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March 03, 2014 at 08:20 AM
You know the stats: 10,000 boomers reach retirement age each and every day. It’s the topic that’s on everyone’s mind, it seems, and tax season can raise additional questions. How are earnings on an IRA taxed? What is the penalty for making excessive contributions to an IRA? How are amounts distributed from a traditional IRA taxed? If your clients come to you with these and other questions, we have the answers.
1. When are funds in an IRA taxed?
Funds accumulated in a traditional IRA generally are not taxable until they actually are distributed. Funds accumulated in a Roth IRA may or may not be taxable on actual distribution. Special rules may treat funds accumulated in an IRA as a “deemed distribution” and, thus, includable in income.
A distribution of a nontransferable, nonforfeitable annuity contract that provides for payments to begin by age 70½ and not to extend beyond certain limits is not taxable, but payments made under such an annuity would be includable in income under the appropriate rules.
A contribution (excess or otherwise) may be distributed income tax-free (provided, in the case of a traditional IRA, that no deduction was allowed for the contribution). If net income allocable to the contribution is distributed before the due date for filing the tax return for the year in which the contribution was made, it must be included in income for the tax year for which the contribution was made even if the distribution actually was made after the end of that year. With respect to distributions of excess contributions after this deadline, the net income amount is included in income in the year distributed. Any net income amount also may be subject to penalty tax as an early distribution.
An individual may transfer, without tax, the individual’s IRA to his or her spouse or former spouse under a divorce or separate maintenance decree or a written instrument incident to the divorce. The IRA then is maintained for the benefit of the former spouse. Any other assignment of an IRA is a deemed distribution of the amount assigned.
See also: IRS issues rollover guidance
Where an individual rolled over his interest in a tax sheltered annuity to an IRA, pursuant to a QDRO, the subsequent transfer of the IRA to the individual’s spouse was considered a “transfer incident to a divorce” and, thus, nontaxable to either spouse.
A taxpayer was liable for taxes on a distribution from his IRA that he subsequently turned over to his ex-wife in satisfaction of a family court order because it was not a “transfer incident to divorce” and the family court order was not a QDRO because it did not specifically require the transfer of assets to come from the IRA. A transfer of funds between the IRAs of a husband and wife that does not come within the divorce exception is a deemed distribution despite IRC provisions that provide that no gain is recognized on transfers between spouses.
The transfer of a portion of a husband’s IRA to his wife to be placed in an IRA for her benefit that was the result of a private written agreement between the two that was not considered incident to a divorce was not eligible for nontaxable treatment under IRC Section 408(d)(6).
Where a taxpayer received a full distribution from his IRA and endorsed the distribution check over to his soon-to-be-ex-wife, the husband was determined to have failed to satisfy the requirements for a non-taxable transfer incident to divorce and was liable for taxation on the entire proceeds of the IRA distribution.
Where two traditional IRAs were classified as community property, the distributions of the deceased spouse’s community interest in the IRAs to relatives other than her surviving husband were taxable only to those recipients and not to the husband.
State community property laws, although disregarded for some purposes, are not preempted by IRC Section 408(g). In a case of first impression, the Tax Court ruled that the recognition of community property interests in IRAs would conflict with existing federal tax rules. IRC Section 408(g) requires application without regard to community property laws. By reason of IRC Section 408(g), the former spouse is not treated as a distributee on any portion of the IRA distribution for purposes of federal income tax rules despite the former spouse’s community property interest in the assets. Therefore, a distribution from an IRA to a former spouse is taxable to the account holder unless it is executed pursuant to decree of divorce, or other written maintenance decree under IRC Section 408(d)(6).
Where taxpayers requested that an IRA be reclassified under state marital property law from individual property to marital property, no distribution under IRC Section 408(d)(1) was deemed to have occurred.
The involuntary garnishment of a husband’s IRA and resulting transfer of such funds to the former spouse to satisfy arrearages in child support payments was a deemed distribution to the husband because it discharged a legal obligation owed by the husband.
Where a taxpayer transferred funds from a single IRA into two newly-created IRAs, the direct trustee-to-trustee transfers were not considered distributions under IRC Section 408(d)(1). The division of a decedent’s IRA into separate subaccounts does not result in current taxation of the IRA beneficiaries.
If any assets of an individual retirement account are used to purchase collectibles (works of art, gems, antiques, metals, etc.), the amount so used will be treated as distributed from the account (and also may be subject to penalty as an early distribution). A plan may invest in certain gold or silver coins issued by the United States , any coins issued under the laws of a state, and certain platinum coins. A plan may buy gold, silver, platinum, and palladium bullion of a fineness sufficient for the commodities market if the bullion remains in the physical possession of the IRA trustee. A plan may purchase shares in a grantor trust holding such bullion.
If any part of an individual retirement account is used by the individual as security for a loan, that portion is deemed distributed on the first day of the tax year in which the loan was made. Amounts rolled over into an IRA from a qualified plan by one of the twenty-five highest paid employees, however, may be pledged as security for repayments that may have to be made to the plan in the event of an early plan termination. A less-than-sixty-day interest-free loan from IRA accumulations is possible under the rollover rules.
If the owner of an individual retirement annuity borrows money under or by use of the contract in any tax year, including a policy loan, the annuity ceases to qualify as an individual retirement annuity as of the first day of the tax year and the fair market value of the contract would be deemed distributed on that day.
If an individual engages in a prohibited transaction during a year, his or her individual retirement account ceases to qualify as such as of the first day of that tax year; the individual is not liable for a prohibited transaction tax. The fair market value of all the assets in the account is deemed distributed on that day. If the account is maintained by an employer, only the separate account of the individual involved is disqualified and deemed distributed.
The transfer to an individual retirement account of a personal note received in a terminating distribution from a qualified plan and the holding of that note is a prohibited transaction.
The use of IRA funds to invest in a personal retirement residence of the taxpayer is considered a prohibited transaction under IRC Section 4975(c)(1)(D) and, thus, is treated as a distribution.
Whether a purchase of life insurance in conjunction with an individual retirement plan but with non-plan funds constitutes a prohibited transaction apparently depends on the circumstances. The IRS has held that the purchase of insurance on the depositor’s life by the trustee of the account with non-plan funds amounted to an indirect prohibited transaction by the depositor. The IRS also has ruled that the solicitation by an association of individuals who maintain individual retirement plans with the association for enrollment in a group life plan did not result in a prohibited transaction where premiums would be paid by the individuals and not out of plan funds.
Institutions may offer limited financial incentives to IRA and Keogh holders without running afoul of the prohibited transaction rules provided certain conditions are met. Generally speaking, the value of the incentive must not exceed $10 for deposits of less than $5,000 and $20 for deposits of $5,000 or more. These requirements also are applicable to SEPs that allow participants to transfer their SEP balances to IRAs sponsored by other financial institutions and to SIMPLE IRAs.
A distribution of any amount may be received free of federal income tax to the extent the amount is contributed within sixty days to another plan under the rollover rules.
Distributions from traditional and Roth IRAs are not subject to the 3.8 percent Medicare contribution tax imposed under the Affordable Care Act. The tax equals 3.8 percent of the lesser of a taxpayer’s net investment income for the taxable year, or the excess (if any) of the taxpayer’s modified adjusted gross income for the year, over a threshold amount ($200,000 for a taxpayer filing an individual return and $250,000 for a taxpayer filing jointly). Internal Revenue Code Sec. 1411 specifically accepts distributions from IRAs and other qualified plans from the definition of “net investment income.”
2. How are earnings on an IRA taxed?
An IRA offers tax-free build up on contributions. The earnings on a traditional IRA are tax deferred to the owner; that is, they are not taxed until the owner begins receiving distributions. The earnings on a Roth IRA may or may not be taxed upon distribution. Like a trust that is part of a qualified plan, an individual retirement account is subject to taxes for its unrelated business income.
Tax deferral is lost if an individual engages in a prohibited transaction or borrows under or by use of an individual retirement annuity. The loss occurs as of the first day of the tax year in which the prohibited transaction or borrowing occurred. For an account established by an employer or association of employees, only the separate account of the individual loses its deferred status.
3. What is “compensation” for purposes of IRA eligibility rules and deduction limits?
For purposes of the eligibility rules and deduction limits applicable to IRAs, “compensation” means wages, salary, professional fees, or other amounts derived from, or received for, personal services actually rendered. “Compensation” also includes alimony paid under a divorce or separation agreement that is includable in the income of the recipient under IRC Section 71.
In the case of a self-employed individual, “compensation” includes earned income from personal services, but in computing the maximum IRA or SEP contribution, such income must be reduced by (1) any qualified retirement plan contributions made by such individual on his or her own behalf and (2) the 50 percent of self-employment taxes deductible by the individual.
Earned income not subject to self-employment tax because of an individual’s religious beliefs is “compensation.”
An individual whose income for the tax year consists solely of interest, dividend, and pension income has no “compensation” and cannot deduct any portion of a traditional IRA contribution. In addition, such a person may not make a Roth IRA contribution.
Compensation does not include earnings and profits from property, such as rental income, interest, and dividend income, or any amount received as pension or annuity income, or as deferred compensation (See IRS Tax Topics No. 451)
Nor does “compensation” include any Social Security or railroad retirement benefits required to be included in gross income. Payments made to employees terminated because of a restructuring of the company are deferred compensation and may not be used as a basis for IRA contributions. Amounts received from an employer as deferred incentive awards, whether in the form of cash, stock options, or stock appreciation rights, also are not “compensation.”
Incentive pay awarded in one year for services performed in that year but paid in the following year is considered “compensation” in that second year, however.
The IRS has ruled that disability income payments, whether made under public or private plans, do not constitute “compensation.” Also, unemployment benefits do not constitute “compensation” because they are paid due to an inability to earn wages and not for personal services actually rendered. Additionally, the IRS has issued a compensation “safe harbor.” The amount properly shown in the box for “wages, tips, other compensation,” less any amount properly shown in the box for “nonqualified plans,” on Form W-2 is considered compensation for purposes of calculating an individual’s IRA contribution.
Amounts paid by a husband to his wife to manage their jointly-owned investment property may not be treated by the wife, on a joint return, as compensation for purposes of an IRA contribution. Similarly, wages paid to a wife by her spouse and deposited in their joint account are not considered compensation because deposit in a joint account does not constitute actual payment of wages to the wife.
Payment in hogs rather than cash by a husband to his wife for her services in running their farm, however, was considered to be compensation for purposes of making an IRA contribution.
A self-employed individual who shows a net loss for the tax year cannot take any IRA deduction. A salaried employee who also is self-employed should disregard net losses from self-employment when computing his or her maximum deduction.
4. Are fees or commissions paid in connection with an IRA deductible?
The IRS has ruled that the payment of administrative or trustee fees incurred in connection with an individual retirement account may be claimed as a miscellaneous itemized deduction (i.e., for the production or collection of income) if such fees are separately billed and paid. Furthermore, if separately billed and paid, the payment of such fees does not constitute a contribution to the individual retirement account and thus will not be an excess contribution or reduce the amount that may be contributed to the account or, in the case of a traditional IRA, deducted. Deduction of administrative fees is subject to the 2 percent floor on miscellaneous itemized deductions.
See also: The good-sense IRA
Sales commissions on individual retirement annuities that are billed directly by an insurance agent to the client and paid separately by the client are not separately deductible, but are subject to the overall limits on contributions and deductions.
Similarly, broker’s commissions incurred in connection with the purchase of securities on behalf of an IRA are not separately deductible, but are subject to the overall limits.
An annual maintenance fee charged for self-directed brokerage accounts that did not vary with the number of transactions, the number of securities involved, or the dollar amount and that was paid to the trustee, not the broker, was not treated as a commission but was separately deductible as an administrative fee.
In addition, brokerage account “wrap fees” that were based on a percentage of assets under management, but that did not vary based on the number of trades in the account, were not treated as a commission and were separately deductible as an administrative fee.
The IRS has held that the payment of fees associated with flexible premium variable annuity contracts that are paid directly from subaccounts within the contract would not be considered a distribution from the contract.
The IRS ruled that assessing expenses against the contract is unrelated to whether or not the participant is currently entitled to benefits under the contract. Therefore, such payments are an expense of the contract and not a distribution.
5. Is interest paid on amounts borrowed to fund an IRA deductible?
The IRS has ruled that because interest paid on amounts borrowed to fund an IRA is not allocable to tax-exempt income. The deduction of such interest is not subject to the general prohibition against deducting interest incurred or carried to purchase tax-exempts. Because such interest is “on amounts borrowed to buy or carry property held for investment,” it would seem that it should be classified as “investment interest expense” and the deduction limited.
Interest paid on money borrowed to buy property held for investment is investment interest. Such interest is deductible but generally limited to the taxpayer’s net investment income for the year. However, interest incurred to produce tax-exempt income is not deductible.
Property held for investment includes property that produces interest, dividends, annuities, or royalties not derived in the ordinary course of a trade or business. It also includes property that produces gain or loss (not derived in the ordinary course of a trade or business) from the sale or trade of property producing these types of income or held for investment (other than an interest in a passive activity). Investment property also includes an interest in a trade or business activity in which you did not materially participate (other than a passive activity).
6. What is the penalty for making excessive contributions to an IRA?
If contributions are made in excess of the maximum contribution limit for traditional IRAs or for Roth IRAs, the contributing individual is liable for a nondeductible excise tax of 6 percent of the amount of the excess (not to exceed 6 percent of the value of the account or annuity, determined as of the close of the tax year). A contribution by a person ineligible to make the contribution is an excess contribution even if it is made through inadvertence.
