Ask the Experts – April 7

Ask the Experts!

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 He has already withdrawn the contribution and its earnings, but is he subject to the 10% early distribution penalty on the earnings?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.

Have a question for the professionals at AUC? Feel welcome to submit it by email. We may post your question and the answer as the question of the day.

Ask the Experts – March 11

Ask the Experts!

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

Question: If my client earns $20,000 and makes the maximum contribution of $17,500 towards her designated Roth 401(k), can she also contribute $5,500 to her Roth IRA, or is she limited at $2,500?

Answer: The IRS hasn’t addressed this issue, but based on the language of the Internal Revenue Code, we think the answer is yes; she can contribute the full $5,500 to her Roth IRA.

Code Section 219(b) tells us that the contribution limit toward a Roth IRA in 2014 is the lesser of:

(A) $5,500 or

(B) “an amount equal to the compensation includible in the individual’s gross income” in 2014 (emphasis added).

Elective deferrals to a traditional employer-sponsored plan of up to $17,500 are not includible in an employee’s gross income on the year. For example, if your client made a $17,500 elective deferral to a traditional 401(k) account, her IRA contribution limit would be reduced to $2,500—the amount of compensation includible in her gross income.

However, elective deferrals contributed to a designated Roth account are includible in gross income, and therefore shouldn’t reduce the limit imposed under Section 219(b). In other words, 100 percent of her compensation, $20,000, is includible in her gross income, and so the $5,500 limit applies (i.e. the lesser of the $5,500 limit and her $20,000 compensation that is includible in gross income).

It might seem like an odd result since your client is contributing more money ($23,000) to her retirement plans than she earns, but based on the statutory language, this should be allowed.

Have a question for the professionals at AUC? Feel welcome to submit it by email. We may post your question and the answer as the question of the day.

Ask the Experts – March 7

Ask the Experts!

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

Question: My client earns too much (around $250,000) to make a Roth IRA contribution. Can he instead make a traditional IRA contribution and thereafter convert it to a Roth IRA?

Answer: Yes. While there are income limitations for making contributions to Roth IRAs, there are no such limitations for either a non-deductible contribution to a traditional IRA or a conversion of a traditional IRA to a Roth IRA.

Therefore, assuming your client doesn’t currently own an IRA, he could make a nondeductible $5,500 to a new traditional IRA, and thereafter convert it to a Roth IRA. This essentially results in a Roth IRA contribution.

However, if your client currently owns an IRA with pre-tax money, he should be careful not to trigger more tax consequences than he’d like.

For example, let’s say your client makes a $5,500 non-deductible contribution to his already existing traditional IRA with $49,500 pre-tax money. He pays taxes on the $5,500 contribution and his IRA is now worth $55,000, consisting of 90 percent pre-tax, and 10 percent after-tax contributions.

Here’s the problem: if he tries to convert $5,500 of the traditional IRA to a Roth, he will owe another taxes on an additional $4,950 income. This is because when an individual makes a distribution from an IRA with both pre- and after-tax money, the distribution consists of both pre- and after-tax money on a pro rata basis.

Therefore, if your client converted $5,500 from his traditional IRA to his Roth, only $550 would be with after-tax money, whereas $4,950 would be converted using pre-tax money—meaning he would owe taxes on an additional $4,950 of income. In the end, his $5,500 contribution would incur taxes on $10,450 of income ($5,500 + $4,950).

He could avoid the extra $4,950 of taxable income in the above example by making a deductible contribution to his traditional IRA (as opposed to a non-deductible contribution). If he does this, he will not pay income taxes on the original $5,500 distribution, but instead will owe taxes on the conversion. This tax result is identical to making an after-tax Roth contribution, but because of his income levels, he can only make a deductible contribution to a traditional IRA if he is not an active participant in an employer-sponsored plan.

Have a question for the professionals at AUC? Feel welcome to submit it by email. We may post your question and the answer as the question of the day.

Ask the Experts – March 4

Ask the Experts!

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

Question: Even though 2013 has ended and my client has already filed his income tax return for 2013, can he still make a contribution to a Roth IRA for 2013?

Answer: Yes, he can generally make contributions until April 15.

According to the IRS in Publication 590:

You can make contributions to a Roth IRA for a year at any time during the year or by the due date of your return for that year (not including extensions).

Therefore, most taxpayers can make a contribution for 2013 by April 15, 2014.

If a contribution is made between January 1 and April 15, the taxpayer should tell the sponsor for which year the contribution is made (i.e. the current year or the previous year). If the taxpayer does not specify which year, the sponsor can assume, and report to the IRS, that the contribution is for the current year.

Contributions to Roth IRAs are not reported on an individual’s tax return, so there should be no need for your client to amend his return.

Have a question for the professionals at AUC? Feel welcome to submit it by email. We may post your question and the answer as the question of the day.

Ask the Experts – February 26

Ask the Experts!

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

Question: Will my client, the owner of a Roth IRA, age 50, incur income taxes and the 10-percent early distribution penalty if she uses the funds to pay for her child’s college tuition? She has owned the Roth IRA for the requisite 5 years.

Answer: She will incur income taxes on the gain portion of the distribution, but she should avoid the 10-percent penalty.

Roth IRA distributions are excludable from gross income if the owner has reached age 59½, died, become disabled, or if she used the proceeds for a first home purchase. Your client meets none of these qualifications, and so the gain portion of the distribution should be included in her gross income and subject to taxation.

However, even though the gain portion of the distribution is subject to ordinary income taxes, she shouldn’t face the 10-percent penalty. Under Section 72(t)(2)(E), the 10-percent penalty does not apply to distributions from Roth IRAs that are used to pay for qualified higher education expenses, such as college tuition.

Have a question for the professionals at AUC? Feel welcome to submit it by email. We may post your question and the answer as the question of the day.

Question of the Day – May 4

Ask the Experts!

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

Question: My client inherited a Roth IRA from his late wife. The client rolled over the money to his own IRA. Does his five year holding period start from the time of the rollover?

Answer: No, he gets credit back to the time his late wife made her initial contribution. The reason the holding period is important is to determine whether any Roth distributions will be qualifying or non-qualifying.

Unlike a traditional IRA, qualifying distributions from a Roth are income tax-free.

A qualifying distribution occurs when an individual takes a distribution following a five year period beginning with the taxable year in which that individual first made a contribution to any Roth IRA in the taxpayer’s own name and one of the following is met:

(1) the distribution is on or after the owner attains age 59-1/2,

(2) the distribution is made to a beneficiary after the death of the owner,

(3) the distribution is on account of the owner’s disability, or

(4) the distribution is a qualified first-time homebuyer distribution.

The ability of the taxpayer to access Roth money on a tax free basis with qualifying distributions is what makes Roth IRAs so attractive.

All other Roth IRA distributions are non-qualifying. Non-qualifying Roth IRA withdrawals are made according to the following ordering sequence: (1) aggregate annual contributions, (2) conversion amounts, (3) earnings on annual contributions and conversion amounts.

The surviving spouse beneficiary of a Roth IRA gets credit for the deceased spouse’s Roth holding period for the purpose of calculating the five year period. See Treas. Reg. §1.408A-6, A-7.

Have a question for the professionals at AUC? Feel welcome to submit it by email. We may post your question and the answer as the question of the day.

Question of the Day – March 14

Ask the Experts!

Here’s the question of the day.

Question: I have a client who contributed to a Roth IRA in 2011, but has actually earned too much to make a contribution. Can the taxpayer simply apply the 2011 contribution to calendar year 2012—in which she will be eligible to make a Roth contribution—without penalty?

Answer: No.

It is possible to apply an excess contribution from an earlier year to the current year without taking a distribution. This method allows the taxpayer to avoid making a distribution, but it does not avoid the 6% tax on excess contributions remaining at the end of the year and reduces the maximum contribution for the current year.

Here’s an example adapted from Publication 590:

Teri was entitled to contribute $1,000 to an IRA in 2011 and will be entitled to contribute $1,500 for 2010. She actually contributed $1,400 in 2011. $400 is an excess contribution for 2011 and will be subject to the 6% excise tax unless withdrawn prior to April 15, 2012. Teri chooses not to make a withdrawal, and therefore owes an excise tax of $24 for the excess contribution. In order to avoid the 6% penalty tax for 2012, Teri can treat the $400 excess contribution as a 2012 contribution. That is, as long as her additional contributions for 2012 are less than $1,100 ($1,500 – $400), the $400 excess contribution for 2011 will be treated as a 2012 contribution and she will not have to take a withdrawal.

If a taxpayer does not make a corrective distribution, a 6% penalty tax will be imposed on the excessive amount, for the current year and for every subsequent year, until the excess contribution is eliminated.

Have a question for the professionals at AUC? Feel welcome to submit it by email. We may post your question and the answer as the question of the day.

Question of the Day – January 11

Ask the Experts!

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

Question: My client had a $5,000 IRA balance, all of which were after-tax contributions in February of this year. That was the client’s only IRA at the time. The client converted the IRA to a Roth. Later in the year, the client rolled over a $95,000 401K account balance to a new traditional IRA. Now the client’s tax preparer insists that the conversion of the original IRA is mostly an income taxable event. Is the tax preparer right?

Answer: Surprisingly, the tax preparer is right.

When a taxpayer takes a distribution from a traditional IRA, or converts a traditional IRA to a Roth, the distribution or conversion is treated as coming pro-rata from the pre-tax and after-tax parts of the IRA. Furthermore, the IRS says that all IRAs must be aggregated for the purpose of figuring out how much of the distribution is taxable.

In the example given, one would expect that if the only IRA existing at the time of conversion consisted 100% of after-tax contributions, the conversion would be completely tax free. Unfortunately, that’s not how it works.

Here’s what Revenue Code Section 408(d) says:

(d) Tax treatment of distributions

(1) In general

Except as otherwise provided in this subsection, any amount paid or distributed out of an individual retirement plan shall be included in gross income by the payee or distributee, as the case may be, in the manner provided under section 72.

(2) Special rules for applying section 72

For purposes of applying section 72 to any amount described in paragraph (1) –

(A) all individual retirement plans shall be treated as 1 contract,

(B) all distributions during any taxable year shall be treated as 1 distribution, and

(C) the value of the contract, income on the contract, and investment in the contract shall be computed as of the close of the calendar year in which the taxable year begins. (Emphasis added.)

For purposes of subparagraph (C), the value of the contract shall

be increased by the amount of any distributions during the

calendar year.

The Code Section says that not only do you need to do a pro-rata calculation based on all IRAs in existence at the time of conversion (or distribution), you must also factor in all IRA balances that exist at the end of the year of conversion.

For the client in this example, that means that the IRA money created by the late-year rollover is part of the pro-rata calculation. Taking that account into consideration, it means that only 5% of the conversion amount would be tax-free—the other 95% would be taxable.

A taxpayer in similar circumstances to that in the example would be best advised to wait to do the IRA rollover in the calendar year following the conversion.

Have a question for the professionals at AUC? Feel welcome to submit it by email. We may post your question and the answer as the question of the day.

Question of the Day – December 28

Ask the Experts!

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

Question: The IRS limits the ability of taxpayers who are active participants in employer-sponsored pension plans to make deductible IRA contributions. What is an active participant?

Answer: In 2012, a 45 year old single person with $100,000 of earned income who is not an active participant in an employer-sponsored pension plan may make a $5,000 deductible contribution to a traditional IRA. The same person, if an active participant, may NOT make a deductible contribution to a traditional IRA.

So who is an active participant? The definition depends on the type of pension plan that is available to the taxpayer:

If the taxpayer is eligible to participate in a 401K or 403b plan, but makes no employee salary-deferred contributions to the plan in a calendar year, the taxpayer is not an active participant.

If the taxpayer is eligible to participate in a defined benefit pension plan, the taxpayer is always an active participant.

If the employer makes a contribution on the taxpayer’s behalf into a target benefit or money purchase plan for the tax year in question, the taxpayer is an active participant for that year.

If the taxpayer is eligible to participant in a SEP IRA or profit sharing plan, but the employer makes no contributions to the plan for a given tax year, the taxpayer is not an active participant for that year.

Taxpayers who are ineligible to make deductible IRA contributions may be eligible for contributions to a nondeductible IRA or a Roth IRA.

Have a question for the professionals at AUC? Feel welcome to submit it by email. We may post your question and the answer as the question of the day.

Question of the Day – December 16

Ask the Experts!

Here’s the question of the day.

Question: I have a client who wants to do a Roth conversion with his traditional IRA. The client will start the conversion in the current calendar year, but will finish it (by 60 day rollover) in the next one. In which year will the income tax result occur?

Answer: The tax result for a Roth conversion will occur in the year the distribution from the traditional IRA takes place.

Say Fred takes distribution from his traditional IRA on December 15, 2011. He rolls over the money—converting it—to a Roth IRA on February 1, 2012. The income tax result associated with the conversion is a calendar year 2011 event—even though Fred could have theoretically rolled over the distribution to another traditional IRA and avoided taxation in 2012.

Have a question for the professionals at AUC? Feel welcome to submit it by email. We may post your question and the answer as the question of the day.