Advanced Underwriting Consultants

Ask the Experts – June 17, 2015

Question: If my client activates the income rider on my annuity, does that qualify for the substantially equal periodic payments exception to the early distribution penalty?

Answer:  Not necessarily.

The IRS gives us three methods under Code Section 72(t) to determine substantially equal periodic payments in order to avoid the 10% additional tax on distributions taken from qualified accounts before age 59 ½. The methods can be found in Revenue Ruing 2002-62, they are:

  • Required minimum distribution method
  • Amortization method
  • Annuitization method

Each of these methods requires its own calculation based upon the account value and the life expectancy of the account owner. Simply receiving a set amount each year from an income rider does not necessarily meet these calculation requirements.

The payments from the income rider would have to exactly equal to the Section 72(t) substantially equal periodic payments determined by one of these methods to qualify as an exception to the additional tax on early distributions.

There is a free calculator for Section 72(t) distributions at http://72t.net/72t/Sepp/Calculators.

Ask the Experts – June 13, 2014

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The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers. Here’s the question of the day.

Question: My client (age 62, resident of Colorado) owns an IRA. Are IRA distributions subject to state income tax? If he wants to do a Roth conversion, will it be subject to state income tax?

Answer: It depends on the state. Colorado imposes a flat 4.63% state income tax is on its residents’ federal taxable income. Since both IRA distributions and Roth conversions are taxable on the federal level, they are both generally taxable on the Colorado state level.

However, Colorado allows a pension/annuity subtraction for taxpayers who are age 55 or older as of the last day of the tax year, or who are receiving a pension or annuity because of the death of the person who earned it. The pension/annuity subtraction allows a Colorado taxpayer to reduce his taxable income by the taxable amount he receives as a distribution from his IRA, up to $20,000 (or $24,000 if age 65 or older).

For example, suppose your client accurately reported $60,000 as taxable income on his federal income tax return. Generally, your client would owe $2,778 (4.63% of $60,000) in state income taxes. But suppose that $20,000 of his taxable income came from a distribution from his IRA. He can exclude this $20,000 distribution, resulting in a new taxable base of $40,000.

Additionally, the pension/annuity subtraction rule applies to Roth conversions. Therefore, as long as your client converts $20,000 or less to a Roth IRA in the taxable year, and doesn’t use the pension/annuity subtraction on another taxable distribution throughout the year, he may exclude the converted amount from the Colorado income tax.

Each state has different rules when it comes to income taxes, and there’s no universal rule as to the taxability of IRAs at the state level.

Sources: Col. Rev. Stat. § 39-22-104(f)(4); FYI Income 25: Pension/Annuity Subtraction, http://www.colorado.gov/cms/forms/dor-tax/Income25.pdf.

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Ask the Experts – June 11, 2014

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The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers. Here’s the question of the day.

Question: My client received a distribution from his 401(k) plan. The distribution was comprised mostly of stocks and bonds which he sold shortly after the distribution. Can he still roll the proceeds over to an IRA if he’s still within the 60-day period, or does selling the distributed property preempt him from completing the rollover?

Answer: Your client may complete the rollover as long as the 60-day period has not expired even though he sold the distributed property.

When the property is distributed, the participant’s basis in the property is generally equal to its fair market value. If the participant sells the distributed property for a gain within the 60-day period, he may still complete the rollover and contribute all of the proceeds from the sale to his IRA. Additionally, no gain (or loss, if applicable) will be recognized if he completes the rollover.

For example, let’s say your client took a complete distribution from his 401(k) plan, which consisted of various stocks worth $300,000. Assume he holds on to the distributed property for 45 days, and the stock value increased to $310,000 in total. Your client then liquidates the stock for $310,000, resulting in a $10,000 gain. Under this situation, your client may still roll over the $310,000 cash proceeds from the sale of the stocks. Additionally, if he rolls over the full amount, he will not have to pay taxes on the gain portion until he withdraws the funds from the IRA.

Sources: I.R.C. § 402(c)(6).

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Ask the Experts – April 30

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The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers.  Here’s the question of the day.

Question: My client is the executor of an estate, and the estate itself is the beneficiary of an IRA and a deferred annuity. How does an executor decide when and to whom to make distributions from these retirement accounts?

Answer: Since the estate is the beneficiary of the deferred annuity, the deferred annuity must be liquidated within 5 years from the original owner’s death. The same rule applies to the IRA if the deceased was younger than 70 ½ at her death. If older, the estate has the option to stretch distributions over the life expectancy of the deceased based on her age at her death using the single life table published by the IRS.

The executor should make sure these distribution rules are met to ensure that these two accounts aren’t hit with RMD penalties. Additionally, the estate is liable for income taxes on these distributions, and estates are typically taxed at higher rates than individuals.

The next step is getting the annuity and IRA funds from the estate to the estate’s beneficiaries. The executor must work with the probate court to figure out who receives what portion of these distributions. Once it’s determined, the executor can make the proper distributions.

On a related note, estates often incur various bills. The executor can seek permission from the probate court to apply estate funds to such bills.

This may seem troublesome and potentially costly, but it could have been avoided by not naming the estate as beneficiary of the deceased’s IRA and annuity. Keep in mind that this choice was made when the deceased named her estate as the beneficiary to her retirement accounts.

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Ask the Experts – April 7

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The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers.  Here’s the question of the day.

Question: My client contributed $6,500 to a Roth IRA last year, but it turns out he earned too much to contribute anything. He has already withdrawn the contribution and its earnings, but is he subject to the 10% early distribution penalty on the earnings?

Answer: We think so.

Neither Congress nor the IRS has addressed the precise issue of whether earnings from excess contributions are subject to the 10% early distribution penalty. Since there’s no special rule, the general rule—that the 10% penalty applies to early distributions—should apply to any gain earned from the excess contribution.

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Ask the Experts – March 19

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The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers.  Here’s the question of the day.

Question: My client, age 64, is receiving his Social Security retirement benefits early. He’s not working, but he is periodically taking distributions from his employer-sponsored retirement plan. Do these distributions reduce my client’s Social Security benefits?

Answer: No.

The general rule is that if an individual begins receiving Social Security benefits before his full retirement age (age 66 for your client), and earns more than $15,480 in 2014, then his benefits will be reduced by one dollar for every two dollars in earnings above the limit.

What income counts toward this $15,480 limit? Here’s what the Social Security Administration says:

If you work for someone else, only your wages count toward Social Security’s earnings limit. If you are self-employed, we count only your net earnings from self-employment. For the earnings limit, we do not count income such as other government benefits, investment earnings, interest, pensions, annuities and capital gains.

Therefore, your client’s retirement benefits shouldn’t be reduced merely because he is also receiving money from his retirement plan.

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Ask the Experts – March 17

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The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers.  Here’s the question of the day.

Question: Can a participant of a SIMPLE 401(k) take a penalty-free distribution if he is age 55 and severed from his employment? Does it matter if it’s a SIMPLE IRA instead of a SIMPLE 401(k)?

Answer: Under Section 72(t), certain retirement plans, including IRAs and 401(k) accounts, are subject to a 10-percent penalty for distributions made prior to age 59 ½ unless an exception is met. The exception to which you’re referring states that as long as the participant is at least 55 years of age and has ended his employment with the employer-sponsor, the 10-percent penalty does not apply. However, this exception does not apply to IRAs.

Since a SIMPLE 401(k) is not an IRA, the age-55, severance from employment exception applies. Therefore, the 10-percent early distribution penalty should not apply to your client’s situation.

Since a SIMPLE IRA is an IRA, the age-55, severance from employment exception does not apply. If an individual takes a distribution, it would be subject to the 10-percent penalty found in Section 72(t).

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Ask the Experts – March 14

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The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers.  Here’s the question of the day.

Question: My client has a governmental 457(b) account to which he rolled over funds from his former employer’s retirement account. Under the old plan, he could receive distributions after he reached age 59 ½, but under his current 457(b) plan, he cannot access the funds until he is age 70 ½. If the rollover amounts are separately accounted for in the 457(b) plan, can my client still access the rolled over funds after he reaches age 59 ½?

Answer: Yes, he can access the rollover contributions prior to age 70 ½ as long as the governmental 457(b) plan documents allow it.

The general rule is that 457(b) accounts cannot be accessed until the participant:

  • Reaches age 70 ½;
  • Stops working with the employer; or
  • Is faced with an unforeseeable emergency.

However, the IRS issued Revenue Ruling 2004-12, holding that the restrictions on distributions do not apply to rollover contributions:

If the receiving plan is a § 457 eligible governmental plan or a tax-sheltered annuity described in § 403(b)(7) or (11), amounts attributable to rollovers that are maintained in separate accounts are permitted to be distributed at any time even though distribution of other amounts under the plan or contract is restricted pursuant to § 457(d)(1)(A) and § 403(b)(7) or (11), respectively (emphasis added).

Therefore, the client could receive a distribution of that money prior to age 70 ½ (or severance from employment or an emergency). However, keep in mind that the 10-percent penalty under section 72(t) still applies if your client is younger than age 59 ½.

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Ask the Experts – February 28

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The professionals at Advanced Underwriting Consultants (AUC) answer the tax questions posed by producers.  Here’s the question of the day.

Question: My client, age 45, received half of each of her ex-husband’s IRA and 401(k) accounts pursuant to a divorce settlement. If she withdraws all the funds from both accounts, will she incur the 10-percent penalty on the proceeds?

Answer: The rules are different based on the type of plan.

The proceeds from the 401(k) account will not be subject to the 10-percent penalty as long as the plan was split pursuant to a qualified domestic relations order (QDRO). The distributions will still generally be subject to ordinary income taxes—just not the penalty.

On the other hand, a distribution from the IRA will be subject to the 10-percent penalty unless another exception applies (e.g., disability, SEPP plan, medical expenses) since QDROs don’t apply to IRAs.[1] However, like the 401(k), an IRA distribution will still generally be subject to ordinary income tax treatment.

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[1] See I.R.C. §§ 414(p)(9), 401(a)(13), 408.