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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. Copyright Erland Education Services (formerly Erland Financial Education Services) 2008, 2009, 2010, 2011, 2012
Table of Contents CHAPTER ONE: AN INTRODUCTION TO RETIREMENT SAVINGS... 1 RETIREMENT TODAY... 1 RETIREMENT INCOME... 1 Personal Savings... 1 Social Security... 2 Qualified Retirement Plans... 3 RETIREMENT SAVINGS FACTORS... 4 Life Expectancy... 4 Inflation... 4 Risk... 5 Health Care Costs... 5 Rule of Thumb... 6 CHAPTER ONE STUDY QUESTIONS... 7 Answers to Chapter One Study Questions... 8 CHAPTER TWO: AN INTRODUCTION TO TRADITIONAL IRAS... 9 WHAT IS A TRADITIONAL IRA?... 9 ELIGIBILITY REQUIREMENTS FOR A TRADITIONAL IRA... 10 TYPES OF TRADITIONAL IRAS... 10 Individual Retirement Account... 11 Individual Retirement Annuity... 11 Simplified Employee Pension... 12 Employer and Employee Association Trust Account... 12 TRANSFERS... 12 Trustee-to-Trustee Transfers... 12 Rollovers... 12 Transfers Due to a Divorce... 13 IRA INVESTMENTS... 13 CHAPTER TWO STUDY QUESTIONS... 15 Answers to Chapter Two Study Questions... 17 CHAPTER THREE: CONTRIBUTION RULES OF TRADITIONAL IRAS... 18 CONTRIBUTION LIMITS... 18 General Contribution Limit... 18 Catch-Up Contributions... 19 Spousal Limit... 19 Contributions Above or Below Limits... 20 Commissions and Fees... 21 IRA Products and Simple Plans
Qualified Reservist Repayments... 21 CONTRIBUTION DEADLINES... 22 CHAPTER THREE STUDY QUESTIONS... 23 Answers to Chapter Three Study Questions... 25 CHAPTER FOUR: DEDUCTING TRADITIONAL IRA CONTRIBUTIONS... 26 DEDUCTING CONTRIBUTIONS... 26 Full Deduction... 26 Spousal Deduction... 26 Commissions and Fees... 27 EMPLOYER PLAN DEDUCTIONS... 27 Defined Contributions Plans... 27 Defined Benefit Plans... 27 Plans That Are Not Employer Plans... 28 Deduction Phaseout... 28 NONDEDUCTIBLE CONTRIBUTIONS... 29 CHAPTER FOUR STUDY QUESTIONS... 30 Answers to Chapter Four Study Questions... 31 CHAPTER FIVE: DISTRIBUTION RULES OF TRADITIONAL IRAS... 32 MINIMUM DISTRIBUTIONS... 32 Distribution Period... 32 Life Expectancy... 33 Beneficiaries... 33 EARLY DISTRIBUTIONS... 35 Exceptions... 35 TAXABILITY OF DISTRIBUTIONS... 36 Fully and Partly Taxable... 37 Special Tax Situations... 37 CHAPTER FIVE STUDY QUESTIONS... 38 Answers to Chapter Five Study Questions... 40 CHAPTER SIX: TRADITIONAL IRA TRANSFERS AND ROLLOVERS... 41 TRUSTEE-TO-TRUSTEE TRANSFERS... 41 Recharacterizations... 41 ROLLOVERS TO A TRADITIONAL IRA... 42 ROLLOVERS FROM A TRADITIONAL IRA... 43 Rollover From One Traditional IRA to Another... 43 Rollover From An Employer s Plan... 43 ROLLOVER TIME LIMITS... 45 TRANSFERS INCIDENT TO A DIVORCE... 45 Changing Names... 46 IRA Products and Simple Plans
Direct Transfer... 46 AUTOMATIC ROLLOVERS AND SAFE HARBOR IRAS... 46 CHAPTER SIX STUDY QUESTIONS... 47 Answers to Chapter Six Study Questions... 49 CHAPTER SEVEN: ROTH IRAS... 50 WHAT IS A ROTH IRA?... 50 ROTH IRA ELIGIBILITY RULES... 50 ROTH IRA CONTRIBUTION RULES... 52 CONVERSIONS AND ROLLOVERS... 53 Conversions... 53 Failed Conversions... 53 Special Rules for Income Inclusion in 2010... 54 Rollover from Another Roth IRA... 54 ROTH IRA DISTRIBUTION RULES... 54 Qualified Distributions... 54 Non-Qualified Distributions... 55 Minimum Distributions... 56 CHAPTER SEVEN STUDY QUESTIONS... 57 Answers to Chapter Seven Study Questions... 59 CHAPTER EIGHT: IRA PRODUCTS... 60 CERTIFICATES OF DEPOSIT... 60 MUTUAL FUNDS... 60 Stocks... 61 Bonds... 61 Loads... 61 Fees... 61 Money Market Mutual Funds... 61 ANNUITIES... 62 Fixed Annuities... 62 Variable Annuities... 63 SELF-DIRECTED IRAS... 63 CHAPTER EIGHT STUDY QUESTIONS... 65 Answers to Chapter Eight Study Questions... 67 CHAPTER NINE: TRADITIONAL IRAS VS. ROTH IRAS... 68 ELIGIBILITY... 68 Traditional IRA... 68 Roth IRA... 68 CONTRIBUTIONS... 68 Traditional IRA... 68 Roth IRA... 68 DISTRIBUTIONS... 68 IRA Products and Simple Plans
Traditional IRA... 68 Roth IRA... 69 TAXES... 69 ROTH IRA CONVERSIONS... 69 Conversion Tax... 69 Age at Conversion... 70 Tax Benefits... 70 Tax Bracket... 70 IRA as an Inheritance... 70 CHAPTER NINE STUDY QUESTIONS... 71 Answers to Chapter Nine Study Questions... 73 CHAPTER TEN: SIMPLE IRAS... 74 WHAT IS A SIMPLE PLAN?... 74 EMPLOYER RULES FOR ESTABLISHING A SIMPLE IRA PLAN... 74 Employee Limit... 74 Qualified Plan... 75 Account Requirements... 75 Notification Requirements... 75 EMPLOYEE ELIGIBILITY RULES... 76 Compensation... 77 CHAPTER TEN STUDY QUESTIONS... 78 Answers to Chapter Ten Study Questions... 80 CHAPTER ELEVEN: SIMPLE IRA CONTRIBUTIONS AND DISTRIBUTIONS... 81 SIMPLE IRA EMPLOYEE CONTRIBUTIONS... 81 Salary Reduction Contributions... 81 Catch-up Contributions... 82 SIMPLE IRA EMPLOYER CONTRIBUTIONS... 82 Employer Matching Contributions... 82 Nonelective Contributions... 83 SIMPLE IRA CONTRIBUTION DEDUCTIONS... 83 SIMPLE IRA DISTRIBUTIONS... 84 CHAPTER ELEVEN STUDY QUESTIONS... 85 Answers to Chapter Eleven Study Questions... 87 CHAPTER TWELVE: SEP-IRAS... 88 WHAT IS A SEP-IRA?... 88 ELIGIBILITY REQUIREMENTS... 88 Employers... 88 Eligible Employees... 89 ESTABLISHING A SEP... 89 Formal Written Agreement... 89 IRA Products and Simple Plans
Specific SEP Information... 90 SEP-IRA for Each Employee... 90 TAX CREDIT FOR STARTUP COSTS... 90 CHAPTER TWELVE STUDY QUESTIONS... 92 Answers to Chapter Twelve Study Questions... 94 CHAPTER THIRTEEN: SEP-IRA CONTRIBUTIONS AND DISTRIBUTIONS... 95 SEP-IRA CONTRIBUTIONS... 95 Contribution Limits... 95 Excess Contributions... 96 DEDUCTING CONTRIBUTIONS... 96 Self-Employed Individuals... 96 Excess Contribution Carryover... 97 Timing... 97 SEP DISTRIBUTIONS... 97 CHAPTER THIRTEEN STUDY QUESTIONS... 98 Answers to Chapter Thirteen Study Questions... 100 CHAPTER FOURTEEN: SARSEPS... 101 WHAT IS A SARSEP?... 101 SARSEP ELIGIBILITY REQUIREMENTS... 101 SARSEP ADP Test... 101 ELECTIVE DEFERRAL LIMITS... 102 Catch-up Contributions... 102 Overall Limit... 103 ELECTIVE DEFERRALS AND TAXES... 103 Excess Deferrals and Contributions... 103 CHAPTER FOURTEEN STUDY QUESTIONS... 104 Answers to Chapter Fourteen Study Questions... 106 CHAPTER FIFTEEN: SAVER S TAX CREDIT... 107 WHAT IS THE SAVER S CREDIT?... 107 SAVER S CREDIT INDIVIDUAL ELIGIBILITY REQUIREMENTS... 107 Birth date... 107 Full-Time Student... 107 Tax Exemption... 108 Adjusted Gross Income... 108 ELIGIBLE CONTRIBUTIONS... 108 Reducing Eligible Contributions... 109 SPOUSAL DISTRIBUTIONS... 110 CHAPTER FIFTEEN STUDY QUESTIONS... 111 Answers to Chapter Fifteen Study Questions... 113 IRA Products and Simple Plans
Chapter One: An Introduction to Retirement Savings Saving for retirement is an important concern for us all. This chapter discusses this critical topic, including trends in retirement savings, the components of retirement savings and key factors in determining how much to save. Retirement Today It is expected that in the next 20 years, 74 million workers will be retiring. The twentieth century has seen an increase in the prevalence of retirement among both men and women. This has chiefly been the result of more income earned by modern Americans, who today earn an average income that is equal to approximately eight times the income of Americans who lived a hundred years ago. Retirement is no longer a luxury that only the rich can afford, thanks to this increased affluence and, for now at least, the safety-net of Social Security. The nature of retirement has also changed in modern times. No longer is retirement confined to a few short years at the end of an individual s life. Nor are retirees expected to be dependent upon children, as in the past. Rather, it is common for them to spend an extended amount of time in post-working years, often striving to continue to live as independently as possible. Retirement Income Personal Savings The rate of personal savings in the United States at the end of 2010 was about 5.4%. This rate had dropped to almost zero after the economic plunge we saw in 2008. Many are encouraged that the savings rate has increased, but there are still very real concerns stemming from the fact IRA Products and Simple Plans Page 1
that most Americans are not saving enough to pay for their retirement years. Europeans have a personal savings rate that is double that of the average American, while the Japanese save at a rate triple this amount. The lack of savings in America means that retirement goals are becoming increasingly unreachable. Modern Americans are having to work longer in order to afford to retire and may also experience a reduction in their quality of life during retirement. Personal savings are not the only source of retirement funds, however. Other sources include Social Security and qualified retirement plans. It should be noted that a 2001 study by the Social Security Administration found that personal savings make up approximately 52% of all retirement income. Social Security Today, nearly 40% of Americans postretirement income comes from Social Security. But Social Security s percentage of an individual s needed retirement income is decreasing and the individual s responsibility for retirement savings is increasing. President Franklin D. Roosevelt advocated Social Security in the United States in the 1930s in reaction to the devastation of the Great Depression. Officially created in 1935 through the passage of the Social Security Act, it was originally meant to be a means to provide benefits for poor, elderly Americans. However, miscalculations of population growth and longevity in the United States at its creation has led to a system that is unable to provide for all the needs of forthcoming retirees. The first of the 74 million-strong Baby Boomer generation began retiring in 2010. The exodus of retirees from the workforce may strain the Social Security System to the extent that full benefits will not be able to be paid to later generations without a significant structural overhaul. By some estimates, if no changes to the system are made, the Social Security trust funds will run out of money by 2040. In order for contributions to be matched after that time, benefits will have to be reduced by 37%. Despite these problems, Social Security will probably remain in effect, but is likely to be subject to significant change in coming years. IRA Products and Simple Plans Page 2
Social Security benefits are based on how much an individual puts into the system and at what point he or she begins receiving benefits. Benefits are divided into the following three categories: Retirement Income These benefits are assessed on the average of the 35 years of highest earned wages. Lower benefits are provided when individuals have worked less than 35 years. Retirement benefits are distributed once an individual reaches full retirement age. This age is dependent on an individual s birth year. The following table outlines the specifications related to year of birth and retirement age: Year of Birth Full Retirement Age 1937 or earlier 65 1938 65 and 2 months 1939 65 and 4 months 1940 65 and 6 months 1941 65 and 8 months 1942 65 and 10 months 1943-1954 66 1955 66 and 2 months 1956 66 and 4 months 1957 66 and 6 months 1958 66 and 8 months 1959 66 and 10 months 1960 or later 67 Disability These payments are provided to those individuals who have not yet retired, but who have been disabled for over one year and are unable to work in any employment. Survivor Survivor benefits are distributed to a surviving spouse at full retirement age. They may also be distributed at a reduced benefit at age 60. Children under 18 and dependent parents over 62 may also receive these benefits. Qualified Retirement Plans Today, nearly 20% of postretirement income comes from qualified retirement plan assets. That number is expected to increase dramatically in coming years. Qualified plan assets are those assets in employersponsored retirement plans on which taxes have not yet been paid. They are found in such investments as pensions, 401(k)s and Individual Retirement Accounts (IRAS). IRA Products and Simple Plans Page 3
Qualified plans come in two employer-sponsored forms: defined benefit and defined contribution plans. Defined benefit plans provide a stated benefit, while defined contribution plans allow an individual to decide when and how much plan income to withdraw on the basis of the performance of the plan assets. Retirement Savings Factors How much retirement savings will an individual need? There are several factors to consider when considering this important question. Life Expectancy One crucial retirement savings factor is life expectancy. Life expectancy has increased dramatically in recent years, so much so that many Americans can now expect to live nearly a third of their lives in retirement. Knowing how much longer one is expected to live provides a good estimate of the amount of retirement savings needed. The following table presents the average life expectancy of men and women in a format of expected years left to live: Age Life Expectancy 70 17.0 75 13.4 80 10.2 85 7.6 90 5.5 95 4.1 100 2.9 Inflation When saving for retirement, inflation must always be considered. Prices for goods and services will not remain static, thus a dollar saved today for retirement will not stretch as far in 10, 20 or 30 years when it is used. Inflation fluctuates greatly from year to year and month to month. For instance, in the early part of 2008 inflation hovered just above 4%. However, in the same period in 2007 inflation was at just above 2%. In 2009, the inflation rate was -.4% and 2010 was 1.6% and at the end of 2011 was 3.2%. For many years, the U.S. inflation rate averaged 3%. IRA Products and Simple Plans Page 4
Risk Retirement saving must also take into account various risks that affect the money saved. Such risks include: Market Risk Retirement funds invested in the stock and bond market are subject to market fluctuation risk. Business Risk In recent years, corporations such as WorldCom and Enron have created headlines as they collapsed, taking their employees retirement plans along with them. Any business, industry or sector is subject to a certain amount of inherent risk of failure or downside, and the return on the stocks and bonds they issue are affected by this risk. Interest Rate Risk Interest rates affect the value of bonds and bond mutual funds. When interest rates rise, the value of these instruments fall. It is important that when a retirement savings plan is devised, the individual seek professional advice to help make sure money in the plan is diversified among different types of savings and investments. Having a diversified retirement savings plan can help protect against large losses, since the types of investments and savings are subject to different types of financial risks. Health Care Costs Health care costs are a necessary expense in retirement years, and the increase in these costs must be considered when saving for retirement. For instance, in 2011 total national health expenditures were projected to rise 4.2 percent. This is especially significant since the inflation rate was about 1.6%. For older retiring couples, it is estimated that $200,000 to $300,000 in savings is necessary just to pay for basic medical coverage during the retirement years. IRA Products and Simple Plans Page 5
Rule of Thumb Most financial experts have a standard rule of thumb for the amount of money needed for every year an individual spends in full retirement: 80% of pre-retirement annual income Experts expect that certain expenses will be reduced during retirement years. For example, the costs of commuting, parking, eating meals out during working hours and keeping up a working wardrobe go away when an individual no longer works. In addition, it is expected that certain long-term expenses will have disappeared by retirement, such as the mortgage payment. However, every situation is different, so this 80% rule of thumb may or may not apply in any specific individual s life. Again, it is wise for individuals to seek professional advice when planning for retirement, for help in thinking through what expenses they are likely to have during their retirement years, and to help them develop a plan for paying off items while they are working so that they don t have to pay them during their fixed income years. IRA Products and Simple Plans Page 6
Chapter One Study Questions 1. In the United States, Social Security was created in reaction to which crisis? a. The Civil War b. The Great Depression c. The Cold War d. The Vietnam War 2. Compared to 20 years ago, health care costs in the United States can be most accurately described as being: a. In a state in decline b. In a state of marginal growth c. In a state of significant growth d. In a static state 3. Cynthia s annual pre-retirement income is $200,000. How much will she need for retirement annually, according to the rule of thumb? a. $100,000 b. $160,000 c. $200,000 d. $240,000 4. Frank is getting ready to retire and is studying the state of Social Security. The most accurate statement of what he has discovered is that Social Security s percentage of Frank s needed retirement income is and the Frank s responsibility for retirement savings is. a. Increasing; increasing b. Decreasing; decreasing c. Increasing; decreasing d. Decreasing; increasing IRA Products and Simple Plans Page 7
Answers to Chapter One Study Questions 1. b. Social Security was created in reaction to the Great Depression. 2. c. Health care costs have been significantly increasing over the past twenty years. 3. b. The experts rule of thumb for needed retirement income is 80% of pre-retirement income, which is $160,000 ($200,000 x.80). This is only a rule of thumb, however, some people will continue to have large fixed payments after retirement, such as a mortgage, or may have large medical bills due to a chronic condition. An individual s situation should be discussed with a professional for help in determining how much money to set aside for retirement. 4. d. As our life expectancy increases and as health care costs increase, Social Security is becoming a smaller and smaller percentage of needed retirement income for the average individual. IRA Products and Simple Plans Page 8
Chapter Two: An Introduction to Traditional IRAs The first type of individual retirement account plan to be created was that of the traditional IRA. In this chapter, traditional IRA plans are introduced. Their eligibility requirements, types of plans, ways to transfer them, and basic IRA investments are all explained. What is a Traditional IRA? In 1974, President Ford signed the Employee Retirement Income Security Act (ERISA) into law. The Act s purpose was to safeguard and improve the retirement security of Americans by creating standards for employee benefit plans. ERISA also created the first Individual Retirement Account (IRA). This IRA would come to be known as a traditional IRA. It was originally created to serve two functions: 1. To provide a tax-deferred savings vehicle through private organizations for workers without employer-sponsored retirement coverage 2. To protect employer-sponsored retirement plan assets by allowing rollovers of those assets into IRAs at retirement or upon a job change IRAs were incredibly popular from the start. In 1975 alone, the very first year IRAs were available, $1.4 billion in contributions were made to IRAs in the United States. At the end of 2009, IRAs made up about 26% of the U.S. retirement market and they hold about $4.1 trillion in retirement assets. In 2011, approximately 46.1 million households in the United States owned IRAs. This is approximately 39% of all U.S. households. Various other types of IRAs were created following the conception of the traditional IRA. An employer-based IRA known as the Simplified Employee Pensions (SEP) IRA was created in 1978. Universal IRAs were created in 1982. This type of plan eased eligibility requirements for participants, but it was discontinued in 1987. Congress created the Savings Incentive Match Plan for Employees (SIMPLE) IRA, an account for small businesses, in 1996. The most recent creation in the line of IRAs is the Roth IRA Products and Simple Plans Page 9
IRA. It was formed in 1997 as an account for after-tax retirement contributions. This chapter will specifically address traditional IRAs. Eligibility Requirements for a Traditional IRA An individual may establish and make contributions to a traditional IRA if he (or his spouse, if a joint return is filed) received taxable compensation during the year. He must also be under 70 ½ years old. If each spouse in a marriage receives taxable compensation and is under 70 ½ years old, both spouses may set up an individual IRA. They may not both participate in the same IRA, however. Taxable compensation includes: earned wages and salaries, commissions, income earned in self-employment, alimony payments, and nontaxable combat pay (applicable to members of the U.S. Armed Forces). This definition does not include: earnings and profit from property (i.e. rental income, interest income), or income from pensions or annuities, or deferred compensation, or Any amounts that are excluded from income (including foreign earned income or housing costs) An individual covered by any other retirement plan may still establish a traditional IRA. However, he may not be allowed to deduct all of his contributions if he (or his spouse) is covered by an employer retirement plan. Types of Traditional IRAs Different types of IRAs may be established with diverse organizations. These include banks, mutual fund companies, or life insurance companies. An IRA may also be established through a stockbroker. A traditional IRA could be an individual retirement account, an individual retirement annuity, part of a simplified employee pension, or part of an employer or employee association trust account. IRA Products and Simple Plans Page 10
Individual Retirement Account An individual retirement account is a trust or custodial account established for the exclusive benefit of a plan owner or beneficiaries. It is subject to the following requirements: Trustee or custodian must be a: o Bank; or o Federally insured credit union; or o Savings and loan association; or o Any other entity approved by the IRS to act as trustee or custodian Trustee or custodian usually cannot accept contributions over the deductible amount for the year Contributions (not including rollover contributions) must be in cash Plan owners must have nonforfeitable rights to the assets in the account at all times (this means that the money in the account may not be used as security for a loan or other such purpose) Assets in the account may not be used to buy life insurance, and generally may not be combined with other property Distributions must begin by April 1 of the year after the plan owner turns 70 ½ Individual Retirement Annuity An individual retirement annuity is established when an annuity or endowment contract is purchased from a life insurance company. An annuity contract is designed to pay the contract owner at specific intervals, while an endowment contract is designed to pay the contract owner a lump sum after a specified period of time. An individual retirement annuity may only be issued in a plan owner s name. Either the plan owner or his surviving beneficiaries are required to receive the benefits from the annuity. Individual retirement annuities are subject to the following requirements: The plan owner s entire contract interest must be nonforfeitable The contract must stipulate that no portion of the annuity may not be transferred to any other person All contracts issued after November 6, 1978 are required to have flexible premiums that allow payment changes in the case of any compensation alteration Contributions may not be more than the deductible amount for an IRA for the year. IRA Products and Simple Plans Page 11
Any refunded premiums must be used to pay future premiums or to purchase more benefits before the end of the calendar year after the year in which the refund was received. Distributions must begin by April 1 of the year after the plan owner turns 70 ½ Simplified Employee Pension Simplified Employee Pensions (SEPs) are written arrangements under which an employer is allowed to make deductible contributions to a traditional IRA for an employee. Distributions from SEP-IRAs are usually subject to the withdrawal and tax rules that apply to traditional IRAs. SEP-IRAs will be discussed in detail in a later chapter. Employer and Employee Association Trust Account A trust account may be established by an employer, labor union, or other employee association to provide individual retirement accounts for employees or members. The same requirements to which individual retirement accounts are subject apply to these types of accounts. Transfers A primary feature of traditional IRAs is their ability to transfer assets in a tax-advantaged manner. Assets may be transferred from other retirement programs to a traditional IRA tax-free. Transfers come in the following forms: Trustee-to-trustee transfers Rollovers Transfers due to a divorce Trustee-to-Trustee Transfers A trustee-to-trustee transfer is a transfer of funds in a traditional IRA from one trustee directly to another. This is done either at the IRA owner s request, or the request of the trustee. This kind of transaction is tax-free because there is no distribution to the owner. This type of transfer is also known as a direct rollover. Rollovers A tax-free distribution of cash or other assets from one retirement plan to another is called a rollover. Rollover contributions are those contributions made from the first retirement plan to the second. IRA Products and Simple Plans Page 12
Numerous plan assets may be rolled over into a traditional IRA, including assets from: Another traditional IRA An employer s qualified retirement plan A government deferred compensation plan A tax-sheltered annuity plan Conversely, a distribution from a traditional IRA may be rolled over into a qualified plan. Such plans include: A Federal Thrift Savings Fund A government deferred compensation plan A tax-sheltered annuity plan Transfers Due to a Divorce Interest in a traditional IRA could be transferred from an individual s spouse (or former spouse) by a divorce. The interest, starting from the date of the transfer, is then treated as the individual s IRA. This transfer is also tax-free. The two most commonly used methods of transfer due to a divorce are (1) changing the name on the IRA, and (2) making a direct transfer of the assets in the IRA. Transfers will be discussed in more detail in a later chapter IRA Investments The investment options of a traditional IRA are numerous; in fact, there are relatively few that are not permitted. Some common investments include: Stocks Stocks are a category of securities that indicates ownership in a corporation, and come in two main forms: common and preferred. Common stock generally allows the stockowner to have a vote in shareholders meetings. Common stock owners also receive dividends. Preferred stock owners are usually not allowed to have voting rights, but they do have a higher claim on assets and earnings than do common stock owners. Bonds Bonds are a kind of debt investment. An individual investing in a bond is loaning money to an entity that is borrowing those funds for a definite period at a fixed rate. The entity promises an interest rate, and guarantees when the loaned funds will be returned. Categories of bonds include corporate bonds, municipal bonds, and U.S. Treasury bonds. IRA Products and Simple Plans Page 13
Mutual funds Mutual funds are investment vehicles that are made up of a collection of funds from numerous investors. The funds are collected for the purpose of investing in securities, and are managed by money managers. These managers invest the capital from the mutual fund and try to create capital gains and income. Money market funds Money market funds are investment vehicles that attempt to earn interest for shareholders while also generally maintaining a $1 net asset value per share (i.e., attempting not to have a negative share value). These kinds of funds are offered by mutual funds, brokerage firms, and banks. These kinds of funds are considered low-risk and low-return. Real Estate Real estate may include individually owned rental and vacation properties as well as investment vehicles such as real estate investment trusts. The risk of real estate as an investment depends on the type of property owned and how income is being generated from the property. An individual, wholly owned rental property in a stable real estate market is relatively low risk. A real estate investment trust made up of commercial properties in a city where commercial occupancy is volatile may be high risk. An IRA holder can purchase real estate investments that reflect the risk and return of virtually every facet of the risk spectrum. IRA Products and Simple Plans Page 14
Chapter Two Study Questions 1. Eileen is 60 years old and earns income from an annuity. She is not eligible to make contributions to a traditional IRA. Which of the following is the most likely reason? a. She is too old to make contributions b. She is too young to make contributions c. She does not earn any taxable compensation d. She is not eligible for Social Security 2. Joe is the owner of a traditional IRA that is established with an Individual Retirement Account. Trish is the owner of a traditional IRA that is established with an Individual Retirement Annuity. Which one of the following requirements is solely applicable to Trish s IRA? a. Plan owners must have nonforfeitable rights b. Distributions must begin by April 1 of the year after the plan owner turns 70½ c. All contracts issued after November 6, 1978 are required to have flexible premiums that allow payment changes in the case of any compensation alteration d. Contributions must be in cash 3. Which of the following types of IRAs was discontinued in 1987? a. SEP-IRA b. Traditional IRA c. Universal IRA d. Roth IRA 4. Frank moves his assets in his traditional IRA into another traditional IRA via a rollover. What percentage of the assets will be taxed under this transfer? a. 0% b. 10% c. 20% d. 50% IRA Products and Simple Plans Page 15
5. Fanny sets up a traditional IRA as an individual retirement annuity. It could have been funded with: a. An annuity, only b. Either an annuity or an endowment contract c. An endowment contract, only d. Either an annuity, endowment contract, or mutual fund IRA Products and Simple Plans Page 16
Answers to Chapter Two Study Questions 1. c. Of the options given, Eileen must not have earned taxable compensation. She is 60, and neither too young nor too old to make an IRA contribution. Being or not being eligible for Social Security does not impact the ability to make an IRA contribution. 2. c. Individual Retirement Annuities are required to allow flexible payment amounts. 3. c. Universal IRAs were discontinued in 1987. 4.a. When IRA funds are moved through a rollover, the transaction is not taxable. 5. b. Individual retirement annuities can accept funds as an annuity or an endowment contract IRA Products and Simple Plans Page 17
Chapter Three: Contribution Rules of Traditional IRAs The contribution limits of traditional IRAs are explained in this chapter. There are special contribution amounts allowed for those age fifty and over. Contributions to these plans must be made by a specified date in order for the contributions to be deductible for a tax year. In addition, there may be tax penalties if excess contributions are made. Contribution Limits The contribution limits for Traditional IRAs vary based on age. General Contribution Limit The traditional IRA is subject to certain contribution rules. The general contribution limit sets forth the maximum that an individual is allowed to contribute to the IRA per year. In 2012, the general contribution limit is the lesser of $5,000 ($6,000 for those older than 50) or the total amount of an individual s taxable compensation for the year. The traditional IRA general contribution amount has increased in recent years: Tax Year < Age 50 Age 50 2004 $3,000 $3,500 2005 $4,000 $4,500 2006 $4,000 $5,000 2007 $4,000 $5,000 2008 $5,000 $6,000 2009 $5,000 $6,000 2010 $5,000 $6,000 2011 $5,000 $6,000 2012 $5,000 $6,000 Under the law, the maximum contribution amount rises with inflation after 2009. However, these increases are only authorized to continue until IRA Products and Simple Plans Page 18
2010 under current tax laws. The contribution amounts did not increase for 2010, 2011 or 2012. Some individuals own more than one traditional IRA. In this instance, the general contribution limit applies to the total amount of contributions made to all traditional IRAs on the owner s behalf over the entire year. If an individual owns an individual retirement annuity, the general contribution limit also applies. The annuity or endowment contract will be disqualified if this limit is exceeded. Catch-Up Contributions As noted in the preceding section, those individuals aged 50 and over are allowed to contribute more to traditional IRAs than younger individuals. This is thanks to the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001. Among other things, this Act allowed for changes in the laws relating to IRAs, and provided for increases in the contribution limits. The catch-up contribution it created was devised as a savings incentive for older Americans who had not had the same opportunities as younger Americans to save for retirement in earlier years. There was a special rule applying to catch-up contributions as they relate to certain employer bankruptcies that applied through 2009. If an individual participated in an employer-sponsored 401(k) plan, and his employer declared bankruptcy, then an additional $3,000 may be contributed to an IRA (for a total general contribution limit of $8,000). This catch-up contribution does not allow those individuals 50 and over to have a higher contribution limit, however; the $8,000 limit applies no matter what an individual s age. This special rule does not apply for contributions made for 2010 and beyond. Spousal Limit If an individual files a joint tax return, and his taxable compensation is less than that of his spouse, then a certain limit applies to the amount he may contribute to his own traditional IRA. In 2012, this amount is the lesser of $5,000 ($6,000 for those older than 50) or the total compensation includible in the gross income of both spouses. The latter amount is reduced by two amounts: the annual IRA Products and Simple Plans Page 19
IRA contribution of the higher-earning spouse and any contributions made to a Roth IRA (this will be discussed in a later chapter) on behalf of the higher-earning spouse. The total combined contributions that can be made in 2012 to an individual s traditional IRA and his spouse s IRA can be as much as: $10,000, if both spouses are under age 50 $11,000, if one spouse is under age 50 $12,000, if both spouses are age 50 or older Example: Mark is a 24 year-old, full-time med school student who does not earn any taxable income. He marries Lisa, a 23 year-old dental hygienist who has a taxable compensation of $35,000 in one year. She and Mark file a joint tax return. This means that each of them may contribute $5,000 (totaling $10,000 as a combined contribution) to a traditional IRA. This is possible because Mark can add Lisa s compensation (reduced by the amount of her IRA contribution) to his own compensation to figure his maximum contribution limit. Contributions Above or Below Limits If an individual contributes less than the maximum annual amount allowable to a traditional IRA during a certain year, he is prohibited from contributing more to the IRA to make up the difference after the due date of his tax return for that year. Example: Gloria is 39 years old. She earns $40,000 in 2011. Although she may contribute $5,000 in 2012, she only contributes $2,500. After April 15, 2012, Gloria may not make up the difference between her actual contribution for 2011 and her limit for that year. She also may not contribute $2,500 more than the contribution limit for any future year. The maximum contribution amount that applies to any contribution year must be made from January 1 of that year through the tax filing date of the following year only. Excess contributions are those contributions that exceed applicable contribution limits. If excess contributions are made to a traditional IRA but are not withdrawn by the date a tax return for the year is due, a 6% tax will generally be levied. This tax must be paid each year on excess amounts that remain in a traditional IRA at the end of the tax year. Note that the tax is not allowed to exceed 6% of the combined value of all an individual s IRAs at the end of a tax year. IRA Products and Simple Plans Page 20
However, if an individual contributes more than the maximum annual amount allowable to his traditional IRA, he may apply the excess contribution to a later year. Note that this is only possible if the contributions for that later year are less than the maximum allowed for that year. Commissions and Fees It is important to note that brokers commissions that are paid in connection with a traditional IRA are subject to contribution limits. However, trustee s administrative fees are not subject to these limits. For example, if an IRA is opened in which mutual funds are used as an investment and the broker charges $100 for the product, the IRA contribution amount for an individual under 50 may not be $5,100 in 2012. The contribution limit is still $5000. Qualified Reservist Repayments Members of reserve components who were ordered or called to active duty after September 11, 2001 may be allowed to repay amounts to an IRA that are equal to any qualified reservist distributions they receive. Reserve component refers to the: Army National Guard of the United States, Army Reserve, Naval Reserve, Marine Corps Reserve, Air National Guard of the United States, Air Force Reserve, Coast Guard Reserve, or Reserve Corps of the Public Health Service These repayment contributions may be made even if they would cause the total contributions to the IRA to exceed the general contribution limit. An individual is considered to have received a qualified reservist distribution if all of the following requirements are met: An individual is ordered or called to active duty after September 11, 2001 and before December 31 of the year for which the IRA contribution is being made An individual is ordered or called to active duty for a period of more than 179 days, or for an indefinite period, because of membership of a reserve component IRA Products and Simple Plans Page 21
The distribution is from an IRA The distribution was not made any earlier than the date of the order or call to active duty and was not made any later than the close of the active duty period Contribution Deadlines Contributions may be made to a traditional IRA as soon as it is established. They must be in the form of money; this means cash, check, or money order. Contributions may not be property. But, certain property may be allowed to be transferred or rolled over from one retirement plan to another retirement plan. Contributions may be made to a traditional IRA for every year that an individual receives compensation and has not reached age 70 ½. Contributions may not be made in any year when an individual does not work, unless alimony or nontaxable combat pay is received, or a joint tax return is filed with a spouse who has compensation. Even if contributions are not made during a certain year, amounts contributed in past years remain in the IRA. Contributions for a particular year can be made to a traditional IRA at any time during the year, or by the due date for filing the tax return for that year (excluding extensions). IRA Products and Simple Plans Page 22
Chapter Three Study Questions 1. Karen is 49 years old. What is the maximum she may contribute to a traditional IRA in 2012? a. $5,000 b.$3,000 c. $4,000 d. $6,000 2. Michael is 61 years old. He owns two different traditional IRAs. What is the maximum he may contribute to both traditional IRAs (in total) in 2012? a. $5,000 b. $6,000 c. $10,000 d. $12,000 3. Jim may contribute $8,000 to his traditional IRA in 2012. The most likely reason for this is: a. He is 50 or older b. He is disabled c. He participated in an employer-sponsored 401(k) plan, and his employer went bankrupt d. He is 50 or older, he participated in an employersponsored 401(k) plan, and his employer went bankrupt 4. Samantha contributes $1,000 over the general traditional IRA contribution limit that applies to her. The contribution is withdrawn by the date her tax return for the year is due. How much will she owe as a tax for the excess contribution? a. $0 b. $60 c. $100 d. $500 IRA Products and Simple Plans Page 23
5. Paul makes a contribution to his traditional IRA that is not in the form of a transfer or rollover. The contribution may be in any of the following forms, except: a. Cash b. Check c. Money order d. Stock certificate IRA Products and Simple Plans Page 24
Answers to Chapter Three Study Questions 1. a. The maximum traditional IRA contribution amount for people under 50 in 2012 is $5000. 2. b. The maximum traditional IRA contribution amount for people fifty and over in 2012 is $6000. 3. c. This special limit applies to those who have a 401(k) plan with an employer who went bankrupt. 4. a. Since she withdrew the excess contribution prior to her tax due date, no tax is due on the excess contribution. 5. d. IRA contributions must be in cash, which means, cash, checks and money orders, but not stock certificates. IRA Products and Simple Plans Page 25
Chapter Four: Deducting Traditional IRA Contributions Traditional IRA contributions are deductible in certain circumstances. The amount of the deduction is dependent upon whether the owner or spouse is covered by an employer retirement plan and on income levels. This chapter describes the rules applicable to the tax-deductibility of traditional IRA contributions. Deducting Contributions Full Deduction One valuable feature of traditional IRAs is the deductibility of contributions. An individual is generally allowed to deduct the lesser of: The general contributions limit ($5,000 for those under 50; $6,000 for those 50 and older), or 100% of the individual s compensation Spousal Deduction If a married couple with unequal compensation files a joint tax return, deduction limits apply to any contributions made to a traditional IRA. For the spouse earning the smaller amount of compensation, the deduction is the lesser of: The general deduction amount ($5,000 for those under 50; $6,000 for those 50 and older); or The total compensation that is includible in the gross income of both spouses for the year, as reduced by the following amounts: o The IRA deduction of the greater-earning spouse for the year o Any designated nondeductible contribution for the year made on behalf of the greater-earning spouse o Any contributions for the year to a Roth IRA on behalf of the greater-earning spouse. IRA Products and Simple Plans Page 26
Commissions and Fees Administrative fees charged for trustees that are billed separately and are paid in connection with a traditional IRA are not deductible as contributions. Brokers commissions are seen as part of IRA contributions, however, and may be deducted. Employer Plan Deductions Certain rules apply to contributions made by individuals who are also covered by an employer-sponsored retirement plan in addition to contributing to a traditional IRA. If an individual (or his or her spouse) was covered by an employer retirement plan for any part of the year, the contribution amount may not be allowed to be deducted, or may only be allowed to be partially deducted. This depends upon income and filing status. Defined Contributions Plans Employer-sponsored retirement plans include defined contribution plans and defined benefit plans. Defined contribution plans are those that provide a separate account for each individual covered, and define exactly the amount that will be contributed. The total amount contributed to a participant s account (and any earnings and losses on those contributions) determine the level of benefits provided for the participant. Examples of defined contribution plans include: Profit sharing plans Stock bonus plans Money purchase pensions plans IRAs 401(k) plans Defined Benefit Plans Defined benefit plans spell out the level of benefits that each participant is given. The administrator of the plan calculates the amount needed to provide the promised benefits and also those amounts that must be contributed to the plan. Defined benefit plans include pension plans and annuity plans. An individual is seen as being covered by a defined benefit plan if he is eligible to participate in that plan for the plan year, even if the individual: Declined to participate in the defined benefit plan, Did not make a required contribution, or IRA Products and Simple Plans Page 27
Did not perform the minimum service required to accumulate a benefit for the year Plans That Are Not Employer Plans Certain plans are not classified as employer plans for traditional IRA deduction purposes. Individuals in any of the following situations are not covered by an employer retirement plan under traditional IRA rules: Those individuals covered under Social Security or railroad retirement coverage Those individuals receiving benefits solely from a previous employer s retirement plan Those individuals who are U.S. Reservists, and who participate in a plan solely because of membership of a reserve unit, if: o The plan participated in is established for employees by the U.S., a state or political subdivision of a state, or an instrumentality of either; and o No more than 90 days on active duty during the year were served (not including duty for training) Those individuals who are volunteer firefighters, and who participate in a plan solely because of that status, if: o The plan participated in is established for employees by the U.S., a state or political subdivision of a state, or an instrumentality of either; and o Retirement benefits accrued at the beginning of the year will not provide more than $1,800 a year at retirement Deduction Phaseout If an individual (or his or her spouse) was covered by an employer retirement plan, depending on his income and filing status, he may only be entitled to a partial contribution deduction, or possibly no deduction at all. The IRA deduction will be reduced (or phased out ) when his income exceeds a certain amount, and is eliminated upon reaching a specified higher amount. In order to determine deduction phaseout, an individual must determine his modified adjusted gross income (AGI) and filing status. Modified AGI is an individual s gross income (gross income is income before standard or itemized deductions are claimed), as adjusted by certain allowable deductions. It can be determined by using the following IRS worksheet: IRA Products and Simple Plans Page 28
In 2012, if an individual is covered by an employer retirement plan, then the deduction will not be reduced unless his modified AGI is: More than $58,000 but less than $68,000 (single individual or head of household) More than $92,000 but less than $112,000 (married couple filing jointly; or qualifying widow(er)) Less than $10,000 (married individual filing separately) Note that for those individuals filing as single individual or head of household, no deduction may be taken if modified AGI exceeds $68,000. For individuals who are part of a married couple filing jointly, or a qualifying widower, no deduction may be taken in if modified AGI exceeds $112,000. For those married individuals filing separately, deductions are not allowed if modified AGI exceeds $10,000. Nondeductible Contributions Nondeductible contributions are those contributions that exceed the limit for IRA deductions, but are under the total permitted contribution limit. Example: Felicity is 30 years old and is a married individual filing separately from her spouse. In 2012 she was covered by an employer retirement plan. Her salary is $78,312, and her modified AGI is $68,000. She is not allowed to deduct a $5,000 contribution she makes to her traditional IRA for tax purposes. Therefore, this contribution is considered a nondeductible contribution. IRA Products and Simple Plans Page 29
Chapter Four Study Questions 1. Kaitlyn is 52 years old, single filing individually, and makes contributions to a traditional IRA. If her annual compensation is $27,000, what is the maximum she may deduct for those contributions per year? a. $3,000 b. $5,000 c. $6,000 d. $8,000 2. Dave s employer-sponsored retirement plan is a defined contribution plan. The plan could be any of the following, except: a. A traditional IRA b. A 401(k) c. A profit sharing plan d. A pension plan 3. Christine files her taxes as a single individual. She makes contributions to a traditional IRA. If she is also covered by an employer retirement plan, and her AGI is $65,000, the deductions for contributions to his IRA: a. Are allowed b. Are phased out c. Are fully deductible d. Are considered excess contributions 4. Ben makes contributions to a traditional IRA. For IRA deduction purposes, in which of the following situations is he considered to be covered by an employer-sponsored retirement plan? a. He is covered under Social Security b. He receives benefits from a previous employer s plan in addition to benefits form a current employer s plan c. The only reason he participates in an employer-sponsored plan is because is a qualified reservist d. The only reason he participates in an employer-sponsored plan is because he is a volunteer firefighter IRA Products and Simple Plans Page 30
Answers to Chapter Four Study Questions 1. c. The maximum deductible contribution for Kaitlyn, who is 50 or over and has compensation of $27,000, is $6000. 2. d. Defined contribution plans may be 401(k), money purchase, profit sharing or stock bonus plans, but not pension plans. 3. b. As a single taxpayer, at her AGI of $65,000, her deductible IRA contributions are being phased out. 4. b. For IRA deduction purposes, he is considered to be covered by an employer plan because he receives benefits from a previous employer s plan in addition to benefits form a current employer s plan. Being covered by Social Security is not being covered by an employer plan, and participation by volunteer firefighters and qualified reservists are not considered to be covered by employer plans. IRA Products and Simple Plans Page 31
Chapter Five: Distribution Rules of Traditional IRAs There are minimum distributions that must be made from traditional IRAs when the owner reaches age 70 ½. The minimum distribution rules as well as the taxation of early distributions are explained in this chapter. Minimum Distributions Funds may not be kept in a traditional IRA for an indefinite period. Rather, distributions must begin by April 1 of the year following the year in which an IRA owner turns 70 ½ or be subject to a hefty 50% tax. These distributions are subject to certain minimum distribution requirements, which govern how much an individual must distribute from his IRA on an annual basis. The required minimum distribution for each year is calculated by dividing the balance of the IRA as of December 31 of the preceding year by the applicable distribution period or life expectancy. Distribution Period The distribution period is the maximum number of years over which an IRA owner is allowed to take distributions from an IRA. The following is an excerpt of a table published by the IRS used to determine the distribution period of individuals of a certain age: Age Distribution Period 70 27.4 75 22.9 80 18.7 85 14.8 90 11.4 95 8.6 Example: Jean is the owner of a traditional IRA. The balance in her IRA at the end of 2011 is $200,000. She turns 80 years old in 2012. Her distribution period is 18.7, therefore, her required minimum distribution for 2011 is: $10,695.19 ($200,000 / 18.7). IRA Products and Simple Plans Page 32
Life Expectancy Life expectancy may also be used to calculate the required minimum distribution: Age Life Expectancy 70 17.0 75 13.4 80 10.2 85 7.6 90 5.5 95 4.1 Example: Gerry is the owner of a traditional IRA. The balance in his IRA at the end of 2011 is $200,000. He turns 80 years old in 2012. His life expectancy is 10.2 years, therefore, his required minimum distribution for 2012 is: $19,607.84 ($200,000 / 10.2). Life expectancy is calculated differently for those IRA owners whose sole beneficiary spouse is more than 10 years younger. In this case, the life expectancy used is the joint life and last survivor expectancy from another table published by the IRS: Ages 70 71 72 73 74 75 76 80 18.7 18.1 17.5 16.9 16.4 15.9 15.4 81 18.5 17.9 17.3 16.7 16.2 15.6 15.1 82 18.3 17.7 17.1 16.5 15.9 15.4 14.9 83 18.2 17.5 16.9 16.3 15.7 15.2 14.7 84 18.0 17.4 16.7 16.1 15.5 15.0 14.4 85 17.9 17.3 16.6 16.0 15.4 14.8 14.3 86 17.8 17.1 16.5 15.8 15.2 14.6 14.1 Example: David is the owner of a traditional IRA. His wife, Elaine, is the sole beneficiary of his IRA, and is 11 years younger than him. The balance in his IRA at the end of 2011 is $200,000. David turns 86 in 2012 and Elaine turns 74. David s joint and last survivor expectancy is 15.2 years, therefore his required minimum distribution for 2012 is: $13,157.89 ($200,000 / 15.2). Beneficiaries If the sole beneficiary of a traditional IRA is a surviving spouse, then he or she may decide to either be treated as the beneficiary or the owner of the IRA Products and Simple Plans Page 33
account. If ownership status is chosen, the spouse determines the required minimum distribution (if applicable) as if he or she were the owner beginning with the year in which this ownership status is assumed. It should be noted, however, that if the spouse becomes the owner in the year the deceased spouse died, then he or she may take the deceased owner s required minimum distribution for that year. If a traditional IRA owner dies on or after the required distribution beginning date, the designated beneficiary usually must base the required minimum distributions on the longer of either his single life expectancy, or the owner s life expectancy. However, if the traditional IRA owner died before the required distribution beginning date, the designated beneficiary bases the required minimum distribution on his or her single life expectancy only. Required minimum distributions for traditional IRA beneficiaries are determined differently if the beneficiary is an individual or not (such as if the beneficiary were a trust or an estate). If the beneficiary is an individual, the IRA account balance is divided by the appropriate life expectancy. Example: Megan s father died in 2011. She is the designated beneficiary of his traditional IRA. She is 70 years old in 2012. Her life expectancy that year is 17.0. The IRA is worth $200,000 at the end of 2011, therefore, her required minimum distribution for 2012 is $11,764.71 ($200,000 / 17.0). If the beneficiary is not an individual, and the traditional IRA owner died on or after the required minimum distribution beginning date, the distributions are determined by dividing the account balance at the end of the year by the appropriate life expectancy for the IRA owner in the year of his or her death. Example: The owner of a traditional IRA died in 2011 at age 90. His traditional IRA went to his estate as beneficiary. His life expectancy for 2011 is 9.0. The IRA is worth $200,000 at the end of 2011, therefore, the required minimum distribution is $25,000 ($200,000 / 8.0). Note that the owner s life expectancy was reduced by one to determine the account balance for the year following his death. It is important to note that a special rule could apply to beneficiary distributions: In certain situations, beneficiaries who are individuals may be required to take the entire balance of the IRA by the end of the 5 th year IRA Products and Simple Plans Page 34
after the year of the owner s death. This rule could also apply to beneficiaries who are not individuals as well. This requirement could apply if a traditional IRA owner died before the required minimum distribution beginning date. Early Distributions Early distributions are generally defined to be those amounts distributed from a traditional IRA account (or annuity) before the owner reaches age 59 ½. They are also amounts received when retirement bonds are cashed in before that same age. If distributions are taken when a traditional IRA owner reaches age 59 ½, a 10% additional tax on the distribution of any assets in the IRA applies. Exceptions Certain exceptions apply to the early distribution penalty rule. If an individual is in one of the following situations, he generally will not have to pay the 10% additional tax: Medical Expenses The additional 10% tax is not levied if an individual has unreimbursed medical expenses that are more than 7.5% of his adjusted gross income. Medical Insurance If the early distributions are not more than the cost of an individual s medical insurance, then the additional tax does not apply. This applies to medical insurance for the individual, his spouse, and his dependents, and is subject to all of the following conditions: The individual lost his job The individual received unemployment compensation paid under federal or state law for 12 consecutive weeks because of a lost job The distributions were received either during the year the unemployment compensation was received, or the year following The distributions are received no later than 60 days after reemployment Disability If an individual can provide proof that he cannot do any substantial gainful activity because of a physical or mental disability, he will not be required to pay the early withdrawal tax. A physician is required to confirm that the disability is expected to result in death or be of a long, continued, and indefinite length. IRA Products and Simple Plans Page 35
Beneficiary of Deceased IRA Owner The 10% tax will not be applied to the distribution of assets from a traditional IRA if the owner dies before reaching age 59½. Distributions as an Annuity If distributions are made from a traditional IRA that are part of a series of substantially equal payments over an individual s life or life expectancy (or over the lives or joint life expectancies of that individual and his beneficiary), no early distribution tax will be required, no matter when the distributions are made. This applies as long as an IRS-approved distribution method is used, and at least one distribution is made annually. Higher Education Expenses If an individual uses early distribution to pay expenses for higher education for either himself, a spouse, children or grandchildren, the 10% tax will not apply, as long as the amount is not more than the qualified higher education expenses. These expenses include tuition, fees, books, supplies, room and board, and the like. First Home The 10% tax is waived if an individual takes a distribution of no more than $10,000 to buy, build, or rebuild a first home. Distribution due to IRS Levy Distributions made because a qualified plan is subject to an IRS levy are not subject to the 10% additional tax. Taxability of Distributions Distributions made from a traditional IRA are generally taxable in the year they are received. This is true even for distributions made without an IRA owner s consent from a state agency acting as the receiver of a failed financial institution. Certain exceptions to the taxability of distributions in the year in which they are received apply, including: Rollovers Qualified charitable distributions (distributions made directly by the trustee of an IRA to an eligible organization) Tax-free withdrawals of contributions (contributions withdrawn by the due date of a tax return, under certain conditions) The return of nondeductible contributions IRA Products and Simple Plans Page 36
Fully and Partly Taxable Distributions from a traditional IRA could be fully or partly taxable depending on whether or not any nondeductible contributions were made to the IRA. Distributions are fully taxable when received if only deductible contributions were made. However, if nondeductible contributions are made, then the IRA owner receives a cost basis (i.e. investment in the contract) that equals the amount of those nondeductible contributions. This means that the nondeductible contributions will not be taxed when they are distributed, but are seen as a return of the investment in the IRA. It should be noted that only the nondeductible portion of any distributions is tax-free. If nondeductible contributions are made, then distributions consist of both nondeductible contributions and deductible contributions. Until all of the nondeductible contributions have been distributed, each distribution is partly taxable and partly nontaxable. Special Tax Situations Certain distributions are subject to special tax rules. For instance, if a traditional IRA owner directs the trustee or custodian of his account to use the amount in the account to buy an annuity contract, no taxes will be levied when the owner receives the annuity contract. However, when payments are received under the contract, taxes will be charged. Also, if the owner of a traditional IRA cashes in retirement bonds, he will be taxed on the entire amount received. If the bonds are not cashed in before the owner reaches age 70 ½, he will be required to pay taxes on the entire value of the bonds at that time. IRA Products and Simple Plans Page 37
Chapter Five Study Questions 1. Katie is the owner of a traditional IRA. The balance in her IRA at the end of 2010 is $100,000. She turns 80 years old in 2012. If her distribution period is 18.7, then her required minimum distribution for 2012 is: a. $2,740.00 b. $5,437.59 c. $13,992.88 d. $18,354.01 2. Bill is the owner of a traditional IRA. His wife, Jamie, is the sole beneficiary of his IRA. If Bill turns 86 in 2012, and the applicable joint and last survivor life expectancy is 15.2, how old is Felicity? Joint and Last Survivor Life Expectancy Ages 70 71 72 73 74 75 76 80 18.7 18.1 17.5 16.9 16.4 15.9 15.4 81 18.5 17.9 17.3 16.7 16.2 15.6 15.1 82 18.3 17.7 17.1 16.5 15.9 15.4 14.9 83 18.2 17.5 16.9 16.3 15.7 15.2 14.7 84 18.0 17.4 16.7 16.1 15.5 15.0 14.4 85 17.9 17.3 16.6 16.0 15.4 14.8 14.3 86 17.8 17.1 16.5 15.8 15.2 14.6 14.1 a. 72 years old b. 74 years old c. 79 years old d. 82 years old IRA Products and Simple Plans Page 38
3. Carolyn is the beneficiary of a traditional IRA. The owner of the IRA died before the required minimum distribution beginning date. On what must Carolyn base the required minimum distributions from the traditional IRA? a. Her single life expectancy, only b. The IRA owner s life expectancy, only c. The longer of either her single life expectancy or the IRA owner s life expectancy d. The shorter of either her single life expectancy or the IRA owner s life expectancy 4. The owner of a traditional IRA died in 2012 at age 90. His traditional IRA went to his estate as beneficiary. His life expectancy for 2011 is 9.0. If the IRA is worth $100,000 at the end of 2012, then the required minimum distribution is: a. $10,000.00 b. $11,111.11 c. $12,500.00 d. $14,285.71 5. Molly received early distributions from her traditional IRA because she was younger than: a. 47 years old b. 59 ½ years old c. 65 years old d. 70 ½ years old IRA Products and Simple Plans Page 39
Answers to Chapter Five Study Questions 1. b. $100,000 divided by 18.7 is $5,437.59 2. b. 15.2 is the box that corresponds to ages 86 and 74: Joint and Last Survivor Life Expectancy Ages 70 71 72 73 74 75 76 80 18.7 18.1 17.5 16.9 16.4 15.9 15.4 81 18.5 17.9 17.3 16.7 16.2 15.6 15.1 82 18.3 17.7 17.1 16.5 15.9 15.4 14.9 83 18.2 17.5 16.9 16.3 15.7 15.2 14.7 84 18.0 17.4 16.7 16.1 15.5 15.0 14.4 85 17.9 17.3 16.6 16.0 15.4 14.8 14.3 86 17.8 17.1 16.5 15.8 15.2 14.6 14.1 3. a. As a single beneficiary on the IRA when the IRA holder died prior to making required minimum distributions, the distributions must be made based on her single life expectancy 4. c. The life expectancy is reduced by one year when the distribution is after the death of the IRA holder, and $100,000 divided by 8 years is $12,500. 5. b. Early distributions are those taken before the IRA holder is 59 ½. IRA Products and Simple Plans Page 40
Chapter Six: Traditional IRA Transfers and Rollovers Recall from Chapter Two that IRA transfers come in three forms: trustee-to-trustee transfers, rollovers, and transfers incident to divorce. This chapter explains these transfer forms in more detail. Trustee-to-Trustee Transfers A trustee-to-trustee transfer is a transfer of funds in a traditional IRA from one trustee directly to another. This is done either at the IRA owner s request, or the request of the trustee. This kind of transaction is tax-free because there is no distribution to the owner. Recharacterizations Contributions made to one type of IRA may be able to be treated as having been made to a different type of IRA. This is referred to as recharacterizing the contribution and is done by having the contribution transferred from the first IRA to the second IRA in a trustee-to-trustee transfer. The contribution may be treated as having been made originally to the second IRA instead of the first IRA only if it is made by the due date for an individual s tax return for the year during which the contribution was made. For example, Samantha made a $4000 contribution to a traditional IRA in February, 2012. She decided she really wanted the Trustee-to-trustee transfers occur when money from one IRA or qualified retirement plan is sent directly from the existing plan to another IRA or qualified plan. For example, an IRA holder may have his IRA in a bank CD sent directly to a mutual fund company s IRA program. The IRA holder never receives the funds in a trustee-to-trustee transfer; the transaction is handled directly between the plans. contribution to be made to a Roth IRA, and treated as a Roth IRA contribution. She filled out appropriate paperwork with the traditional IRA trustee to move the funds directly to a Roth IRA in July 2012. Samantha successfully recharacterized the $4000 contribution as a Roth IRA contribution. If an individual has his contribution recharacterized, he must do all of the following: IRA Products and Simple Plans Page 41
Include any net income allocable to the contribution in the transfer. This may be a negative amount if there was a loss. Report the recharacterization on the tax return for the year in which the contribution was made. Treat the contribution as having been made to the second IRA on the date that it was made to the first IRA. Contributions made to the first IRA may not be deducted. Any net income transferred with the recharacterized contribution is seen as being earned in the second IRA. In order to recharacterize a contribution, the trustee of the first IRA and the trustee of the second IRA must be notified (only one notification is necessary if both IRAs are maintained by the same trustee). The notifications must be made by the date of transfer. The notification must include: The type and amount of the contribution to the first IRA that is to be recharacterized The date on which the contribution was made to the first IRA, as well as the year for which it was made A direction to the trustee of the first IRA to transfer (in a trustee-totrustee transfer) the amount of the contribution and any net income allocable to the contribution to the trustee of the second IRA The name of the trustees of both the first IRA and the second IRA Any additional information needed to make the transfer Rollovers to a Traditional IRA Rollovers are a tax-free distribution of cash or other assets from one retirement plan to another. Rollover contributions are those contributions made from the first retirement plan to the second. Plan assets may be rolled over into a traditional IRA, including assets from: Another traditional IRA An employer s qualified retirement plan A deferred compensation plan of state and local governments A tax-sheltered annuity plan Note that rollover contributions cannot be deducted for tax purposes. IRA Products and Simple Plans Page 42
Rollovers from a Traditional IRA Distributions from a traditional IRA may be rolled over into a qualified retirement plan. Such plans include: Other IRAs Qualified Trusts A Federal Thrift Savings Fund A deferred compensation plan of state and local governments A tax-sheltered annuity plan Usually, when basis (i.e. a non-deductible contribution) is in an IRA, any distribution is considered to include both nontaxable and taxable amounts, in proportion to the amount of the basis to the total value of the IRA. If this rule were applied to rollover situations, the nontaxable portion of a distribution could not be rolled over. But a special rule applies to distributions that are rolled over into an eligible retirement plan (other than an IRA) from a traditional IRA. This rule treats the distributions as including only otherwise taxable amounts if the amount left in the IRAs or the amount that is not rolled over is at least equal to the basis in the traditional IRA. This allows the amount in a traditional IRA that may be rolled over to an eligible retirement plan to be as large as possible. Rollover From One Traditional IRA to Another All of the assets from one traditional IRA may be withdrawn and reinvested in the same or another traditional IRA tax free, as long as the reinvestment occurs within 60 days. Recall that this amount may not be deducted. If a rollover is made from one traditional IRA to another, the rollover is only tax free if the property that is reinvested is the same property that was originally distributed. Partial rollovers are also allowed. Assets may be withdrawn from a traditional IRA and part of those assets may be rolled over tax free, while the rest of the assets may be retained. This amount, however, will generally be taxable, and may be subject to the 10% early withdrawal additional tax. Rollover From An Employer s Plan Eligible rollover distributions from an employer-sponsored retirement plan may be rolled over into a traditional IRA. Eligible rollover distributions are generally any distribution of all or part of the balance credited to an employee in a qualified retirement plan. However, the following are not considered eligible rollover distributions: IRA Products and Simple Plans Page 43
A required minimum distribution A hardship distribution A series of substantially equal periodic distributions that are paid at least once a year over: o The employee s lifetime or life expectancy o The employee and the employee s beneficiary s lifetimes or life expectancies o A period of 10 years or more Corrective distributions of excess contributions or deferrals, and income allocable to the excess, or of excess annual additions and allocable gains A loan treated as a distribution because it does not satisfy certain requirements when it is made or later (unless the employee s accrued benefits are reduced to repay the loan) Dividends on employer securities The cost of life insurance If an eligible rollover distribution is paid directly to an employee, an employer is generally required to withhold 20% of it, even if the employee plans to roll the distribution into a traditional IRA. This can be avoided if the employee chooses the direct rollover option, or if: The distribution and all previous eligible rollover distributions the employee received during the tax year from the same plan equals less than $200 The distribution is only employer securities, plus cash of $200 or less in lieu of fractional shares For example, John has $34,000 in a 401(k) plan. He leaves his employment to join another firm. If he has his $34,000 401(k) plan distributed to him, and then places the funds in an IRA in 60 days, his prior employer must withhold $6800 of the proceeds for taxes. If John makes the rollover within the 60 days, the 20% withheld is claimed on his next tax income return, and he will receive it back, or it will reduce his overall tax liability. If instead John had the money directly rolled from the employer 401(k) plan to an IRA, no amount has to be withheld, and John avoids the paperwork hassles of reporting the withheld amount on his tax returns. Note that the 1-year time limit between rollovers does not apply to rollover distributions from an employer plan. IRA Products and Simple Plans Page 44
Rollover Time Limits Generally, rollover contributions must be made no more than 60 days after a distribution from an IRA or employer plan is received. If the contributions are made after the 60-day period, then those amounts will not qualify for tax-free treatment. The 60-day requirement could be waived in certain situations. Some of those situations include casualty, disaster, or other events that are beyond the reasonable control of the individual involved. There is an automatic waiver that applies only if all of the following conditions are met: The financial institution receives the rollover funds before the end of the 60-day rollover period All of the procedures for depositing the funds into an eligible retirement plan (as set by the financial institution) were followed The funds were not deposited into an eligible retirement plan with the rollover period only because of an error made by the financial institution The funds are deposited into an eligible retirement plan no more than 1 year from the beginning of the rollover period The rollover would have been valid if the financial institution had deposited the funds as charged There is also a waiting period between rollovers. If a tax-free rollover of any part of a distribution from a traditional IRA is made, an individual is generally not allowed to make another tax-free rollover of a later distribution from that same IRA with a 1-year period. The 1-year period does not begin on the date the assets are rolled over into the IRA; rather, it begins on the date the IRA distribution is received. An exception to this 1-year rule applies only if all of the following requirements are met: 1. The distribution was made from a failed financial institution by the Federal Deposit Insurance Corporation as its receiver 2. It was not initiated by the custodial institution or the depositor 3. It was made because the custodial institution is insolvent and the receiver is unable to find a buyer for the institution Transfers Incident to a Divorce Interest in a traditional IRA could be transferred from an individual s spouse (or former spouse) by a divorce. The interest, starting from the date of the transfer, is then treated as the individual s IRA. This transfer is IRA Products and Simple Plans Page 45
also tax-free. The two most commonly used methods of transfers due to a divorce are changing the name on the IRA, and making a direct transfer of the assets in the IRA. Changing Names Assets may be transferred by changing the name of the IRA from an individual s name, to the name of his spouse (or former spouse). This is done only if all the assets from the IRA are to be transferred. Direct Transfer Under a direct transfer, the trustee of the traditional IRA is directed to transfer only the assets affected directly to the trustee of a new or existing traditional IRA that is set up in the name of an individual s spouse (or former spouse). If his spouse (or former spouse) is allowed to keep the portion of the IRA assets belonging to that spouse in the individual s existing IRA, then the trustee may be directed to transfer the assets the individual is permitted to keep directly into a new or existing traditional IRA set up in his name. The name of the IRA that contains the spouse s portion of the assets would then be changed to reflect the change in ownership. Automatic Rollovers and Safe Harbor IRAs Before the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) was passed, qualified retirement plans were allowed to make immediate cash out distributions to participants who terminated employment with the company that maintained the plan. These cash out distributions could be made without the plan participant s consent, if that participant s vested accrued benefit was not more than $5,000. But EGTRRA amended the Internal Revenue Code of 1986 to require that the plan administrator must (without direction from the participant as to the distribution) automatically rollover the mandatory distribution to an IRA if the mandatory distribution amount is greater than $1,000, but less than or equal to $5,000. The plan administrator is also required to notify the plan participant in writing that the distribution might be transferred to another individual retirement plan without cost or penalty. The IRA receiving the mandatory distribution is known as a safe harbor IRA. IRA Products and Simple Plans Page 46
Chapter Six Study Questions 1. Ken has his 2011 IRA contributions recharacterized. When must the recharacterization have been accomplished by? a. The due date for Ken s 2011 tax return b. The due date for Ken s 2012 tax return c. Before January 1, 2011 d. Before January 1, 2012 2. Mark and his wife Sharon get a divorce. Sharon s interest in Mark s traditional IRA is transferred to another IRA. The interest left in the IRA, starting from the date of the transfer, is then treated as Mark s IRA. If the interest left in the traditional IRA is $100,000, and the amount transferred out of the IRA is $50,000, then the transfer will be subject to a tax of: a. $0 b. $1,000 c. $5,000 d. $10,000 3. Madeleine has $46,000 in a traditional IRA. $1,000 of this amount is from a non-deductible contribution made one year when she had income much higher than she normally has. How much can Madeleine rollover from her IRA into a SIMPLE Plan with her new employer as a nontaxable distribution? a. $0 b. $1,000 c. $45,000 d. $46,000 IRA Products and Simple Plans Page 47
4. Eligible rollover distributions of $100,000 from Jordan s employersponsored retirement plan are rolled over into a traditional IRA. If the eligible rollover distributions were paid directly to Jordan, his employer will most likely be required to withhold: a. $0 b. $10,000 c. $20,000 d. $50,000 5. If a qualified retirement plan makes a mandatory distribution to a safe-harbor IRA for a participant who terminated employment with the company that maintained the plan, then the mandatory distribution amount must not be less than: a. $1,000 b. $3,000 c. $5,000 d. $6,000 IRA Products and Simple Plans Page 48
Answers to Chapter Six Study Questions 1. a. In order to recharacterize IRA contributions, the recharacterization must be done by the tax due date for the tax year for which the contribution was made, in this case, the tax due date for 2011 taxes. 2. a. This transaction is not taxable. 3. c. The deductible contributions and earnings may be rolled over, which amounts to $45,000. 4. c. When a distribution is made from an employer plan to an employee, even if the amount is rolled into an IRA, there is a requirement that 20% of the distribution be withheld. $100,000 x 20% = $20,000 5.a. A safe harbor IRA must be used when the employer has no direction from the participant and the amount in the employer plan is not less than $1000 and not more than $5000. IRA Products and Simple Plans Page 49
Chapter Seven: Roth IRAs This chapter introduces the Roth IRA. These IRAs may provide even greater tax benefits to the holder than traditional IRAs. The eligibility, contribution and distributions rules of Roth IRAs are all detailed in this chapter. What is a Roth IRA? The Roth IRA is named for a retired Republican senator named William V. Roth. Senator Roth was instrumental in the enactment of legislation that authorized this new type of IRA under the Tax Payer Relief Act of 1997. The passage of this Act stimulated new interest in IRAs, which had lagged since 1986 when Congress reversed the deductibility of IRAs for many people. A Roth IRA is subject to many of the same rules that govern traditional IRAs. However, unlike traditional IRAs, contributions cannot be deducted, but are made from after-tax dollars. And, qualified distributions are tax-free, rather than being taxable in the year in which they are received. In addition, contributions may be made to a Roth IRA after age 70 ½ and amounts may be left in a Roth IRA for as long as an individual is alive. Roth IRA Eligibility Rules In 2012, individuals can contribute to a Roth IRA, but have reduced contribution amounts, if they have a modified AGI of: At least $173,000 but less than $183,000 (married individual filing jointly or qualifying widow(er)) At least $110,000 but less than $125,000 (single individual, head of household, or married individual filing separately who did not live with a spouse any time during the year) More than $0 but not less than $10,000 (married individual filing separately who lived with a spouse at any time during the year) IRA Products and Simple Plans Page 50
Individuals with modified AGI at the following levels may not contribute to Roth IRAs for 2012: $183,000 or more (married individual filing jointly or qualifying widow(er)) $125,000 or more (single individual, head of household, or married individual filing separately who did not live with a spouse any time during the year) $10,000 or more (married individual filing separately who lived with a spouse at any time of the year) The following form is found in IRS Publication 590, and is used to determine modified AGI for Roth IRAs: IRA Products and Simple Plans Page 51