IRAS, PENSION PLANS & RETIREMENT

It is never too early to plan for your retirement. This section includes a number of features to assist you with your retirement questions. For a more comprehensive look at your retirement planning needs, please call this office.

401(k) Contribution Limits

Many employers offer what are commonly referred to as 401(k) plans, named after the tax code section that created the plans. These plans allow employees to defer part of their earnings for retirement. Some employers offer matching contributions that increase the attractiveness of the programs.

The value of 401(k) plans is enhanced even further by increasing the general contribution limit and allowing individuals over age 50 to make additional contributions. Where an employer’s plan permits, individuals can contribute amounts that are not excluded from income to a 401(k) plan in a manner similar to Roth IRA contributions.

Catch-up contributions are exempt from the regular dollar limits on deferrals provided that all 401(k) plan participants are permitted to make catch-up contributions.

The table below summarizes the inflation adjusted limits for 401(k) plans for 2009 through 2012. If you have additional questions about participating in your employer’s 401(k) plan, please call this office.

Year	2009 - 2011	2012
Under Age 50  	16,500	17,000
Age 50 & Over	22,000	22,500

 

Don't Mix Required Minimum Distributions!

Taxpayers who have reached the age of 70½ and have qualified retirement plans are generally required to take minimum distributions from those plans annually. Quite frequently, taxpayers have multiple IRA accounts in addition to one or more types of qualified plans.This gives rise to a commonly asked question, "Must I take a distribution from each individual account?" For purposes of the annual required minimum distribution, a separate distribution must be taken from each type of plan. However, a taxpayer may have multiple accounts for each type of plan, which for tax purposes are treated as one plan. For example, you have three IRA accounts. The three separate accounts are treated as one for tax purposes, and the distribution can be taken from any combination of the accounts.

Substantially Equal Payment Exception

The decline in the stock market has adversely affected the value of taxpayer’s retirement investments. This decline in value of retirement accounts has uniquely affected taxpayers who have taken early retirement.

Generally, taxpayers who withdraw from their pension plans including IRAs before reaching age 59 ½ are subject to the 10% early withdrawal penalty. However, taxpayers who retire can avoid that penalty by using a special exception that requires that they take substantially equal payments from their pension plan for a period of time that is the longer of five years or the until they reach 59 ½.

The substantially equal payments are computed based on the value of the retirement account. Those retirees who retired before the decline in the market may have substantially equal payments that are excessive for account that have substantially declined in value and are depleting the plan to a point that future recovery is threatened.

Because of this, the IRS has announced that it will allow taxpayers to make a one-time change to the Minimum Required Distribution method, which is the same method used by individuals who have reached the age of 70 ½.

This one-time change will only allow a taxpayer to switch to the Required Minimum Distribution (RMD) method. Caution: switching to the RMD may substantially reduce the annual distribution and may not allow an affected taxpayer to withdraw enough to meet their current financial obligations while they wait to meet the 5-year or age 59 ½ rule. Many of them are counting on the early pension withdrawals until they start receiving their Social Security or employer retirement. Once they switch, they cannot increase or decrease their withdrawal without violating the exception.

Pension Start-Up Credit

This is a nonrefundable income tax credit for 50% of the administrative and retirement-education expenses for any small business (less than 100 employees) that adopts a new qualified defined benefit or defined contribution plan (including a Code Sec. 401(k) plan), SIMPLE plan, or simplified employee pension ("SEP"). The credit is limited to 50% of the first $1,000 of administrative and employee retirement-education expenses in each of the first three years of the plan.

Avoiding Premature Traditional IRA Distribution Penalties

You may encounter certain financial situations making it necessary to withdraw funds from your IRA account. Funds withdrawn from a Traditional IRA are taxed at the regular income tax rates AND are subject to a 10% early withdrawal penalty if you are under 59-1/2 years of age at the time of the withdrawal. However, in addition to death, there are exceptions to this 10% penalty when you meet certain conditions or the funds withdrawn are used to pay certain qualified expenses. But remember even if you avoid the penalty with one of the following exceptions, the withdrawal is still taxable for regular tax purposes.

• Higher education expenses such as tuition, fees, books, supplies, and equipment required for the enrollment or attendance of a qualified student at an eligible educational institution. In addition, if the individual is at least a half-time student, room and board is a qualified higher education expense.
  
  
• First-time homebuyer acquisition costs (within 120 days of the distribution) for the main home of a first-time homebuyer that is the taxpayer, spouse, child, grandchild, parent or other ancestor. The distribution is limited to $10,000 and if both husband and wife are first-time homebuyers, they each can withdraw up to $10,000 penalty-free.
  
  
• Unreimbursed medical expenses, that are not more than: 1) The amount you paid for unreimbursed medical expenses during the year of the withdrawal, minus 2) 7.5% of your adjusted gross income for the year of the withdrawal.
  
  
• Medical insurance premiums that you made as a result of becoming unemployed.
  
  
• Disability - you are considered disabled if you cannot perform any substantial gainful activity because of your physical or mental condition. A physician must determine that your condition can be expected to result in death or to last for a continued and indefinite duration.
  
  
• Annuity distributions - if you retire before reaching the age of 59-1/2, you can avoid the penalty provided that the withdrawals are part of a series of substantially equal payments over your life (or your life expectancy), or over the lives (or joint life expectancies) of you and your beneficiary. The payments under this exception must continue for at least 5 years, or until you reach the age of 59-1/2, whichever is the longer period.

The foregoing is a brief synopsis of the exceptions to the early withdrawal penalty. The rules pertaining to these exceptions are extensive and you are cautioned to consult with this office prior to making any withdrawals to insure you qualify under the more detailed requirements.

Parents Should Encourage Roth IRAs For Their Children

The long-term benefits of tax-free accumulation provided by Roth IRAs are hard to ignore. Parents can do their children a real service by encouraging them to establish a Roth IRA at the first opportunity. A Roth IRA, left untouched until retirement, will ensure that your child has a substantial nest egg.

Take for example a youngster, age 17, who contributes $2,000 to a Roth IRA and allows that single deposit to accumulate untouched until retirement at age 65. At a conservative 8% annual growth, the Roth IRA will have grown to $80,421.

Consider what the result would be if that same young person continued to deposit $2,000 a year to their Roth IRA. Assuming an 8% annual growth, the Roth IRA will grow to $980,264 by the time they reach retirement age of 65.

But keep in mind that children, like adults, must have "earned income" to establish a Roth IRA. Generally, earned income is income from working, not from investments. Earned income can include income from a part-time job, summer employment, baby-sitting, yard work, etc. The amount that can be contributed to either a Traditional or a Roth IRA is limited to the lesser of earned income or the annual contribution limit. The following is the annual limits by year for younger individuals. For 2011, the contribution limit is $5,000, unchanged from 2010.

Your children may balk at having to give up their earnings, especially since their focus at their age will not be on retirement. But this is not an obstacle if parents, grandparents or others are willing to fund all or part of the child’s Roth contribution.

If the parents or others contribute the funds, they need to keep in mind that once the funds are in the child’s IRA account, the funds belong to the child. The child will be free to withdraw part or all of the funds at any time. If the child withdraws funds from the Roth IRA, the child will be liable for any early withdrawal tax liability.

Saver's Credit

The Saver's Credit provides a nonrefundable tax credit for contributions made by eligible, low income taxpayers to IRAs and qualified elective income deferrals. The plan provides incentives for lower income individuals to save for their retirement through available qualified plans. To qualify, the taxpayer must have reached the age of 18 by the close of the year and cannot be a full-time student or dependent of another.

The credit ranges from 10% to 50% of the first $2,000 contributed by each taxpayer to a qualified plan during the year. The credit gradually phases out as a taxpayer’s modified AGI increases. This phase out is inflation adjusted from year to year, and the phase outs are included in a link accessed below:

CLICK HERE FOR THE CREDIT PHASE-OUT TABLES

Modified AGI - Adjusted gross income is determined without regard to foreign and protectorate income exclusions or foreign housing exclusions.

The credit is nonrefundable and offsets alternative minimum tax liability as well as regular tax liability.

Example – Eric and Heather are married and file a joint return. Eric contributed $3,000 through his 401(k) plan at work, and Heather contributed $500 to her IRA account. Their modified AGI for the year was $30,000. The credit is computed as follows:
 

Eric and Heather file a joint return using the standard deduction for married couple and their tax for the year is computed as follows:

 

Caution – To prevent taxpayers from withdrawing contributions from existing plans, and subsequently recontributing the funds in order to qualify for the credit, Congress built-in a two-year look back period that generally reduces a taxpayer’s current year contribution by withdrawals during the look-back period.

Self-Employed Pension Plan Contribution Limits

Tax laws provide for plans that allow self-employed individuals to establish retirement plans for themselves and their employees, if they have any. Those most frequently encountered are the SEP (Simplified Employee Pension) and Keogh Profit Sharing Plans. Even though they are not IRAs, the SEP plans utilize an IRA account as the depository for the SEP plan contribution, thus minimizing the administration requirements of the employer.

The compensation limits for both of these plans is generally 25% of compensation. The following details the differences between contributions for employees and the amount allowed for the self-employed individual.

• Employees: Contributions in 2010 and 2011 on behalf of an employee are generally limited to the lesser of $49,000 or 25% of the employee’s compensation (up to the compensation limit). The compensation limit for 2010 and 2011 is $245,000. 
  
  
• Self-Employed Individual: The contribution limit is 25% of the net profits from self-employment (20% of the net profits before deducting the contribution itself). The contribution is also limited same maximum contribution amount and compensation limits as the employee.
  
  Both the compensation limit and the annual contribution limit are adjusted annually for inflation.

How Taxable Distributions from a Roth IRA are Determined

Withdrawals from a Roth IRA are tax-free if the funds have met the five year aging requirement and the following criteria is met. 

• The account owner is at least 59-1/2, or
• The funds are used for a qualified first-time home purchase (up to $10,000), or
• The accountholder becomes disabled or dies.

Suppose a taxpayer does not meet the requirements for a tax-free withdrawal. The funds contributed to the IRA are always tax-free, because taxes were paid on those funds before they were deposited. Only the earnings would be taxable. Then the question becomes which funds are withdrawn first? Anticipating this question, the IRS has established a set of “Ordering Rules” which specify the sequence in which funds are withdrawn. All Roth IRAs, regardless of where they are deposited, are treated as one for purposes of the “Ordering Rules.”

First from contributions until all contributions have been withdrawn (these funds would be withdrawn tax and penalty-free);

Next from all converted (rollover amounts) until all have been withdrawn (these funds would be withdrawn tax-free, but see acceleration clause below);

Finally, from earnings (these funds would be taxable, and subject to the early withdrawal penalty when the taxpayer is under 59-1/2 years of age.)

Planning Your Taxable IRA Withdrawals

Your age at the time you make a taxable withdrawal from your Traditional IRA account can make a big difference in the amount of tax you will pay. Generally, there are three periods within your lifetime where different tax rules apply:

• Under Age 59½ - If you withdraw the IRA funds before you reach age 59 ½, you will pay tax and a 10% early withdrawal penalty unless you can avoid the penalty through one of the several exceptions provided in the tax law. Note: Some states also have small early withdrawal penalties.
  
  
• Age 59½ to Age 70½ - During this period you can make withdrawals of any amount without penalty. You are only subject to the income tax.
  
  
• Above Age 70½ - After reaching age 70 ½, you must begin taking at least the required minimum distributions or face the 50% excess accumulation penalty.

The number one key to minimizing taxes on IRA distributions is to match withdrawals to tax years in which you are in a low tax bracket or even have a negative taxable income. Take for example a year when because of illness, disability, unemployment, large business losses etc. that your income, less your deductions and personal exemptions, leaves you with a negative taxable income for the year. To the extent your taxable income is negative, you could make a taxable IRA withdrawal and avoid any tax on the amount withdrawn, and even if you are under 59 ½, you would only pay the small early withdrawal penalty.

Generally, except as mentioned above, if you are under 59½, your IRA funds are not a good source of cash except in cases of extreme need simply because of the tax liability and penalties. But if there are no alternatives, it may be possible to avoid part or all of the penalties by carefully planning the withdrawals so that they qualify for one or more of the early withdrawal penalty exceptions; (1) amounts withdrawn to pay un-reimbursed medical expenses, (2) amounts withdrawn while qualifying as disabled, (3) amounts withdrawn and used to pay for medical insurance while unemployed, (4) amounts used to pay higher education expenses, (5) amounts up to $10,000 for the purchase a first home, and (6) early retirement amount withdrawn as an retirement annuity. Taxpayers must meet certain criteria to qualify for these exceptions, so be sure to contact this office to make sure you meet those qualifications before proceeding.

For retired individuals, receiving Social Security benefits, planning IRA distributions can also be beneficial. Social Security itself is only taxable when ½ of the taxpayer’s Social Security benefits added to the taxpayer’s other income exceeds $25,000 ($32,000 for a married couple filing jointly). Once this threshold is reached, every additional dollar of other income will cause 50 to 85 cents of the Social Security benefits to also become taxable. Therefore, if a taxpayer’s other income is under the threshold, it is generally good practice to withdraw just enough taxable IRA funds to bring the income up to the threshold amount even if the funds are not needed in that year. They can be set-aside for a future year when they might be used for some unplanned need or large purchase. Retirees, with income that already puts them over the Social Security taxable threshold, should avoid large uneven withdrawals that might push them into a larger tax bracket one year and way below that tax bracket change in other years.

Remember, once a taxpayer reaches 70½, they must begin taking distributions equal to or greater than the Required Minimum Distribution, somewhat limiting planning options. If you wish to explore any of these or other tax saving techniques, please contact this office.