Roth IRA: Spouse as Beneficiary

The spouse only receives the gain in the Roth-IRA tax-free if the Roth-IRA had met the five year rule. If not, the gain would be taxable to the spouse but no penalty would apply.

Assuming the Roth-IRA had met the five year rule, the beneficiary spouse would be able to either take the proceeds of the Roth-IRA tax-free, or even better, simply make the Roth-IRA their own. Since there is no requirement to begin RMDs at 70 1/2, if the spouse did not need the money in the Roth-IRA, they could then let it pass to their beneficiary(s) at their death. Non-spousal beneficiaries must remove the assets (tax-free) within five years of death, or can spread distributions out over their lifetime tax-sheltered and tax-free.

If distributions from a Roth-IRA are ever taxable, they will be taxed as ordinary income.

Posted by Boston Institute of Finance at 2:30 PM, June 23, 2006

Taxability of Distributions from a Nondeductible IRA

When a taxpayer makes a nondeductible IRA contribution, the nontaxable distribution is based on the following formula: (nondeductible IRA contributions / FMV of account before distribution) x distribution = nontaxable portion. Total distribution – nondeductible portion = taxable portion. The taxable portion is subject to ordinary income tax and a possible 10% penalty if an exception does not apply.

For example: Taxpayer made $20,000 of nondeductible IRA contributions and $20,000 of deductible IRA contributions over a period of years. FMV of account before distribution is $100,000 and a $15,000 distribution is taken. The nondeductible portion is $3,000 ($20,000 / $100,000 x $15,000) and $12,000 of the distribution is taxable as ordinary income (subject to a 10% penalty if an exception does not apply).

Posted by Boston Institute of Finance at 7:05 PM, July 6, 2006

10% Penalty on Distributions used for Medical Expenses

An example of the exception to the 10% penalty is as follows. Assume a 35-year-old taxpayer has AGI of $50,000 and takes a $20,000 distribution from an IRA for medical purposes. The amounts subject to tax and the 10% penalty are listed below:

1) The $20,000 distribution is subject to ordinary income.
2) The 10% penalty is $375 calculated as: $50,000 AGI x 7.5% = $3,750 subject to penalty x 10% penalty. (Note: The exception to the 10% penalty on amounts above 7.5% of AGI for medical purposes can be distributed from either an IRA or a qualified plan.)
3) The taxpayer does not have to itemize deductions to qualify for this 10% penalty exception.

Posted by Boston Institute of Finance at 5:25 PM, October 31, 2006

State Income Taxes Affecting Retirement Cash Flow Projections

When looking at the net cash flow of a pension dollar received, you need to compute the state taxes that apply. However, if the state taxes are also deducted on the individual’s income tax return as an itemized deduction, the benefit of the federal deduction needs to be taken into account.

For example, say you have a $1 of pension income subject to a 25% federal marginal rate and 4% state rate. The following is the net cash flow:

• The tax is computed as $1 x 25% = .25 federal tax plus $1 x 4% = .04 state tax. The net cash flow is .71 (1.00 – .25 – .04) for an effective rate of .29 / 1.00 or 29% when not itemizing.
• The tax is computed as $1 x 25% = .25 federal tax plus $1 x 4% = .04 minus a state tax benefit of .04 x .25 = .01. The net cash flow is .72 (1.00 – .25 – .04 + .01) for an effective rate of .28 / 1.00 or 28% when itemizing.

I assumed in the above calculation that AMT does not apply or that itemized deductions are not being phased out.

Software programs usually adjust for the above state tax issue. However, there is no one correct answer as cash flows change over time, marginal tax rates change, and the issue to itemize might change. The projection of time value of money calculations are to be used as watermarks.

Based on a client’s unique set of facts and circumstances, the calculations can be quite broad or extremely detailed. When discussing the issues with the client, you will determine what course to take.

Posted by Boston Institute of Finance at 11:10 AM, February 26, 2009

Should You Make a Deductible IRA Contribution or a Non-Deductible Roth Contribution?

Say you meet the earned income eligibility and you do not exceed the AGI limits for a $5,000 contribution. Should you contribute to a deductible IRA or a non-deductible Roth IRA? Assume the following:

1. A marginal tax rate of 33%, which will stay the same over the holding period.

1. An 8.5% annual rate of return for 30 years.

What will be the value of these investments if they are both liquidated at the end of the holding period?

Step 1 – Calculate the value of the Roth IRA and the cost of paying taxes today.

n = 30; i = 8.5; PV = ($5,000); FV = $57,791 value of Roth

n = 30; i = 8.5; PV = ($1,650) [$5,000 x 33% tax]; FV = $19,071 the opportunity cost of paying $1,650 to the IRS at time of contribution

The FV after tax is the $57,791 tax-free balance – $19,071 lost savings/opportunity cost of paying the government with a nondeductible contribution = $38,720 after tax

Step 2 – Calculate the value of the taxable IRA.

n = 30; i = 8.5; PV = ($5,000); FV = $57,791 before tax value of deductible IRA

FV after tax = $57,791 – ($57,791 x 33%) = $38,720 after tax value of deductible IRA

Note: The above calculations show that the two will equal $38,720. The step most people miss is to subtract the future value of the lost savings by paying the IRS with a nondeductible contribution. Notice that if the IRA is subject to a marginal rate of 25%, there is a savings. Step one is still computed as $38,720. However, in step two, the value is $43,343, as calculated below.

Step 2 (Alt.) – Calculate the value of the taxable IRA.

n = 30; i = 8.5; PV = ($5,000); FV = $57,791 before tax value of deductible IRA

FV after tax = $57,791 – ($57,791 x 25%) = $43,343

Notice the savings is $4,623 ($43,343 value at a 25% marginal rate – $38,720 value at a 33% marginal rate) or just $57,791 x (33% – 25%) = $4,623 savings.

Posted by Boston Institute of Finance at 10:27 AM, October 1, 2009

SEP Contribution

There are no minimum funding requirements with a SEP. For the owner of the company, the 25% contribution is 20% (as you take the contribution .25 divided by one plus the contribution of 1.25) and 25% for all other employees.

For example, if there is a 10% contribution to the employees, it is 9.09% (.1 / 1.1) for the owner. The contribution for 2010 is the lesser of 25% of $245,000 of compensation, or $49,000.

Here are the rules regarding the SEP qualification:

1) SEP contributions are discretionary.
2) The SEP must cover all employees who are at least 21 years of age and who have worked for the employer during three of the preceding five calendar years.
3) Contributions need not be made on behalf of employees whose compensation for the calendar year was $550 or less.

Posted by Boston Institute of Finance at 10:27 AM, July 30, 2010

Intergration / Permitted Disparity

Think of integration/permitted disparity as a benefit to participants who have income exceeding the social security base of $106,800 for 2011. Because employees who earn income at or above the social security base will both receive the same maximum social security benefit, integration allows the qualified plan to provide an additional benefit to the employee exceeding the social security wage base. In short, the plan allows a limited discrimination of additional benefits to the individual exceeding the social security base.

For example, if a company has a 10% profit-sharing plan, and John earns $120,000 and Mary earns $100,000, the amount of profit-sharing by each participant received will be as follows:

John = $12,000 ($120,000 x 10%)
Mary = $10,000 ($100,000 x 10%)

However, if the plan allows for the maximum permitted disparity, the amount of profit-sharing that each participant will receive is as follows:

John = $12,752 ($106,800 x 10% + $13,200 x 15.7%)
Mary = $10,000 ($100,000 x 10%)

Note that John receives $752 more when integration is implemented: $752 = ($13,200 x 5.7%). The 5.7% is the maximum permitted disparity. The amount is computed by doubling the profit-sharing percentage of the plan but not exceeding 5.7%.

Therefore, if the profit-sharing contribution is 2%, permitted disparity is 4% (2% x 2). If the profit-sharing contribution is 5%, permitted disparity is 10% (5% x 2). If the profit-sharing contribution is 6%, permitted disparity is 11.7% (6% + 5.7%), as 6% doubled cannot exceed 5.7%. Thus, in my example above, the 10% + 5.7% allows for a 15.7% contribution for income over the $106,800 social security base for 2011.

If you prefer to implement permitted disparity for a threshold under the $106,800 social security base, the 5.7% permitted disparity can be reduced to no less than 4.3%.

Posted by Boston Institute of Finance at 9:33 AM, July 26, 2011

Single Tax Filer Phase Out of Deductible IRA

Can an unmarried, 30-year-old individual who is in a 401(k) profit-sharing plan contribute to a deductible IRA for 2011 if AGI is $61,000 (all W-2 income)?

To answer this appropriately, you must know some rules and alternatives. A single taxpayer can contribute $5,000 to an IRA for 2011. However, only half of this contribution is deductible, as the AGI phaseout for a Traditional IRA for a single taxpayer is $56,000 – $66,000, with this particular taxpayer being at the midpoint.

Next, what to do with the $2,500 nondeductible IRA? Do you contribute to a non-deductible IRA or contribute to a Roth IRA?

Because neither type of contribution is tax-deductible, I would suggest a contribution to the Roth IRA, because this grows tax-free. The 2011 AGI phaseout for the Roth is $107,000 – $122,000 for a single taxpayer.

Posted by Boston Institute of Finance at 3:58 AM, November 29, 2011

Does a 457(b) Plan Enjoy Creditor Protection?

ERISA plans enjoy anti-alienation protection, and IRAs have protection under the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) of 2005. So where does the 457(b) plan fall with regard to creditor protection?

As deferred compensation plans, the assets are deemed to be held by the employer. For a governmental 457(b) plan, the assets should be set aside in a trust, annuity contract, or custodial account beyond the reach of creditors. For non-governmental plans, the assets may be accessible by the employer’s creditors.

Therefore, although not specifically settled by any court cases, it is assumed that these accounts enjoy the same protection afforded to IRA accounts under BAPCPA ’05.

Posted by Boston Institute of Finance at 8:59 AM, March 8, 2012

Social Security Wage Base

Social Security’s wage base is $110,100 for 2012 and is indexed each year. Earned income up to the Social Security wage base is subject to a rate of 6.2% for the employer and 4.2% for the employee for a total combined rate of 10.4%. The Medicare tax has no ceiling and is 1.45% of earned income for the employer and 1.45% for the employee for a total combined rate of 2.9%.

Posted by Boston Institute of Finance at 10:42 AM, August 24, 2012