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. Chapter 11 – Retirement and other tax-deferred plans and annuities

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. The Internal Revenue Code provides benefits to encourage individuals to save for retirement or education. Individuals can participate in retirement plans sponsored by their employer or plans that the individual sets up on their own. In general, retirement plans allow individuals to save for retirement and not pay taxes on the money saved until they retire,

LO #1 – The Basics Understand retirement plan terminology Annuity Beneficiary Contributions Distributions Donor Tax-deferred retirement (or other) plan Trustee It is important to understand the terminology related to a retirement plan.

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. The basic premise of most, but not all, retirement plans is that contributions are made with money which the eventual recipient has not yet paid tax. These are pre-tax, or untaxed, dollars. If this is the case, then when the money is withdrawn, tax will be due. Some retirement plans are funded with dollars that have already been taxed. In this case, withdrawals are generally not taxed.

LO #1 – The Basics – Concept Check 11-1 1. Tax-deferred retirement accounts are, essentially, tax-free accounts. True or false? False 2. The period in which accumulated assets are paid to plan beneficiaries is known as the _________ period. Distribution 3. A Keogh plan is an example of an individual-based retirement plan. True or false?

LO #1 – The Basics – Concept Check 11-1 4. Two examples of employer-based retirement plans are _____________ and ___________. Qualified pension/profit sharing, 401(k), Keogh, SEP, SIMPLE 5. Distributions from pension plans are taxable if the contributions were made using dollars that were not previously taxed. True or false? True

LO #2 – Employer-Sponsored Retirement Plans Employer-sponsored plans include Qualified pension and profit sharing plans 401(k) plans Keogh plans Simplified Employee Pensions SIMPLE plans Some retirement plans are established, run, and are sponsored by an employer. Five types of employer-sponsored plans are noted.

LO #2 – Employer-Sponsored Retirement Plans Plans provide benefits to employers and employees Employer gets immediate deduction for contribution. Employer contributions are not taxable to employee. Earnings from plan investments are not taxed. Plan assets are not taxable to employee until withdrawn. Employer sponsored plans provide benefits to both employers and employees. In general, these plans provide the employer with a tax deduction for the dollars contributed, the contributions grow tax-free, and the contributions are not taxable to the employee until withdrawn.

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. There are two types of employer-sponsored plans. One is a defined-contribution plan. In this case, the amount of the contribution is known. However, the amount of money that will be distributed upon retirement will vary. The other type is a defined-benefit plan. Here, the benefit is known with certainty. However, the amount that needs to be contributed will vary. The key notion is that contributions will be invested and will earn a return. We do not know, with certainty, what that return will be. As a result, we can pre-determine either the input (the contribution) or the output (the distribution) but we cannot know both.

LO #2 – Employer-Sponsored Retirement Plans Qualified pension & profit sharing plans: Non-discriminatory, minimum vesting rules, contributory or non-contributory Additions to defined contribution plan can’t exceed lesser of $45K or 100% of compensation Additions to defined benefit plan can’t result in benefits more than the lesser of $180K or 100% of compensation Qualified plans must meet certain non-discrimination and vesting rules. There are also dollar limits on either the amount of the annual contribution or the annual benefit.

LO #2 – Employer-Sponsored Retirement Plans 401(k) plans Meet nondiscrimination rules Employee can elect to defer up to $15.5K (additional $5K if age 50 or over) Keogh plans For self-employed Contribution limits generally the same as qualified plans 401(k) and Keogh plans are two types of pension plans. They are both subject to certain contribution limits.

LO #2 – Employer-Sponsored Retirement Plans Simplified Employee Pensions (SEP) Employer creates and contributes to employee IRA’s Maximum contribution is lesser of 25% of compensation or $45K. SIMPLE plans Employer creates IRA or 401(k) for employee Employee contributes a % up to $10.5K (additional $2.5K allowed if age 50 or over) Employer makes matching contribution of 3% or 2%. SEP and SIMPLE plans are two employer-sponsored plans. As with other plans, these are subject to certain rules related to eligibility and contribution limits.

LO #2 – Employer-Sponsored Retirement Plans – Concept Check 11-2 1. Qualified pension plans are either defined-_______ plans or defined-_______ plans. Benefit; contribution 2. Employees must make contributions to qualified pension plans. True or false? False 3. The maximum contribution to a 401(k) plan is _______ for individuals under age 50. $15,000

LO #2 – Employer-Sponsored Retirement Plans – Concept Check 11-2 4. A Keogh plan can be used by self-employed individuals. True or false? True 5. A SIMPLE plan can be used by employers with fewer than 100 employees who also meet other requirements. True or false?

LO #3 – Individual-Sponsored Retirement Plans Traditional Individual Retirement Accounts (IRA) and Roth IRA. Contributions limited to smaller of $4,000 or 100% of compensation. If over age 50, the dollar limit is $5,000. An Individual Retirement Account is one of the most common individual-sponsored retirement plans. An IRA can be either a traditional IRA or a Roth IRA.

LO #3 – Individual-Sponsored Retirement Plans Individuals covered under an employer plan Deductible contribution amount begins to phase out when AGI reaches $83K (married) or $52K (others) and is fully phased out at $93K and $62K, respectively. Married filing separately, the phase out starts at $0. Can still make non-deductible contribution up to the $4K or $5K limits Individuals covered under an employer retirement plan cannot make a deductible IRA contribution if their income exceeds certain AGI limits. Non-deductible contributions are always allowed.

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 < $156K. There are special rules for married taxpayers.

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 $156K (MFJ), $99K (single or HoH), $0 (MFS) Phase out range is $10K joint, $15K others With a traditional IRA, contributions are made with pre-tax (or untaxed) dollars. Distributions are fully taxed. With a Roth IRA, contributions are made with dollars that have already been taxed (after-tax dollars) and withdrawals are tax-free (if the Roth has been active for at least five years).

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. For traditional IRA’s and Roth IRA’s, contributions and distributions receive different tax treatment.

LO #3 – Individual-Sponsored Retirement Plans – Concept Check 11-3 1. Two types of individual-sponsored retirement plans are ______________ and ____________. Traditional and Roth 2. A single individual, age 58, with wages of $30,000 can make a tax-deductible contribution of up to $_______ to a traditional IRA. $5,000 3. A married couple with earned income of $200,000 is ineligible to make a deductible contribution to a traditional IRA. True or false? False 4. Generally, distributions from a Roth IRA are not taxable. True or false? True

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 other person, themselves included. Coverdell Education Savings Accounts provide a tax-advantaged way to save for education expenses. A CESA has similar tax attributes to a Roth IRA in that contributions are not deductible (in other words, contributions are made with after-tax dollars) and the distributions are not taxable if used for higher education expenses.

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. CESA contributions are limited to $2,000 per beneficiary. Multiple individuals can contribute to a single CESA, but the total contributions cannot exceed the $2,000 limit.

LO #4 – Tax-Deferred Nonretirement Plans – Concept Check 11-4 1. Contributions to Coverdell Education Savings Accounts (CESA) are not deductible. True or false? True 2. The maximum annual contribution to a CESA is $___________. $2,000 3. Contributions to CESA accounts begin to be phased-out when AGI reaches $__________ for a single taxpayer. $95,000

LO #5 - Distributions Generally, distributions are taxable if contributions were deductible. Often some (but not all) contributions were made with previously taxable dollars. In this case, distributions will be partially tax free and partially taxable. Use simplified method. In general, if retirement plan contributions are made with pre-tax or previously untaxed dollars, the distributions will be fully taxable. If the contributions are made with a combination of previously taxed and previously untaxed dollars, the distributions will be partially taxable and partially tax free.

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. The simplified method is used when retirement plan distributions are partially taxable and partially non-taxable. The method uses the life expectancy tables given in the chapter.

LO #5 - Distributions Other plans have required minimum distributions (RMD) that must begin by April 1 of year following after taxpayer reaches age 70.5. RMD is based on single or dual life expectancy tables from IRS (in book) Can use “term certain” method or refigure life expectancy from IRS tables each year. Most retirement plans have Required Minimum Distributions. Roth IRA accounts are and exception to the RMD rules. Generally, distributions must begin no later than April 1 of the year following the year the taxpayer reaches age 70 ½.

LO #5 – Distributions – Concept Check 11-5 1. A participant in a defined benefit plan is only entitled to a stream of payments. True or false? True 2. Distributions from qualified pension plans may be taxable, nontaxable, or both. True or false? 3. The number of anticipated payments from a pension plan for a single individual, age 68, is ______. 210 4. The number of anticipated payments from a pension plan for a married couple aged 59 and 63 is ______. 310 5. Distributions are required from a traditional IRA. True or false?

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 to determine Hope or lifetime learning credits Roth IRA distributions are not taxable if the account has been held at least five years. CESA distributions are not taxable if the distribution is used to pay for qualified education expenses of the beneficiary. The education expenses used as qualified education expenses for CESA purposes cannot be used again to determine education tax credits. In other words, the taxpayer can’t “double dip.”

LO #5 - Distributions Premature distributions generally subject to 10% penalty. Some exceptions apply 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. Premature distributions from a retirement plan are subject to a 10% penalty unless they are made subject to one or more of the exceptions noted in the text on page 11-17 Generally, taxpayers can transfer their retirement assets from one plan to another. That is called a rollover. Rollovers are generally tax free although there are exceptions.

LO #5 – Distributions – Concept Check 11-6 1. IRA distributions are taxable if funded with deductible contributions. True or false? True 2. Distributions are never required from a Roth IRA. True or false? 3. Roth IRA distributions are not taxable if they have been held for at least five years. True or false? 4. Distributions from Coverdell Education Savings Accounts can be used for any purpose once the beneficiary reaches age 30. True or false? False

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 An annuity is a series of payments pursuant to a contract. Generally, annuity payments are tax-free to the extent of tax basis in the annuity.

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. The cost of the annuity is the amount the recipient paid for the annuity contract. Payments from the annuity are tax free to the extent of the proportional share represented by the amount paid.

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. To determine the tax free amount of each payment, the taxpayer must calculate the “expected return” on the contract.

LO #6 – Annuities – Concept Check 11-7 1. An annuity is a ______ of payments under a ______. Series; contract 2. Annuity payments are always the same amount each period. True or false? False 3. Annuity payments often have a taxable component and a non-taxable component. True or false? True