IRA MISFORTUNE 101
Learn the best kept secrets in the financial world today!By Tim H. CooperTrafford Publishing
Copyright © 2009 Tim H. Cooper, CRFA
All right reserved. ISBN: 978-1-4269-1595-6Contents
Introduction.........................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................vChapter 1 Retiring or Leaving the Company What is a Rollover Completing Your Rollover Net Unrealized Appreciation (NUA) Combining Retirement Accounts Ten Year Averaging FDIC and SIPC Insurance...............................................................................................................................................................................................................................................................................................................................................................................................................................................1Chapter 2 Managing your Retirement Fund Selecting a Custodian Prohibited Transactions Real Estate in an IRA Purchasing the Property Lifetime Tax Minimization Short Hold Stocks Index or Low Turnover Funds Tax Free Bonds Concentrated Stock Positions Tax Reporting of Rollovers An Early Application After Tax Contributions Interesting Years: 2010, 2011 Selecting Investments Fiduciary How to Purchase Property with in IRA Operating an IRA Property Growth Mutual Funds Taxable Bond/Bond Funds Long Hold Stocks Annuities Moving your IRA Waiver Can I do a Partial Rollover? Roth Conversion.....................19Chapter 3 Distributions Mandatory Distributions Roth Distributions Activation of 72(t) Distributions Taking Distributions Early Pre 591/2 Distributions.........................................................................................................................................................................................................................................................................................................................................................................................................................................................................................57Chapter 4 Leaving it to Heirs Understanding Estate Taxes Problems with Custodians Yikes! Look at the Taxes Titling of Inherited IRAs Spousal Advantages Creating Trusts for IRAs Protect your IRA Value Creditors and Bankruptcy What is Gift Tax? IRA Misfortune...........................................................................................................................................................................................................................................................................................................................................................................101Chapter 5 You Just Inherited a Retirement Plan.......................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................123Chapter 6 Advance Issues Divorce The Pro Rata Rule Deducting an IRA Loss Exceptions to 701/2 Rule Exceptions to 10% Penalty Tax Attention 701/2 and Over.......................................................................................................................................................................................................................................................................................................................................................................................................................................................................................131Appendix One Questions and Answers...................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................145Appendix Two Exhibits Unified Estate and Gift Tax Tax Brackets for 2009 IRA and Pension Plan Limits What is Your Social Security Retirement Age Timetable Reduction in SS Benefits to Carry on Working Social Security Notes and FYI 2009 Retirement Calendar Failed Banks List per FDIC.....................................................................................................................................................................................................................................................................................................................................................147
Chapter One
Whether you are moving towards an independent lifestyle, changing jobs, or an employment termination, you need to know what to do with your employer sponsored retirement plan before your leave. Once you leave a job for whatever reason, you may request to:
Rollover the money into an IRA. Take the lump sum and pay the income tax and any IRS enforced penalties.
Leave the money at the company if the company offers that as an option.
Rollover the money into your new employer's plan, if that plan accepts rollovers.
Transfer the money to your favorite charity
Realize that the above are options offered by the IRS. However, your employer's retirement plan rules may be more restrictive, and if so, there may be limited options for you. For example, if you have a pension plan that offers payout options over your lifetime, or jointly over the lifetimes of you and your spouse, but there is no option to rollover a lump sum to an IRA, the rollover option isn't available to you. In other words, the "summary plan document" is your rule book. You may want to get a copy of that now and have your financial advisor review it so that you know what options you have. Our experiences has shown that most individuals sign up for a company retirement plan, and choose investment options for these accounts in just a few seconds, spending no time evaluating evidence to support their reasons for employing their money in tax deferred accounts.
What is a Rollover?
Rollover means to move money from a retirement plan such as a 401(k), 403b (tax sheltered annuity), or 457 (municipal deferred compensation) into an IRA or other plan. If you receive a payout from your employer-sponsored retirement plan, a rollover IRA could be to your advantage. You would continue to receive the tax-deferred status of your retirement savings and would avoid penalties.
There are three reasons that rollovers are favored over other options:
You have virtually unlimited investment selections. Unlike your employer's plan which may have ten, twenty or maybe fifty investment options. With an IRA, you can choose any stock, mutual fund, money market, certificate of deposit, and a host of other investments.
Company plans often can restrict choices for non-spouse beneficiaries. Specifically, they may not be able to stretch IRA distributions over their lifetime. The concept behind a "Stretch IRA" is that the IRA defers taxes and allows the funds to potentially grow longer and larger in a tax-deferred environment. There are special retirement accounts that can allow your IRA to buy real estate, land, vacation properties, commercial properties, loan your IRA money to others, buy a business and much more. We will discuss the options later in book.
One reason to leave your retirement plan with your company (if permitted) is to afford continued coverage by ERISA protecting it from creditors. However, under the new Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, the creditor protection will follow the money if it is rolled into an IRA and not co-mingled with other IRA money from annual contributions. For example: Your IRA is insured from creditors up to $1,000,000. I suggest a review of your state statutes on filing bankruptcy when you have creditors.
Combining Retirement Accounts:
The rollover IRA is usually funded by the eligible distributions from a company-sponsored retirement plan. These distributions can be combined with your existing IRA(s) or placed into a separate IRA, but see the new creditor protection rule mentioned above. In fact, the IRS permits these funds to be combined with other types of retirement accounts. For example, say you have been self employed and you have a one-person profit sharing plan (maybe a Keogh plan), you could rollover the employer-plan assets into your profit sharing plan. Or, if you have a second job and that employer has a 403(b) plan and also accepts rollover contributions, you could rollover your 401 (k) balance into that 403(b) plan.
Completing your Rollover:
When it's time to retire, you have a few options on moving the money from your employer's plan.
Direct Rollover: Your employer can directly rollover your retirement plan payout into a Rollover IRA and you will avoid the 20% IRS withholding tax. This is exactly what you should do by providing your employer the name, address and account number of your new Rollover IRA custodian. For example, you give your employer instructions to send your retirement account to Big Street Securities, account #AOH-8889999. Funds are sent directly to the IRA account and you never touch them. This is the preferred method of moving retirement funds.
Payout by Check: If your employer hands you a check for your retirement funds, the employer must withhold 20% for potential taxes. You can avoid the 20% IRS withholding tax on a payout by check from your employer if you deposit the check plus 20% into a rollover IRA within 60 days. In order to complete the tax free rollover, you now have 80% of your IRA rollover in your hand, and you must take the other 20% out of your pocket so that you have a completely tax free rollover (you will get the 20% income tax withheld as a refund after you file your tax return). This payment option may require you to take money out of your pocket to complete your rollover.
Taking a lump sum distribution: This option will trigger ordinary income tax on the distribution, most likely at the top of your current tax bracket. It is also possible that some of this distribution will be pushed into the next higher tax bracket. If you are under age 591/2 you will pay an additional 10% early withdrawal tax. However, there may be reasons to take a taxable distribution. If you are set on buying a $300,000 boat and spending the rest of your life floating about the globe, then you should discuss your plan with a qualified advisor. The advisor may choose to use a scientific model to review several strategies to help you minimize the tax and maximize the benefit. However, if you can avoid using these funds and don't mind deferring happiness, this money may bring today, with a bit of luck, this nest egg will be there when you mature in age!
Ten Year Averaging
What is Qualified Lump Sum Distribution for Ten Year Averaging?
It is the distribution or payment in one tax year of a plan participant's entire balance from all of an employer's qualified plans of one kind (for example, pension, profit-sharing, or stock bonus plans) in which the participant had funds. The participant's entire balance does not include deductible voluntary employer contributions or certain forfeited amounts
The participant must have been born before January 2, 1936.
If you are a plan beneficiary to a taxpayer whose date of birth was before January 2,1936, you may qualify for ten year averaging on a lump sum distribution. Ten year averaging allows up to 50% of the total distribution to be tax free and the balance will be subject to very low tax rates as described.
Distributions upon death of the plan participant. If you received a qualifying distribution as a beneficiary after the participant's death, the participant must have been born before January 2, 1936, for you to use Form 4972 for that distribution.
Distributions to alternate payees. If you are the spouse or former spouse of a plan participant who was born before January 2, 1936, and you received a qualified lump-sum distribution as an alternate payee under a qualified domestic relations order, you can use Form 4972 to make the 20% capital gain election and use the ten year tax option to figure your tax on the distribution.
Consider this: A beneficiary of a taxpayer who is eligible for this option is also eligible to use the election. If the money is in the company plan and the retiree dies, the beneficiary retains this option to withdraw the funds in one tax year and use ten year forward averaging.
This option will not be favorable for all taxpayers, and must be calculated against other alternatives to determine which option appears best.
Communication point: If the taxpayer leaves one employer with assets that qualify for ten year averaging, he may keep that option if the assets are tallied into a conduit IRA, kept separate from other retirement funds, and later rolled into another employer's qualified plan.
Net Unrealized Appreciation (NUA)
I own Company Stock in my Retirement Plan!
Many advisors driven to acquire IRA rollover accounts may fall short of reviewing or asking you if you had bought or own company stock in your retirement plan. Some people retire or leave a company, and in such cases, the tax law provides special optional tax benefits on that employer's stock. This stock is referred to as "Net Unrealized Appreciation" stock or "NUA shares" because these shares have hopefully been purchased at a lower price than their current value. Consequently, the share value contains unrealized appreciation.
Using the NUA strategy, individuals can take a distribution of employer's stock from their qualified plan and pay ordinary income tax only on their basis at the time of distribution (i.e. immediately), allowing for continued tax deferral on the balance of their shares. The difference between the basis and the fair market value at distribution-the net unrealized appreciation- is taxed at long-term capital gains rates when the stock is eventually sold, regardless of the holding period. Subsequent appreciation (earned after the distribution from the qualified plan) is taxed at short or long-term capital gains rates according to the length of the holding period, as measured from the date of the distribution continued tax deferral on the balance of their shares. The difference between the basis and the fair market value at distribution-the net unrealized appreciation-is taxed at long-term capital gains rates when the stock is eventually sold, regardless of the holding period. Subsequent appreciation (earned after the distribution from the qualified plan) is taxed at short or long-term capital gains rates, according to the length of the holding period, as measured from the date of the distribution.
At first, it may seem crazy to pay tax immediately on any part of your distribution when you can do a rollover and defer all taxes. However, the following has made this a lower-cost strategy in some instances because of:
The large spread between the max capital gains rate (15%) and the top ordinary income tax rate (35%).
Large amounts of stock appreciation that occurred between 1982 and 2000.
Let's take a look at a simplified example, assuming tax rates of 15% for capital gains and 30% for ordinary income, and that your shares do not have additional appreciation after you leave your employer.
Over the years, you opted to have some of your 401(k) Contributions invested in shares of your employer's stock. A total of $10,000 was invested in your employer's stock. Those shares are now worth $100,000. Your option is to have the stock distributed to you when you leave the company and pay tax on the basis (the $10,000 invested). Alternately, you could roll over all of the shares into your IRA and pay tax later, possible decades later.
Below you see the difference in your options:
Take stock and pay ordinary tax now on $10,000 (30%) and on the appreciation later at capital gains rate (15%) = total tax of $16,500.
Roll over the shares to your IRA and pay tax at ordinary rates (30%) later, $100,000 = total tax of $30,000.
You save almost half of the tax by using the net unrealized appreciation rules.
NOTE: You may opt to use NUA treatment for only some of your employer's shares and rollover the rest.
Communication Point:
Many companies hold employer's stock in "stock funds", the units of which are composed of shares of stock and cash. These also are eligible for special NUA tax treatment if the plan provides for an "in-kind" distribution of stock from the plan. although this is a long shot, it's worth asking if the shares in a stock fund can be distributed separately.
To take advantage of the NUA option, you must elect a lump sum, in-kind distribution from the plan (a complete distribution of all plan assets in a single calendar year). A lump sum distribution is defined as "distribution or payment within one taxable year of the recipient of the balance to the credit of an employee, which becomes payable to the recipient on account of the employee's death, after the employee attains age 591/2, on account of the employee's separation from service, or after the employee has become disabled." Last but not least, keep in mind the use of NUA options does not require that you use it for all employer's shares. You may have 20,000 shares of your employer's/ ex-employer's stock, and you can decide to rollover 5,000 shares and avoid current taxation and pay tax on the other 5,000 shares per the NUA rules. To maximize such a division, you want to obtain the cost basis of various lots of their stock from your plan administrator and review them to determine which shares might benefit most from the special NUA tax treatment. For example, it might make sense to use the NUA strategy on shares with the lowest cost basis relative to fair market value at distribution (and thus the greatest amount of NUA), and roll over shares with a higher cost basis relative to the fair market value at distribution.
The reduced 15% tax rate on eligible dividends and capital gains, previously scheduled to expire in 2008, has been extended through 2010 as a result of the Tax Increase Prevention & Reconciliation Act President Bush signed in 2006 (P.L. 109-222).
In 2011 these reduced tax rates will "sunset" or revert to the rates in effect before 2003, which were generally 20%. President Obama's budget, announced on February 25, 2009, calls for the Capital Gains Tax to be reverted to the 20% rate before the Sunset date of 2011.
This beneficial taxation on employer securities and ten year averaging can be used in combination. In order to do this, none of the distribution may be rolled to an IRA-the entire distribution must be taxed. You can elect to have just the cost basis or the entire value of the NUA shares subject to ten-year averaging. If there has not been much appreciation in your shares, it could pay to have the entire value taxed now under favorable ten year averaging rates. You know those bean counters in school we avoided; they became tax professionals and are now your best friend.
If you are one of those 401(k) participants that are considering ROTH conversion, pay particular attention to the new notice released by IRS (Notice 2009-75)
FDIC & SIPC Insurance
Today appears to be the most challenging of times, with the volatility of the stock market, U.S. national debt is over 11 trillion dollars, 17 trillion dollars in retirement accounts, investor fraud, corporate giants disappearing in the night and government intervention in the business world. Interesting enough that since 2000, there have been over 90 bank failures, 71 of those failed in 2008 through June 2009. See a complete chart of these bank failures in (appendix 2). The chart below (Table 1.1) shows a snap shot of the number of failures for each year. The next chart (Table 1.2) is for bank failures through June 2009. It appears that if you had your assets allocated correctly based on the FDIC rules, you lost no money. Billions of dollars were handed over to financial institutions and corporations like peanuts. As this book goes to the publisher, 45 bank have collapsed and the FDIC has taken them over.
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Excerpted from IRA MISFORTUNE 101by Tim H. Cooper Copyright © 2009 by Tim H. Cooper, CRFA . Excerpted by permission.
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