Advanced Underwriting Consultants

Ask the Experts – July 2, 2015

Question:  My client has an IRA with substantially equal periodic payments set up in order to avoid the additional tax on early distributions.  Can she roll out part of the funds in the IRA if they are not needed to satisfy the SEPP requirements?

Answer:   No.

As we discussed in the preceding question and answer, substantially equal periodic payments can be established as a way to avoid the additional 10% tax on distributions from a qualified account if money is needed before a person reaches 59 ½. A person who has established a SEPP plan cannot modify the payments or the account. If a modification occurs, the IRS will go back and retroactively apply the additional 10% penalty tax on all of the distributions that have been made  from the account pre 59 ½. The IRS however allows for a modification or termination of the SEPP plan when the owner reaches the age 59 ½ or has taken the SEPP distributions for 5 years, whichever is longer.

If a person tries to roll over part of the money in an account being used for SEPP distributions, the IRS will consider the SEPP plan busted. The IRS will apply the additional 10% tax to all of the prior distributions taken to that point.

Ask the Experts – March 17, 2015

Question: Do IRA distributions count as income for the Affordable Care Act (ACA)?

Answer:  Yes, any taxable portion of an IRA distribution is included in income for determining whether or not an individual qualifies for tax credits or cost assistance subsidies under the ACA.

Beginning in 2014 an individual’s Modified Adjusted Gross Income (MAGI) is used to determine whether or not a person will be eligible for insurance premium tax credits or cost assistance subsidies. The ACA uses the same calculations to determine MAGI as the IRS.

MAGI is determined by figuring a person’s Adjusted Gross Income (AGI) and then adding back certain income.  Generally AGI includes all of your taxable income for the year minus certain adjustments. Many of the items that are deducted from income to determine AGI are actually added back to arrive at MAGI. Most importantly, some types of income that are not included in AGI are added to determine MAGI–for example, the non-taxable portion of social security, and tax-exempt interest is included in MAGI, but not in AGI. For many folks this means their MAGI is higher than their AGI.

The taxable portion of an IRA distribution is included in AGI, and is therefore also included in MAGI. The taxable portions of IRA distributions are just one of many types of income included in MAGI. For more information on determining MAGI please see the IRS’s Modified Adjusted Gross Income Computation worksheet.

Ask the Experts – March 10, 2015

Question: I have a client turning 70 ½ this year in 2015. I know she is still eligible to contribute to a Traditional IRA for 2014, but not for 2015. If she opens a new IRA and contributes $6,500 for 2014, will she have to take a required minimum distribution for 2015 from that account?

Answer:  No

IRS Publication 590 Individual Retirement Arrangements clarifies that an individual can make contributions to their IRA for a given year until the due date for filing their tax return for that year, not including extensions. In other words an individual generally has until April 15, 2015 to make a contribution to their IRA for 2014.

Publication 590 also gives us the rules for determining when required minimum distributions must start and how to calculate them. An individual must receive at least a minimum amount from their IRA beginning with the year they turn 70 ½. In order to figure the amount for the required minimum distribution, the account balance as of December 31 for the preceding year is divided by the applicable distribution period or life expectancy factor for the individual.

In this case the individual client made the initial contribution in 2015 for year 2014. Since the account was opened in 2015, there is no account balance as of December 31 2014. Because there is a zero account balance as of December 31, 2014 there is no required minimum distribution due for 2015 from this account. The client will have to take required minimum distributions from this account in 2016 and for the following years.

Ask the Expert – September 5, 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 is retiring this year and he has a nongovernmental 457(b) plan that he would like to roll over to an IRA. Is this possible?

Answer: No, nongovernmental Section 457(b) plans (also referred to as “Top Hat” plans) are not eligible for rollover treatment to other types of retirement plans.

A Section 457(b) plan is a deferred compensation plan available for certain state and local governments and nongovernmental, tax-exempt entities. Governmental 457(b) plans are eligible for rollover into other retirement accounts like IRAs, qualified plans and 403(b) annuities. This leads many to mistakenly believe that all 457(b) plans are eligible for rollover.

When a nongovernmental 457(b) participant retires, he should consult with the plan documents to see what his options are. The participant’s options can range from cashing the account out completely, annuitizing, installment distributions, and deferring distributions until a predetermined age but not later than age 70.5.

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Ask the Experts – July 9, 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: Are inherited IRA funds exempt from creditors in bankruptcy?

Answer: It depends on the state. All states have their own bankruptcy exemption laws, but regardless of whether a state opts out of the federal bankruptcy protections, retirement funds held within a tax-qualified retirement account must be protected from creditors in bankruptcy.

At first this might seem like a pretty simple rule—for example, 401(k) accounts, governmental 457(b) plans, 403(b) tax-sheltered annuities, and IRAs (up to $1,245,475) are all excludable from the bankruptcy estate. Does this mean inherited IRAs are protected as well? After all, an inherited IRA is still an “individual retirement account.”

On June 6, the Supreme Court addressed the issue of whether funds held inside an inherited IRA qualify as “retirement funds” within the meaning of the bankruptcy code. The Court held that they are not.

In Clark v. Rameker, Heidi Heffron-Clark, a Wisconsin resident, inherited an IRA from her mother. Ms. Heffron-Clark thereafter filed for bankruptcy and sought to exempt her $300,000 inherited IRA from the bankruptcy estate under the federal bankruptcy exemption laws. She argued that the IRA exemption applies, so she should be able to exclude the IRA from her bankruptcy estate.

The Supreme Court disagreed. It held that funds held inside an inherited IRA are not retirement funds. But how are funds held inside of a “retirement account” not retirement funds?

To fully understand the decision of the Court and its reasoning, it’s important to understand the difference between a traditional IRA and an inherited IRA.

With a traditional IRA the owner may make contributions until he turns age 70 ½, at which point he is required to start taking distributions (RMDs). Additionally, until he turns 59 ½, if he withdraws any money from his IRA, he faces a 10 percent penalty unless an exception applies.

On the other hand, inherited IRAs cannot receive contributions, so the owner may never invest additional money into the account. Additionally, regardless of the new owner’s age, he must take periodic distributions from the account or fully distribute it within five years. Finally, there are no penalties for taking distributions prior to age 59 ½.

After taking into account the differences between traditional IRAs and inherited IRAs, the Court looked at what it means for funds to be defined as “retirement funds.” It held that the term means “money set aside for the day an individual stops working.” It reasoned that funds inside an inherited IRA, which must be distributed either within five years from the original owner’s death or stretched throughout the life of the beneficiary, couldn’t possibly be set aside for a later date.

The Court also looked at the characteristics of an inherited IRA to determine whether funds held inside such an account could be viewed as money set aside for retirement. The Court pointed to three aspects of inherited IRAs to show that such IRAs are not retirement funds.

      • The holder of the inherited IRA may never invest additional money in the account.
      • The holder of the inherited IRA must take RMDs.
      • The holder of the inherited IRA may take distributions at any time without penalty.

Because inherited IRAs are much more restricted than traditional or Roth IRAs, the Court found that an inherited IRA should not be considered a retirement vehicle. Therefore, the funds inside an inherited IRA are not retirement funds for federal bankruptcy purposes and are not protected from creditors.

What is the lesson of the Clark case? Inherited IRAs are not protected under federal law during bankruptcy. States may still carve out their own exemptions for inherited IRAs, though.

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Ask the Experts – June 23, 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 owns an IRA and will turn 70 ½ next year. Since she still works and plans on working indefinitely, can she roll over the IRA to her 401(k) and thereby avoid having to take RMDs until she retires?

Answer: Yes. RMDs are not required to be taken from 401(k) plans until the latter of (1) the year the employee turns 70 ½, or (2) the year the employee retires. For your client, the latter will be the year she retires. On the other hand, IRAs are required to start RMDs in the year the account holder turns 70 ½.

However, when an account holder rolls over money from an IRA to a 401(k), the funds become part of the 401(k) and therefore are governed under the 401(k) rules—which means the account holder may defer RMDs until retirement.

Keep in mind that not all employer-sponsored plans allow rollovers, so check with the plan administrator first. Also beware of the restrictions attached to some employer-sponsored plans. For example, your client’s plan might not allow withdrawals from the 401(k) plan until she retires.

Finally, since your client turns 70 ½ next year, she will need to complete the roll over this year to avoid next year’s RMD.

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Ask the Experts – June 20, 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: Can my client invest his IRA funds in real estate?

Answer: It depends on the IRA custodian. As long as the rules prohibiting self-dealing are followed, there’s nothing in the tax code that disallows an IRA from investing in non-traditional investments like land or a business. However, as evidenced by a recent Tax Court case, Dabney v. Commissioner, T.C. Memo. 2014-108 (6/5/14), the IRA custodian will have the last word as to what the IRA may purchase.

In Dabney, the taxpayer owned a traditional IRA which he rolled over to a self-directed IRA with Charles Schwab. The taxpayer was interested in buying a piece of real estate with the funds in his IRA, but Charles Schwab did not allow what it referred to as “alternative investments,” including real property.

The taxpayer was aware of Charles Schwab’s refusal to allow investments in real estate, but he nevertheless transferred the IRA funds directly to the seller of the real estate, who was instructed to name his IRA as the owner of the property. (The seller accidentally titled the property to the taxpayer himself, but the court held that either way, the transaction results in an early distribution of the IRA funds.)

The court held that although IRAs are perfectly capable of investing in real estate, a trustee typically has broad powers that are only limited by statute or the terms of the trust, and “IRA trustees and custodians generally have broad latitude to direct or limit the investment of funds in an IRA.” Since Charles Schwab has the power to prohibit the purchase of real property, the taxpayer’s IRA was not capable of holding real property, and therefore the IRA did not purchase the property.

The result is that the money transferred to the seller of the real property was treated as a normal distribution, subject to both income taxes and the 10% penalty since the taxpayer was younger than 59 ½.

The Tax Court noted that if the taxpayer had instead transferred the IRA funds from Charles Schwab to a different IRA that permitted the purchase and holding of real property, he would have achieved his goal without any unintended tax consequences.

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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 12, 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 is trying to decide between setting up a SIMPLE or SEP IRA for her small business. What should I tell her?

Answer: Without more details, you can only speak in generalities. You should start with the differences between the two.

A SIMPLE IRA (savings incentive match plan for employees) is very similar to a 401(k) plan in that it’s primarily a way for an employee to choose to contribute the employee’s money to a pension plan.

SIMPLE IRAs may include both employee deferrals and employer contributions. The employer must either (1) match the employee’s deferral dollar-for-dollar, generally up to 3% of the employee’s salary; or (2) make a 2% nonelective contribution to all eligible employees—regardless of whether the employee made a contribution.

An employee’s deferral limit for a SIMPLE IRA is $12,000 (in 2014, indexed for inflation).  The employee’s deferral must be deposited by the employer within 30 days from the end of the month in which the election was made, and the employer’s matching or 2% nonelective contribution must be made by the time tax returns are due in the following year.

To implement a SIMPLE IRA, an employer must have 100 or fewer employees who receive more than $5,000 per year. Every employee who earns at least $5,000 from the employer is an eligible employee and must be allowed to participate in the SIMPLE plan.

A SEP IRA (simplified employee pension) is easier to describe and implement than a SIMPLE IRA. It’s essentially an IRA set up on behalf of an employee to which the employer makes contributions based on a percentage of the employee’s compensation (the maximum compensation taken into account is $260,000 in 2014). The percentage contributed must be the same for every eligible employee.  There are no employee deferrals into a SEP plan.

An eligible employee is one who (1) is 21 years or older, (2) has worked 3 of the last 5 years or more, and (3) earned $550 in compensation. The contribution limit is 25% of the employee’s salary, or $52,000 (in 2014, indexed for inflation), whichever is lesser.

Understanding the differences between these plans can help your client decide which plan makes more sense. For example, if the business consists of only your client, the most important aspect is probably the contribution limits.

If the business generates relatively small amounts of income, a SEP IRA will limit the owner’s contribution. For example, let’s say your client has a side business bringing in $16,000 per year in salary. Under a SEP, the most he may contribute is $4,000 (25% of $16,000). On the other hand, with a SIMPLE IRA, he may make the full $12,000 contribution and have the business make a matching $480 contribution (3% of $16,000).

But if he earns $100,000 per year through his business, the business may contribute $25,000 (25% of $100,000) under a SEP, and he can only defer $12,000 (plus a $3,000 matching contribution from the business) under a SIMPLE plan.

Sources: I.R.C. § 408(k), (p); § 402(h)(2)(A).

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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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