Retirement Plans

Retirement plans allow employees and the self-employed to set aside money for retirement where earnings can accumulate tax-free. The contributions to a retirement plan must come from earned income, which is compensation for active work — the source of contributions cannot be from investments. Contributions can be made either with pretax dollars to tax-deferred accounts or with after-tax dollars to nontaxable accounts, such as a Roth IRA or a Roth 401(k). To achieve these tax savings, the retirement plans must satisfy tax rules, in which case, they are referred to as qualified retirement plans. Qualified retirement plans cannot discriminate in favor of owners or highly compensated employees and the amount that can be contributed annually is restricted, depending on the type of plan. The withdrawal of money from a retirement account is referred to as a distribution.

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Qualified tax-deferred plans have several tax advantages:

Except for IRAs, qualified retirement plans are also protected from the claims of creditors. Although IRAs are not protected from the claims of creditors, up to $1 million held in IRAs is exempt under bankruptcy.

Retirement accounts can be classified as either defined contribution plans or defined benefit plans. The benefit of defined contribution (DC) plans depends on the amount contributed and the investment return of the contributions. This is the most common type of retirement plan offered by businesses because it is simpler than a defined benefit plan to set up and the cost to the business of the retirement benefit is equal to the contributions.

Defined-benefit (DB) plans pay a specified amount during retirement that is usually based on a certain percentage × the number of years that the employee worked for the employer × average wages earned by the employee in the last 3 years. So if an employee earns an average of $100,000 during the last 3 years before retirement and worked for 30 years where the annual percentage is 2%, then at retirement, the employee will receive 30 × .02 × $100,000 = 60% × $100,000 = $60,000. Most employers, especially those without a unionized labor force, no longer offer DB plans, because the employers are obligated to fund the plan with a contribution large enough to pay the defined benefit, so they incur most of the risk of the plan, whereas with the DC plan, the employee bears the risk that the plan may be underfunded to satisfy the employee's retirement needs. Furthermore, DB plans are more complicated to set up because they depend on actuarial tables of the workers' life expectancies.

To fund tax-deferred plans, most employers set up a salary reduction plan, which is based on a salary reduction agreement that is signed by each employee who wishes to fund a retirement account for themselves, where the employer makes a contribution to the employee's account by the amount of the reduction in wages. The employer may also contribute an additional amount. The contribution is not subject to ordinary income tax, but is subject to Social Security and Medicare (FICA) taxes. Self-employed taxpayers simply deduct the contributions as an adjustment for gross income, which can be deducted whether the taxpayer itemizes or not. As for employees, the contributions are still subject to employment taxes.

Tax-deferred accounts and nontaxable accounts are best illustrated by the traditional IRA and the Roth IRA. If a taxpayer in the 25% tax bracket makes a $5000 contribution to a traditional IRA account, then he saves $1250 in taxes in the year of the contribution. But when the money is withdrawn during retirement, then both contributions and earnings will be subject to ordinary income tax. Another taxpayer in the same tax bracket that contributes the same amount to a Roth IRA saves nothing in taxes in the year of the contribution, but the contributions and the earnings can be withdrawn tax-free when the taxpayer retires.

Because contributions to retirement accounts do not save on FICA taxes, there is not much tax savings for low income workers. To encourage low income workers to save for retirement, the federal government offers the retirement savings contribution credit — often referred to as the saver's credit — that matches up to $1000 of contributions for qualified taxpayers who contribute to their IRAs or 401(k)s.

Maximum Contribution Limits

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All qualified retirement plans have a maximum limit on annual contributions. One limit that applies to all retirement accounts is that the contribution cannot be any greater than the participant's compensation, which, for defined contribution plans, is the compensation received during the tax year, while the limit for defined benefit plans is the highest average compensation for 3 consecutive calendar years. If not limited by compensation, then the following limits, not including any allowable catch-up contributions, apply:

Catch-up contributions allow taxpayers who are at least 50 years of age to contribute up to $1,000 more annually.

Excess Contributions

For most taxpayers, contributions are made throughout the year, so some taxpayers may end up contributing more than is allowed. Furthermore, because contributions are limited by the employee's income or by the business income of the employer, the amount that can actually be contributed may not be known until the end of the year. Excess contributions must be withdrawn by a certain time, usually by the due date of the return for the tax year, including extensions; otherwise, they may be subject to a tax penalty, such as the 6% excise tax that is assessed on excess contributions to IRAs.

Tax Warning! — Excess Contributions to Self-Directed IRAs in the Form of Paid Expenses

Self-directed IRAs allow the account owner to invest in riskier investments, such as rental properties. Although this can be advantageous, only money in the IRA can be used to cover potential expenses related to the properties. Expenses paid directly by the taxpayer will be considered an IRA contribution.

Adjusted Gross Income Limits

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There are also some income limits for contributing to certain retirement plans, which vary according to the type of plan and by the year of contribution. Moreover, there are special rules regarding highly compensated and key employees, who are defined as employees with at least the following inflation-adjusted minimum incomes:

Required Minimum Distributions

Because the government wants to get its money eventually, there are required minimum distributions (RMDs) from any tax-deferred accounts, such as the traditional IRA. Note that RMDs are reported as ordinary income in the Income section on Form 1040, so the marginal tax rate on ordinary income applies. There is no preferred tax treatment for long-term capital gains and qualified dividends. There is an exception for some retirement account owners who hold appreciated stock of the employer in an employer-provided retirement plan. Any net unrealized appreciation (NUA) on such stock is taxed at the long-term capital gains rate. In contrast to tax-deferred retirement accounts, there are no distribution requirements for Roth IRAs or Roth 401(k)s, because they are funded with after-tax dollars. In other words, the contributions to these accounts have already been taxed.

RMDs must begin by April 1 of the following year when the taxpayer becomes 70½. Otherwise, a hefty 50% tax penalty will be assessed on an amount equal to the required distribution minus the amount actually distributed. The RMD is calculated by dividing the total amount in the tax-deferred accounts on December 31 of the previous year by the distribution period, which can be found in tables published by the IRS, such as this one that applies to most taxpayers. The distribution periods are based on the current age and life expectancy of the taxpayer and may also be based on a presumed beneficiary. For instance, the tables used for IRA owners presumes that the owner has a beneficiary who is 10 years younger. So if the taxpayer is 84 and has $100,000 in tax-deferred accounts, then the distribution period is equal to 15.5, so the RMD for the year = $100,000/15.5 = $6451.61

Generally, distributions from different traditional IRA accounts can be combined to determine if the required minimum distribution has been received. However, there is an RMD for each 401(k) account, so they cannot be combined, either with other 401(k) accounts or traditional IRA accounts, to determine if an RMD has been received.

Net Unrealized Appreciation (NUA) of Employer Stock

Although capital gains are taxed at ordinary tax rates in retirement accounts, any net unrealized appreciation (NUA) of the employer's stock can be taxed at the long-term capital gains rate when sold.

When the stock is distributed in a lump sum, the total cost of the stock, which is the sum of the employer's and the employee's costs, is taxed as ordinary income. Any appreciation of the stock above the cost until it is distributed is treated as NUA, which is taxed at long-term capital gains rates when it is sold regardless of the holding period. Any appreciation beyond the FMV after the stock is distributed is taxed as long-term capital gains if the stock was held at least 1 year after the distribution; otherwise, the non-NUA appreciation is taxed as ordinary income.

To qualify for the NUA, all assets from all qualified plans of the former employer must be distributed, not just the ones containing shares of stock. The shares must be deposited in a taxable brokerage account, with the basis of the stock equal to what was paid for it, although the plan will determine both the tax basis and the resulting NUA. If a lump-sum payment is not made, then NUA treatment will only be available on shares that were bought with after-tax contributions.

The following requirements must be satisfied:

Example: you paid $10,000 for company stock with pre-tax earnings, which appreciated to $100,000, at which time it was distributed. The $90,000 of depreciation will be treated as NUA, and will not be taxed until it is sold. The $10,000 basis will be deemed a taxable distribution from the 401(k), subject to ordinary income tax rates. If the stock is sold at distribution, then it will be taxed as a long-term capital gain. If the stock is held, then any further gains will be taxed at capital gains rate depending on the holding period that begins when the stock was distributed. So, if the stock was held 1 year or longer, then the extra gain will be taxed at the long-term capital gains rate; otherwise, it will be taxed at the short-term capital gains rate. The $90,000 will still be taxed at the long-term capital gains rate, regardless of how the extra appreciation is taxed. So if you sold the stock for $120,000 6 months after receiving it, the $20,000 of extra appreciation will be taxed at ordinary income tax rates but the $90,000 NUA will still be taxed at the favorable long-term capital gains rate.

On the other hand, if the stock is rolled over into an IRA, then no tax will be due at the time of the rollover, but when it is sold, it will be taxed as ordinary income. It is permissible to rollover the non-NUA assets into another retirement account while distributing the company stock to a taxable brokerage account where it will receive NUA treatment.

The NUA will be listed on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. from the 401(k) trustee, showing the basis in the NUA. The basis is taxed as ordinary income. If the taxpayer is younger than 55, then a 10% early withdrawal penalty tax will apply. Because NUA is income in respect of a decedent, the stock is not stepped up in basis upon the death of the taxpayer except for any appreciation above the NUA.

Example: Taxation of Appreciated Shares Contributed Only by the Employer
Employer's Cost per Share$100
Number of Shares$10
Taxable Distribution$1,000 = Employer's Cost / Share × # of Shares
FMV of Stock during Lump-Sum Distribution$1,400
Non-Taxed NUA at Distribution$400 = FMV – Taxable Distribution
Sale Price$1,600
Long-Term Capital Gain on NUA$400 Regardless of Holding Period
Capital Gain on Non-NUA Appreciation$200 Capital Gain Rate Depends on Holding Period.

Because the shares are distributed in kind, there is no tax withholding on the distribution nor when the stock is sold, so withholding should be increased from employment sources or estimated tax should be paid to avoid possible penalties.

If the distribution is not a lump sum, then NUA treatment applies only to appreciation on the stock purchased by the employee. Both employer's contribution of shares and the appreciation thereof are taxed as ordinary income. Employer contributions will be listed on Form 1099-R.

Example: Distribution Not a Lump-Sum
Average Cost of Shares$1,000
Employee Contribution Percentage55%
Employee Contribution$550 = Average Share Cost × Employee Contribution %
Employer Contribution$450
FMV of Stock at Distribution$1,900
Employee NUA$495
Employer NUA$405 = (FMV – Average Share Cost) × Employee Contribution %
Total NUA$900
Employee Taxable Income Due To Stock$855 = Employer's Portion of Both Cost and NUA
Employee's Stock Basis$1,405 = Employee Contribution + Reported Taxable Income

If there is a loss on the stock when distributed, then the FMV at distribution is a taxpayer's stock basis. The loss cannot be claimed when the stock is distributed, but is claimed when the stock is sold for less than the stock basis.

Example: Shares Valued below Taxpayer's Cost Contribution
Taxpayer Contribution$600
Employer Contribution$400
Total Contribution$1,000 = Taxpayer + Employer Contributions
Stock Basis$600 = Taxpayer Contribution
Case 1
Sale Price$400
Capital Gain or Loss($200)= Sale Price – Stock Basis
Case 2
Sale Price$700
Capital Gain or Loss$100 = Sale Price – Stock Basis

Whether the NUA treatment is desirable will depend on other factors, such as how long until retirement, and the percentage of basis out of the total value. Additionally, taking advantage of NUA will reduce IRA balances, thus lowering required minimum distributions. An election can be made to forgo the NUA treatment and include it as ordinary income, which may be advantageous if the capital gain is insubstantial and the taxpayer wants to accelerate the income, especially if the taxpayer wishes to claim averaging or capital gains treatment on Form 4972, Tax on Lump-Sum Distributions.

Tax Penalties for Early Withdrawals

To prevent abuses and to fulfill the objective of retirement plans, there are penalties for taking distributions if the taxpayer is younger than the IRS-defined retirement age of 59½, although there are some exceptions. Unless an exception applies, early withdrawals from tax-deferred accounts are not only subject to ordinary income taxes, but they are also subject to a 10% tax penalty. So if a taxpayer in the 25% tax bracket receives an unqualified distribution of $1000, then there will be an assessment of $250 of ordinary income tax plus a $100 tax penalty on the distribution. However, if the retirement plan allows it, the taxpayer may receive part of the fund as a loan without penalty. The general exceptions that allow for a penalty-free distribution include the following:

Additionally, some distributions from a traditional IRA may be penalty free if used to pay for:

However, the employment termination exception that generally applies to qualified retirement accounts does not apply to traditional IRAs. Also, for a SIMPLE IRA plan, the early withdrawal penalty is 25% during the 1st 2 years after the account is established.

Tax Tip: Remember that taking a distribution from a retirement account will increase your adjusted gross income (AGI), which may incur additional taxes, such as the net investment income tax or the Additional Medicare Tax imposed on higher income taxpayers, or the distribution may reduce deductions and tax credits. For instance, if you are receiving a subsidy for insurance premiums under the Affordable Care Act (aka Obamacare), then a distribution may lower, or even eliminate, that subsidy.

Nonqualified Retirement Plans

Because qualified retirement plans do not allow discrimination in favor of owners or highly compensated employees and because of the contribution limits of qualified retirement plans, some employers set up nonqualified retirement plans as part of a compensation package for key employees. A major employer benefit of nonqualified retirement plans is that they do not have to be funded, since they are basically a promise by the employer to pay the employee at some future date. However, the major drawback to nonqualified plans is that they are not deductible by the employer until the employee receives the payment. Moreover, the employee bears the risk that the employer may renege on the promise or may not be able to pay the deferred compensation if the employer becomes insolvent or declares bankruptcy, or if the company is subject to a hostile takeover.

To mitigate this risk, an employer can set up a so-called rabbi trust — so-called because a synagogue 1st used this method of deferred compensation — by paying the deferred compensation to an irrevocable trust. The Rabbi trust must be domestic; otherwise, IRC §409A provides for the immediate taxation of the employee for payments to an offshore Rabbi trust, along with the imposition of tax penalties. Contributions to the trust are not taxed until the employee receives the compensation if the arrangement satisfies tax rules, including that the assets of the trust must be subject to the employer's creditors and neither the employees nor their beneficiaries can have preferred claims on the trust's assets. Hence, the rabbi trust simply makes it more difficult for an employer or a successor to renege on its promise of payment, but offers no protection against insolvency or bankruptcy. If the employee dies, then payments to beneficiaries are taxed as income in respect of a decedent.

To reduce the risk inherent in nonqualified retirement plans for the plans' participants, especially with a change in control or a deterioration of the financial condition of the company, many nonqualified retirement plans have benefit triggers, causing the immediate payment of benefits to the plan participant based on some event. Historically, benefit triggers could be based on changes in financial ratios, or a change in the net worth of the company. However, §409A allows only benefit triggers based on the company's financial stress or a change in control of the business.