Fact and Fiction for IRA RMDs

by | Dec 1, 2015 | News

If you are age 70 1/2 or older and if you have a traditional IRA (or SEP or SIMPLE IRA or 401k), you must take your 2015 required minimum distributions (“RMD”) by December 31, 2015. In short, the RMD rules require you to distribute a portion of funds from your retirement account to yourself personally. These distributed funds are subject to tax and need to be included on your personal tax return. Let’s take an example to illustrate how the rule works. Sally is 72 and is required to take RMD each year. She has an IRA with $250,000 in it. According to the distribution rules, see IRS Publication 590, she will need to distribute $9,765 by the end of the year. This equates to about 4% of her account value. Next year, she will re-calculate this annual distribution amount based on the accounts value and her age. Once you know how to calculate the RMD, determining the distribution amount is relatively easy. However, the rules of when RMD applies and to what accounts can be confusing. To help sort out the confusion, I have outlined some facts and fiction that every retirement account owner should know about RMDs. First, let’s cover the facts. Then, we’ll tackle the fiction.

Fact

  1. No RMD for Roth IRAs: Roth IRAs are exempt from RMDs. Even if you are 70/12 or older, you’re not required to take distributions from your Roth IRA. Why is that? Because there is no tax due when you take a distribution from your Roth IRA. As a result, the government doesn’t really care whether you distribute the funds or not as they don’t receive any tax revenue.
  2. RMD Can Be Taken From One IRA to Satisfy RMD for All IRAs: While each account will have an RMD amount to be distributed, you can total those amounts and can satisfy that total amount from one IRA. It is up to you. So, for example, if you have a self directed IRA with a property you don’t want to sell to pay RMD and a brokerage IRA with stock you want to sell to pay RMD, then you can sell the stock in the brokerage IRA and use those funds to satisfy the RMD for both IRAs. You can’t combine RMD though for 401(k) and IRA accounts. Only IRA to IRA or 401(k) to 401(k).
  3. 50% Excise Tax Penalty: There is a 50% excise tax penalty on the amount you failed to take as RMD. So, for example, if you should’ve taken $10,000 as RMD, but failed to do so, you will be subject to a $5,000 excise tax penalty. Check back next month where I will summarize some measures and relief procedures you can take if you failed to take required RMD.
  4. 401(k) Account Holder Still Working for 401(k) Employer: If you have a 401(k) with a current employer and if you are still working for that employer, you can delay RMD for as long as you are still working at that employer. This exception doesn’t apply to former employer 401(k) accounts even if you are otherwise employed.

Fiction

  1. RMD Due by End of Year: You can make 2015 RMD payments until the tax return deadline of April 15, 2016. Wrong! While you can make 2015 IRA contributions up until the tax return deadline of April 15, 2016, RMD distributions must be done by December 31, 2015.
  2. Roth 401(k)s are Subject to RMDs: While Roth IRAs and Roth 401(k)s are both tax-free accounts, the RMD rules apply differently. As I stated above, Roth IRAs are exempt from RMD rules. However, Roth 401(k) owners are required to take RMD. Keep in mind, you could roll your Roth 401(k) to a Roth IRA and thereby you would avoid having to take RMD but if you keep the account as a Roth 401(k) then you will be required to start taking RMD at age 70 ½. The distributions will not be subject to tax but they will start the slow process of removing funds from the tax-free account.
  3. RMD Must Be Taken In Cash: False. Required Minimum distributions may be satisfied by taking cash distributions or by taking a distribution of assets in kind. While a cash distribution is the easiest method to take RMD, you may also satisfy RMD by distributing assets in kind. This may be stock or real estate or other assets that you don’t want to sell or that you cannot sell. This doesn’t occur often but some self directed IRA owners will end up holding an asset they don’t want to sell because of current market conditions (e.g. real estate) and they decide to take distributions of portions of the real estate in-kind in order to satisfy RMD. This process is complicated and requires an appraisal of the asset(s) being distributed and partial deed transfers (or partial LLC membership interest transfers, if the IRA owns an LLC and the LLC owns the real estate) from the IRA to the IRA owner. While this isn’t the recommended course to satisfy RMD, it is a potential solution to IRA owners who are holding an asset, who have no other IRA funds to distribute for RMD, and who wish to only take a portion of the asset to satisfy their annual RMD.

The RMD rules are complicated and it is easy to make a mistake. Keep in mind that once you know how the RMD rules apply in your situation it is generally going to apply in the same manner every year thereafter with only some new calculations based on your age and account balances each year thereafter.

Click here for a nice summary of the RMD rules from the IRS.

Avoiding the 20% Withholding Tax on 401(k) Distributions

by | Nov 17, 2015 | News

Distributions from a 401(k) to its owner are subject to a 20% withholding tax whereas distributions from an IRA are not subject to a withholding tax. As a result, any amounts distributed from a 401(k) to its owner will be reduced by 20% and that 20% will be sent to the IRS in expectation of the taxes that will be due from the account owner for the distribution. Any amounts distributed from an IRA, however, are not subject to the 20% withholding as the IRA owner can elect out of withholding. The discrepancy in the rules is one advantage of using an IRA in retirement as opposed to a 401(k) since the amounts distributed from the IRA can be received in their entirely. Keep in mind, the tax owed on a distribution from an IRA or 401(k) is the exact same. The difference is when you are required to pay it. In both instances you will receive a 1099-R from your custodian/administrator but in the 401(k) distribution you are required to set aside and effectively pre-pay the taxes owed.

The 401(k) Withholding Rule in Practice

Let’s walk though a common situation that outlines the issue. Sarah is 64 and has a 401(k). She would like to distribute $100,000 from the 401(k). She contacts her 401(k) administrator and is told that on a $100,000 distribution they will send her $80,000 and that $20,000 will be sent to the IRS for her to cover the 20% withholding requirement. Since this 20% withholding requirement does not apply to IRAs, Sarah decides to roll/transfer the $100,000 from her 401(k) directly to an IRA. Once the funds arrive at the IRA, Sarah takes the $100,000 distribution from the IRA and there is no mandatory 20% withholding so she actually receives $100,000 in total. Keep in mind, Sarah will still owe taxes on the $100,000 distribution from the IRA and she will receive a 1099-R to include on her tax return. That being said. Sarah has given herself the ability to access all of the amounts distributed for her retirement account without the need for sending withholding to the IRS at the time of distribution.

It’s that simple. Don’t take distributions from a 401(k) and subject yourself to the 20% withholding tax when you can roll/transfer those 401(k) funds to an IRA and receive the entire distribution desired without a 20% withholding.

Maximizing 2015 401(k) Contributions with Your S-Corp

by | Oct 20, 2015 | News

It’s time to start thinking about year-end tax planning and as every savvy business owner knows, effective 2015 tax planning happens before December 31, 2015. One of the most commonly used strategies for our clients is an s-corporation and a 401(k). A properly structured s-corporation is utilized best for tax purposes when the business owner adopts and contributes to a 401(k) plan as the contributions to 401(k) are tax deductible. Whether the business has only one owner/employee (or spouses only) or whether the business has dozens or even hundreds of employees, a 401(k) is a great tool to help defer taxable income. Simply put, a 401(k) plan can be used as a tool for putting the income of the business owner (and applicable employees) away for retirement with the added benefit of a tax deduction for every dollar that can be contributed. There are numerous benefits and options in a 401(k) plan.  For example, you can do Roth 401(k) account, you can self direct a 401(k) account, and you can even loan money to yourself from your 401(k) account. While books have been written about all of these options and benefits, one of the most misunderstood concepts of 401(k) plans is how s-corporation owners can contribute their income to the plan. That is the focus of this article.

Rules for 401(k) Contribution

In order to understand how s-corporations income can be contributed to a 401(k) plan, you need to understand the following three basic rules.

  1. Only W-2 Salary Income can be Contributed to a 401(k). You cannot make 401(k) contributions from dividend or net profit income that goes on your K-1. See IRS.gov for more details. Since many s-corporation owners seek to minimize their W-2 salary for self-employment tax purposes, you must carefully plan your W-2 and annual salary taking into account your annual planned 401(k) contributions. In other words, if you cut the salary too low you won’t be able to contribute the maximum amounts. On the other hand, even with a low W-2 Salary from the s-corporation you’ll still be able to make excellent annual contributions to the 401(k) (up to $18,000 if you have at least that much in annual W-2 salary).
  1. Easy Elective Salary Deferral Limit of $18,000 or 100% of Your W-2, whichever is less. If you have at least $18,000 of salary income from the s-corporation, you can contribute $18,000 to your 401(k) account.  Every employee under the plan is allowed to make this same contribution amount. As a result, many spouses are added to the s-corporation’s payroll (where permissible) to make an additional $18,000 contribution for the spouse’s account. If you are 50 or older, you can make an additional $6,000 annual contribution.  Follow this link for the details from the IRS on the elective salary deferral limits. The elective salary deferral can be traditional dollars or Roth dollars.
  1. Non-Elective Deferral of 25% of Income Up to a $53,000 total Annual 401(k) Contribution. This is usually maximized best in solo 401(k) plans where you as the business owner decided to offer them most generous company match allowed by law (25% of wages). Rarely is this offered or maximized like this in a group 401(k) scenario where you have other employees because what you offer yourself, you must offer to all employees who qualify for the plan (full-time, worked for you a year, over 21). If you are in the solo 401(k) situation, this additional 25% deferral is an excellent tool because in addition to the $18,000 annual elective salary contribution, an s-corporation owner can contribute 25% of their salary compensation to their 401(k) account up to a maximum of a $53,000 total annual contribution.  This non-elective deferral is always made with traditional dollars and cannot be Roth dollars. So, for example, if you have an annual W-2 of $100,000, you’ll be able to contribute a maximum of $25,000 as a non-elective salary deferral to your 401(k) account. If you have employees who participate in the plan besides you (the business owner) and your spouse, then the non-elective deferral calculation gets much more complicated because you’d have to offer it to those employees too. But for now, let’s assume there are no other employees and run through the examples.

Examples

Let’s run through two examples. The first is an s-corporation business owner looking to contribute around $30,000 per year. The second is a business owner looking to contribute the maximum of $53,000 a year.

Example 1: Seeking a $30,000 Annual Contribution.

  • S-Corporation Owner W-2 Salary = $50,000
  • Elective Salary Deferral = $18,000
  • 25% of Salary Non-Elective Deferral = $12,500 (25% of $50,000)
  • Total Possible 401(k) Contribution = $30,500

Example 2: Seeking Maximum $52,000 Annual Contribution

  • S-Corporation Owner W-2 Salary = $140,000
  • Elective Salary Deferral = $18,000
  • 25% of Salary Non-Elective Deferral = $35,000 (25% of  $140,000)
  • Total Possible 401(k) Contribution  (maximum) = $53,000

As a result of the calculations above, in order to contribute the maximum of $53,000, you need a W-2 salary from the s-corporation of $140,000. Keep in mind that if you have other employees in your business (other than owner and spouse) that you are required to do comparable matching on the 25% non-elective deferral and as a result such maximization is often difficult to accomplish in 401(k)s with employees other than the owner and their spouse. Consequently, the additional 25% non-elective salary deferral is best used in owner only 401(k) plans. If you do have employees though you can at least do $18,000 per year without having a matching requirement for your employees. That’s still three times what you can contribute to a traditional or a roth IRA. There are also common matching formulas used where you end up matching yourself and your employees contributions  at a rate of 4% of salary (safe harbor).

Keep in mind that while 401(k) contributions can be made until the tax return deadline (personal, 4/15/16 and s-corp 3/15/16), including extensions, that the 401(k) must be established before the end of 2015 in order to later make 2015 contributions. As a result, you just need to establish the 401(k) before the end of 2015 and that will allow you to later make 2015 contributions prior to filing your 2015 returns.

Who are Self Directed IRA Investors? An Essay

by | Oct 6, 2015 | News

I was recently interviewed and asked, “what has caused so many investors to self-direct their retirement plan?” As many people know, self-directed retirement plan investors use their self-directed IRA and 401(k)s to invest into real estate, private companies, precious metals and other “non-wall street” investments. I’ve worked with thousands of self-directed IRA and 401(k) investors and as I reflected on the question, I realized that there are three primary categories of self-directed investors.

I. COMPETITIVE ADVANTAGE INVESTORS USING ROTH ACCOUNTS

These investors like to invest in what they know. They avoid mutual funds and the stock market because they have a competitive advantage over other investors and usually have a special expertise over other investors. Because they have a special expertise, they often expect to make significant returns and therefore will frequently use Roth IRA or 401(k) accounts for their investments. Let me offer a few examples from actual un-named clients of mine that all resulted in 7 figure returns.

  • Software Engineer. Software Engineer who used Roth IRA funds along with some other technology savvy investors and funded an LLC. This LLC then engaged and paid some un-related developers to develop new programming that the Roth IRA investors knew would have value. The LLC owned by the Roth IRAs then in turn negotiated a royalty agreement with an unrelated company who wanted the technology to be used in a specific software program that it would sell commercially. The LLC receives royalties on the use/sales of the product. The income goes back to the Roth IRAs tax free.
  • Real Estate Developer. Real estate developers and investors personally develop millions of dollars of real estate a year and decides to use his Roth IRA to fund a specific real estate investment. Real estate developer converted a couple hundred thousand dollars of traditional IRA funds to Roth IRA funds so that he could acquire a specific piece of real estate that was to be held and later sold. The developer knows the land would have significant value over the next few years as a result of zoning law changes and planned development from neighboring property. The Roth IRA paid for some paper development zoning changes upon acquisition and then held the property as an investment for a few years. The property later increased nearly 10 times in value as neighboring development took off.
  • Bio-Tech Start-Up Entrepreneur. An experienced bio-tech investor had an opportunity to invest at early stages in a patent that was going to be the basis for a new bio-tech start-up. The investor used Roth IRA funds and funded additional research costs in exchange for an interest in the patent that was being developed by un-related researchers for commercial purposes. The patent was the basis of value for a start-up venture and the Roth IRA received a significant share of the company in exchange for the patent interest.

This group would also include former Republican Party Nominee, Mitt Romney, and famous Venture Capitalist, Peter Theil, whose large self-directed IRAs have been reported on extensively.

Keep in mind, the rules for these investments are complex and careful planning must be taken to avoid prohibited transactions, as well as unrelated business income tax (UBIT). However, when properly executed with the right investment, this group can sock away significant returns in tax-free Roth accounts. There’s no better deal in the tax code than this!

II. SEEKING INCREASED RETURNS AND TIRED OF POOR FUND OR STOCK PERFORMANCE

This is the largest group of self directed IRA investors. These investors have seen stagnant performance, losses, or ridiculous fees eat away at their retirement account.  They are generally tired of the ups and downs of the stock market and want stable investments they can actually understand. This group usually invests in real estate, in its various forms, because it can offer more stable returns and because the investor can actually understand the investment (something they can’t do from a 100 page mutual fund prospectus). Here are a couple of actual client examples.

  • Retired Corporate Manager Becomes a Real Estate Investor. A retired real estate investor client of mine rolled over former employer 401(k) funds to a traditional self-directed IRA. This investor is in their early 60’s and uses the income from her retirement account to live on. She invested her traditional IRA into a modest 3 bd 2 bth single family rental. The property has no debt and the cash-flow goes back into her IRA. She routinely takes distributions of the cash-flow to supplement her retirement income. Since this is a traditional IRA she is taxed on the distributions (as she would with any traditional IRA) but she is not reducing the actual investment value of the IRA as she only distributes the cash-flow. This client has had an increase in confidence as the rental income has proven to be consistent over time and she still knows that her IRA owns the property so she doesn’t feel like she’s depleting her retirement account when she takes distributions of the cash-flow. Frankly, I’ve talked to hundreds if not thousands of clients in a scenario similar to this.
  • Real Estate Broker Loans Solo 401(k) Funds to Other Investors. This real estate broker uses his self-directed 401(k) to loan money to real estate investors buying investment properties. Some people refer to use these loans as hard money loans or as trust deed loans. The 401(k) will loan funds to other real estate investors in situations where banks are typically un-willing to lend. The real estate broker lends to properties in markets that he knows and receives a first or second place deed of trust (mortgage) securing his loan. The typical loan terms are 10% annual interest with 2 points. This self-directed investor knows real estate and has been able to receive annual returns far in excess of the stock market.

III. HARD ASSETS OVER PAPER ASSETS

These investors value hard assets over paper assets. They are generally disillusioned by the stock market and feel that price to earnings ratios of publically traded companies have sky-rocketed without regard to company performance. They tend to believe that stock prices have nothing to do with actual value but instead are propped up by the Wall Street money machine. They’ve usually had retirement accounts for years and have seen their account go through the dot-com bubble and the financial crisis. They have little faith in paper assets and desire to move to a self-directed account at a time when they believe the market is going to collapse. Most of these investors will invest in precious metals or real estate.

  • Retired Corporate 401(k). A retired corporate employee rolls over a portion of his prior employer’s 401(k) to a self-directed IRA and buys actual precious metals that are stored at a depository for his IRA. The precious metals are not an ETF or a fund but are actual, physical, gold bullion that meets the retirement plan rules for ownership by an IRA. Common precious metals would be gold or silver bullion as well as specifically approved American Eagle coins.
  • Working Corporate Employee with Prior Employer 401(k). A 50 year old corporate employee uses her present employer retirement plan for standard mutual fund investments based on risk factors and tolerances for investors her age. Her current employer’s plan cannot be self-directed but she rolls over a prior employer’s 401(k) to a self-directed IRA and uses that self-directed IRA to invest in real estate investments with other like-minded investors. The investors use their self directed IRAs and each invest into the newly created IRA/LLC (and LLC owned by IRAs). The LLC then uses the combined funds to purchase a multi-family property. In the end, her IRA owns a 20% interest in an LLC that owns an apartment building.

There are many other characteristics of self-directed investors and even more examples of these groups in the industry. However, the three groups above seem to capture 90% of the growing self-directed retirement plan market. Additionally, many investors have cross over and identify in two or all three of these groups. Because self-directed IRAs and 401(k)s give investors options for greater control and because they provide better access to investment opportunities, we will only continue to see growth in the self-directed retirement plan market.

By: Mat Sorensen, Attorney and best-selling Author of The Self Directed IRA Handbook

Mat has been at the forefront of the self-directed IRA industry since 2006. He is the CEO of Directed IRA & Directed Trust Company where they handle all types of self-directed accounts (IRAs, Roth IRAs, HSAs, Coverdell ESA, Solo Ks, and Custodial Accounts) which are typically invested into real estate, private company/private equity, IRA/LLCs, notes, precious metals, and cryptocurrency. Mat is also a partner at KKOS Lawyers and serves clients nationwide from its Phoenix, AZ office.

He is published regularly on retirement, tax, and business topics, as well as a VIP Contributor at Entrepreneur.com. Mat is the best-selling author of the most widely used book in the self-directed IRA industry, The Self-Directed IRA Handbook: An Authoritative Guide for Self-Directed Retirement Plan Investors and Their Advisors.

SEP IRA Versus Solo 401(k): Which is Best For You?

by | Sep 21, 2015 | News

sep-ira-vs-solo-401kSelf-employed persons have two options when it comes to establishing a retirement account. If you are self-employed and you want to save for retirement, two of your primary options will be a SEP IRA or a Solo 401K. The SEP IRA is a super-charged IRA account that runs off of IRA rules while the Solo 401(K) is an employed based retirement plan used solely for the business owner(s) when they have no other employees.

Both a SEP IRA and a Solo 401(k) can be self-directed and invested into real estate, private company stock, or precious metals. Under a SEP IRA, you will have a self-directed IRA custodian. Under a Solo 401K, you can serve as your own trustee and administrator or you could use a custodian.

While a SEP IRA and a 401(k) can be used by business owners with employees other than the business owners, this article compares the two account options for those who are self-employed with no other employees other than themselves (and partners and family).

 

SEP IRA Solo 401K
Contribution Max $53,000 max annual contribution (it takes $265K of self-employment income to max out). Contributions are all employer contributions. $53,000 max annual contribution (it takes $140K of wage/se income to max out). Contributions are employee and employer.  Because a solo K is easier to max out each year on less income, it gives greater opportunity for utilization over the SEP IRA.
Traditional & Roth All SEP contributions are traditional dollars and all funds in a SEP must be traditional dollars. SEP IRA funds can be converted to a Roth IRA though. A solo 401(k) can have a traditional account and a roth account within the same plan. You can convert traditional sums over to Roth as well. Because you can have Roth accounts and Traditional account in the 401K, that provides more options in the solo 401(k).
Contribution & Establishment Deadline Date of the company tax return INCLUDING extensions. You may also establish a new SEP IRA at the time you make the first contributions even if that is for the prior tax year. For people making contributions for the first time for a prior year (e.g. in April of 2015 for 2014 contributions), this is a big benefit as a 401K) cannot be used unless it was set up in the tax year of the contribution. Date of the company tax return INCLUDING extensions. However, for new plans, they must be established by December 31 of the year you are seeking to make contributions. This means you have to plan ahead and establish the 401(k) before the end of the year.
Custodian Requirement An IRA must have a third party custodian involved on the account (e.g. bank. Credit union, trust company) who is the trustee of the IRA. A 401(k) can be self trustee, meaning the business owner can be the trustee of the 401(k). This provides for greater control but also greater responsibility.
Investment Details A SEP IRA is invested through the self directed IRA custodian. A SEP IRA can be subject to a tax called UDFI/UBIT on income from debt leveraged real estate. A Solo 401(k) is invested by the trustee of the 401(k) which could be the business owner. A solo 401(k) is exempt from UDFI/UBIT on income from debt leveraged real estate.

 

In sum, there are many differences between a solo 401(K) and a SEP IRA but the solo 401(k) has proven to be an excellent tool that provides greater flexibility when saving and investing for retirement.

California Rollover IRAs Can Receive ERISA-Style Creditor Protection

by | Sep 15, 2015 | News

Have you rolled over your 401(K) plan or other employer based plan to a rollover IRA? Has someone told you that your rollover IRA in California isn’t protected from creditors. They’re wrong.

California Exemptions

Retirement plans are known for being great places to build wealth and they have numerous tax and legal advantages. One of the key benefits of building wealth in a retirement account is that those funds are generally exempt from creditors. However, some states have laws that protect employer based retirement plans (aka, ERISA Plans) more extensively than IRAs. California is one of those states as their laws treat IRAs and ERISA based plans differently (the California Code refers to ERISA based plans, such 401(k)s, as private retirement plans) .

California Code of Civ. Proc., § 704.115, subds. (b),(d), treats funds held in a private retirement plan as fully exempt from collection by creditors. “Private retirement plans” include in their definition “profit-sharing” plans. The most common type of profit sharing plan is commonly known as a 401(k) plan.

IRAs, on the other hand, are only exempt from creditors up to an amount “necessary to provide for the support of the … [IRA owner, their spouse and dependents] … taking into account all resources that are likely to be available…” In other words, the exemption protection for IRAs is “limited”. California Code of Civ. Proc., § 704.115, subdivision (e).

McMullen v. Haycock

Notwithstanding the limited creditor protections for IRAs outlined above, the California Court of Appeals has ruled that rollover IRAs funded from “private retirement plans” receive full creditor protection as if they were a fully protected private retirement plan under California law. McMullen v. Haycock, 54 Cal.Rptr.3d 660 (2007). In McMullen v. Haycock, McMullen had a judgement against Haycock for over $500,000.  McMullen attempted to get a writ of execution against Haycock’s IRA at Charles Schwab. In defending against the writ of execution, Haycock claimed that the entire IRA was a rollover IRA funded and traceable to a private retirement plan and thus fully protected from collection as a private retirement plan. Haycock relied on California Code of Civ. Proc., § 703.80, which allows for the tracing of funds for purposes of applying exemptions.

Haycock lost at the trial court level but appealed and the appellate court found in his favor and ruled that his rollover IRA was fully protected from the collection of creditors as the funds in the rollover IRA were traceable to a fully exempt private retirement plan (e.g. former employer’s 401(k) plan).

As a result of McMullen v. Haycock, California IRA owners whose IRAs consist entirely of funds rolled over from a private retirement plan of an employer are fully protected from the collection efforts of creditors. IRAs that consist of individual contributions and are not funded from a prior employer plan rollover will only receive limited creditor protection. It is unclear so far how an IRA would be treated that consists of both private retirement plan rollover funds and new IRA contributions. Presumably, the Courts will trace the funds and separate out the private retirement plan rollover IRA portions from the regular IRA contributions and the regular IRA contributions would then receive the limited protection. Unfortunately, there is no case law or guidance yet as to rollover IRAs with mixed rollover and regular IRA contributions.

McMullen v. Haycock was a big win for IRA owners with funds rolled over from a private retirement plan and one that should be kept in mind when planning your financial and asset protection plan.