More Wealthier Individuals Should Be Making Nondeductible Traditional IRA Contributions - They Just Need Some Help and You Can Provide It

Posted by James M. Carlson
Jun 07 2016

Wealthier individuals should be rushing to their bank to make a non-deductible IRA contribution. This is certainly true if they are a 401(k) participant.

This author admits his bias, many individuals should be making non-deductible traditional IRA contributions and they don’t do so because they (and their advisors) many times don’t understand the benefits, including how the related tax rules apply.

Every person should contribute as much as possible to a Roth IRA. Why? There are very few times under US income tax laws where INCOME is not taxed. That is, no taxes are owed with respect to Roth IRA funds if the Roth owner has met a 5-year rule and is age 59½ or older or the Roth owner is a beneficiary who has inherited the Roth IRA and the 5-year rule has been met.

The federal tax laws have been expressly written to make it impossible for a person with a high income to make an annual Roth IRA contribution. Some people (i.e. many Democrats) don’t want “wealthier” individuals to gain the benefit of contributing funds to a Roth IRA and earning tax-free income. They want them to pay more income taxes. A person who had tax filing status of single was ineligible to make a 2015 Roth IRA contribution if his or her MAGI (modified adjusted gross income) was $132,000 or more. A person who had filing status of married filing jointly was ineligible to make a 2015 Roth IRA contribution if the couple’s MAGI (modified adjusted gross income) was $193,000 or more. A person who had filing status of married filing separately was ineligible to make a 2016 Roth IRA contribution if his or her MAGI (modified adjusted gross income was $10,000 or more.

For discussion and illustration purposes, we will assume that Jane Doe has the following situation. She is age 54. She is married. Her husband, Mark Doe, is a bank president. He is age 57. Their joint income is sufficiently high that neither one of them is eligible to make an annual Roth IRA contribution. Their joint income is sufficiently high that neither one of them is eligible to made a deductible traditional IRA annual contribution.

This article is going to discuss the question, “should these two each make a non-deductible traditional IRA contribution?” The primary concern is Jane’s situation, but we will also discuss Mark’s situation.

For the reasons discussed below, both should make a maximum non-deductible traditional IRA contribution until each is no longer eligible to make a traditional IRA contribution (i.e. the year a person attains age 70½).

On March 15, 2016, Jane contributed $6,500 to a traditional IRA she had established in 1984. She designated her contribution as being for 2015. The IRA balance at the time of contribution was $8,500. With the addition of her $6,500 contribution the IRA balance became $15,000. Since then the account has earned $40 of interest.

It is now assumed that Jane has no other IRA funds in any traditional, SEP or SIMPLE IRAs. The IRA taxation rules require in applying the taxation rules that all non-Roth IRA funds be aggregated. One cannot avoid the pro-rata taxation rule by setting up separate IRAs or having separate time deposits.

The couple’s tax preparer has recently informed Jane that her contribution is non-deductible as her husband participates in a 401(k) plan and their MAGI is sufficiently high that they are not permitted to claim any tax deduction for her $6,500 contribution. What tax options are available to her? What options are unavailable to her?

  1. She may not use the recharacterization rules to make her traditional IRA contribution a Roth IRA contribution as their 2015 MAGI is too high
  2. There is no IRS guidance allowing the IRA custodian to switch the year for which the IRA contribution was made from 2015 to 2016
  3. The IRS has issued rules allowing her to withdraw her 2015 IRA contribution with no adverse tax consequences as long as she does so by 10-15-16, no deduction is claimed on the 2015 tax return and the related income is withdrawn. If she withdraws her $6,500 contribution she is required to withdraw the related income and it is taxable for 2016 since the contribution was made in 2016. The related income is a pro-rata amount of the $40 determined as follows: 6500.15000 x $40 = $17.33. Since she is younger than age 59½ she does owe the 10% additional tax on this $17.33. The bank as the IRA custodian will prepare a 2016 Form 1099-R inserting the codes (81) in box 7, box 1 would show $6,517.33 and box 2a would show $17.33
  4. In 2016 she is eligible to make a Roth IRA conversion of any amount in the range of $.01 to $15,040. If she would convert $15,040 into her Roth IRA she/they would include in income on their 2016 tax return the amount of $8,540. She as many taxpayers does not want to include the $8,540 in her/their income and pay tax on it.

Jane as many taxpayers would like to convert only her non-deductible contribution of $6,500. This would allow her to pay no taxes since she would not be converting any of the $8,540.

The tax rules require use of the standard pro-rata taxation rule when an IRA has taxable funds and non-taxable funds. If she converts $6,500, a portion would be taxable and a portion would not be. The taxable portion is: $6,500 x $8,540/$15,040 ($3,690.82) and the non-taxable portion is $6,500 x $65,00/15,040 ($2809.18) . Jane made a nondeductible IRA contribution for 2015. She is required to file Form 8606 and attach to the couple’s Form 1040. If it was not filed with the original return, an amended tax return should be filed and the 2015 Form 8606 attached. She is not relieved of this duty because she withdraws the $6,500 or converts it. A $50 penalty applies to a person who fails to file Form 8606 unless she could show a reasonable cause why she did not file it. A person must pay a $100 penalty if a person overstates the amount of nondeductible contributions.

Note that Jane will also be required to file a 2016 Form 8606 regardless if she withdraws a portion or all of the $6,500.

Having to include in income the amount of $8540 and pay tax on this amount should not influence Jane or any other wealthy person to not make non-deductible contributions. But it does. Tax on $8540 should not be that material to a couple who are ineligible to make annual Roth IRA contributions.

From a practical standpoint, Jane could convert her traditional IRA over a 2-4 year time period to lessen the amount of income which would be taxed each year.

The best of all “planning” situations would be if Jane would either work for an employer that had a 401(k) plan written to accept rollovers from traditional IRAs or if she could work for the bank and become eligible under the bank’s 401(k) plan. Why? If Jane was a participant of a 401(k) plan, the tax rules have been so written that if she wants to make a rollover contribution, the amount rolled over “first” is the taxable portion. The prorate rule does not apply in this situation.

If Jane only rolls over $8,540, this means that the $6,500 remaining in the IRA are non-taxable. She may then convert such amount to a Roth IRA. This is her goal, this any person’s goal.

In summary, Jane wants to make as make non-deductible IRA contributions (currently $6,500 but his amount which change as it is indexed for inflation) as she can between ages 54-701/2 because she should convert all such funds into a Roth IRA.

What about her husband, Mark? He too wants to make the maximum amount of nondeductible IRA contributions from ages 57-70½ and at some point convert such contributions to a Roth IRA. The sooner the conversion can be completed the better as the earnings realized after the conversion will be tax-free if the qualified distribution rules are met.

Most likely Mark participates in a 40(k) plan which will allow him to move “taxable” IRA money into his 401(k) account. If not, he probably has the ability to rewrite the plan so he would have this right.

The 401(k) plan in which he participates may allow him to make Designated Roth deferrals and he exercises that right to the maximum. This would be $24,000 for 2016 ($18,000 + $6,000). Good for him. But why not contribute an additional $6,500 to his traditional IRA as a non-deductible contribution and convert it? Contributing $6500 for 12 years would result in an additional $78,000 in a Roth IRA.

In summary, Mark too should want to make as many non-deductible traditional IRA contributions as he is eligible for until he is no longer eligible to make traditional IRA contribution.

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Warning – Determine if Your IRA Processor Has Prepared Some of Your Institution’s 5498 Forms Incorrectly

Posted by James M. Carlson
Jun 07 2016

An IRA custodian called CWF with the following situation/question. Jane Doe has her own personal traditional IRA and she has an inherited traditional IRA arising from her mom. The IRA processor prepared just one combined 2015 Form 5498. Is this correct or permissible?

It is incorrect. Two 5498 forms must be prepared. It is understandable why a software engineer would think that it is better and simpler if just one form 5498 record is prepared rather than multiple forms. It is not simpler. The IRS rules do not permit aggregation of the data when there are multiple IRA plan agreements. The IRS has had the rule for a long time that contributions, distributions and fair market value statements are prepared and reported on a per plan agreement basis.

IRA tax data may be aggregated on a per IRA plan agreement basis, but it is not permissible to aggregate data from multiple IRA plan agreements. For example, Jane Doe age 53 has IRA Plan #1 and makes three $2,000 contributions for tax year 2015 on 3/10/15, 9/10/15 and 3/1/16 and she made a rollover contribution from a 401(k) plan to IRA Plan #1 of $12,000 on 6/10/15 and another rollover contribution from her 401(k) plan of $23,000 on 10/10/15. Box 1 will be completed with $6,000 and box 2 will be completed with $35,000.

As the discussion below illustrates, there is tax logic to the rule that there must be a separate IRA reporting form prepared on a per IRA plan agreement basis rather than allowing the reporting entity to aggregate the information and then furnish one form.

For example, Jane Doe has her own traditional IRA and she has has also inherited her mom’s traditional IRA. There must be two also separate 5498 forms prepared for her. For income taxation purposes she does not aggregate her IRA with the inherited IRA from her mother.

Preparation of a combined Form 5498 is a violation of IRS requirements. The IRS has the authority to assess a fine of $50 for each incorrect form and $50 for each missed form. Remember, the fines are doubled in the sense that one form goes to the IRS and one copy to the individual. Most likely the processor in its contract tries to have the IRA custodian be liable for this type of mistake. It’s CWF opinion that if the processor has written its software to not comply, it should be liable for any IRS fines.

What tax harm is being caused by such impermissible aggregation?

A person must do separate tax calculations for distributions from personal IRAs and inherited IRAs. This capability is lost if the data is aggregated.

If two 5498 forms both show a rollover contribution, most likely the IRS will determine that only one of them qualifies to be a rollover contribution because of the once per year rule and the other would be a taxable distribution. This audit capability is lost if there is just one combined Form 5498 prepared. The IRS prepares many statistical studies based on the info set forth on the 5498 forms. Many analytic capabilities are lost if there is not one Form 5498 prepared for each plan agreement.

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CWF's Guidance on Transfers and Direct Rollovers

Posted by James M. Carlson
Jun 02 2016

Direct rollovers from 401(k) plans into traditional IRAs average more than $75,000.

The tax rules applying to a transfer contribution are very different from those applying to rollover contribution (direct or indirect).

Procedures must exist to minimize IRA custodian errors. Errors arise because IRA personnel do not understand that the tax rules differ from transfers and direct rollovers. They are not the same and IRA staff sometimes fail to know this.

For example, a check for $65,000 is sent to First State Bank (FSB) fbo Jane Doe's traditional IRA. The personnel of First State Bank process the contribution as a transfer as they forget to ask the question, "what type of plan issued the check?". The problem is, the check was issued because Jane Doe had instructed her former employer's 401(k) plan to directly roll over her 401(k) funds to a traditional IRA. Since the check was processed as a transfer, FSB did not report this contribution on the Form 5498 as a rollover as it is required to do. No doubt the IRS will contact your customer who will contact you and the IRS will be interested in learning why FSB did not report this rollover on the Form 5498.

Solution. Determine that you and your IRA staff know what is needed to be known regarding transfers, direct rollovers and rollovers. We at CWF can assist. Call us at 800.346.3961 or visit our website for information on webinars, IRA Tests, IRA Procedure Manual and IRA Rollover Certification Forms.

If your IRA rollover form has a print or revision date prior to 2015, it is obsolete and should be discarded.

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Inheriting HSA Beneficiary - Duty to Prepare Form 8889

Posted by James M. Carlson
May 25 2016

If the HSA owner's surviving spouse is the designated beneficiary, the surviving spouse becomes the HSA owner. Consequently, he or she completes Form 8889 for transactions occurring after the HSA owner's death.

If the HSA owner has designated a non-spouse beneficiary and dies, the HSA ceases being an HSA. If the inheriting beneficiary is not the HSA owner's estate, the beneficiary completes Form 8889 as follows.

  1. Across the top of the form write, “Death of HSA Owner.
  2. At the top the beneficiary will insert his/her name and social security number. Part I (Contributions) is not to be completed. It is to be skipped as no additional HSA contributions may be made by a beneficiary
  3. On line 14a the HSA’s fair market value as of the date of death is inserted. The beneficiary includes this amount in his or her taxable income for the year during the HSA owner died. This is true even if the beneficiary withdraws the funds in a following year. The 20% penalty for non-medical use does not apply. Any earnings realized after the death of the HSA owner are included in the beneficiary's income for the withdrawal year. The HSA Custodian/trustee prepares the Form 1099-SA to report the distribution to the beneficiary for the year during which the withdrawal occurs
  4. The remainder of Part II (Distributions) is to be completed
  5. If the beneficiary pays within one year of the date of death medical expenses incurred by the HSA owner prior to his or her death, then such amount is to be listed on line 15. At times the beneficiary may need to file an amended tax return.

If the inheriting beneficiary is the HSA owner's estate, the final tax return and Form 8889 for the HSA owner as follows.

  1. Across the top of the form write, “Death of HSA Owner.
  2. Part I is to be completed, if applicable. That is, if the HSA owner made contributions prior to his death, they are reported
  3. On line 14a the HSA1s fair market value as of the date of death is inserted. This amount is included on the deceased HSA owner's final tax return for the year he or she died. This is true even if the personal representative withdraws the funds in a following year.
  4. The remainder of Part II (Distributions) is to be completed
  5. If the estate pays within one year of the date of death medical expenses incurred by the HSA owner prior to his or her death, then such amount is to be listed on line 15. At times the final tax return for the deceased HSA owner may need to file an amended tax return.

There are two times when a person is apparently required to file a paper tax return (versus an electronic filing) and file multiple 8889 forms.

The first situation is the person has his or her own personal HSA and then inherits an HSA. The person must prepare a Form 8889 for each HSA and a summary Form 8889. “StatementM is to be written at the top of each of the non-summary 8889 forms. These statements are to be attached to the summary Form 8889. The IRS instructions use the term “controlling 8889”, we prefer “summary 8889.”

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CWF Discusses - Non-Deductible Traditional IRA Contributions by Bank Presidents and other High Income Individuals

Posted by James M. Carlson
May 24 2016

More Wealthier Individuals Should Be Making Non-deductible Traditional IRA Contributions - They Just Need Some Help and You Can Provide It.

Wealthier individuals should be rushing to their IRA custodian/trustee to make a non-deductible IRA contribution. This is certainly true if they are a 401(k) participant.

Many individuals should be making non-deductible traditional IRA contributions and they don’t do so because they (and their advisors) many times don’t understand the benefits, including how the related tax rules apply. Every person should contribute as much as possible to a Roth IRA. Why? There are very few times under US income tax laws where Income is not taxed. That is, no taxes are owed with respect to Roth IRA funds if the Roth owner has met a 5-year rule and is age 59½ or older or the Roth owner is a beneficiary who has inherited the Roth IRA and the 5-year rule has been met.

The federal tax laws have been expressly written to make it impossible for a person with a high income to make an annual Roth IRA contribution. Some people (i.e. many Democrats) don’t want “wealthier” individuals to gain the benefit of contributing funds to a Roth IRA and earning tax free income. They want them to pay more income taxes. A person who had tax filing status of single was ineligible to make a 2015 Roth IRA contribution if his or her MAGI (modified adjusted gross income) was $132,000 or more. A person who had filing status of married filing jointly was ineligible to make a 2016 Roth IRA contribution if the couple’s MAGI was $193,000 or more. A person who had filing status of married filing separately was ineligible to make a 2016 Roth IRA contribution if his or her MAGI was $10,000 or more.

For discussion and illustration purposes, we will assume that Jane Doe has the following situation. She is age 54. She is married. Her husband, Mark Doe, is a bank president. He is age 57. Their joint income is sufficiently high that neither one of them is eligible to make an annual Roth IRA contribution. Their joint income is sufficiently high that neither one of them is eligible to made a deductible traditional IRA annual contribution.

This article is going to discuss the question, “should these two each make a non-deductible traditional IRA contribution?” For the reasons discussed below, both should make a maximum non-deductible traditional IRA contribution until each is no longer eligible to make a traditional IRA contribution (i.e. the year a person attains age 70½).

On March 15, 2016, Jane contributed $6,500 to a traditional IRA she had established in 1984. She designated her contribution as being for 2015. The IRA balance at the time of contribution was $8,500. With the addition of her $6,500 contribution the IRA balance became $15,000. Since then the account has earned $40 of interest. It is now assumed that Jane has no other IRA funds in any traditional, SEP or SIMPLE IRAs. The IRA taxation rules require in applying the taxation rules that all non-Roth IRA funds be aggregated. One cannot avoid the pro-rata taxation rule by setting up separate IRAs or having separate time deposits.

The couple’s tax preparer has recently informed Jane that her contribution is non-deductible as her husband participates in a 401(k) plan and their MAGI is sufficiently high that they are not permitted to claim any tax deduction for her $6,500 contribution. What tax options are available to her? What options are unavailable to her?

She may not use the recharacterization rules to make her traditional IRA contribution a Roth IRA contribution as their 2015 MAGI is too high.

There is no IRS guidance allowing the IRA custodian to switch the year for which the IRA contribution was made from 2015 to 2016.

The IRS has issued rules allowing her to withdraw her 2015 IRA contribution with no adverse tax consequences as long as she does so by 10-15-16, no deduction is claimed on the 2015 tax return and the related income is withdrawn. If she withdraws her $6,500 contribution she is required to withdraw the related income and it is taxable for 2016 since the contribution was made in 2016. The related income is a pro-rata amount of the $40 determined as follows: 6500.15000 x $40 = $17.33. Since she is younger than age 59½ she does owe the 10% additional tax on this $17.33. The bank as the IRA custodian will prepare a 2016 Form 1099-R inserting the codes (81) in box 7, box 1 would show $6,517.33 and box 2a would show $17.33.

In 2016 she is eligible to make a Roth IRA conversion of any amount in the range of $.01 to $15,040. If she would convert $15,040 into her Roth IRA she/they would include in income on their 2016 tax return the amount of $8,540. She as many taxpayers does not want to include the $8,540 in her/their income and pay tax on it. Jane as many taxpayers would like to convert only her non-deductible contribution of $6,500. This would allow her to pay no taxes since she would not be converting any of the $8,540. The tax rules require use of the standard pro-rata taxation rule when an IRA has taxable funds and nontaxable funds. If she converts $6,500, a portion would be taxable and a portion would not be. The taxable portion is: $6,500 x $8,540/$15,040 ($3,690.82) and the non-taxable portion is $6,500 x $65,00/15,040 ($2,809.18) . Jane made a non-deductible IRA contribution for 2015. She is required to file Form 8606 and attach to the couple’s Form 1040. If it was not filed with the original return, an amended tax return should be filed and the 2015 Form 8606 attached. She is not relieved of this duty because she withdraws the $6,500 or converts it. A $50 penalty applies to a person who fails to file Form 8606 unless she could show a reasonable cause why she did not file it. A person must pay a $100 penalty if a person overstates the amount of non-deductible contributions. Note that Jane will also be required to file a 2016 Form 8606 regardless if she withdraws a portion or all of the $6,500.

Having to include in income the amount of $8,540 and pay tax on this amount should not influence Jane or any other wealthy person to not make non-deductible contributions. But it does. Tax on $8,540 should not be that material to a couple who are ineligible to make annual Roth IRA contributions. From a practical standpoint, Jane could convert her traditional IRA over a 2-4 year time period to lessen the amount of income which would be taxed each year.

The best of all “planning” situations would be if Jane would either work for an employer that had a 401(k) plan written to accept rollovers from traditional IRAs or if she could work for the bank and become eligible under the bank’s 401(k) plan. Why? If Jane was a participant of a 401(k) plan, the tax rules have been so written that if she would rollover a portion of the $15,040, the amount rolled over “first” is the taxable portion. The prorate rule does not apply in this situation. If Jane only rolls over $8,540, this means that the $6,500 remaining in the IRA are non-taxable. She may then convert such amount to a Roth IRA. This is her goal, this any person’s goal.

Jane wants to make as many non-deductible IRA contributions (currently $6,500 but his amount which change as it is indexed for inflation) as she can between ages 54-70½ because she should convert all such funds into a Roth IRA. What about her husband, Mark? He too wants to make the maximum amount of non-deductible IRA contributions from ages 57-70½ and at some point convert such contributions to a Roth IRA. The sooner the conversion can be completed the better as the earnings realized after the conversion will be tax free if the qualified distribution rules are met.

Most likely Mark participates in a 40(k) plan which will allow him to move ‘taxable IRA money into his 401(k) account. If not, he probably has the ability to rewrite the plan so he would have this right. The 401(k) plan in which he participates may allow him to make Designated Roth deferrals and he exercises that right to the maximum. This would be $24,000 for 2016 ($18,000 + $6,000). Good for him. But why not contribute an additional $6,500 to his traditional IRA and convert it? Contributing $6500 for 13 or 14 years would result in an additional $84,500 or $91,000 in a Roth IRA. Those individuals attaining age 70 between July and December 31st are eligible to make a contribution for their "70" year whereas those who attain age 70 and 70½ are ineligible.

Be aware that under existing laws Roth IRA funds are ineligible to be rolled over into a 401(k) plan. This is true even for 401(k) plans having Designated Roth features.

Mark too should want to make as many non-deductible traditional IRA contributions as he is eligible for until his 70½ year.

In summary, a bank president and his/her spouse want to make as many non-deductible traditional IRA contributions as possible prior to his/her 70½ year. With some pre-planning, it will be possible to convert these to be Roth IRA conversion contributions.

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Obama Administration Again Proposes Taxing Some Roth IRA Distributions And Other Law Changes

Posted by James M. Carlson
May 06 2016

Below is a summary of the President’s fiscal year 2017 budget proposal for IRA and pension law changes. Unsurprisingly, the proposals seek to reduce the tax benefits realized by individuals with higher incomes.

  1. The law will “cap” the tax benefit (exclusion or tax deduction) that a person may receive from an IRA, 401(k) or other tax preferred plan at the 28% bracket. That is, those individuals in a higher tax bracket (33%, 35%, 39.6%, etc) would not be able to claim a tax deduction for the full amount or claim a full tax exclusion. This is the first proposal or discussion making some Roth IRA distributions taxable. New for 2016
  2. The standard RMD rules would apply to a person who had funds within a Roth IRA in the same manner as they know apply to funds within a traditional IRA, SEP-IRA and SIMPLE IRA. This change does not generate any additional tax revenues, but is being made to lower the amounts in Roth IRAs earning tax free income. Proposed in 2015. This change would only apply to those Roth IRA accountholders who attain age 70½ in 2016 or later
  3. Required distributions would no longer apply to individuals who had an aggregated balance of less than $100,000 in IRAS, 401(k)’s and other retirement accounts. A special rule would apply in the case of certain defined benefit plans. Proposed in 2015
  4. A person who has after-tax dollars in an IRA or pension plan would lose the right to convert such dollars into a Roth IRA. That is, a person will be eligible to convert only “taxable” funds, he or she could not convert after-tax funds. New for 2016.
  5. Require most non-spouse beneficiaries to take required distributions using the 5-year Rule. The life distribution rule no longer could be used. This is a large revenue raiser and it raises greatly the taxes to be paid by non-spouse beneficiaries. This change would only apply if the IRA accountholder died on or after January 1, 2017
  6. The proposed law will “cap” the amount of funds a person may accumulate within tax preferred plans. This was also proposed in the 2015 budget proposal. The person would be required to aggregate the balance he or she has within personal IRAs with the balance within all employer sponsored retirement plans. Once a certain limit is reached, then no additional contributions could be made by the individual or by the individual’s employer on his or her behalf. The account balance could grow if due to earnings, but not on account of new contributions. The law would permit a person to accumulate an initial balance of $3,400,000 as that is the actuarial equivalent of a joint and 100% survivor annuity of $210,000 per year. The $210,000 limit would be adjusted for cost of living increases.CWF Observation. This proposal would greatly complicate the administration of IRAs and pension plans. There would be a tremendous increase in the need for actuarial and accounting services. It may well be an employee would need to inform his/her current employer what he/she has accumulated in his/her IRAs and other pension plans.
  7. The proposed law would allow certain non-spouse beneficiaries who mistakenly are paid a distribution from an inherited to roll over such distribution if certain rules are met. This was also proposed in the 2015 proposal
  8. The 401(k) plan rules would be changed so that an employer would have to let those employees working 500-999 hours per year for three consecutive years to be able to make elective deferral contributions. Under current law, an employer is not required allow employees who work less than 1,000 hours to participate in the plan. Although the employer would have to let such employees make elective deferral, the employer would not be required to make any contributions, matching or profit sharing, on behalf of such employees
  9. The IRS and the DOL are big fans of automatic enrollment pension plans. Under current law an employer’s decision to sponsor a pension or profit sharing plan is totally voluntary. Many small and moderate size employers choose to not offer a plan due to the regulatory complexity. The IRS and the DOL don’t seem to accept why so many employers choose to not offer such plans. Their solution, change the law so an employer must offer a simplified retirement plan. An employer with more than 10 employees which has been in business for at least two years would be required to offer a payroll deduction IRA program. Employees would automatically be enrolled to have 3% of compensation withheld unless they expressly waived coverage. An employee could have a larger percentage withheld. Funds could go into either a traditional IRA or a Roth IRA. To offset some of the cost for maintaining this plan there would various tax credits extended to the small employers
  10. The current tax rules applying to the taxation of net unrealized appreciation would be repealed. The general tax rule is, when a person takes a distribution from his or her IRA or 401(k) plan, such amount is combined with other wage or ordinary income for such year and taxed at the applicable marginal income tax bracket. Many times a person will move into a higher tax bracket on account of the IRA/401(k) distribution. Current law allows an employee who has been distributed employer stock to be taxed differently. He or she will include the cost basis of the stock in his or her income for the year of distribution, but is able to defer further taxation to when the stock is subsequently sold. There is no time limit by when the individual must sell the stock. It may be the government won’t see any tax revenues for 20-50 years. Example. Jane works for ABC, Inc from ages 22-38. Her employer has a profit sharing which invests in employer stock. The corporation has been very successful. The corporation contributes stock which at the time contributed had a cost basis of $45,000, but has a value of $450,000 when distributed to her. Although she has various options, she elects to have the stock distributed to her inkind. Under this method she includes the $45,000 in her income and pays tax on such amount. Now assume the stock appreciates to $600,000 and she then decides to sell the stock. She would have $555,000 of long term gain and it would be taxed at a rate of 28% under current law. That is, she will not pay any tax on the stock appreciation until she sells the stock. And at that time she will most likely qualify to pay tax at then existing capital gain rates on the stock gain. The current tax rate is 28% but there were times during 2009-2012 when the tax rate was 10%, 15% or 20%. This change would not apply to a person who was age 50 or older as of 12/31/15.
  11. The current tax laws allowing a publicly traded company to claim a tax deduction for dividends paid with respect to stock held in an ESOP would be repealed. Most of the above proposals have little chance of being enacted as the Republicans for the time being control Congress. The purpose of this article is, the politicians will certainly be discussing many of these same IRA and pension topics with some modifications. CWF believes it is only a matter of time before the law is changed to reduce the distribution period applying to an inheriting IRA beneficiary. The reason, the life expectancy approach means there is too long of a time of tax deferral and the government is waiting too long time to receive the tax payments associated with these tax-deferred funds. Tax laws should be reasonable, but what one person thinks is reasonable another person does not. Compromises will be made.

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Inherited IRA Situation - Daughter Dies, Then Dad Dies, Then Mom Dies

Posted by James M. Carlson
Apr 21 2016

Jane Martin was age 37 in 2012 when she died. At the time she had an IRA with ABC Bank with a balance of $70,000. Her IRA account balance was due to a 401(k) rollover made in 2008 plus she had made a number of annual contributions. She had designated her dad, Tom Doe, to receive 50% of her IRA and her mom, Karen Doe, to receive the other 50%. Tom’s date of birth was June 10, 1944 and Karen Doe’s date of birth was December 15, 1950.

ABC Bank established on its computer systems two inherited IRA as follows: (“Tom Doe as beneficiary of Jane Martin’s traditional IRA”) and (“Karen Doe as beneficiary of Jane Martin’s traditional IRA.’)’

Tom designated his wife, Jane, to be the beneficiary of his inherited IRA (“Tom Doe as beneficiary of Jane Martin’s traditional IRA”) and she designated Tom to be the beneficiary of her inherited IRA (“Karen Doe as beneficiary of Jane Martin’s traditional IRA”).

With respect to Tom’s inherited IRA, required distributions were made to him for 2013, 2014 and 2015. Tom recently died on March 13, 2016. He had not taken his 2016 RMD prior to his death.

Since he was age 69 in 2013, the initial divisor for the RMD calculation for his inherited IRA was 17.8 and the schedule to be used was:

2013 17.8

2014 16.8

2015 15.8

2016 Tom died 14.8

2017 13.8

2018 12.8

etc.

With respect to Karen’s inherited IRA, required distributions were made to Karen for 2013, 2014 and 2015. Since she was age 63 in 2013, the initial divisor for the RMD calculation for her inherited IRA was 22.7 and the schedule to be used was:

2013 22.7

2014 21.7

2015 20.7

2016 19.7

2017 18.7

2018 17.7

etc.

With Tom’s passing, Karen now has two inherited IRAs. The one she inherited from her daughter (“Karen Doe as beneficiary of Jane Martin’s traditional IRA”) and the one she inherited from Tom. Although we at CWF have some doubts, the IRS instructions are to title this inherited IRA, “Karen Doe as beneficiary of Tom Doe’s IRA.”

Technically, these two inherited IRAs are not like-kind IRAs for purposes of applying the RMD aggregation rule since the IRAs were inherited from different people.

What RMDs need to be distributed for 2016 to Karen? She needs to be paid Tom’s RMD as calculated for her second inherited IRA as he had not taken it and she will need to take the RMD as calculated for her first inherited IRA (“Karen Doe as beneficiary of Jane Martin’s traditional IRA”)

What about the RMDs for 2017 and subsequent years? The most conservative approach for Karen is to continue to maintain two separate inherited IRAs and to take two required distributions. She would wish to designate a “new” beneficiary for each inherited IRA. As Jane had a brother, Mark Doe, Karen now designates Mark to be the beneficiary of these two inherited IRAs.

From a practical standpoint, Karen may wish to maintain only one inherited IRA. She would combine the two inherited IRAs since both had originated from her daughter’s IRA. The title should be, (“Karen Doe as beneficiary of Tom Doe’s IRA.”) The use of only one of the RMD schedules (the one requiring the larger distribution) would mean she would be withdrawing more than her true RMD amounts, but she may find maintaining only one inherited IRA worthwhile.

Upon Karen’s death, the new inherited IRA would be titled, (“Mark Doe as beneficiary of Karen Doe’s inherited IRA.”) Mark would continue use the divisor schedule being used by Karen. Current rules require the RMD divisor schedule applying to the “first” beneficiary will apply to all subsequent beneficiaries. There is no recalculation for any subsequent beneficiary.

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No Form 1099-R Prepared to Report IRA Funds Moving From the Decedent’s IRA to an Inherited IRA

Posted by James M. Carlson
Apr 21 2016

Some mainframe software vendors just don’t understand the IRS procedures for reporting once an IRA accountholder dies. These mainframe software writers have incorrectly adopted the approach that the Form 1099-R is to be prepared when an inherited IRA is being established.

A Form 1099-R is prepared only if there is a reportable distribution. Establishing an inherited IRA involves transferring the IRA funds from the decedent’s IRA to one or more inherited IRAs. Such transfers are not to be reported on the Form 1099-R.

Preparing a Form 1099-R which is not required to be prepared is an incorrect form and will result in penalty. The penalty is now $250 (times 2) if an IRA custodian submits an incorrect Form 1099-R

It may not be the best way, but the IRS has the IRA custodian complete the Form 5498 in a special way to inform the IRS that the decedent’s IRA funds have moved to an inherited IRA for one or more beneficiaries. Using the title, “John Doe as beneficiary of Jane Doe,” informs the IRS that funds have been moved from Jane Doe’s IRA into a inherited IRA for John Doe. The Form 1099-R is not used for this purpose.

The software vendor is causing real problems for the individual if it prepares an incorrect Form 1099-R as he or she must explain the distribution on his or her tax return. A non-spouse beneficiary is unable to rollover a distribution from an inherited IRA Putting a 0.00 in box 2a does not make things better.

Categories: Traditional IRAs

IRS Biased Against Inherited Roth IRAs

Posted by James M. Carlson
Apr 20 2016

The IRS should not be biased against inherited Roth IRAs, but the IRS is. Some IRS administrations are more biased against inherited Roth IRAs than others.

The IRS does not like the fact that a person may inherit a Roth IRA and earn tax-free income over the beneficiary’s life expectancy. This will be accomplished if the beneficiary limits his or her distributions to the required amount each year using the life distribution rule. This will not be accomplished if the 5-year rule is used.

The IRS last revised model Form 5305-RA in March of 2002. In Article V it is clearly stated that a beneficiary will use the life distribution rule to comply with the required distribution rules unless he or she elects the 5-year rule. The 5-year rule applies automatically if there is no designated beneficiary (e.g. the estate is the beneficiary).

Article V

1. If the depositor dies before his or her entire interest is distributed to him or her and the depositor’s surviving spouse is not the designated beneficiary, the remaining interest will be distributed in accordance with (a) below or, if elected or there is no designated beneficiary, in accordance

with (b) below:

(a) The remaining interest will be distributed, starting by the end of the calendar year following the year of the depositor’s death, over the designated beneficiary’s remaining life expectancy as determined in the year following the death of the depositor.

(b) The remaining interest will be distributed by the end of the calendar year containing the fifth anniversary of the depositor’s death.

The IRS in Publication 590-B (Distributions from IRAs), page 36, gives murky guidance discussing distributions after the Roth IRA owner’s death. “Generally, the entire interest in the Roth IRA must be distributed by the end of the fifth calendar after the year of the owner’s death unless the interest is payable to a designated beneficiary over the life or life expectancy of the designated beneficiary.” The IRS could and should be informing a Roth IRA beneficiary that if he or she elects to use the 5-year rule that one loses the right to earn tax-free income and therefore most beneficiaries should use the life distribution rule.

In recent years the IRS has adopted rules and procedures to be more fair and transparent. At times the IRS has a great conflict of interest and should make this known. The IRS should revise its discussion of inherited Roth IRAs to not try to induce a beneficiary to use the 5-year rule.

Categories: Roth IRAs

CWF Reminder - 4/30/16 is Deadline to Update Certain Old Keogh and Profit Sharing Plans

Posted by James M. Carlson
Mar 31 2016

Any old Keoghs or old profit sharing plans sitting in any files? Forgotten gems or forgotten liabilities?

Substantial tax benefits are realized by sponsoring businesses and participants of qualified profit sharing plans and 401(k) plans. In order to gain such tax benefits such plans must be amended and restated on a timely basis.

April 30, 2016 is the deadline for most defined contribution plans to be amended and restated. If a plan has been updated within the last 1-20 months, it should be in compliance. If it has not been updated, it should be by April 30th, 2016.

CWF has been a prototype plan submitter since 1984. Contact us if your institution or any of your business clients would benefit by using a CWF document to amend and restate its retirement plan. The consequences of missing this deadline means an employer will have to pay substantially higher fees to bring the plan into compliance. The IRS may argue the plan is no longer qualified and the funds are deemed distributed and taxable.

The IRS has always taken the tax position that a distribution in any pension plan is eligible to be rolled over or directly rolled over to any type of IRA or other plan only if the plan is "qualified" at the time of the distribution. To be qualified at the time of distribution the plan document must set forth the current laws. Thus, the need to amend and restate the plan.

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