401(K) plans have taken a prevalent role in retirement planning over the past number of years. The recent market downturn has caused them to come under some scrutiny, and if you are one of those people doing the scrutinizing, then you should be equipped with all the information. Today, let’s start to take a look at some specifics behind 401(K) plans and how they will function in your retirement planning.
The Basics
When participating in a 401(K) plan, you, as the employee, make an election to receive pay as a contribution to the 401(K) plan on a pretax basis rather than in your paycheck. These elective contributions are excluded from your current gross income and become invested on a tax-deferred basis. As such, the elective deferrals are not subject to income tax withholding at the time of deferral and will not be taxed as a portion of your income on your 1040. However, they are included as wages subject to Social Security, Medicare, and federal unemployment taxes. Be aware, the government will get its taxes, so when your elective contributions are paid out at the time of retirement, the distributions will be taxed as ordinary income. With a majority of 401(K) plans, employee contributions are matched, up to a certain percentage, by employer contributions. These employer contributions are taxed in the same way that employee contributions are taxed.
Distribution Options/Rules
In this down economy, many people have searched for ways to find liquidity of their funds. There are methods for this to be achieved through the use of your 401(K) funds. If you are considering the following topics of discussion, they should be considered carefully and please consult your Financial planner and/or CPA. There are three basic ways to tap into the funds accumulated in your 401(K) plan.
1. 401(K) Hardship Distributions:
The rules for hardship distributions are very restrictive and specific. If considering, the best source
for information may be your 401(K) Plan sponsor and/or Company HR. The IRS has a good amount of
information in Publication 575. I’m going to highlight a few key points here. First, Hardship
distributions are limited to the amount of the employee’s elective deferrals and generally do not
include any income earned on the deferred amounts. If the plan permits, certain employer matching
contributions and employer discretionary contributions may also be included. Second, a Hardship
distribution is treated as such only if it is made on the account of an immediate and heavy financial
need of the employee AND is necessary to satisfy that financial need. For these two primary
requirements, there are a number of sub-requirements that must be examined to determine if you
meet the criteria for a hardship distribution. This is a decision that must be analyzed carefully before
proceeding, along with the help of professional advice.
If you’ve already taken a Hardship distribution or are considering one, please note that income tax is
due on the withdrawn amount, regardless of whether an early withdrawal penalty is also due.
2. 401(K) Plan Loans:
Again, the IRS Publication 575 is a great resource for Plan loans. First and foremost, the plan
document must specify if loans are permitted or not. If a plan loan meets the following criteria, then
it is not taxable:
The plan participant may borrow up to 50% of their vested account balance up to a
maximum of $50,000.
The loan must be repaid within 5 years (unless used in a first time home purchase)
Repayment of the loan must be in “substantially level payments”, at least quarterly.
If the loan is deemed to not meet the above criteria, then entire distribution is taxable and subject to
the 10% premature distribution penalty. Further, if an individual is unable to repay the loan and
defaults, the IRS treats the outstanding loan balance as a premature distribution, subject to income
tax and the 10% penalty. This is another form of 401(K) distributions to proceed cautiously with for
there a number of angles, calculations, and considerations to take into account before making a
decision. Again, please consult with your professional advisors.
3. Regular Distributions:
This is the form of distributions majority of taxpayers is familiar with, so I won’t spend much time here.
Again, Publication 575 can provide you with much greater detail. The first important thing to note is
that you are Required to take distributions upon April 1 of the first year following the later of (1) the
calendar year in which you reach age 70 ½ or (2) the calendar year in which you retire. A 401(K) Plan
must provide that you will either receive your entire amount in the 401(K) by your Required
Distribution date or begin receiving periodic distributions by the Required Distribution date, often
referred to as your Required Minimum Distribution (RMD). These distributions are taxable as ordinary
income in the year in which they are made.
Above is a brief discussion of some of the taxability issues surrounding 401(K) Plans. If you have further questions regarding your situation, we are equipped here at McArthur & Company to help you find the answers you need. Next week, we are going to build off of this topic and dive into a discussion that has been getting a lot of press this year – the 401(K) to Roth IRA conversion. Does it fit your circumstances and what exactly are the rules?
info@mcarthurco.com
704.544.8429
Tuesday, February 16, 2010
Tuesday, February 2, 2010
Seeking Safety with Annuities
The decision to invest in an annuity should be made carefully and with the help of your trusted financial team. Due to the market decline and economic downturn, annuity investments have found favor in the eyes of many investors who see the possibility of outliving their retirement savings, especially without a strong recovery and/or the emergence of another market decline. The quick and dirty of an annuity arrangement is that an individual makes a lump-sum or other front-loaded investment, in exchange for periodic payments starting at a certain date. There are a number of options as to how you can have your annuity structured, so contacting a professional is suggested if you are considering an annuity as the right investment choice for you.
Today, we’re going to focus on the tax nature of annuities and how they can be a piece of your retirement planning.
As with all investment vehicles, the taxation of the vehicle will depend on what “garage” you decide to hold it in. As we previously discussed, there are really two options here and that is to hold it outside of a traditional tax-favored retirement account or to hold it inside such an account, i.e. Traditional IRA. The decision where to hold your annuity investment is important and should be considered with your Financial Planner and CPA. These are some factors to consider when making this decision:
• Tax rates on income generated by the investment
• Ability to Defer Income
• Future tax rates
• Flexibility needed to use funds
Generally, a distribution from an annuity is subject to ordinary income tax. However, any individual who receives an annuity payment will have the ability to exclude part of the payment from their gross income. The reason behind this is that a portion of each payment is considered to be a return on capital (your initial investment). The exclusion amount is calculated via a formula that multiplies the annuity amount received by the exclusion ratio. The exclusion ratio is calculated by dividing the investment in the annuity by the expected return under the annuity.
If an annuity is held in an IRA, remember a few key taxation points:
• To the extent allowed by law, if you make a Annuity contribution to your Traditional
IRA, it is tax deductible. Contributions made directly to annuities, outside of IRA’s, is
not tax deductible. The key here is whether or not you are eligible to make tax
deductible contributions to an IRA.
• Be careful or the contribution limits associated with IRA’s and how this will affect how
much you can fund your annuity held in an IRA.
• RMD at age 70 ½: For an annuity held in an IRA, the owner will be required to start
taking distribution in the year in which they reach age 70 ½. This is not the case if you
hold your annuity outside of an IRA structure.
Next week, we will continue talking about retirement vehicles and tax issues related to them. On the docket is 401(K) plans and some offshoots that are inevitably encountered by some of our readers. W-2’s, 1099’s, etc. should be in, so remember, it’s never too early to start your tax work!
Today, we’re going to focus on the tax nature of annuities and how they can be a piece of your retirement planning.
As with all investment vehicles, the taxation of the vehicle will depend on what “garage” you decide to hold it in. As we previously discussed, there are really two options here and that is to hold it outside of a traditional tax-favored retirement account or to hold it inside such an account, i.e. Traditional IRA. The decision where to hold your annuity investment is important and should be considered with your Financial Planner and CPA. These are some factors to consider when making this decision:
• Tax rates on income generated by the investment
• Ability to Defer Income
• Future tax rates
• Flexibility needed to use funds
Generally, a distribution from an annuity is subject to ordinary income tax. However, any individual who receives an annuity payment will have the ability to exclude part of the payment from their gross income. The reason behind this is that a portion of each payment is considered to be a return on capital (your initial investment). The exclusion amount is calculated via a formula that multiplies the annuity amount received by the exclusion ratio. The exclusion ratio is calculated by dividing the investment in the annuity by the expected return under the annuity.
If an annuity is held in an IRA, remember a few key taxation points:
• To the extent allowed by law, if you make a Annuity contribution to your Traditional
IRA, it is tax deductible. Contributions made directly to annuities, outside of IRA’s, is
not tax deductible. The key here is whether or not you are eligible to make tax
deductible contributions to an IRA.
• Be careful or the contribution limits associated with IRA’s and how this will affect how
much you can fund your annuity held in an IRA.
• RMD at age 70 ½: For an annuity held in an IRA, the owner will be required to start
taking distribution in the year in which they reach age 70 ½. This is not the case if you
hold your annuity outside of an IRA structure.
Next week, we will continue talking about retirement vehicles and tax issues related to them. On the docket is 401(K) plans and some offshoots that are inevitably encountered by some of our readers. W-2’s, 1099’s, etc. should be in, so remember, it’s never too early to start your tax work!
Subscribe to:
Posts (Atom)
