1. McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11 Retirement and Other Tax-Deferred Plans and Annuities “The income tax laws do not profess to embody perfect economic theory.” -- Oliver Wendell Holmes, Jr.

2. 11-2 LO #1 – The Basics Retirement plans are encouraged and receive tax advantages. –Encourage saving for retirement or education –Generally, taxation is deferred (not eliminated) Retirement plans include employer- sponsored plans and individual-based plans.

3. 11-3 LO #1 – The Basics Understand retirement plan terminology –Annuity –Beneficiary –Contributions –Distributions –Donor –Tax-deferred retirement (or other) plan –Trustee

4. 11-4 LO #1 – The Basics Tax-deferred does not mean tax-free. Generally, untaxed contributions are taxed when distributed. Previously- taxed contributions are not taxed on distribution. Contributions can provide a tax deduction to the person/company that makes them.

5. 11-5 LO #2 – Employer-Sponsored Retirement Plans Employer-sponsored plans include: –Qualified pension and profit-sharing plans –401(k) plans –403(b) plans –Keogh plans –Simplified Employee Pensions (SEP) –SIMPLE plans

6. 11-6 LO #2 – Employer-Sponsored Retirement Plans Plans provide benefits to employers and employees –Employer gets immediate deduction for contributions. –Employer contributions are not compensation to employee. –Earnings from plan investments are not taxed when earned. –Plan assets or earnings are not taxable to employee until withdrawn.

7. 11-7 LO #2 – Employer-Sponsored Retirement Plans Defined-contribution plans pre-establish the amount of the contribution –The amount of the eventual distribution is not known with certainty and will vary. Defined-benefit plans pre-establish the amount of the benefit –The amount of the contribution is not known with certainty and will vary.

8. 11-8 LO #2 – Employer-Sponsored Retirement Plans Qualified pension & profit-sharing plans: –Nondiscriminatory, minimum vesting rules, contributory or noncontributory –Additions to defined-contribution plan can’t exceed lower of $49K or 100% of compensation –Additions to defined-benefit plan can’t result in benefits more than the lower of $195K or 100% of compensation

9. 11-9 LO #2 – Employer-Sponsored Retirement Plans 401(k) plans –Must meet nondiscrimination rules –Employee can elect to defer up to $16,500 (additional $5,000 if age 50 or over) Keogh plans –For self-employed –Contribution limits generally the same as qualified plans

10. 11-10 LO #2 – Employer-Sponsored Retirement Plans Simplified Employee Pensions (SEP) –Employer creates and contributes to employee IRAs –Maximum contribution is lower of 25% of compensation or $49,000. SIMPLE plans –Employer creates IRA or 401(k) for employee –Employee contributes a % up to $11,500 (additional $2,500 allowed if age 50 or over) –Employer makes matching contribution of 3% for all employees or 2% for all eligible employees.

11. 11-11 LO #3 – Individual-Sponsored Retirement Plans Traditional Individual Retirement Account (IRA) and Roth IRA. Contributions limited to smaller of $5,000 or 100% of compensation. If age 50 or over, the dollar limit is $6,000.

12. 11-12 LO #3 – Individual-Sponsored Retirement Plans Individuals covered under an employer plan –Deductible contribution amount begins to phase out when AGI reaches $90K (married) or $56K (others) and is fully phased out at $110K and $66K, respectively. Married filing separately, the phase out starts at $0. –Can still make nondeductible contribution up to the $5K or $6K limits

13. 11-13 LO #3 – Individual-Sponsored Retirement Plans Married taxpayers –If both employed and neither are covered under an employer plan, then both spouses can make a deductible IRA contribution up to the $ limits. –If only one spouse is employed and that person is not covered under an employer plan, can contribute up to the maximum for both persons. –If one spouse is covered under an employer plan, and the other is not, the non-covered spouse can contribute up to the dollar limits if AGI < $169,000.

14. 11-14 LO #3 – Individual-Sponsored Retirement Plans Roth IRA contributions are not deductible but withdrawals are not taxable Contribution limits are the same as with a traditional IRA Phase out starts at $169K (MFJ), $107K (single or HoH), $0 (MFS) –Phase out range is $10K MFJ, $15K others

15. 11-15 LO #3 – Individual-Sponsored Retirement Plans Traditional IRA vs Roth IRA –Contributions are deductible for traditional IRA but not for Roth IRA –Distributions are taxable for traditional IRA but not for Roth IRA Taxpayers are trading off the non- deductibility of contributions against the non-taxability of distributions.

16. 11-16 LO #4 – Tax-Deferred Nonretirement Plans Coverdell Education Savings Account (CESA) –Contributions not deductible, account grows tax-free, distributions are not taxable if used exclusively to pay higher education expenses of beneficiary. –Any person can establish and fund a CESA for any person, him or herself included.

17. 11-17 LO #4 – Tax-Deferred Nonretirement Plans CESA contributions limited to $2,000 per beneficiary –From all sources combined Contributions phased out when AGI of contributor reaches $190K (MFJ), $95K others. –Totally phased out at $30K or $15K above those numbers, respectively.

18. 11-18 LO #5 - Distributions Generally, distributions are taxable if contributions were deductible. When some (but not all) contributions were made with previously taxed dollars, then distributions will be partially tax free and partially taxable. Use simplified method.

19. 11-19 LO #5 - Distributions Simplified method. For cases where distributions are partially taxable. –Determine number of anticipated payments using single life or dual life tables in text –Determine total contributions from previously-taxed dollars. –Fraction: previously taxed $ / # payments –Fraction represents proportion of each payment that will be tax-free.

20. 11-20 LO #5 - Distributions Other plans have required minimum distributions (RMD) that must begin by April 1 of year following the year taxpayer reaches age 70.5. RMD is based on life expectancy tables from IRS (normally Table III in text) Use these IRS tables to determine life expectancy each year.

21. 11-21 LO #5 - Distributions Roth IRA distributions are generally not taxable. –Earnings are taxable if withdrawn prior to an initial five-year holding period. Coverdell Education Savings Account distributions are tax-free if used to pay for qualified education expenses of beneficiary. –Can’t use education expenses paid by CESA also for American Opportunity/Hope or lifetime learning credits

22. 11-22 LO #5 - Distributions Premature distributions generally subject to 10% penalty. –Some exceptions apply. See page 11-17 Rollovers are generally tax-free. Rollovers to a Roth IRA are taxable. –If rollover $ are distributed to the taxpayer, there is a 60-day window to deposit $ in new plan. Otherwise, entire amount is taxable.

23. 11-23 LO #6 - Annuities An annuity is a series of payments pursuant to a contract. Normally, annuity payments are partially taxable and partially tax-free to recipient

24. 11-24 LO #6 - Annuities The tax-free component is based on the cost of the annuity contract and expected return The cost of the annuity contract is the amount the recipient paid for the contract. –The portion of the payments that is represented by the cost of the contract is tax-free.

25. 11-25 LO #6 - Annuities The expected return is the total amount the recipient anticipates receiving over the annuity contract. –For contracts that will last a specified amount of time, the expected return is the periodic payment × the number of payments. –For contracts that will provide payments for life, the recipient must refer to the life expectancy tables to determine length of time.