include tax reporting, issuing statements, and executing transactions. Typical administration fees range from $10 to $25 dollars. Risk Besides the risks attributable to the types of securities invested in, all mutual funds contain some market risk, meaning that the value of shares in a mutual fund may go up or down. If a distribution must be made when share values are low, the IRA owner may sustain a loss: the share value at the time of liquidation may be lower than the share value was at time of purchase. Choosing a mutual fund with the correct amount of risk with plans to remain in the fund for the suggested time frame for that fund is very important to help reduce the effects of market risk. INDIVIDUAL STOCKS AND BONDS Since individual stocks and bonds may only be purchased through a Self-Directed Individual Retirement Account (SDIRA), a brief overview of SDIRAs follows: Self-Directed IRAs Self-Directed Individual Retirement Accounts provide the IRA owner with the opportunity to place IRA funds in a variety of investments, all within one IRA plan. A self-directed IRA plan may allow investment in CDs, annuities, mutual funds, individual stocks and bonds, even real estate. This is in contrast to the typical bank or mutual fund IRA plan which will normally allow the purchase of a particular bank s CDs, or a particular mutual fund company s mutual funds, respectively. The SDIRA trustee will provide one statement on all investments, which is one of the key advantages of a SDIRA. 94

95 Fees Self-Directed IRAs often charge relatively high fees for administration and liquidation. Annual fees are often about $35 and liquidation fees about $50. For this reason, it is recommended that a SDIRA be used only if several different investment types will be purchased. It makes little economic sense to place two mutual funds which each normally charging $10 administration fees, into a SDIRA that charges $35. Note that when a product is placed into a SDIRA, the IRA administration charges normally associated with that product no longer apply. The SDIRA fees take their place. Product commission charges and withdrawal charges still apply, however. Calculation of RMD for Regular IRAs SDIRA trustees will calculate and distribute required distributions and may or may not charge an additional fee for this service. Most SDIRA trustees will calculate distributions under the amortization, recalculation or non-recalculation methods. Individual Stocks and Bonds. Often, individual stocks are placed in a SDIRA via a rollover from a qualified employer plan. Or, they may be part of a large IRA portfolio. Solely placing funds in individual stocks or bonds is not generally recommended for the smaller investor who may be better off in a diversified mutual fund portfolio. Bonds can provide known income and conservation of principal if held to maturity. This stability can be attractive for those concerned with these issues. However, if the bond is liquidated before maturity, it is subject to interest rate risk. If interest rates have risen since the purchase of the bond and the bond is liquidated, the bond will not be worth as much as if interest rates had remained constant or had decreased. FIXED ANNUITIES Interest Rate Fixed annuities are tax-deferred contracts issued by insurance companies. Tax-deferral is an annuity feature whether purchased as an IRA or not. Therefore, the interest rate paid on a fixed annuity purchased as an IRA plays a greater role in its relative attractiveness as an investment than when purchased as a non-ira investment, when tax-deferral is often a primary purchasing factor. Fixed annuities generally pay a rate that is guaranteed for continuous one-year periods. Fixed annuity rates do not generally provide the earnings potential of mutual funds, particularly when compared to equity mutual funds. Risk and Conservation of Principal The legal reserve requires life insurance companies to comply with state regulations. Some annuities also include a guarantee of principal provision which ensures the return of principal if the customer liquidates the annuity contract in full. Surrender Charges Surrender charges are assessed for certain withdrawals made from annuities within a certain time frame. The time frame, or surrender period, is generally from five to seven years. 95

96 Generally, withdrawals of earnings or up to 10% of accumulated value do not incur charges, and so are known as penalty free withdrawals. Unlike banks, insurance companies generally do not waive surrender charges for amounts greater than the penalty free amount for customers over 59 ½. Calculation of RMD for Regular IRAs Many insurance companies will calculate and distribute RMDs. A fixed annuity can be annuitized, which means to begin paying annuity income, so the annuity method of required minimum distribution calculation is available. Required distributions may also be taken through random or systematic withdrawals from an annuity. Normally, no fee is assessed by insurance companies offering fixed annuities for the calculation of RMD payments. Features Fixed annuities have some unique features. For example, many annuities include a waiver of surrender charges for withdrawals made in conjunction with certain stays in a hospital or long-term care facility. Fixed annuities also may offer a bail-out option under which a customer can liquidate the contract without penalty if the rate falls below a certain level. EQUITY-INDEX ANNUITIES Equity-index annuities are annuities that offer the advantage of growth that can exceed a fixed annuity without some of the risks associated with variable annuities. Equity-index annuities provide a return that is related to a stock index, most commonly the S&P 500. The insurance company offering the annuity also provides guaranteed minimum returns, which provides the purchaser with reduced exposure to market risks. Besides these unique features, equity-indexed annuities provide many of the same advantages as other annuities, such as tax-deferral and avoidance of probate. Risk and Return Guarantees The return on equity-index annuities can be greater than fixed annuities. This can make them attractive to those looking for a higher return than a standard fixed annuity, with some return guarantees. The purchaser must understand that the equity-index annuity has the potential for returns less than a fixed annuity. Many equity-index annuities guarantee 3% on 90% of premium, while fixed annuities typically guarantee 3% on the entire premium contributed. Opportunity For Growth Because the return of an equity-index annuity is tied to an index, the return may be significantly higher than the return of a fixed annuity. In addition, equities have commonly outpaced the inflation rate, so an equity-index annuity can have the benefit of a return that acts as a hedge against inflation. The equity-index annuity pays a return based on changes in the index to which the annuity is linked. The insurer promises to pay this return based on the index benefit formula provided for in the contract. Unlike a variable annuity, which pays a return based directly on the performance of sub-accounts, the return on most equity-index annuities is based on the returns in the insurer s general account. Unless an equity-index annuity is registered with 96

97 the Securities and Exchange Commission as an investment product, the insurer uses the general account portfolio as its underlying portfolio to generate the annuity s return, not a separate account composed of sub-accounts as is used in variable annuities. Guaranteed Minimum Return Non-registered equity-index annuities include a guaranteed minimum rate of return. They also include a minimum index return. Variable annuities often have a minimum death benefit guarantee (as do some equity-index annuities), but the variable sub-accounts do not include a minimum rate of return. The guarantee features can make the equity-index annuity attractive to those who would like the opportunity to participate in equity return, but who do not want to take on the risk of negative return found in equity variable sub-accounts. Calculation of RMD for Regular IRAs An equity-index annuity may be annuitized in order to meet required distribution rules. As with other annuity forms, required distributions may also be taken through random or systematic withdrawals from an equity-index annuity. VARIABLE ANNUITIES Sub-Accounts A variable annuity offers a variety of sub-account investment options within an annuity wrapper. Variable annuities are issued by insurance companies and have the same taxdeferral features as a fixed annuity. Sub-accounts are pools of securities with a specific investment objective. Rather than shares, sub-account units are purchased by the variable annuity owner. The units fluctuate in value based on the performance of the underlying securities. A sub-account has the risks, return potential and suggested investment timeframe related to its investment objective and investment policies. The historical performance of a variable annuity s sub-accounts, along with its objective, are key determinants of the variable annuity s relative attractiveness and suitability as an IRA vehicle. Calculation of RMD for Regular IRAs A variable annuity can offer the return potential of a mutual fund family with the added advantage of the availability of the annuity required minimum distribution method. Like a fixed annuity, required minimum distributions may be taken through systematic withdrawals. Surrender Charges and Fees Surrender charges are applied to certain withdrawals from a variable annuity. Generally, a free withdrawal amount of interest earned or up to 10% of the accumulated value is allowed annually. Administration charges generally run from $25 to $35 a year. Stepped up Death Benefit Variable annuities often include a stepped-up death benefit feature. A stepped up death benefit fixes the variable annuity value at certain intervals, e.g. every five to seven years. This value will be paid as the death benefit if the annuity value is lower than the stepped-up value at the time of death. 97

98 Other Features Variable annuities do not generally include a medical or long-term care waiver, and any rate guarantees, including bail out rates, would be applicable only if the variable annuity provided a fixed annuity investment option along with the sub-accounts. SUMMARY Since IRA rules do not vary based on the product selected, the best IRA investment depends upon whether the product features match the investment objectives of the owner, including risk tolerance, desire for growth and investment time frame. If conservation of principal and safety are important, a CD or fixed annuity may be good choices. If growth potential and a long investment horizon are factors in choosing an IRA savings product, a growth mutual fund or variable annuity sub-account may be best. Equity-index annuities may be utilized as an instrument that may provide a higher return than a CD or fixed annuity, but may not include all the risks of a variable annuity or a mutual fund. Low fees are found in CDs, fixed annuities and some mutual funds. Virtually unlimited investment options are found in SDIRAs. Whatever the objectives of the IRA holder, a product can be found to meet them. 98

99 CHAPTER THIRTEEN: SEP PLANS A SEP, or Simplified Employee Pension plan, is a form of IRA for small businesses. It is not, strictly speaking, a qualified plan. Rather, it is a special plan that includes some qualified plan features, and therefore is subject to some qualified plan rules. Other qualified plan rules are not applied to a SEP because a SEP does not include all the features of qualified plans. For example, loans are not allowed through a SEP plan. There is no vesting schedule in a SEP -- all contributions are immediately 100% vested. Because the rules are simplified, the plan is low-cost and therefore attractive to many small businesses, especially those with fewer than employees. Because the SEP is an IRA, contributions are made to accounts which are owned by the individual employee participants. With some restrictions, the employee may withdraw, transfer or roll the SEP moneys just as those in an IRA are withdrawn, transferred or rolled. A form of SEP-IRA known as a Salary Reduction Simplified Employee Pension Plan, or SAR- SEP, was available for certain businesses until December 31, After this date, new SAR- SEP plans are no longer available. Businesses that had established a SAR-SEP prior to December 31, 1996 may continue to maintain and contribute to SAR-SEP plans. SEP AND SAR-SEP ADVANTAGES Tax Deferral Contributions to SEPs and SAR-SEPs grow tax-deferred until withdrawn. Ease of Establishment Like an IRA, a SEP plan can be opened with a minimum of paperwork. If the IRS prototype SEP plan is used, the employer completes an IRS form 5305 on each employee and maintains a copy. The product providers often will handle the minimal tax reporting and statement generation the SEP requires. Flexibility Contributions may be made to many investments and do not have to be made annually. Easy to Transfer and Combine The SEP and SAR-SEP plans may be rolled and transferred to and from like an IRA. Relative Low Cost The fees for SEP and SAR-SEP plans are typically very low. Product providers normally charge fees of an IRA - from ten to twenty dollars annually per account. 99

100 Tax Deductibility Employer contributions are tax-deductible, and salary deferred contributions reduce taxable income for the employee. ELIGIBILITY SEPs can be established by the self-employed sole-proprietorships and partnerships and small businesses. Although any size business can establish a SEP, generally businesses of up to fifty employees are most suitable for SEP plans. Larger companies may select a qualified plan in order to include options such as vesting and plan loans. A SEP plan can allow all employees to participate, or may include eligibility requirements. The plan may not exclude employees who are over 21 or who have provided service to the employer in at least three of the immediately preceding five years. Service is defined in IRS Form 5305-SEP as any work performed for [the employer] for any period of time, however short. Excluded Employees A SEP plan may exclude employees covered by a collective bargaining agreement whose retirement benefits were bargained for in good faith by the employer and the union, nonresident aliens, and employees who received less than $600 (a figure indexed annually for inflation) CONTRIBUTIONS The contributions maximum for a SEP is 25% of compensation up to $265,000, up to a maximum of $53,000. This $265,000 figure is subject to adjustment for inflation. The employer must contribute the same percentage for all eligible employees. This percentage also applies to the owner. Compensation includes wages, tips, salaries, commissions, fees and bonuses. For the self-employed person, compensation is equal to earned income from the business. Individuals 50 and over may make catch up contributions to a SAR-SEP. The additional amount that such an individual may defer is the lesser of the applicable dollar amount, as shown in the table below, or the excess, if any, of (a) the participant s compensation for the year, over (b) any of the participant s other elective deferrals for the year. The maximum catch-up amount that can be contributed to a SAR-SEP is $6000 in Catch-up contributions are not allowed to be made to SEPs. Contributions do not have to be made each year, nor does the same percentage have to be contributed each year contributions are made. For example, in year one an employer contributes 3% of compensation to a SEP-IRA for each eligible employee. In year two, the business does extremely well, so the employer contributes 10% of compensation per employee. In year three, profits are still way up, but the employer decides to purchase a new building to accommodate the growth in the business, so contributes 3% again for each employee. 100

101 Contributions to both SEPs and SAR-SEPs may be made until April 15 of the year following the tax year, or until the tax filing date if different. SEP and SAR-SEP plans may be established up until this date and apply to the previous tax year. Contributions are not considered compensation for the employee and are not taxable until withdrawn. Employer contributions are deductible by the employer. Excess Contributions If an excess contribution is made, it must be withdrawn on or before April 15 (or the tax filing date) of the year following the year it was made. If the excess contribution and earnings are not withdrawn by this date, they are subject to a 6% excess contribution tax. The excess contribution distribution is not subject to the 10% tax on premature distributions, but the earnings on the excess are subject to this tax. SAR-SEP PLANS A SAR-SEP is a form of SEP-IRA that allows contributions by the employee through salaryreduction. It was available to businesses with up to twenty-five eligible employees. The SAR-SEP includes the advantages of the SEP with the added advantages of salary reduction. Like many 401(k) plans, SAR-SEPs are participant directed -- the participant may decide into what products to place contributions. Beginning after December 31, 1996, new SAR-SEP plans may not be established. A new form of salary reduction plan for small employers, called the SIMPLE plan is available after this date. SIMPLE plans are discussed in the next chapter. ELIGIBILITY The SAR-SEP allowed the same excludable employees as the SEP. The plan may not exclude employees over age 21 or who have provided service to the employer in at least three of the immediately preceding five years. Excluded employees may include those who received compensation of less than $450 (indexed for inflation), nonresident aliens, and employees covered by a collective bargaining agreement. CONTRIBUTIONS The contribution limit for the SAR-SEP is the same as the SEP. Elective Deferrals Elective deferrals may only be made if at least 50% of the eligible employees elect to make them. The maximum amount of salary deferral contributions that may be made to a SAR- SEP is $18,000 in 2015, as it is for elective contribution qualified plans like the 401(k). Excess Deferrals If elective deferrals are made which exceed the maximum level, the employee must withdraw the excess deferral by April 15 of the year following the year the excess deferral was made. If not, the excess deferral is considered an excess contribution, as discussed under SEPs, above. 101

102 Highly Compensated Employee Elective Contributions Under a SAR-SEP a highly compensated employee s maximum elective deferral cannot exceed the average deferral percentage of the non-highly compensated employees by more than a multiple of Highly compensated employees are restricted from withdrawing or transferring elective, or salary reduction, contributions until March 15 of the year following the year they were made, or 2½ months after the end of the plan year if different from the calendar year. Employer Contributions To avoid going through top-heavy tests and requirements, the employer must contribute at least 3% of compensation to each eligible employee s SAR-SEP. If a higher percentage is contributed, the employer must contribute that percentage for each employee. PLAN INVESTMENTS SEP and SAR-SEP contributions may be placed into many different products -- bank accounts, mutual funds, fixed and variable annuities, individual stocks and bonds. Prohibited investments include collectibles, other than certain US Gold and Silver coins, and life insurance. The exclusion of life insurance does not include annuities, however. The owner of the SEP or SAR-SEP can choose which product into which contributions will be made. Very often, the employer provides the employees with a selection of mutual funds or a variable annuity to use as a SEP vehicle, but the employee is not required to use these vehicles. Practically speaking, many employees appreciate the convenience of leaving the SEP funds in the plan the employer selected. DISTRIBUTIONS Distributions from a SEP plan generally follow those for IRAs and qualified plans. Premature Distributions SEP and SAR-SEP exceptions to the premature distribution tax of 10% for withdrawals prior to 59½ are the same as those for an IRA. The exceptions are: a) Disability. b) Death Distributions made to beneficiaries due to the death of the participant are not subject to the additional 10% tax. c) Payments which are part of a series of substantially equal payments which are made over the participant s lifetime. These payments may also be made over the participant and a designated beneficiary s lifetime. At least one payment must be made annually. The payments may not be modified until the participant reaches age 59 1/2, or at least five years from the first payment. whichever is greater. If the payments are modified prior to this time period, the entire amount distributed will become subject to the additional 10% tax, unless the modification in payments was due to disability or death of the participant. d) Medical Care 102

103 Distributions less than or equal to the amount allowable as a medical deduction for income tax purposes for amounts paid during the year for medical care are not subject to the additional 10% tax. Currently, the allowable medical deduction amount is equal to amounts in excess of 7 ½% of adjusted gross income. e) Certain Health Insurance Premiums Distributions to unemployed individuals for health insurance premiums are not subject to the 10% additional tax. To qualify as an exception to the premature distribution tax, the IRA holder must have separated from employment and must have received unemployment compensation for twelve consecutive weeks, or, if self-employed, must be eligible to receive unemployment compensation if he or she were not self-employed. The distribution must be made either during the tax year the participant received the unemployment compensation, or in the succeeding tax year. If the distribution is made after the IRA holder has been re-employed for at least sixty days after separation of employment, the distribution is not exempt from the premature distribution tax under these rules. Distributions From A Sep With Non-Deductible Ira Contributions IRA contributions may be made to a SEP or SAR-SEP plan. Therefore, it is possible that nondeductible IRA contributions are made to the plan. If distributions are made from a SEP or SAR-SEP with non-deductible IRA contributions, each payment is considered to be partly taxable and partly non-taxable. To determine the taxable and non-taxable portions of the distribution, the ratio of nondeductible contributions to the total value of the IRA or SEP is applied to each distribution. For example, assume Mr. Jones has never taken a distribution. He has made a total of $10,000 in non-deductible contributions to his SEP. His balance is now $100,000. To determine the percent of each distribution which is non-taxable, divide the non-deductible contribution amount by the total value in the plan: $10,000 / $100,000 = 10% If he distributes $20,000, $2000 of the distribution would be non-taxable: $20,000 x 10% = $2000. Mr. Jones now has $8000 of non-deductible contributions remaining in his plan. The following year, the value has grown to $84,800. He makes another distribution of $20,000. The non-taxable portion of the distribution is now calculated using the $8000 of nondeductible contributions within the plan and the total value of $84,800: $8000 / $84,800 = 9.43% $20,000 x 9.43% = $1886 $1886 is the non-taxable portion of the distribution. Of course, Mr. Jones should consult a tax professional to ensure accurate calculation of the non-taxable amount of his distribution. ROLLOVERS AND TRANSFERS SEP and SAR-SEPs, as IRAs, may be rolled over or transferred to eligible retirement plans. Unlike rollovers from qualified plans, rollovers from SEP plans are not subject to mandatory 20% withholding requirements. 103

104 POTENTIAL DISADVANTAGES OF SEP AND SAR-SEP PLANS Lack of Vesting and Loan Options Disadvantages in a SEP and SAR-SEP plan include the lack of the vesting options and loan provisions found in qualified plans. The lack of vesting requirements can limit the plan s usefulness as an encouragement for an employee to stay with a company. 104

105 CHAPTER FOURTEEN: SIMPLE PLANS Another type of IRA is the SIMPLE IRA. SIMPLE stands for Savings Incentive Match Plan For Employees of Small Employers. It is a retirement plan which allows both employer and employee contributions. The SIMPLE plan replaced the Salary Reduction SEP after December 31, 1996 as a salary reduction retirement plan available to small businesses. SIMPLE PLAN ADVANTAGES Ease of Establishment SIMPLE plans, if the IRS prototype plans are used, are as easy to establish as a SEP plan. Easy To Transfer and Combine SIMPLE plans may be transferred to and from through rollover and transfer IRA rules. Relative Low Cost Compared to other salary reduction plans, administration costs of SIMPLE plans are lower, due to simplified administration rules. Tax Deductibility Employer contributions to a SIMPLE plan are deductible to the employer in the tax year for which they were contributed. Employee contributions are salary reduction contributions, meaning the contributions are pre-tax dollars. By making contributions, the employee reduces his or her taxable compensation by the amount contributed. ELIGIBILITY An employer may allow all employees to participate in a SIMPLE plan, or may restrict eligibility, within limits. All those employees who are reasonably expected to earn at least $5000 in compensation in a tax year and who received at least $5000 in compensation from the employer in any two preceding years may elect to make salary reduction contributions to a SIMPLE plan. Employers may establish a SIMPLE plan if the employer had no more than 100 employees who earned $5000 or more in compensation in the prior year and if the employer does not maintain another qualified plan during the year. Excluded Employees A SIMPLE plan may exclude from participation those employees covered under a collective bargaining agreement whose retirement benefits were bargained for in good faith by the employer and a union. CONTRIBUTIONS The employee may elect to make salary reduction contributions to a SIMPLE plan up to a maximum applicable dollar amount. The applicable dollar amount for 2015 is $12,

106 Individuals 50 and over may make catch up elective deferrals to a SIMPLE plan. The additional amount that such individuals may defer is the lesser of the applicable dollar amount, as shown in the table below, or the excess, if any, of (a) the participant s compensation for the year, over (b) any of the participant s other elective deferrals for the year. For tax years beginning in: The applicable dollar amount is: 2002 $ $ $ $ and thereafter $2500 The employer generally must make a matching contribution equal to the amount deferred by the employee, but not exceeding 3% of the employee s compensation. Compensation is deferred as wages, tips and other compensation from the employer subject to federal income tax. It includes salary reduction contributions. The employer may contribute less than 3%, but not less than 1%, of the employee s compensation, but the lower contribution percentage may not be made more than two calendar years of a five-year period. If the employer elects to make this lower contribution amount, the employer must notify the employees in a reasonable amount of time prior to the sixty-day period prior to January 1 of the plan year. The employee can make or modify a salary reduction election during this period. The employer has the option of making a nonelective contribution rather than a matching contribution. If so, the nonelective contribution must be equal to 2% of compensation for each eligible employee who has at least $5,000 in compensation. The maximum compensation amount for the purposes of this calculation is $265,000, a figure subject to adjustment for inflation. INVESTMENT OPTIONS SIMPLE plans, as IRAs, allow the same investment options as an IRA. Like SEPs, the employer generally sets up a SIMPLE account for each participant. The employee is 100% vested, or has ownership of, all contributions made to a SIMPLE plan. If the SIMPLE contributions will be made to a financial institution designated by the employer, the IRS provides a prototype plan through Form 5305-SIMPLE. If each employee can designate the financial institution to which SIMPLE contributions are made, an IRS prototype plan can be established using form 5304-SIMPLE. DISTRIBUTIONS If a withdrawal is made from a SIMPLE plan in the first two years in which the employee participates, and the withdrawal does not qualify as an exception to the IRA premature distribution tax rules, as described in the last chapter on SEPs, the tax on this distribution is 25%. Otherwise, SIMPLE plans are subject to the same distribution rules as are regular IRAs. 106

107 ROLLOVERS AND TRANSFERS SIMPLE plans are subject to the rollover and transfer rules of IRAs. SIMPLE plan proceeds may be rolled over or transferred to another SIMPLE plan, or to an IRA. POTENTIAL DISADVANTAGES OF SIMPLE PLANS Employer contributions must be made annually. Its simplicity precludes vesting options and loan provisions found in other qualified plans. 107

108 SEC INDIVIDUAL RETIREMENT ACCOUNTS (a) Individual retirement account For purposes of this section, the term ``individual retirement account'' means a trust created or organized in the United States for the exclusive benefit of an individual or his beneficiaries, but only if the written governing instrument creating the trust meets the following requirements: (1) Except in the case of a rollover contribution described in subsection (d)(3) in section 402(c), 403(a)(4), 403(b)(8) or 457(e)(16), no contribution will be accepted unless it is in cash, and contributions will not be accepted for the taxable year on behalf of any individual in excess of the amount in effect for such taxable year under section 219(b)(1)(A). (2) The trustee is a bank (as defined in subsection (n)) or such other person who demonstrates to the satisfaction of the Secretary that the manner in which such other person will administer the trust will be consistent with the requirements of this section. (3) No part of the trust funds will be invested in life insurance contracts. (4) The interest of an individual in the balance in his account is nonforfeitable. (5) The assets of the trust will not be commingled with other property except in a common trust fund or common investment fund. (6) Under regulations prescribed by the Secretary, rules similar to the rules of section 401(a)(9) and the incidental death benefit requirements of section 401(a) shall apply to the distribution of the entire interest of an individual for whose benefit the trust is maintained. (b) Individual retirement annuity For purposes of this section, the term ``individual retirement annuity'' means an annuity contract, or an endowment contract (as determined under regulations prescribed by the Secretary), issued by an insurance company which meets the following requirements: (1) The contract is not transferable by the owner. (2) Under the contract-- (A) the premiums are not fixed, (B) the annual premium on behalf of any individual will not exceed the dollar amount in effect under section 219(b)(1)(A), and (C) any refund of premiums will be applied before the close of the calendar year following the year of the refund toward the payment of future premiums or the purchase of additional benefits. (3) Under regulations prescribed by the Secretary, rules similar to the rules of section 401(a)(9) and the incidental death benefit requirements of section 401(a) shall apply to the distribution of the entire interest of the owner. (4) The entire interest of the owner is nonforfeitable. Such term does not include such an annuity contract for any taxable year of the owner in which it is disqualified on the application of subsection (e) or for any subsequent taxable year. For purposes of this subsection, no contract shall be treated as an endowment contract if it matures later than the taxable year in which the individual in whose name such contract is purchased attains age 70-1/2; if it is not for the exclusive benefit of the individual in whose name it is purchased or his beneficiaries; or if the aggregate annual premiums under all such contracts purchased in the name of such individual for any taxable year exceed the dollar amount in effect under section 219(b)(1)(A). (c) Accounts established by employers and certain associations of 108

109 employees A trust created or organized in the United States by an employer for the exclusive benefit of his employees or their beneficiaries, or by an association of employees (which may include employees within the meaning of section 401(c)(1)) for the exclusive benefit of its members or their beneficiaries, shall be treated as an individual retirement account (described in subsection (a)), but only if the written governing instrument creating the trust meets the following requirements: (1) The trust satisfies the requirements of paragraphs (1) through (6) of subsection (a). (2) There is a separate accounting for the interest of each employee or member (or spouse of an employee or member). The assets of the trust may be held in a common fund for the account of all individuals who have an interest in the trust. (d) Tax treatment of distributions (1) In general Except as otherwise provided in this subsection, any amount paid or distributed out of an individual retirement plan shall be included in gross income by the payee or distributee, as the case may be, in the manner provided under section 72. (2) Special rules for applying section 72 For purposes of applying section 72 to any amount described in paragraph (1)-- (A) all individual retirement plans shall be treated as 1 contract, (B) all distributions during any taxable year shall be treated as 1 distribution, and (C) the value of the contract, income on the contract, and investment in the contract shall be computed as of the close of the calendar year in which the taxable year begins. For purposes of subparagraph (C), the value of the contract shall be increased by the amount of any distributions during the calendar year. (3) Rollover contribution An amount is described in this paragraph as a rollover contribution if it meets the requirements of subparagraphs (A) and (B). (A) In general Paragraph (1) does not apply to any amount paid or distributed out of an individual retirement account or individual retirement annuity to the individual for whose benefit the account or annuity is maintained if-- (i) the entire amount received (including money and any other property) is paid into an individual retirement account or individual retirement annuity (other than an endowment contract) for the benefit of such individual not later than the 60th day after the day on which he receives the payment or distribution; or (ii) the entire received (including money and any other property) is paid into an eligible retirement plan for the benefit of such individual not later than the 60 th day after the date on which the payment of distribution is received, except that the maximum amount which may be paid into such plan may not exceed the portion of the amount received which is includible in gross income (determined without regard to this paragraph). 109

110 For purposes of clause (ii), the term eligible retirement plan means an eligible retirement plan described in clause (iii), (iv), (v), or (vi) of section 402(c)(8)(B). (B) Limitation. This paragraph does not apply to any amount described in subparagraph (A)(i) received by an individual from an individual retirement account or individual retirement annuity if at any time during the 1-year period ending on the day of such receipt such individual received any other amount described in that subparagraph from an individual retirement account or an individual retirement annuity which was not includible in his gross income because of the application of this paragraph. (C) Denial of rollover treatment for inherited accounts, etc. (i) In general. In the case of an inherited individual retirement account or individual retirement annuity (I) this paragraph shall not apply to any amount received by an individual from such an account or annuity (and no amount transferred from such account or annuity to another individual retirement account or annuity shall be excluded from gross income by reason of such transfer), and (II) such inherited account or annuity shall not be treated as an individual retirement account or annuity for purposes of determining whether any other amount is a rollover contribution. (ii) Inherited individual retirement account or annuity An individual retirement account or individual retirement annuity shall be treated as inherited if-- (I) the individual for whose benefit the account or annuity is maintained acquired such account by reason of the death of another individual, and (II) such individual was not the surviving spouse of such other individual. (D) Partial rollovers permitted (i) In general If any amount paid or distributed out of an individual retirement account or individual retirement annuity would meet the requirements of subparagraph (A) but for the fact that the entire amount was not paid into an eligible plan as required by clause (i), or (ii) of subparagraph (A), such amount shall be treated as meeting the requirements of subparagraph (A) to the extent it is paid into an eligible plan referred to in such clause not later than the 60th day referred to in such clause. (ii) Eligible plan For purposes of clause (i), the term ``eligible plan'' means any account, annuity, contract, or plan referred to in subparagraph (A). (E) Denial of rollover treatment for required distributions This paragraph shall not apply to any amount to the extent such amount is required to be distributed under subsection (a)(6) or (b)(3). (F) Frozen deposits For purposes of this paragraph, rules similar to the rules of section 402(c)(7) (relating to frozen deposits) shall apply. (G) Simple retirement accounts. In the case of any payment or distribution out of a simple retirement account (as defined in subsection (p)) to which section 72(t)(6) applies, this paragraph shall not apply unless such payment or distribution is paid into another simple retirement account. (H) Application of section

111 (i) in general. If -- (I) a distribution is made from an individual retirement plan, and (II) a rollover contribution is made to an eligible retirement plan described in section 402(c)(8)(B)(iii), (iv), (v), or (vi) with respect to all or part of such distribution, then notwithstanding paragraph (2), the rules of clause (ii) shall apply for purposes of applying section 72. (ii) Applicable rules. In the case of a distribution described in clause (i) -- (I) section 72 shall be applied separately to such distribution, (II) notwithstanding the pro rata allocation of income on, and investment in, the contract to distributions under section 72, the portion of such distribution rolled over to an eligible retirement plan described in clause (i) shall be treated as from income on the contract (to the extent of the aggregate income on the contract from all individual retirement plans of the distributee), and (III) appropriate adjustments shall be made in applying section 72 to other distributions in such taxable year and subsequent taxable year. (I) Waiver of 60-day requirement. The Secretary may waive the 60-day requirement under subparagraphs (A) and (D) where the failure to waive such requirement would be against equity or good conscience, including casualty, disaster, or other events beyond the reasonable control of the individual subject to such requirement. (4) Contributions returned before due date of return Paragraph (1) does not apply to the distribution of any contribution paid during a taxable year to an individual retirement account or for an individual retirement annuity if-- (A) such distribution is received on or before the day prescribed by law (including extensions of time) for filing such individual's return for such taxable year, (B) no deduction is allowed under section 219 with respect to such contribution, and (C) such distribution is accompanied by the amount of net income attributable to such contribution. In the case of such a distribution, for purposes of section 61, any net income described in subparagraph (C) shall be deemed to have been earned and receivable in the taxable year in which such contribution is made. (5) Certain distributions of excess contributions after due date for taxable year (A) In general In the case of any individual, if the aggregate contributions (other than rollover contributions) paid for any taxable year to an individual retirement account or for an individual retirement annuity do not exceed the dollar amount in effect under section 219(b)(1)(A), paragraph (1) shall not apply to the distribution of any such contribution to the extent that such contribution exceeds the amount allowable as a deduction under section 219 for the taxable year for which the contribution was paid-- (i) if such distribution is received after the date described in paragraph (4), (ii) but only to the extent that no deduction has been allowed under section 219 with respect to such excess contribution. If employer contributions on behalf of the individual are paid for the taxable year to a simplified employee pension, the dollar limitation of the preceding sentence shall be increased by the lesser of the amount of such contributions or the dollar limitation in effect under section 415(c)(1)(A) for such taxable year. (B) Excess rollover contributions attributable to erroneous information 111

112 If-- (i) the taxpayer reasonably relies on information supplied pursuant to subtitle F for determining the amount of a rollover contribution, but (ii) the information was erroneous, subparagraph (A) shall be applied by increasing the dollar limit set forth therein by that portion of the excess contribution which was attributable to such information. For purposes of this paragraph, the amount allowable as a deduction under section 219 shall be computed without regard to section 219(g). (6) Transfer of account incident to divorce The transfer of an individual's interest in an individual retirement account or an individual retirement annuity to his spouse or former spouse under a divorce or separation instrument described in subparagraph (A) of section 71(b)(2) is not to be considered a taxable transfer made by such individual notwithstanding any other provision of this subtitle, and such interest at the time of the transfer is to be treated as an individual retirement account of such spouse, and not of such individual. Thereafter such account or annuity for purposes of this subtitle is to be treated as maintained for the benefit of such spouse. (7) Special rules for simplified employee pensions (A) Transfer or rollover of contributions prohibited until deferral test met Notwithstanding any other provision of this subsection or section 72(t), paragraph (1) and section 72(t)(1) shall apply to the transfer or distribution from a simplified employee pension of any contribution under a salary reduction arrangement described in subsection (k)(6) (or any income allocable thereto) before a determination as to whether the requirements of subsection (k)(6)(a)(iii) are met with respect to such contribution. (B) Certain exclusions treated as deductions For purposes of paragraphs (4) and (5) and section 4973, any amount excludable or excluded from gross income under section 402(h) shall be treated as an amount allowable or allowed as a deduction under section 219. (e) Tax treatment of accounts and annuities (1) Exemption from tax Any individual retirement account is exempt from taxation under this subtitle unless such account has ceased to be an individual retirement account by reason of paragraph (2) or (3). Notwithstanding the preceding sentence, any such account is subject to the taxes imposed by section 511 (relating to imposition of tax on unrelated business income of charitable, etc. organizations). (2) Loss of exemption of account where employee engages in prohibited transaction (A) In general If, during any taxable year of the individual for whose benefit any individual retirement account is established, that individual or his beneficiary engages in any transaction prohibited by section 4975 with respect to such account, such account ceases to be an individual retirement account as of the first day of such taxable year. For purposes of this paragraph-- (i) the individual for whose benefit any account was established is treated as the creator of such account, and (ii) the separate account for any individual within an individual retirement account maintained by an employer or association of employees is treated as a separate individual retirement account. (B) Account treated as distributing all its assets 112

113 In any case in which any account ceases to be an individual retirement account by reason of subparagraph (A) as of the first day of any taxable year, paragraph (1) of subsection (d) applies as if there were a distribution on such first day in an amount equal to the fair market value (on such first day) of all assets in the account (on such first day). (3) Effect of borrowing on annuity contract If during any taxable year the owner of an individual retirement annuity borrows any money under or by use of such contract, the contract ceases to be an individual retirement annuity as of the first day of such taxable year. Such owner shall include in gross income for such year an amount equal to the fair market value of such contract as of such first day. (4) Effect of pledging account as security If, during any taxable year of the individual for whose benefit an individual retirement account is established, that individual uses the account or any portion thereof as security for a loan, the portion so used is treated as distributed to that individual. (5) Purchase of endowment contract by individual retirement account If the assets of an individual retirement account or any part of such assets are used to purchase an endowment contract for the benefit of the individual for whose benefit the account is established-- (A) to the extent that the amount of the assets involved in the purchase are not attributable to the purchase of life insurance, the purchase is treated as a rollover contribution described in subsection (d)(3), and (B) to the extent that the amount of the assets involved in the purchase are attributable to the purchase of life, health, accident, or other insurance, such amounts are treated as distributed to that individual (but the provisions of subsection (f) do not apply). (6) Commingling individual retirement account amounts in certain common trust funds and common investment funds Any common trust fund or common investment fund of individual retirement account assets which is exempt from taxation under this subtitle does not cease to be exempt on account of the participation or inclusion of assets of a trust exempt from taxation under section 501(a) which is described in section 401(a). [(f) Repealed. Pub. L , title XI, Sec. 1123(d)(2), Oct. 22, 1986, 100 Stat. 2475] (g) Community property laws This section shall be applied without regard to any community property laws. (h) Custodial accounts For purposes of this section, a custodial account shall be treated as a trust if the assets of such account are held by a bank (as defined in subsection (n)) or another person who demonstrates, to the satisfaction of the Secretary, that the manner in which he will administer the account will be consistent with the requirements of this section, and if the custodial account would, except for the fact that it is not a trust, constitute an individual retirement account described in subsection (a). For purposes of this title, in the case of a custodial account treated as a trust by reason of the preceding sentence, the custodian of such account shall be treated as the trustee thereof. (i) Reports The trustee of an individual retirement account and the issuer of an endowment contract described in subsection (b) or an individual retirement annuity shall make such reports regarding such account, contract, or annuity to the Secretary and to the individuals for whom the account, contract, or annuity is, or is to be, maintained with respect to contributions (and the years to which they relate), 113

114 distributions aggregating $10 or more in any calendar year, and such other matters as the Secretary may require. The reports required by this subsection (1) shall be filed at such time and in such manner as the Secretary prescribes, and (2) shall be furnished to individuals (A) not later than January 31 of the calendar year following the calendar year to which such reports relate, and (B) in such manner as the Secretary prescribes. In the case of a simple retirement account under subsection (p), only one report under this subsection shall be required to be submitted each calendar year to the Secretary (at the time provided under paragraph (2)) but, in addition to the report under this subsection, there shall be furnished, within 31 days after each calendar year, to the individual on whose behalf the account is maintained a statement with respect to the account balance as of the close of, and any account activity during, such calendar year. (j) Increase in maximum limitations for simplified employee pensions In the case of any simplified employee pension, subsections (a)(1) and (b)(2) of this section shall be applied by increasing the amounts contained therein by the amount of the limitation in effect under section 415(c)(1)(A). (k) Simplified employee pension defined (1) In general For purposes of this title, the term ``simplified employee pension'' means an individual retirement account or individual retirement annuity-- (A) with respect to which the requirements of paragraphs (2), (3), (4), and (5) of this subsection are met, and (B) if such account or annuity is part of a top-heavy plan (as defined in section 416), with respect to which the requirements of section 416(c)(2) are met. (2) Participation requirements This paragraph is satisfied with respect to a simplified employee pension for a year only if for such year the employer contributes to the simplified employee pension of each employee who-- (A) has attained age 21, (B) has performed service for the employer during at least 3 of the immediately preceding 5 years, and (C) received at least $300 in compensation (within the meaning of section 414(q)(4)) from the employer for the year. For purposes of this paragraph, there shall be excluded from consideration employees described in subparagraph (A) or (C) of section 410(b)(3). For purposes of any arrangement described in subsection (k)(6), any employee who is eligible to have employer contributions made on the employee's behalf under such arrangement shall be treated as if such a contribution was made. (3) Contributions may not discriminate in favor of the highly compensated, etc. (A) In general. The requirements of this paragraph are met with respect to a simplified employee pension for a year if for such year the contributions made by the employer to simplified employee pensions for his employees do not discriminate in favor of any highly compensated employee (within the meaning of section 414(q)). (B) Special rules. For purposes of subparagraph (A), there shall be excluded from consideration employees described in subparagraph (A) or (C) of section 410(b)(3). 114

115 (C) Contributions must bear uniform relationship to total compensation. For purposes of subparagraph (A), and except as provided in subparagraph (D), employer contributions to simplified employee pensions (other than contributions under an arrangement described in paragraph (6)) shall be considered discriminatory unless contributions thereto bear a uniform relationship to the compensation (not in excess of the first $200,000) of each employee maintaining a simplified employee pension. (D) Permitted disparity For purposes of subparagraph (C), the rules of section 401(l)(2) shall apply to contributions to simplified employee pensions (other than contributions under an arrangement described in paragraph (6)). (4) Withdrawals must be permitted A simplified employee pension meets the requirements of this paragraph only if-- (A) employer contributions thereto are not conditioned on the retention in such pension of any portion of the amount contributed, and (B) there is no prohibition imposed by the employer on withdrawals from the simplified employee pension. (5) Contributions must be made under written allocation formula The requirements of this paragraph are met with respect to a simplified employee pension only if employer contributions to such pension are determined under a definite written allocation formula which specifies-- (A) the requirements which an employee must satisfy to share in an allocation, and (B)the manner in which the amount allocated is computed. (6) Employee may elect salary reduction arrangement (A) Arrangements which qualify (i) In general A simplified employee pension shall not fail to meet the requirements of this subsection for a year merely because, under the terms of the pension, an employee may elect to have the employer make payments (I) as elective employer contributions to the simplified employee pension on behalf of the employee, or (II) to the employee directly in cash. (ii) 50 percent of eligible employees must elect Clause (i) shall not apply to a simplified employee pension unless an election described in clause (i)(i) is made or is in effect with respect to not less than 50 percent of the employees of the employer eligible to participate. (iii) Requirements relating to deferral percentage Clause (i) shall not apply to a simplified employee pension for any year unless the deferral percentage for such year of each highly compensated employee eligible to participate is not more than the product of-- (I) the average of the deferral percentages for such year of all employees (other than highly compensated employees) eligible to participate, multiplied by (II) (iv) Limitations on elective deferrals Clause (i) shall not apply to a simplified employee pension unless the requirements of section 401(a)(30) are met. (B) Exception where more than 25 employees 115

116 This paragraph shall not apply with respect to any year in the case of a simplified employee pension maintained by an employer with more than 25 employees who were eligible to participate (or would have been required to be eligible to participate if a pension was maintained) at any time during the preceding year. (C) Distributions of excess contributions (i) In general. Rules similar to the rules of section 401(k)(8) shall apply to any excess contribution under this paragraph. Any excess contribution under a simplified employee pension shall be treated as an excess contribution for purposes of section (ii) Excess contribution. For purposes of clause (i), the term ``excess contribution'' means, with respect to a highly compensated employee, the excess of elective employer contributions under this paragraph over the maximum amount of such contributions allowable under subparagraph (A)(iii). (D) Deferral percentage For purposes of this paragraph, the deferral percentage for an employee for a year shall be the ratio of-- (i) the amount of elective employer contributions actually paid over to the simplified employee pension on behalf of the employee for the year, to (ii) the employee's compensation (not in excess of the first $200,000) for the year. (E) Exception for State and local and tax-exempt pensions This paragraph shall not apply to a simplified employee pension maintained by-- (i) a State or local government or political subdivision thereof, or any agency or instrumentality thereof, or (ii) an organization exempt from tax under this title. (F) Exception where pension does not meet requirements necessary to insure distribution of excess contributions This paragraph shall not apply with respect to any year for which the simplified employee pension does not meet such requirements as the Secretary may prescribe as are necessary to insure that excess contributions are distributed in accordance with subparagraph (C), including-- (i) reporting requirements, and (ii) requirements which, notwithstanding paragraph (4), provide that contributions (and any income allocable thereto) may not be withdrawn from a simplified employee pension until a determination has been made that the requirements of subparagraph (A)(iii) have been met with respect to such contributions. (G) Highly compensated employee For purposes of this paragraph, the term ``highly compensated employee'' has the meaning given such term by section 414(q). (H) Termination This paragraph shall not apply to years beginning after December 31, The preceding sentence shall not apply to a simplified employee pension of an employer if the terms of simplified employee pensions of such employer, as in effect on December 31, 1996, provide that an employee may make the election described in subparagraph (A). (7) Definitions For purposes of this subsection and subsection (l)-- (A) Employee, employer, or owner-employee 116

117 The terms ``employee'', ``employer'', and ``owner-employee'' shall have the respective meanings given such terms by section 401(c). (B) Compensation Except as provided in paragraph (2)(C), the term ``compensation'' has the meaning given such term by section 414(s). (C) Year The term ``year'' means-- (i) the calendar year, or (ii) if the employer elects, subject to such terms and conditions as the Secretary may prescribe, to maintain the simplified employee pension on the basis of the employer's taxable year. (8) Cost-of-living adjustment The Secretary shall adjust the $300 amount in paragraph (2)(C) at the same time and in the same manner as under section 415(d) and shall adjust the $200,000 amount in paragraphs (3)(C) and (6)(D)(ii) at the same time, and by the same amount, as any adjustment under section 401(a)(17)(B); except that any increase in the $300 amount which is not a multiple of $50 shall be rounded to the next lowest multiple of $50. (9) Cross reference For excise tax on certain excess contributions, see section (l) Simplified employer reports (1) In general An employer who makes a contribution on behalf of an employee to a simplified employee pension shall provide such simplified reports with respect to such contributions as the Secretary may require by regulations. The reports required by this subsection shall be filed at such time and in such manner, and information with respect to such contributions shall be furnished to the employee at such time and in such manner, as may be required by regulations. (2) Simple retirement accounts. (A) No employer reports. Except as provided in this paragraph, no report shall be required under this section by an employer maintaining a qualified salary reduction arrangement under subsection (p). (B)Summary description. The trustee of any simple retirement account established pursuant to a qualified salary reduction arrangement under subsection (p) and the issue of an annuity established under such an arrangement shall provide to the employer maintaining the arrangement, each year a description containing the following information: (i) The name and address of the employer and the trustee or issuer. (ii) The requirements for eligibility for participation. (iii) The benefits provided with respect to the arrangement. (iv) The time and method of making elections with respect to the arrangement. (v) The procedures for, and effects of, withdrawals (including rollovers) from the arrangement. (C)Employee notification. The employer shall notify each employee immediately before the period for which an election described in subsection (p)(5)(c)may be made of the employee s opportunity to make such election. Such notice shall include a copy of the description in subparagraph (B). (m) Investment in collectibles treated as distributions (1) In general 117

118 The acquisition by an individual retirement account or by an individually-directed account under a plan described in section 401(a) of any collectible shall be treated (for purposes of this section and section 402) as a distribution from such account in an amount equal to the cost to such account of such collectible. (2) Collectible defined For purposes of this subsection, the term ``collectible'' means-- (A) any work of art, (B) any rug or antique, (C) any metal or gem, (D) any stamp or coin, (E) any alcoholic beverage, or (F) any other tangible personal property specified by the Secretary for purposes of this subsection. (3) Exception for certain coins and bullion. For purposes of this subsection, the term collectible shall not include-- (A) any coin which is -- (i) a gold coin described in paragraph (7), (8), (9), or (10) of section 5112(a) of title 31, United States Code, (ii) any silver coin described in section 5112(e) of title 31, United States Code, (iii) a platinum coin described in section 5112(k) of title 31, United States Code, or (iv) a coin issued under the laws of any State, or (B) any gold, silver platinum, or palladium bullion of a fineness equal to or exceeding the minimum fineness that a contract market (as described in section 7 of the Commodity Exchange Act, 7 U.S.C. 7) requires for metals which may be delivered in satisfaction of a regulated futures contract, if such bullion is in the physical possession of a trustee described under subsection (a) of this section. (n) Bank For purposes of subsection (a)(2), the term ``bank'' means-- (1) any bank (as defined in section 581),(2) an insured credit union (within the meaning of section 101(6) of the Federal Credit Union Act), and (3) a corporation which, under the laws of the State of its incorporation, is subject to supervision and examination by the Commissioner of Banking or other officer of such State in charge of the administration of the banking laws of such State. (o) Definitions and rules relating to nondeductible contributions to individual retirement plans (1) In general Subject to the provisions of this subsection, designated nondeductible contributions may be made on behalf of an individual to an individual retirement plan. (2) Limits on amounts which may be contributed (A) In general The amount of the designated nondeductible contributions made on behalf of any individual for any taxable year shall not exceed the nondeductible limit for such taxable year. (B) Nondeductible limit For purposes of this paragraph-- (i) In general The term ``nondeductible limit'' means the excess of-- 118

119 (I) the amount allowable as a deduction under section 219 (determined without regard to section 219(g)), over (II) the amount allowable as a deduction under section 219 (determined with regard to section 219(g)). (ii) Taxpayer may elect to treat deductible contributions as nondeductible If a taxpayer elects not to deduct an amount which (without regard to this clause) is allowable as a deduction under section 219 for any taxable year, the nondeductible limit for such taxable year shall be increased by such amount. (C) Designated nondeductible contributions (i) In general For purposes of this paragraph, the term ``designated nondeductible contribution'' means any contribution to an individual retirement plan for the taxable year which is designated (in such manner as the Secretary may prescribe) as a contribution for which a deduction is not allowable under section 219. (ii) Designation Any designation under clause (i) shall be made on the return of tax imposed by chapter 1 for the taxable year. (3) Time when contributions made In determining for which taxable year a designated nondeductible contribution is made, the rule of section 219(f)(3) shall apply. (4) Individual required to report amount of designated nondeductible contributions (A) In general Any individual who-- (i) makes a designated nondeductible contribution to any individual retirement plan for any taxable year, or (ii) receives any amount from any individual retirement plan for any taxable year, shall include on his return of the tax imposed by chapter 1 for such taxable year and any succeeding taxable year (or on such other form as the Secretary may prescribe for any such taxable year) information described in subparagraph (B). (B) Information required to be supplied The following information is described in this subparagraph: (i) The amount of designated nondeductible contributions for the taxable year. (ii) The amount of distributions from individual retirement plans for the taxable year. (iii) The excess (if any) of-- (I) the aggregate amount of designated nondeductible contributions for all preceding taxable years, over (II) the aggregate amount of distributions from individual retirement plans which was excludable from gross income for such taxable years. (iv) The aggregate balance of all individual retirement plans of the individual as of the close of the calendar year in which the taxable year begins. (v) Such other information as the Secretary may prescribe. (C) Penalty for reporting contributions not made For penalty where individual reports designated nondeductible contributions not made, see section 6693(b). (p) Simple retirement accounts. (1 )In general 119

120 For purposes of this title, the term simple retirement account means an individual retirement plan (as defined in section 7701(a)(37) (A) with respect to which the requirements of paragraphs (3), (4), and (5) are met; and (B) with respect to which the only contributions allowed are contributions under a qualified salary reduction arrangement. (2) Qualified salary reduction arrangement. (A) In general. For purposes of this subsection, the term qualified salary reduction arrangement means a written arrangement of an eligible employer under which (i) an employee eligible to participate in the arrangement may elect to participate in the arrangement may elect to have the employer make payments (I) as elective employer contributions to a simple retirement account on behalf of the employee, or (II) to the employee directly in cash, (ii) the amount which an employee may elect under clause (i) for any year is required to be expressed as a percentage of compensation and may not exceed a total of the applicable dollar amount for any year, (iii) the employer is required to make a matching contribution to the simple retirement account for any year in an amount equal to so much of the amount the employee elects under clause (i)(i) as does not exceed the applicable percentage of compensation for the year, and (iv) no contributions may be made other than contributions described in clause (i) or (iii). (B)Employer may elect 2-percent nonelective contribution. (i) In general, An employer shall be treated as meeting the requirements of subparagraph (A)(iii) for any year if, in lieu of the contributions described in such clause, the employer elects to make nonelective contributions of 2 percent of compensation for each employee who is eligible to participate in the arrangement and who has at least $5000 of compensation from the employer for the year. If an employer makes an election under this sub-paragraph for any year, the employer shall notify employees of such election within a reasonable period of time before the 60-day period for such year under paragraph (5)(C). (ii) Compensation limitation. The compensation taken into account under clause (i) for any year shall not exceed the limitation in effect for such year under section 401(a)(17). (C)Definitions. For purposes of this subsection (i)eligible employer (I) In general. The term eligible employer means, with respect to any year, an employer which had no more than 100 employees who received at least $5,000 of compensation from the employer for the preceding year. (II) 2-Year grace period. An eligible employer who establishes and maintains a plan under this subsection for 1 or more years and who fails to be an eligible employer for any subsequent year shall be treated as an eligible employer. If such failure is due to any acquisition, disposition, or similar transaction involving an eligible employer, the preceding sentence shall apply only in accordance with rules similar to the rules of section 410(b)(6)(C)(i). (ii) Applicable percentage (I) In general. The term applicable percentage means 3 percent. 120

121 (II) Election of lower percentage. An employer may elect to apply a lower percentage (not less than 1 percent) for any year for all employees eligible to participate in the plan for such year if the employer notifies the employees of such lower percentage within a reasonable period of time before the 60-day election period for such year under paragraph (5)(C). An employer may not elect a lower percentage under this subclause for any year if that election would result in the applicable percentage being lower than 3 percent in more than 2 of the years in the 5-year period ending with such year. (III) Special rule for years arrangement not in effect. If any year in the 5-year period described in subclause (ii) is a year prior to the first year for which any qualified salary reduction arrangement is in effect with respect to the employer (or any predecessor), the employer shall be treated as if the level of the employer matching contribution was at 3 percent of compensation for such prior year. (D)Arrangement may be only plan of employer. (i) In general. An arrangement shall not be treated as a qualified salary reduction arrangement for any year if the employer (or any predecessor employer) maintained a qualified plan with respect to which contributions were made, or benefits were accrued, for service in any year in the period beginning with the year such arrangement became effective and ending with the year for which the determination is being made. If only individuals other than employees described in subparagraph (A) or (B) of section 410(b)(3) are eligible to participate in such arrangement, then the preceding sentence shall be applied without regard to any qualified plan in which only employees so described are eligible to participate. (ii) Qualified plan. For purposes of this subparagraph, the term qualified plan means a plan, contract, pension, or trust described in subparagraph (A) or (B) of section 219(g)(5). (iii) Grace period. In the case of an employer who establishes and maintains a plan under this subsection for 1 or more years and who fails to meet any requirement of this subsection for any subsequent year due to any acquisition, disposition, or similar transaction involving another such employer, rules similar to the rules of sectino 410(b)(6)(C) shall apply for purposes of this subsection. (E) Applicable dollar amount; cost-of-living adjustment. (i) In general. For purposes of subparagraph (A)(ii), the applicable dollar amount shall be the amount determined in accordance with the following table: For taxable years beginning in calendar year: The applicable dollar amount: $7, $8, $9, or thereafter $10,000 (ii) Cost-of-living adjustments. In the case of a year beginning after December 31, 2005, the Secretary shall adjust the $10,000 amount under clause (i) at the same time and in the same manner as under section 415(d), except that the base period taken into account shall be the calendar quarter beginning July 1, 2004, and any increase under this subparagraph which is not a multiple of $500 shall be rounded to the next lower multiple of $

122 (3) Vesting requirements. The requirements of this paragraph are met with respect to a simple retirement account if the employee s rights to any contribution to the simple retirement account are nonforfeitable. For purposes of this paragraph, rules similar to the rules of subsection (k)(4) shall apply. (4) Participation requirements (A) In general. The requirements of this paragraph are met with respect to any simple retirement account for a year only if, under the qualified salary reduction arrangement, all employees of the employer who (i) received at least $5,000 in compensation from the employer during any 2 preceding years, and (ii) are reasonably expected to receive at least $5,000 in compensation during the year, are eligible to make the election under paragraph (2)(A)(I) or receive the nonelective contribution described in paragraph (2)(B). (B) Excludable employees. An employer may elect to exclude from the requirement under subparagraph (A) employees described in section 410(b)(3). (5) Administrative requirements. The requirements of this paragraph are met with respect to any simple retirement account if, under the qualified salary reduction arrangement (A) An employer must (i) make the elective employer contributions under paragraph (2)(A)(i) not later than the close of the 30-day period following the last day of the month with respect to which the contributions are to be made, and (ii) make the matching contributions under paragraph (2)(A)(iii) or the nonelective contributions under paragraph (2)(B) not later than the date described in section 404(m)(2)(B). (B) an employee may elect to terminate participation in such arrangement at any time during the year, except that if an employee so terminates, the arrangement may provide that the employee may not elect to resume participation until the beginning of the next year, and (C) each employee eligible to participate may elect, during the 60-day period before the beginning of any year (and the 60-day period before the first day such employee is eligible to participate), to participate in the arrangement, or to modify the amounts subject to such arrangement, for such year. (6) Definitions. For purposes of this subsection (A) Compensation (i) In general. The term compensation means amounts described in paragraphs (3) and (8) of section 6051(a). (ii) Self-employed. In the case of an employee described in subparagraph (B), the term compensation means net earnings from self-employment determined under section 1402(a) without regard to any contribution under this subsection. The preceding sentence shall be applied as if the term trade or business for purposes of section 1402 included service described in section 1402(c)(6). (B) Employee. The term employee includes an employee as defined in section 401(c)(1). (C) Year. The term year means the calendar year. (7) Use of designated financial institution. A plan shall not be treated as failing to satisfy the requirements of this subsection or any other provision of this title merely because the employer makes all contributions to the individual retirement accounts or annuities of a designated trustee or issuer. The preceding sentence shall 122

123 not apply unless each plan participant is notified in writing (either separately or as part of the notice under subsection (1)(2)(C)that the participant s balance may be transferred without cost or penalty to another individual account or annuity in accordance with subsection (d)(3)(g). (8) Coordination with maximum limitation under subsection (a). In the case of any simple retirement account, subsections (a)(1) and (b)(2) shall be applied by substituting the sum of the dollar amount in effect under paragraph (2)(A)(ii) of this subsection and the employer contribution required under subparagraph (A)(iii) or (B)(i) of paragraph (2) of this subsection, which ever is applicable for the dollar amount in effect under section 219(b)(1)(A). (9) Matching contributions on behalf of self-employed individuals not treated as elective employer contributions. Any matching contribution described in paragraph (2)(A)(iii) which is made on behalf of a selfemployed individual (as defined in section 401(c)) shall not be treated as an elective employer contribution to a simple retirement account for purposes of this title. (q) Deemed IRAs under qualified employer plans. (1) General rule. If-- (A) a qualified employer plan elects to allow employees to make voluntary employee contributions to a separate account or annuity established under the plan, and (B) under the terms of the qualified employer plan, such account or annuity meets the applicable requirements of this section or section 408(A) for an individual retirement account or annuity, then such account of annuity shall be treated for purposes of this title in the same manner as an individual retirement plan and not as a qualified employer plan (and contributions to such account or annuity as contributions to an individual retirement plan and not to the qualified employer plan). For purposes of subparagraph (B), the requirements of subsection (a)(5) shall not apply. (2) Special rules for qualified employer plans. For purposes of this title, a qualified employer plan shall not fail to meet any requirement of this title solely by reason of establishing and maintaining a program described in paragraph (1). (3) Definitions. For purposes of this subsection-- (A) Qualified employer plan. The term qualified employer plan has the meaning given such term by section 72(p)(4); except such term shall not include a government plan which is not a qualified plan unless the plan is an eligible deferred compensation plan (as defined in section 457(b)). (B) Voluntary employee contribution. The term voluntary employee contribution means any contribution (other than a mandatory contribution within the meaning of section 411(c)(2)(C) (i) which is made by an individual as an employee under a qualified employer plan which allows employees to elect to make connections described in paragraph 1, and (ii) with respect to which the individual has designated the contribution as a contribution to which this subsection applies. (r) Cross references (1) For tax on excess contributions in individual retirement accounts or annuities, see section (2) For tax on certain accumulations in individual retirement accounts or annuities, see section

124 CHAPTER FIFTEEN: HOW IRAS COMPARE TO OTHER RETIREMENT SAVINGS PLANS Many retirement savings vehicles are available today, including Keogh, 401k, and non-qualified vehicles such as fixed and variable annuities. Each of these vehicles has its own characteristics, advantages and disadvantages. This chapter contains a brief overview of these alternative retirement savings vehicles and compares their features to those of the traditional IRA. REGULAR AND ROTH IRAS COMPARED TO SEP AND SIMPLE IRAS The small business owner may wonder whether he or she should contribute to a Regular or Roth IRA, or should contribute to an existing SEP Plan or to a SIMPLE Plan. The most obvious reason the small business person will be better off with the SEP or SIMPLE Plan is the higher amount of income he or she is able to contribute and deduct. As we know, the Roth and Regular IRAs are limited to $5500 currently. SEP and SIMPLE Plans allow much higher contribution amounts. On the following pages are tables which compare the maximum contribution limits and other features of the regular and Roth IRA features to those of SEP and SIMPLE Plans. The good news for the small business person, or the person employed by a small business owner, is that contributions can be made to a Roth or Regular IRA AND to the SIMPLE or SEP Plans. The SEP and SIMPLE Plans are treated like other qualified plans in terms of determining whether a Regular IRA contribution is deductible. Deductibility is not an issue in the Roth IRA, so if the small business owner or employee is has adjusted gross income under the maximum limits, he or she may make a contribution to a SEP or SIMPLE Plan as well as to a Roth IRA. As mentioned earlier, new SARSEP plans may no longer be established, but if a business owner already has established a plan, contributions may be made to it. The distribution rules of the regular IRA are found in the SARSEP, SEP and SIMPLE Plans. All three of these plans require that distributions 124

125 EXHIBIT COMPARISON OF REGULAR AND ROTH IRAS TO SEPS Feature Regular IRA Roth IRA SEPs Eligibility All persons under 70 ½ who have compensation All persons who have compensation. Self-employed and small businesses Eligibility Phaseout None to make contributions. Deductible contributions eligibility phased out based on adjusted gross iincome (agi). Between agi of $183,000 to $193,000 for taxpayers married filing jointly. Between agi of $116,000 to $131,000 None Contribution Maximum The smaller of $5500 ( ) or 100% of compensation. Catchup contributions of $1000. The smaller of $5500 ( ) or 100% of compensation. Catch-up contributions of $1000. The smaller of $53,000 or 25% of eligible compensation Non-Earner Spouse Contribution Yes, maximum of $5500 (increases using same schedule as non-spousal IRA) Yes, maximum of $5500 (increases using same schedule as non-spousal Roth IRA) Salary Reduction Contributions No No Yes, through the SAR- SEP No Taxation of Earnings While In IRA Deductible contributions and all earnings taxable when withdrawn. No taxation while earnings remain in IRA. No taxation while pretax contributions remain in IRA. Mandatory Distributions Must begin the year following age 70 ½, prior to 59 ½, additional tax applies No mandatory distributions. Must begin the year following age 70 ½, prior to 59 ½, additional tax applies Taxation of Distributions Deductible contributions and all earnings taxable when withdrawn. If a qualified distribution, distributions are tax-free. If a non-qualified distribution, contributions are considered to be withdrawn first and are not taxable. Earnings within a qualified distribution are taxable. Deductible contributions and all earnings taxable when withdrawn. Earnings and deductible contributions considered to be taxed before non-deductible contributions. Minimum Holding Period Without Tax Penalty Unless an exception to premature distribution penalty, to age 59 ½. 5 years if a qualified distribution, or if due to death, disability or reaching age 59 ½. Unless an exception to premature distribution penalty, to age 59 ½. Prohibited Investments Life insurance, most collectibles Life insurance, most collectibles Life insurance, most collectibles Rollovers Allowed Regular IRA eligible retirement plans. Regular IRA to Roth IRA rollovers have current taxation ramifications. Roth IRA to Roth IRA SEP IRAs may be rolled to eligible retirement plans 125

126 EXHIBIT COMPARISON OF REGULAR AND ROTH IRAS TO SIMPLE PLANS Feature Regular IRA Roth IRA SIMPLE Plans Eligibility All persons under 70 ½ who have compensation All persons who have compensation. Self-employed and small businesses Eligibility Phaseout None to make contributions. Deductible contributions eligibility phased out based on adjusted gross iincome (agi). Between agi of $150,000 to $160,000 for taxpayers married filing jointly. Between agi of $95,000 to $110,000 None Contribution Maximum The smaller of $5500 ( ) or 100% of compensation. Catch-up contributions of $1000. The smaller of $5500 ( ) or 100% of compensation. Catchup contributions of $1000. Salary reduction contributions up to a maximum of $12,500 for 2015 Non-Earner Spouse Contribution Yes, maximum of $5500 (increases using same schedule as non-spousal IRA) Yes, maximum of $5500 (increases using same schedule as nonspousal Roth IRA) None Salary Reduction Contributions No No Yes Mandatory Distributions Must begin the year following age 70 ½, prior to 59 ½, additional tax applies No mandatory distributions. Must begin the year following age 70 ½, prior to 59 ½, additional tax applies. Taxation of Earnings While In IRA Deductible contributions and all earnings taxable when withdrawn. If a qualified distribution, distributions are taxfree. If a non-qualified distribution, contributions are considered to be withdrawn first and are not taxable. Earnings within a qualified distribution are taxable. No taxation while pre-tax contributions remain in IRA. Minimum Holding Period Without Tax Penalty Unless an exception to premature distribution penalty, to age 59 ½. 5 years if a qualified distribution, or if due to death, disability or reaching age 59 ½. Unless an exception to premature distribution penalty, to age 59 ½. Prohibited Investments Life insurance, most collectibles Life insurance, most collectibles Life insurance, most collectibles Rollovers Allowed Regular IRA eligible retirement plans. Regular IRA to Roth IRA rollovers have current taxation ramifications. Roth IRA to Roth IRA SIMPLE IRAs may be rolled to other SIMPLE IRAs and to regular IRAs. 126

127 begin no later than April 1 after the owner reaches age 70 ½. All three of these plans may also include pre-tax contributions, so the taxation rules are somewhat complex. Since the Roth IRA has only after tax contributions, its distribution rules are much simpler than these other IRA forms. SELF- EMPLOYED PLANS (KEOGH PLANS) Another retirement plan available to the self-employed is the Keogh plan, or Self-Employed Retirement Plan. Self-employed retirement plans may be opened by the self-employed sole proprietor or partner in a partnership. Congressmen Keogh, for whom the original form of these plans were named, sponsored legislation allowing self-employed qualified plans in Since the first Keogh plans, most of the special rules which made qualified plans for the self-employed distinctly unique from other qualified plans have been eliminated. Many of the rules that apply to qualified plans apply to current Keogh plans as well. Today, they are normally referred to as self-employed retirement plans, but sometimes they are still called Keogh plans. Contributions Generally, contributions to a self-employed plan, which are money purchase or profit sharing plans, are limited to the smaller of 25% of eligible compensation or $53,000. Eligible compensation for a self-employed retirement plan is $265,000, which may be indexed for inflation. Eligibility The minimum requirements for employee eligibility in a self-employed retirement plan are full time employees at least 21 years of age who have either one-year of service with the employer, or who have two years of service if 100% vesting in the plan is provided after two years. Vesting Vesting refers to the incidence of ownership in the employee s account allocation. For example, a three-year vesting schedule might provide a one year employee with a thirty percent ownership in his or her account allocation, a two year employee with a seventy-five percent ownership and a three year employee with one hundred percent ownership. If this employee separated from service after one year, he or she would be entitled to thirty percent of the value of his or her plan account, after two years to seventy-five percent, and after three years to one hundred percent. Self-employed retirement plans allow the use of participant vesting. Investment Options Self-employed retirement plans may be funded with a wide variety of investments, including life insurance, annuities, mutual funds, bank accounts, guaranteed investment contracts (GICs), and stock. The amount of life insurance in a qualified plan is subject to regulations which require that the benefits in a qualified plan must be incidental to the plan. In other words, a qualified plan s basic function is to provide retirement benefits, not life insurance death benefits. 127

128 Tax Deductibility Keogh contributions are tax deductible to the employer. Employees may make voluntary contributions to a Keogh of up to ten percent of earned income. The total of the employer and voluntary employee contributions cannot exceed the overall contribution limit for the employee. Voluntary employee contributions are after tax contributions. Distributions Distributions from a self-employed qualified retirement plan must generally begin by April 1 of the year following the year the participant reaches 70 ½ or retirement age, whichever is later. (Participants of qualified plans who are 5-percent owners must begin distributions at this time. Keogh participants generally are 5-percent owners, as defined by the tax code.) Distributions made prior to 59½ are subject to the ten percent distribution tax. The exceptions to the premature distribution tax differ for a self-employed retirement plan from those for the IRA, SIMPLE and SEP plans. The exceptions are: a) death of the participant. b) disability. Disability is strictly defined by the IRS. Generally, a physician must determine that an IRA holder has a condition that will last for a contiguous period of at least twelve months under which he or she cannot do any substantial gainful activity because of his or her physical or mental condition. c) early retirement in accordance with a plan s early retirement provisions, after age 55. d) Payments which are part of a series of substantially equal payments which are made over the employee s lifetime. These payments may also be made over the employee and a designated beneficiary s lifetime. At least one payment must be made annually. The payments may not be modified until the employee reaches age 59 ½, or at least five years from the first payment. whichever is greater. If the payments are modified prior to this time period, the entire amount distributed will become subject to the additional 10% tax, unless the modification in payments was due to disability or death of the employee. e) made to an employee for medical care, to the extent they are deductible under the internal revenue code. f) distributions made as a direct rollover or rollover to an IRA or another qualified plan. The plan will dictate when distributions may be made from the plan. Typically, distributions may not be made prior to the retirement age in the plan unless the employee has separated from service. Therefore, the selection of investments used in the plan are very important. Unlike an IRA or a SEP where the funds belong to the employee and may be rolled and transferred at any time, the funds in a self-employed retirement plan must remain in the plan, as stated above. More and more employers are providing their employees with a wide selection of allowable investments within the plan so different and changing objectives of participants can be met. Advantages Self-employed retirement plan advantages include: Tax deductibility. Employer contributions are tax deductible. 128

129 Vesting. Vesting schedules have the advantage of providing incentive for employees to stay with a company during the vesting period. If an employee leaves during the vesting period, the amount in the employees plan account is reallocated among the remaining employee accounts. The reallocated amount may be used to reduce future employer contributions. Vesting can be an attractive advantage for a plan. Investment Options. Self-employed retirement plans allow a wide variety of investment options. High Contribution Limits. Self-employed retirement plans allow contributions of up to 25% of compensation, up to a maximum of $53,000. Disadvantages Disadvantages of a self-employed retirement plan include: More complicated paperwork than a SEP or a SIMPLE plan. The requirement of some government reporting regarding the plan and the lack of loan availability for a self-employed owner. Depending on the complexity of the plan and the type of qualified plan used, administrative fees are charged which are significantly higher than those for a SEP or IRA plan. Administrative fees may be $50 - $75 annually for a self-employed individual with no employees, and generally increase in amount based on the number of employees and complexity of the plan. 129

130 EXHIBIT 15.3 COMPARISON OF REGULAR AND ROTH IRAS TO KEOGH (SELF EMPLOYED) PLANS Feature Regular IRA Roth IRA KEOGH Plan Eligibility All persons under 70 ½ who have compensation All persons who have compensation. Self-employed sole proprietor or partner Eligibility Phaseout None to make contributions. Deductible contributions eligibility phased out based on adjusted gross iincome (agi). Between agi of $183,000 to $193,000 for taxpayers married filing jointly. Between agi of $116,000 to $131,000 None Contribution Maximum The smaller of $5500 ( ) or 100% of compensation. Catch-up contributions of $1000. The smaller of $5500 ( ) or 100% of compensation. Catchup contributions of $1000. Generally, the smaller of $53,000, or 25% of compensation. Non-Earner Spouse Contribution Yes, maximum of $5500 (increases using same schedule as non-spousal IRA) Yes, maximum of $5500 (increases using same schedule as nonspousal Roth IRA) None Salary Reduction Contributions No No Yes Taxation of Earnings While In Plan Deductible contributions and all earnings taxable when withdrawn. No taxation while earnings remain in IRA. No taxation while pre-tax contributions remain in plan. Mandatory Distributions Must begin the year following age 70 ½, prior to 59 ½, additional tax applies No mandatory distributions. Generally must begin the year following age 70 ½, or when the participant retires Taxation of Distributions Deductible contributions and all earnings taxable when withdrawn. If a qualified distribution, distributions are taxfree. If a non-qualified distribution, contributions are considered to be withdrawn first and are not taxable. Earnings within a qualified distribution are taxable. Pre-tax contributions and all earnings taxable when withdrawn. Earnings and pre-tax contributions considered to be taxed before after tax contributions. Minimum Holding Period Without Tax Penalty Prohibited Investments Unless an exception to premature distribution penalty, to age 59 ½. Life insurance, most collectibles 5 years if a qualified distribution, or if due to death, disability or reaching age 59 ½. Life insurance, most collectibles Unless an exception to premature distribution penalty, to age 59 ½. Life insurance in plan must be incidental to retirement benefits. Rollovers Allowed Regular IRA eligible retirement plans. Regular IRA to Roth IRA rollovers have current taxation ramifications. Roth IRA to Roth IRA Plans may be rolled to other defined contribution plans and to regular IRAs. 130

131 401K PLANS A popular qualified plan vehicle is the 401k plan. 401k plans are a type of defined contribution plan. Defined contribution plans provide for fixed contributions to a qualified plan. In the case of a 401k plan, the employee determines the amount of his or her fixed contribution amount, within certain plan defined limits. Employee contributions are made via salary deferral. In addition, a 401k plan may contain a provision to include an employer match contribution to the plan. The employer may match all or a portion of the contributions the employee defers into the plan. Contributions The maximum amount an employee may defer through salary reduction in a 401(k) Plan, or the applicable dollar amount is listed in the following schedule: For tax years beginning in: The applicable dollar amount is: 2002 $11, $12, $13, $14, $15, and 2008 $15, through 2011 $16, $17, through 2014 $17, $18,000 The total of employer and employee contributions cannot exceed an overall contribution limit for defined contribution profit sharing plans which is the lesser of $53,000 or 25% of eligible compensation, which is $265,000. Elective deferrals and employer contributions are both tax deductible to the employer. Investment Options Allowable 401k investments are identical to the allowable investments in a Keogh and can include life insurance. The plan must designate what investments can be made. The investments may be unlimited, similar to a self-directed IRA plan, or the plan may allow a certain family of mutual funds to be used, or a group of mutual funds along with a GIC or life insurance option. Vesting In a 401(k), employer matching contributions after 2001 must vest according to one of the two following schedules: (1) a participant must have a nonforfeitable right to 100% of employer matching contributions within three years, or (2) a participant must gain a nonforfeitable right to employer matching contributions according to the following schedule: Years of Nonforfeitable 131

132 Distributions Service Percentage Distributions from a 401k plan are allowable under the following circumstances: a) retirement b) death c) disability d) separation from service e) certain plan terminations f) financial hardship. Hardship is defined as an immediate and heavy financial need when other resources are not reasonably available to meet this need. Hardship withdrawals include medical expenses, purchase of principal residence, higher education tuition for the employee, his or her spouse, children or dependents, and to prevent eviction from the employee s principal residence. Generally, distributions from a 401k plan must begin by April 1 of the year following the year the participant reaches 70 ½, or if later, the year in which the participant retires. Premature distribution tax applies to withdrawals prior to 59½. The exceptions to the premature distribution tax for a 401k and the same as those listed for a Keogh. Advantages Advantages of a 401k plan include: Flexibility of contributions. The employee determines the amount to defer and whether or not to participate. Typically, the employee can make the decision to participate and at what amount each quarter. Some plans allow these decisions annually, some at any time. Availability of loans. Qualified plans, including 401k plans, can include a provision to allow loans from an employee s account. These loans must be based on the amount of vested benefits. Most loans must be repaid to the plan within five years. The exception to this is a home loan, which may be repaid over a longer period. Availability of employer matching contributions. 401k plans may allow matching contributions from the employer. Generally, the employer will match a certain percentage of employee contributions up to a specified maximum. These contributions are not included in employee compensation. Tax deductibility. Employer contributions are tax deductible to the employer. contributions are pre-tax contributions, and so reduce taxable income. Employee 132

133 Disadvantages Disadvantages to a 401k include higher plan administration costs and more complex administrative duties, such as government reporting, loan administration, and vesting administration. EXHIBIT 15.4 COMPARISON OF A REGULAR AND ROTH IRA TO 401K PLANS Feature Regular IRA Roth IRA 401k Plan Eligibility All persons under 70 ½ who have compensation All persons who have compensation. Partnerships, corporations Eligibility Phaseout None to make contributions. Deductible contributions eligibility phased out based on adjusted gross iincome (agi). Between agi of $183,000 to $193,000 for taxpayers married filing jointly. Between agi of $116,000 to $131,000 None Contribution Maximum The smaller of $5500 ( ) or 100% of compensation. Catch-up contributions of $1000. The smaller of $5500 ( ) or 100% of compensation. Catchup contributions of $1000. Generally, total contributions may be the smaller of $53,000 or 25% of compensation; employee may defer up to $18,000 for 2015 Non-Earner Spouse Contribution Yes, maximum of $4000 (increases using same schedule as non-spousal IRA) Yes, maximum of $5500 (increases using same schedule as nonspousal Roth IRA) None Salary Reduction Contributions No No Yes Taxation of Earnings While In Plan Deductible contributions and all earnings taxable when withdrawn. No taxation while earnings remain in IRA. No taxation while pre-tax contributions remain in 401k. Mandatory Distributions Must begin the year following age 70 ½, prior to 59 ½, additional tax applies No mandatory distributions. Generally must begin the year following age 70 ½, or when the participant retires Taxation of Distributions Deductible contributions and all earnings taxable when withdrawn. If a qualified distribution, distributions are taxfree. If a non-qualified distribution, contributions are considered to be withdrawn first and are not taxable. Earnings within a qualified distribution are taxable. Pre-tax contributions and all earnings taxable when withdrawn. Earnings and pre-tax contributions considered to be taxed before after tax contributions. Minimum Holding Period Without Tax Penalty Prohibited Investments Unless an exception to premature distribution penalty, to age 59 ½. Life insurance, most collectibles 5 years if a qualified distribution, or if due to death, disability or reaching age 59 ½. Life insurance, most collectibles Unless an exception to premature distribution penalty, to age 59 ½. Life insurance in plan must be incidental to retirement benefits. Rollovers Allowed Regular IRA eligible retirement plans. Regular Roth IRA to Roth IRA 401k Plans may be rolled to other 401k Plans and to 133

134 IRA to Roth IRA rollovers have current taxation ramifications. regular IRAs. EXHIBIT 15.5 COMPARISON OF A REGULAR AND ROTH IRA TO QUALIFIED RETIREMENT VEHICLES Retirement Vehicle Regular IRA Roth IRA SEP SIMPLE Self-Employed Retirement Plans 401k Savings Eligibility Contributions Distributions Salary Reduction All persons under 70 ½ who earn compensation All persons under 70 ½ who earn compensation Self-employed and small businesses Small businesses with no more than 100 employees who earned $5000 or more in compensation Self-employed sole proprietor or partner Partnerships, corporations The smaller of $5500 (2015) or 100% of compensation and catch-up contributions of $1000 in 2015 The smaller of $5500 (2015) or 100% of compensation and catch-up contributions of $1000 in 2015 The smaller of $53,000 or 25% of eligible compensation Salary reduction contributions up to a maximum of $12,500 (2015). Generally, the smaller of $53,000 or 25% of compensation. Generally, total contributions may be the smaller of $53,000 or 25% of compensation; employee may defer up to $18,000 in 2015 Must begin the year following age 70 ½, prior to 59 ½, additional tax applies No mandatory distributions Must begin the year following age 70 ½, prior to 59 ½, additional tax applies Must begin the year following age 70 ½, prior to 59 ½, additional tax applies Must begin the year following age 70 ½, or retirement, prior to 59 ½, additional tax applies Must begin the later of the year following age 70 ½ or retirement, prior to 59 ½, additional tax applies Tax- Deferred No Yes No No Yes No No Yes No Yes Yes No No Yes Yes Yes Yes Yes Vesting Available 134

135 NON-QUALIFIED ANNUITIES Along with qualified retirement savings vehicles, non-qualified deferred annuities can be used, either as a supplement to a qualified plan, or if a person is not eligible for a qualified plan, as a supplement to an IRA. Annuity types include fixed, variable and equity-indexed annuities. Deferred annuities include special features such as annuitization options, medical waivers, rate guarantees, bail out rates, stepped up death benefits, variable annuity subaccount options, and more. These features apply whether an annuity is purchased as an IRA, as a qualified annuity or as a non-qualified annuity. However, tax regulations surrounding a non-qualified annuity are different from those of a qualified or individual retirement annuity. Premature Distributions The premature distribution tax for distributions taken prior to 59 ½ applies to non-qualified annuities. However, the 10% tax is levied on pre-tax contributions and accumulations in a qualified or individual retirement annuity. In a non-qualified annuity, contributions will always be after tax, so the 10% tax on premature distributions is assessed on earnings only Distributions Distributions from a non-qualified annuity do not have to be made at age 70½. Instead, the distribution start date, normally called the annuity start date or maturity date, is dictated by the annuity contract. In some states, distributions are required to start by a certain age or within a certain time frame. Other states allow an annuity to remain in the deferred state until the death of the annuity owner or annuitant. Taxation at Withdrawal Non-qualified deferred annuities are tax deferred products, just like qualified plans and IRAs. No part of the contributions are tax deductible however, nor may they be made as salary deferral contributions. Income tax is paid on earnings as they are withdrawn. Currently, withdrawals from annuities are taxed as though the earnings are distributed first. Withdrawals from qualified plans and IRAs are also taxable as withdrawn, and pre-tax contributions are taxable. In the case of an IRA with non-deductible contributions, the ratio of non-deductible contributions to the total value of the IRA is applied to each distribution to determine the non-taxable portion Exchanges Non-qualified annuities may be transferred to another annuity tax free through IRS section 1035 rules. The 1035 rules state that the annuity moneys must be transferred directly to the new annuity company to retain tax deferral status. If the annuity were distributed to the annuity owner, the distribution is taxable. Both non-qualified annuities and qualified annuities can therefore avoid current tax ramifications if transferred according to the appropriate regulations. However, product penalties are not waived through these regulations. If an annuity is still within the surrender period when transferred, the insurance company will apply surrender charges when the annuity is liquidated and transferred to a new product. In addition, the new annuity will invoke a new surrender schedule and begin a new surrender period. The loss due to 135

136 surrender penalties should be calculated to determine whether the transfer to the new product is in the best interest of the customer. Advantages The advantages of an annuity vary depending upon whether the annuity is fixed, variable or equity-indexed. For the fixed annuity, advantages include relative safety, guaranteed interest rates, many distribution options, medical or nursing home waivers, systematic withdrawal options and penalty-free withdrawals. Variable annuity advantages include the opportunity for relatively higher returns through a variety of investment options through the sub accounts, a variety of distribution options, and features such as stepped up death benefits, systematic withdrawals and penalty-free withdrawals. The advantages of equityindex annuities include flexible withdrawal options and other features of fixed annuities, but also include the opportunity for growth that generally exceeds that of the fixed annuity through the use of index securities. An additional benefit in using a non-qualified annuity as a retirement vehicle is the ability to withdraw funds. Unlike funds in a Keogh, 401k or other qualified plan which must remain in the plan except for very specific restrictions outlined earlier, moneys from an annuity may be withdrawn at any time. Surrender charges apply for a time, and the premature distribution tax applies to earnings withdrawn prior to 59½, but the money can be withdrawn. The biggest advantage of the use of a non-qualified annuity as a retirement savings vehicle is the lack of limits on the amount of contributions that may be made. Unlike IRAs and qualified retirement plans, which have federally mandated annual contribution limits, the only contribution limits on a non-qualified annuity are those imposed by the insurer. An insurer may not allow more than $1,000,0000, for example, to be placed into an annuity. This ability to make contributions of almost any amount is of great benefit to those who have put the maximum contributions into their qualified plans, or are no longer eligible to contribute to qualified plans, and have additional funds they would like to hold in a tax-deferred account. 136

137 EXHIBIT 15.7 COMPARISON OF A REGULAR IRA TO A NON-QUALIFIED ANNUITY Feature IRA Non-Qualified Annuity Contribution Limits Smaller of $5500(2015) or 100% of compensation Up to contract limits, may be as high as $1,000,000 or more. Premature Tax Income Tax Tax-Free Transfers Distribution Distributions Must Begin Annuitization Options Pre-tax withdrawals prior to 59 ½ are assessed a 10% tax unless the withdrawal is : due to disability, due to death, part of a series of substantially equal payments which are made over the life expectancy of the IRA holder, or the joint life expectancy of the IRA holder and beneficiary, a distribution for certain medical expenses, a distribution to an unemployed individual for health insurance premiums. a distribution for certain higher education expenses a distribution for certain first-time homebuyer expenses Due on total withdrawn, except portion attributable to non-deductible contributions. Allowed through IRA rollover and transfer rules. Generally, at age 70 ½, per RMD rules. Must not violate RMD requirements. Earnings withdrawn prior to 59 ½ are assessed a 10% tax unless the withdrawal is : due to disability, due to death, an immediate annuity, part of a series of substantially equal payments which are made over the life expectancy of the contract holder of the joint life expectancy of the contract holder and beneficiary. Due when earnings are withdrawn. Assessed on earnings only. Allowed through 1035 exchange rules. By contractual annuity start date. Based on contract terms. 137

138 Disadvantages Disadvantages of non-qualified annuities as a retirement vehicle include the lack of tax deductibility of any contributions. Earnings are taxed when withdrawn. For tax purposes, earnings are considered to be withdrawn before contributions. SUMMARY All the qualified retirement plans discussed are tax-deferred and provide for the tax deductibility of employer contributions. SEP and SIMPLE plans are the easiest self-employed retirement plans to establish. They include minimal administration while providing contribution limits much higher than those of the IRA. SIMPLE plans include the added advantage of allowing employee contributions through salary deferral. Self-employed retirement (Keogh) plans provide the benefits of qualified plans, such as vesting and reallocation of forfeited benefits, but have more complicated administration rules, so trustees normally charge higher administrative fees than for the SEP or SIMPLE plans. In addition, life insurance may be used as an investment within the Keogh. 401k plans give the employee the advantage of determining the amount of salary deferred contributions and when those contributions will be made. 401k plans require administration of vesting schedules, employee salary reduction, plan loans, as well as government reporting and tax statements. Therefore, 401k plan administrators will generally charge higher fees than those charged for Keoghs, SEPs or SIMPLE plans. Non-qualified annuities include the tax-deferral advantages of qualified retirement plans, but with increased access to accumulations. The IRA remains the retirement vehicle most available to the most people. To contribute to an IRA one does not have to be self-employed or have an employer sponsored qualified retirement plan. However, if an individual is self-employed or covered by an employer sponsored retirement plan, an IRA contribution may still be made. 138

139 CHAPTER FOURTEEN: HEALTH IRAS Take one to reduce pain associated with medical costs.. Another type of IRA became available in 1997: the Medical IRA or the Medical Savings Account (MSA). As of 2001, the MSA was renamed the Archer MSA. MSAs are referred to as Medical IRAs because many of the provisions of IRAs are used in the rules surrounding MSAs. The tax deferred MSA was created by the Health Insurance Portability and Accountability Act of The MSA was created by Congress as a means to reduce health care expenses. Under an MSA program, the individual pays for health care directly. This is in contrast to coverage through a conventional health insurance plan, where the insurance company decides which medical expenses to pay, and how much to pay. By giving the individual the freedom to pay for just those services the individual needs, health expenses should decrease, Congress reasoned. In addition, the individual has an incentive to keep health costs low, since unused values of the MSA can be used for future health care expenses. While money remains in the MSA, it grows tax-deferred. Contributions to MSAs may be deductible as well. An MSA is basically a personal savings account used to pay for unreimbursed medical expenses. A high deductible health plan is purchased on the MSA holder. The MSA holder contributes an amount not greater than a certain percentage of the deductible into the MSA. The amount contributed earns interest tax-deferred in the MSA. When the MSA values are distributed to pay for certain medical expenses, the amount distributed is tax-free. Other distributions are taxable. The ability to open new MSA accounts expired at the end of Congress created a new medical IRA account to replace the MSA: Health Savings Accounts, or HSAs. As of January, 2004, HSAs could be opened by individuals with high deductible health plans. Contributions to HSAs may be used to pay for unreimbursed medical expenses. In this chapter, we will first look at MSA plans. Although new MSA plans may not be opened, individual with existing MSA plans who remain eligible for them may continue to contribute to them and utilize them. After we have explored MSA plans, we will examine HSA plans. ELIGIBILITY AND CONTRIBUTION RULES OF MSAS Eligibility MSAs may be contributed to by those who have already established an MSA prior to January 1, 2008 who are employees or the spouse of an employee of a small employer who maintains an individual or family high-deductible health plan, or HDHP, for the employee. MSAs may also be contributed to by self-employed individuals and the spouse of self- 139