| Roth IRA, Traditional IRA , 401(K), Pension/Profit Sharing Information
TRADITIONAL IRA, HOW DOES IT WORK?
Tax-deductible contributions are predicated on income and other pension plans in existence. Individuals may contribute $2,000 into an IRA. Proceeds in a IRA account accumulate tax deferred.
Under an IRA, distributions are mandatory at age 701/2. A table is available, that demonstrates the minimum distribution one must make.
Failure to withdraw the required distribution amount will generate a 50% penalty from the IRS. Distribution prior to age 591/2 will generate a 10% penalty, in addition to taxes.
ROTH IRA, HOW DOES IT WORK?
Single individuals with a adjusted gross income (AGI) of $95,000 may contribute $2,000 into a Roth IRA.
Married couples filing a joint return, with an AGI of $150,000, may contribute $2,000 each into a Roth IRA.
Married or single, with an AGI of less than $100,000 can convert a traditional IRA to a Roth IRA, without occurring the 10% penalty. Converting will generate a tax on the traditional IRA, but taxes can be paid over a four (4) year period. THIS ONLY APPLIES FOR TAX YEAR 1998. In 1999, converting a traditional IRA to a Roth IRA will require taxes to be paid in a lump sum vs. spreading the tax liability over a four (4) year period.
Contribution into a Roth IRA is “not” deductible. Proceeds in a Roth IRA accumulate tax-free. No mandatory distribution is required.
Maintaining a Roth IRA for five (5) years and to age 591/2, will allow you to withdraw all of your money anytime TAX FREE!!
401(K) & PENSION/PROFIT SHARING INFORMATION
Most large employers now offer their employees a 401(k) retirement plan, sometimes called a "salary-reduction" plan. Typically, the employer sets up the plan with an investment company, an insurance company, or a bank trust department. You, the employee, agree to put part of your salary into a special savings and investment account. Most 401(k) plans offer a variety of investment vehicles, from individual stocks or mutual funds to money market accounts. Importantly, the money you invest isn’t counted as income when you complete your annual tax return. For example, if you earn $35,000 but put $5,000 into a 401(k), your taxable income for the year would be only $30,000. Earnings that accumulate in the account are not taxed until you start making withdrawals, usually after you reach age 59 1/2. If you withdraw earlier, you’ll have to pay taxes on the money and a stiff 10 percent penalty. Most companies that offer 401(k) plans also match employee contributions. For example, the company might add 50 cents to the account for every dollar contributed by the employee. That makes a 401(k) plan a much better vehicle for retirement savings than an individual retirement account, which does not involve a matching contribution from your employer.
HOW IS A 401(K) DIFFERENT FROM A REGULAR PENSION?
The biggest difference between a 401(k) and a "regular pension" is that a 401(k) gives you much more control over your retirement nest egg. A 401(k) is funded with your own money and, in some cases, by a contribution from your employer as well. You decide how much to save and how to invest. A traditional, "regular" pension is funded and controlled by your employer. There are two types of pension plans: defined contribution (where the employer contributes a percentage of compensation determined by the formula in the plan document) and defined benefit. A "defined benefit plan" promises to pay you a specific monthly income in retirement -- in other words, a defined benefit. What you get when you retire will be based on your salary and the number of years you worked for the company. The company must put aside enough money each year to fulfill this promise but occasionally -- as some workers have unfortunately discovered -- it’s a promise that the employer may not be able to keep. Sometimes employers go bankrupt.
Most pension plans are covered by the Pension Benefit Guarantee Corp., which guarantees benefits to workers even if a firm is liquidated in bankruptcy. There are some plans that are not covered, however, such as those offered by professional service firms (such as doctors and lawyers) with fewer than 26 employees, by church groups or by federal, state or local governments.
HOW IS A 401(K) DIFFERENT FROM A PROFIT SHARING PLAN?
Technically, 401(k) plans are considered profit sharing plans. But on a practical level, they’re usually different in several ways from the classic profit-sharing plan. In a profit-sharing plan, the employer makes contributions for eligible employees whether or not they also contribute to the plan. However, In a 401(k) plan eligible employees can choose to participate or not. If they choose to participate, they make their contributions pre-tax through a salary deferral agreement with the employer. Their deferral may or may not be matched by the employer. Since it is a type of profit sharing plan the employer can also make profit sharing contributions to the plan. These contributions (also called non-elective contributions) are allocated to all eligible employees whether they contribute to the plan through deferrals or not.
HOW LONG DO I HAVE TO WAIT AFTER BEING HIRED TO JOIN THE 401(K) PLAN?
Some companies allow workers to join their 401(k) plans immediately. But other companies utilize a federal law that allows firm to wait until a worker has logged at least one year of service before joining the plan. The reason: Many employees quit before their first year is up, and companies want to avoid the administrative costs involved in setting up a 401(k) for a worker who might not stay very long. A company is also allowed to exclude anyone under the age of 21. In part, that’s because younger employees often don’t take advantage of the plans even when they are eligible (even though they should). If younger workers are eligible to join the plan but don’t, their lower participation rate can reduce the amount that other employees are permitted to contribute because of federal rules.
WHAT HAPPENS TO THE MONEY I PUT INTO THE 401(K) PLAN?
The money you put into a 401(k) plan is invested according to the choices you’ve made from a list of options offered by your employer. These options typically include stock and bond mutual funds, money market funds, a guaranteed investment contract (GIC) that pays a fixed interest rate and your company’s stock.
WHAT INFORMATION ABOUT MY 401(K) PLAN AM I LEGALLY ENTITLED TO HAVE?
The federal government requires companies to provide only minimal information to workers who take part in a 401(k) plan. Technically, all you’re entitled to is a summary of how the plan works, a summary annual report and an annual statement. If the plan allows you to invest in the company’s stock, you are also entitled to receive a prospectus or similar document. Fortunately, many companies provide far more, and you can also do your own research. For example, if a mutual fund is offered in your 401(k), you’re free to contact the fund directly and ask for its performance history and other pertinent information. According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), federal disclosure requirements are so minimal "because 401(k) plans are governed by a law that was written before they existed-the 1974 Employee Retirement Income Security Act, better known as ERISA. ERISA didn’t anticipate pension plans in which employees would make most of the investment decisions; consequently, its disclosure rules are relatively undemanding. But don’t worry, you probably won’t have any difficulty getting much more information than ERISA requires. Employers are strongly motivated to provide employees with all the information they need to use the plan wisely."
WHAT RECOURSE DO I HAVE IF MY EMPLOYER AND I DISAGREE ABOUT MY 401(K) ACCOUNT?
Most questions or problems concerning a 401(k) can be cleared up quickly and amicably with a phone call or a letter. But major disagreements must usually be solved through a more formal process. According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), "Your employer is required by law to include a claims review process in which you can file a written claim with the plan administrator. That’s the person or committee responsible for handling the day-to-day administration of the plan. The plan administrator must respond to participant questions and give an explanation for any denial of benefits. If you don’t find the explanation acceptable, you can request a review of the matter. If you’re still not satisfied, you should seek outside support from an attorney and/or the Department of Labor."
HOW DO I KNOW HOW WELL MY 401(K) INVESTMENTS ARE DOING?
If you have invested in a 401(k) retirement plan, it’s important to stay abreast of how your investment is faring. At a minimum, the company that administers your plan will provide an annual statement that shows the amounts you have contributed and how those investments have performed. Many plans report on a semi-annual or quarterly basis, and some even issue monthly updates. Of course, you can probably get a pretty good handle on how your 401(k) retirement portfolio is doing on a daily or weekly basis by checking the business section of your local newspaper or by reading publications such as The Wall Street Journal or Barron’s. If the bulk of your portfolio is in mutual funds or your company’s stock, for instance, those publications can tell you how much their value has changed over the course of a given day or week.
DO EMPLOYERS GUARANTEE 401(K) ACCOUNTS?
Employers never guarantee 401(k) accounts. They are instead considered "fiduciaries" of 401(k) plans, which means they are legally responsible for supervising-not guaranteeing-the money you invest. According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), this supervisory relationship obligates the employer "to protect your financial interests by choosing reputable and competent plan trustees, administrators and investment managers and continuously monitoring their performance of their duties. If employers choose to follow the voluntary 404(c) regulations established by the Department of Labor, they must give plan participants at least three distinctly different investment choices, each of which has a different level of risk. You must also be given the opportunity to move your money among these investments at least quarterly, and sufficient information to make sensible, informed investment decisions. But your employer doesn’t offer you protection against any investment losses you may suffer."
DOES THE GOVERNMENT GUARANTEE MY 401(K) ACCOUNT?
Although most traditional pension plans are insured by the federal government, there is no such guarantee for 401(k) accounts. Traditional pension plans are insured by the federal Pension Benefit Guaranty Corp. because the government wants to ensure that the payments a company promises its retirees will indeed be made. But 401(k) s do not involve a promise of future benefits. The value of your account will rise and fall over the course of the years, and you could theoretically be wiped out if your investments perform badly. If it helps you sleep better, you may want to know that one of the duties of the federal Pension, and Welfare Benefits Administration is to ensure that all employers and 401(k) trustees follow government requirements. That’s not as good as a guarantee, but it’s better than nothing.
WHAT HAPPENS TO MY 401(K) WHEN I RETIRE?
If you have a 401(k) and retire, you will likely have four choices(assuming you are over 59 1/2). According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), those choices will be: 1. Taking the money in a lump sum. If you do, you’ll owe income taxes on all of it. The disadvantage is that after you’ve taken the lump-sum distribution, your money is no longer in a tax-deferred retirement account. That means that the only way to avoid tax on any future earnings is to invest it in tax-exempt instruments. 2. Rolling your entire balance into an IRA. Then you can take out money, as you need it, paying income taxes only on the amount you withdraw. This gives you more flexibility than any other option. Most of your money will continue to be sheltered in a tax-deferred account. You’ll have a nearly unlimited choice of investments, too. 3. Taking a 401(k) payout as a lifetime annuity. Not all plans offer this. An annuity pays a monthly benefit for your lifetime alone or, if you choose a joint-and-survivor annuity, for your lifetime and your spouse’s. The advantage of an annuity is that it provides a guaranteed lifetime benefit. The disadvantage is that, because it’s a fixed amount, its purchasing power will be reduced every year by inflation. 4. Leaving some or all of the money in your 401(k). You must have at least $5,000 in your account to do this. This choice makes little sense, however, since, if you like the investments available in the plan, you can use those same investments in your own IRA and completely control you access to your money. If you leave it with the plan, you’ll need to comply with the plan administrator’s rules and procedures for making withdrawals or changing investments.
WHAT HAPPENS TO MY 401(K) ACCOUNT WHEN I DIE?
One of the first things you are supposed to do when you join a 401(k) is to designate a beneficiary who will receive the money in your account when you die. If you somehow failed to designate a beneficiary, your estate will automatically become the beneficiary. If your beneficiary is your spouse, he or she will have most of the same options with the money that you would have if you were leaving the company to take another job. Your spouse could roll the money over into an Individual Retirement Account (IRA), or withdraw it all and pay income taxes on it. If your spouse decides to roll the money over into an IRA, the rollover should be direct from the employer to the IRA account. This prevents deduction of any withholding tax. If your survivor decides to withdraw the cash and pay the taxes, the Internal Revenue Service will waive its early withdrawal penalty regardless of the spouse’s age. Importantly, though, your spouse will probably not have the right to keep the money invested in the same 401(k) plan. Even more restrictions would be placed on your beneficiary if the beneficiary is not your spouse. For example, the beneficiary couldn’t roll the money over into an IRA. Most plans provide for full vesting when you die, so any matching contributions made by your employer would likely be included in the distribution to your beneficiary.
WHAT HAPPENS TO MY 401(K) ACCOUNT IF I'M DISABLED?
If you are completely disabled and cannot work, you can tap your 401(k) plan without being charged a 10 percent penalty regardless of your age. However, you will owe ordinary income taxes on the money you withdraw. According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), "If you’re disabled, you may also be able to take out any matching contributions your employer made even if you haven’t completed the years of service normally required for vesting. Most plans provide for full vesting whenever a participant becomes disabled. But each plan has its own definition of what’s required to qualify for disability. Ask your human resources or personnel department about your plan’s rules. "If your plan does provide full vesting for disabled employees and your employment is terminated as a result of a qualifying disability, you’ll receive your vested account balance-your contributions and your employer’s contributions and what they earned. If your plan doesn’t have a disability feature, or if you don’t meet the plan’s definition of disability, your distributions from the plan will be processed the same as those of other former employees."
DOES PARTICIPATING IN A 401(K) AFFECT ANY OF MY OTHER BENEFITS?
Participating in a 401(k) plan probably won’t affect any of the other benefits your employer offers, as long as you make sure the amount you contribute is added back to your salary for the purpose of calculating those other benefits. According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), "If you earn $40,000 a year, for example, and contribute $2,000 to the 401(k) plan, your taxable income is reduced to $38,000. That means that if your group life insurance covers you for twice your salary, you’ll have only $76,000 of coverage-unless the 401(k) contribution is included in the calculation. Talk to your human resources or personnel department about it."
WHY ARE THE DIVIDENDS ON THE EMPLOYEE STOCK PORTION OF MY 401(K) PLAN PAID OUT TO ME INSTEAD OF BEING REINVESTED??
Corporations often pay out the dividends on the employee stock portion of their 401(k) plans because doing so can provide the companies with an important tax break. According to "Wealth Enhancement & Preservation" (The Institute Inc., Denver), "Under the Internal Revenue Code, dividends paid on employer stock held in a 401(k) plan are fully deductible to the corporation if paid directly to the employee and are fully taxable to the employee. Therefore, the corporation may want to take this option to get a current year tax deduction."
HOW CAN HAVING A 401(K) HELP MY CHILD QUALIFY FOR FINANCIAL AID?
One commonly overlooked benefit of making the maximum annual contribution to a 401(k) retirement plan is that it can boost your child’s chances of getting financial aid when it’s time to go off to college. According to "Wealth Enhancement & Preservation" (The Institute Inc., Denver), "Increasing your 401(k) contributions to the maximum level might make it easier to qualify for financial aid because these balances are excluded from most college-aid calculations and reduce your taxable income at the same time. Earnings within such plans accumulate on a tax-deferred basis and may be borrowed under certain exacting standards for your children’s education. Interest that you pay back to your account is not tax-deductible, but does accrue to your account balance. You should make sure your plan allows borrowing if you consider this alternative." Before you take this approach you should check out your plan’s loan rules. Some plans don’t allow loans, and some plans have very restrictive provisions that may invalidate this idea.
I'M SAVING MONEY THAT I PLAN TO USE BEFORE I RETIRE, DOES IT MAKE ANY SENSE TO DO IT WITH AFTER-TAX 401(K) CONTRIBUTIONS?
If you’re saving money that you plan to use before you retire, it’s usually better to save it outside your 401(k) plan. According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), "It’s true that usually you can withdraw your after-tax 401(k) contributions at any time without taxes or penalty, but remember, you’ll owe taxes on any interest they earned, as well as a 10% early withdrawal penalty if you’re under age 59 1/2. The 10% penalty is an expense you wouldn’t have if you saved on an after-tax basis outside your 401(k) plan. "But there are situations where it can make sense to use after-tax contributions for short-term savings: if your employer matches your after-tax contributions and if you’re fully vested in the matching contributions by the time you withdraw the money, you may wind up with more money by saving in the 401(k) plan, even after taking the 10% early withdrawal penalty into account."
CAN I BORROW MONEY FROM MY 401(K) BEFORING RETIRING?
Some 401(k) plans do not allow employees to borrow against the money they have built up in their account, but many other plans do. According to "Dun & Bradstreet Guide to Your Investments" (HarperCollins Publishers Inc., New York), many plans that permit borrowing allow employees to tap up to half the amount in the account (but never more than $50,000). You pay interest on the loan to your own account, typically a percentage point less than what banks charge on secured personal loans. You must make payments on the loan at least once every quarter. The entire amount usually must be repaid within five years unless the money is used to purchase a principal residence.
MUST MY SPOUSE AGREE TO A LOAN FROM MY 401(K) PLAN?
If you are married and hope to borrow from your 401(k) plan, your spouse’s approval may be required. Your spouse’s approval will certainly be required if your 401(k) plan follows standard joint-and-survivor rules, which means that you and your spouse have the option of receiving your retirement payout in the form of lifetime annuity payments. Your company’s human resources, personnel or benefits department can give you the details.
IS IT BETTER TO BORROW FROM MY 401(K) ACCOUNT RATHER THEN MAKE AN EARLY WITHDRAWALS?
In some cases, you can borrow from your 401(k) account rather than making an early withdrawal. Borrowing from your 401(k) is a much better option because it will allow you to escape the stiff taxes and 10% penalty that are levied on early withdrawals. Some 401(k) plans permit borrowing, but others do not. The decision rests solely in the hands of your employer. If your employer permits borrowing, there are other reasons why a loan is much better than an early withdrawal. Instead of costing you money, a 401(k) loan will actually earn money for you because you will repay the money -- to yourself -- along with interest. Borrowing from a 401(k) is also much easier than borrowing from a bank because there are no credit standards to meet. Since you own the money in your 401(k), you automatically qualify for a loan if the plan permits them. According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), "Legally, loans can be allowed for any reason. But most plans permit them only in specific, approved situations, such as if you’re using the money to buy a house or pay for college tuition. Employers have two good reasons for restricting plan loans. One is that loans add to the cost of administering the plan. The other is that allowing loans for any reason can defeat a 401(k) plan’s main purpose, to ensure that you retire with a substantial nest egg."
IS THERE ANY DRAWBACK TO TAKING A LOAN FROM MY 401(K) ACCOUNT THAT I SHOULD BE AWARE OF?
Probably the biggest pitfall facing a 401(k) borrower is having to pay all the money back in a lump sum in case you quit your job, get laid off, or are fired. According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), "Very few plans allow a former employee to continue repaying a 401(k) plan loan. If you leave your job, voluntarily or involuntarily, you’ll almost certainly have to repay the outstanding balance within 60 days -- into the 401(k) plan or into a rollover IRA -- or the IRS will treat it as an early withdrawal on which you owe income taxes and an early withdrawal penalty. If you’ve spent all the money, that puts you in a very tough spot." Paying the money back in a lump sum won’t be a problem if you have lots of money tucked away in savings or if you have other investments that can be sold in order to raise cash. Alternatively, if you own a home, you might be able to borrow against your equity to pay the loan back. But if you can’t find a way to pay the loan off, your problems will be compounded by a big tax bill.
HOW MUCH OF MY TOTAL 401(K) ACCOUNT CAN I BORROW?
If your employer allows you to borrow from your 401(k), the maximum loan is half of the value of the account. Federal law will limit the amount to the lesser of $50,000 or 50% of the vested balance. Say you have $80,000 in your 401(k) plan. You could borrow up to 50% of the value of the account, which means you could get up to $40,000. However, if your 401(k) plan is worth $100,000 or more, federal law would prohibit you from borrowing more than $50,000 -- even if your account is worth millions. However, some plans impose even lower limits; the plan document may limit the maximum amount for loans and restrict the availability of loans.
WHAT WILL A LOAN FROM MY 401(K) PLAN COST ME?
When you borrow money from a 401(k), the Internal Revenue Service requires that you charge yourself a "market rate" for the loan. The market rate is considered the rate you’d pay if you got the loan from a bank instead. Usually, the market rate is one or two percentage points above the prime rate. So, if the prime rate is 7%, the rate on your 401(k) loan should be 8% or 9%. Many 401(k) plans also charge loan-processing and administrative fees that can add up to hundreds of dollars. But borrowing from your 401(k) is still much better than borrowing from a bank, because you’re paying the interest to yourself. Essentially, the loan becomes a fixed-rate investment in your own 401(k). When you retire, you’ll get all the money back, but the interest you pay on the loan with after-tax dollars will be taxed a second time when you withdraw it.
HOW SOON DO I HAVE TO REPAY A LOAN FROM MY 401(K)?
If your 401(k) permits borrowing, you will probably have to repay the loan through a series of regular payments. More than likely, your employer will automatically deduct the payments from your regular paycheck -- much as it automatically deducts your 401(k) contributions. According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), "The entire amount you borrowed must be repaid within five years with one exception: if you took a loan to buy a principal residence, the law says that it must be repaid in a ’reasonable’ period of time. Most plans give you up to 25 years to pay it back, but the term of the loan can’t extend beyond your normal retirement date, as defined by the plan." The catch is that if you leave your employer, whether voluntarily or involuntarily, you will probably have to pay all the money back in a lump sum within 60 days. That could put you in a tough spot, especially if you have spent all the money.
IF MY MONEY IS DIVIDED AMONG SEVERAL DIFFERENT FUNDS WITHIN THE 401(K) PLAN, WHICH ONE SHOULD I BORROW FROM?
Most 401(k) investors have their retirement money spread out over two, three or more investments their plan offers. For example, you might have half your money in a stock mutual fund, one-quarter of it in a guaranteed-investment contract that pays a fixed rate of return and the remainder in your companies own stock. If you borrow from your 401(k), the company may have rules that dictate which fund you must borrow from. Other plans simply take a proportionate amount from each investment in the account. Still others let you decide which fund you want to tap for the loan. According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), "From your 401(k) account’s perspective, your loan is a fixed-rate investment. To maintain your current mix of investments, you should borrow the money from a fixed-rate fund. Let’s say that you have $45,000 in your account and it’s currently divided equally between three funds: $15,000 in a diversified stock fund, $15,000 in a corporate bond fund and $15,000 in a guaranteed investment contract (GIC) fund. Of those three investments, only the GIC fund pays a fixed rate of return. So if you want to stay with that investment mix, you’ll reduce the allocation to that fund by the amount of the loan."
IS THE INTEREST I PAY ON THE 401(K) LOAN TAX-DEDUCTIBLE IF I USE THE MONEY TO BUY A HOUSE?
If you are planning to borrow from your 401(k) and use the proceeds to buy a home, it’s important to remember that the interest you pay on the loan from the account will not be tax-deductible, unless the house itself is used as collateral for the loan. When you borrow from your 401(k), the collateral is actually the remaining balance in your account, unless you specify in the loan agreement that the has shall be collateral for the loan. If not, you can’t deduct the interest you pay back to your 401(k) even if you use the loan proceeds to buy a home. This tax rule might seem unfair, but it actually makes perfect sense. By its very nature, a 401(k) is a tax-deferred investment: Allowing you to deduct interest on loans from the account would amount to giving you one tax break on top of another. Before you borrow from your 401(k), check with a few local lenders to make sure they will accept 401(k) loans as down payments. Many banks won’t make loans to buyers who have had to borrow their down payment, in part because they don’t want another creditor coming forward with a claim on the home. But some lenders make an exception for 401(k) loans because the money comes from your own savings.
CAN I USE MY 401(K) ACCOUNT AS COLLATERAL FOR A BANK LOAN?
No. You can’t legally pledge retirement plan assets as collateral, and the vast majority of bankers wouldn’t accept it anyway. Why? Because the money you have socked away in a 401(k) is be protected from creditors under federal law. Lenders understandably don’t want to make a loan based on collateral that they can’t collect.
HOW DO I QUALIFY FOR A HARDSHIP WITHDRAWAL FROM MY 401(K)?
Your eligibility for a hardship withdrawal from your 401(k) plan depends on the plan’s rules. According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), "You’ll probably have to provide relevant information showing your financial need -- an eviction notice, a contract to buy a primary residence, unreimbursed medical bills or a college tuition bill. Some plans require that you sign a form stating that you have no other source of money to deal with this emergency. Other companies instead consider that you’ve exhausted all other resources if:
1) you have taken all permissible loans from the plan;
2) you make no plan contributions for the next 12 months;
3) you make only limited contributions in the year after that; and
4) you withdraw only as much as you need to cover the immediate emergency."
Remember: Even if you qualify for a hardship withdrawal from your 401(k), you will still have to pay a 10% penalty in addition to the normal federal, state and local income taxes.
IS THERE A LIMIT ON HOW MUCH I CAN TAKE IN A HARDSHIP WITHDRAWAL FROM MY 401(K)?
If you qualify for a hardship withdrawal from your 401(k), the amount you can take out is usually limited to your own pre-tax contributions that have accumulated in the plan. Within that limit, you will be able to take out whatever amount is necessary to satisfy your financial emergency and cover the taxes that will be owed on the withdrawal. Period. You cannot withdraw a few thousand dollars extra to take a vacation or pay other non-emergency expenses.
ARE MY EMPLOYER'S CONTRIBUTIONS TO A 401(K) AVAILABLE TO ME IF I MAKE A HARDSHIP WITHDRAWAL, OR CAN I ONLY TAKE OUT MY OWN CONTRIBUTIONS?
If you are eligible to make a hardship withdrawal from your 401(k) retirement plan, your ability to tap your employer’s contributions to the plan in addition to your own may be limited. For plan years starting after December 31, 1988, a hardship distribution is limited to your own contributions. Your employer’s contributions are usually subject to other rules for hardship withdrawals. Ask your company’s personnel, human resources or benefits office to find out what rules apply to your plan.
WHAT TAXES WILL I OWE ON A HARDSHIP WITHDRAWAL FROM MY 401(K)?
If you qualify for a hardship withdrawal from your 401(k), you’ll owe ordinary income taxes on every nickel of the money you take out except for any money you might have contributed to the plan on an after-tax basis. On top of those taxes, you will also likely get slapped with a 10% early withdrawal penalty. Simply meeting the hardship requirements is not enough to avoid the 10% fine. To illustrate, say you are under age 59 1/2 and you withdraw $30,000 from your account for a qualifying hardship situation, such as buying a house or avoiding foreclosure. If your combined federal, state, and local tax rate is 40%, then $12,000 of your withdrawal will be used to pay income taxes. Throw in a 10% early withdrawal penalty of $3,000, and the figure rises to 50%. In other words, you’ll get to keep only $15,000 of the $30,000 you pull out. In short, make an early withdrawal from your 401(k) only if you have nowhere else to get the money.
WHAT IS MEANT BY A PREMATURE DISTRIBUTION FROM A RETIREMENT PLAN?
When you withdraw money from a retirement plan earlier than the age required by the Internal Revenue Service (59 1/2), the money you receive is known as a premature distribution and is subject to a 10% penalty unless you qualify for an exception to the penalty.
IF I WITHDRAW FUNDS FROM MY 401(K) EARLY, WILL I HAVE TO PAY A PENALTY TAX?
As with most other types of retirement plans, the Internal Revenue Service levies a penalty on people who withdraw money from their 401(k) plan before they reach a certain age. As a general rule, you’ll be hit with a 10% penalty on any withdrawals you make from a 401(k) before you have reached age 59 1/2. You will also have to pay taxes on the money you take out, just as you would if you waited until after you turned 59 1/2. In rare cases, the IRS will waive the 10% penalty on early withdrawals. For example, you can avoid the penalty if you are disabled, or if you need money for medical expenses that are greater than 7.5% of your adjusted gross income. You can also avoid the penalty if you are at least 55 years old when you separate from service.
WHY DO I HAVE TO PAY AN EARLY-WITHDRAWAL PENALTY FOR WITHDRAWING MY OWN 401(K) MONEY?
Many people feel it’s unfair for the government to levy a 10% penalty when they make an early withdrawal for their 401(k) plan or Individual Retirement Account (IRA). After all, they point out, it’s their money -- not the government’s. Such feelings are understandable. But it’s important to remember that 401(k)s, IRAs and similar plans were created to reward you with certain tax breaks that would encourage you to save for retirement. The plans were never intended to be vehicles to save for pre-retirement expenses. By imposing a stiff penalty on early withdrawals, the government hopes to keep you from tapping the money early so you’ll have more left over for your golden years.
HOW IS THE 10% PENALTY ON EARLY WITHDRAWALS FROM A 401(K) CALCULATED?
The 10% penalty on early withdrawals from a 401(k) plan applies to the entire taxable amount that’s distributed to you before you reach age 59 1/2 if you are still employed unless you meet one of the exceptions to the penalty.
HOW CAN I WITHDRAW MONEY FROM MY 401(K)EARLY WITHOUT PENALTY?
By law, you may not withdraw funds attributable to elective salary reduction contributions until you reach age 59 1/2, are separated from service, become totally disabled, or show financial hardship. Lump-sum withdrawals are also allowed if the plan terminates. If hardship withdrawals are allowed before age 59 1/2, you are generally subject to the 10% penalty for premature withdrawals. IRS regulations restrict hardship withdrawals. The IRS requires you to show an immediate and heavy financial need that cannot be met with other resources. Financial need includes the following expenses: purchase of a principal residence, tuition and related expenses, medical expenses, preventing your eviction or mortgage foreclosure and paying funeral expenses for a family member.
HOW DOES THE "SAME DESK" RULE AFFECT RETIREMENT PLAN DISTRIBUTIONS?
The "same desk" rule pertains to the situation where a company, a company division, or other operation is sold to another company and the employees are transferred to the buyer company. The IRS has ruled that such a change in employers does not constitute a separation from service on the part of the employees, since they continue to work in the same "business" at the "same desk”. Therefore there can be no distributions from the qualified retirement plan(s) of the seller. Note: The same desk rule is repealed effective January 1, 2002.
WHAT HAPPENS IF I DON'T START TAKING MONEY OUT OF MY RETIREMENT ACCOUNT AT AGE 70 1/2?
If you don’t start taking money out of your retirement account by the time you reach age 70 1/2, you’ll be hit with some extremely serious tax penalties. The Internal Revenue Service will slap you with a 50 percent excise tax on the difference between what you withdrew (if anything) from the account and what you should have withdrawn. On top of that, you’ll owe additional excise tax for each year you fail to make the required distribution. For example, if you should have taken $9,000 from the account but didn’t take out a cent, you would owe the IRS $4,500 for that year’s requirement. If you fail to make the required distribution for the following year, assume its $8,000, you will own another $4,000 for that year. And on top of all that, you’ll owe regular income taxes on each withdrawal as well!
HOW LONG AFTER I RETIRE WILL IT TAKE ME TO GET MY 401(K) MONEY?
After you retire, there’s no legal requirement that says you must receive a check from your 401(k) plan by a specified date. The government merely requires that the plan pay you within 60 days after the end of the plan year during which you reach retirement age. This requirement gives 401(k) plan administrators lots of flexibility when deciding when to cut the checks for retirees. Any procedures your employer establishes within the guideline are OK, as long as they are uniform and treat all of the company’s workers equally.
HOW CAN TEN-YEAR FORWARD AVERAGING MITIGATE MY TAX LIABILITY ON A LUMO-SUM SETTLEMENT WITHDRAWAL FROM A RETIREMENT PLAN?
If you take a lump-sum withdrawal from a retirement plan and don’t roll it over into another qualified account, you will owe taxes on the entire lump sum. Fortunately, if you were born before 1936, you can reduce the tax bite by using an accounting method known as "ten-year forward averaging”.
When you use ten-year forward averaging, you calculate the tax on one-tenth of the amount, using the 1986 tax table, and then multiply the tax by ten. For example, if the lump sum is $250,000, dividing by ten gives us $25,000. The 1986 tax table calculates the tax to be $5,077. Multiplying by ten we get $50,770 for the total tax on the distribution.
When using this method, you can’t take any deductions or exemptions and you must pay taxes at the single taxpayer rate. Nonetheless, the tax you will owe by using forward averaging will likely be much less than without it.
You can use forward-averaging only once in your lifetime. To be eligible, you must have been in the plan for at least five years. In addition, you must stop working for the employer who pays the lump sum and take all the retirement plan account balances in lump sum.
Lump-sum pension payments involve some extremely important tax issues, and forward averaging is only one of them. Anytime you are considering taking a lump-sum payment, talk to a tax and financial planning specialist first.
WHEN DID FIVE-YEAR FORWARD AVARAGING CEASE TO BE AVAILABLE?
Five-year forward averaging was not available after December 31, 1999.
CAN I TAKE A LUMP-SUM DISTRIBUTION FROM MY 401(K) PLAN AND USE FIVE-YEAR AVERAGING, EVEN THOUGH I AM ONLY 57?
Five-year averaging has been repealed and can no longer be used.
I AM RETIRED AND WHEN I GOT MY 401(K) MONEY, THE AMOUNT WAS BASED ON THE VALUE OF MY ACCOUNT AS OF TWO MONTHS EARLIER. wHY DIDN'T I RECEIVE ANY INTEREST FOR THOSE LAST TWO MONTHS?
When you retire and get the proceeds from a 401(k), the size of the check will be based on the most recent valuation of your account. If the most recent valuation was made two months ago, you’ll get the amount that your account was worth two months ago. Don’t worry. You’re not being cheated. According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), "Theoretically, your withdrawal and the valuation date match perfectly. But in real life, there’s an information lag. If your withdrawal is on December 31, for example, the plan’s record keeper may not know the exact value of your account on December 31 until several weeks later. The more frequently a 401(k) plan values accounts, the shorter the time lag. Theoretically, there is no time lag in a plan that is valued daily. In reality, participants don’t always receive a distribution check that includes interest up to the date the check was cut. So what happens to the lost interest? It’s credited back to the plan and shared by all the participants. In other words, you have benefited from this time lag in the past when other people left the plan. If you’ve been in the plan for a long time and many other people have left, you may even be ahead of the game."
CAN I TAKE MY MONEY OUT OF MY 401(K) PLAN IF I STOP CONTRIBUTING TO IT?
According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), "The fact that you’re no longer contributing to the plan doesn’t mean you can start taking withdrawals. There are only three ways to take money out of your 401(k) account: distributions, early withdrawals, and loans. You can take distributions after age 59 1/2 when you leave your job; you can take early withdrawals only for reasons specifically approved by the Internal Revenue Service and the plan. Whether or not you can take a an early distribution or a plan loan depends on your plan’s rules."
| Current Pension & IRA Changes
Good News on Retirement Plan Rules---No Matter Who You Are…
The many retirement-related goodies in the Economic Growth and Tax Relief Reconciliation Act (“EGTRRA”) came as a surprise to many people, and it reminds us of the actor who was an “overnight sensation”----after 15 years on the stage…although startling to some, many of the changes have been proposed for many years, most recently in the Portman-Cardin proposals.
Some commentators have grumbled that the many increased limits have barely put taxpayers even with inflation, but this is irrelevant—the changes are welcome and helpful to many, many people.
What did NOT change?
Income eligibility for deductible IRA’s income eligibility for Roth IRA
Income eligibility for conversion to Roth IRA inability to assign IRA benefits directly to charity
50% excise tax for failure to take Minimum Required Distributions.
What DID change?
•Increased IRA Contribution Limits •Catch-up IRA Contributions
•Increased Elective Deferrals •Catch-up Elective Deferrals
•Increased Defined Contributions Limits •Increased Defined Benefit Maximum
•Increased Covered Compensation •Inflation-Indexed Limits in Future
Starting in 2002, the annual IRA limit is $3,000, and this will increase over the following 6 years---to $5,000 in 2008. Thereafter, this will be adjusted for inflation. An additional “catch-up” contribution will be allowed for taxpayers 50 and older--$500 starting in 2002, increasing to $1,000 by 2006.
Increased IRA Contribution Limits ($$ in thousands)
Year 2002 2003 2004 2005 2006 2007 2008 2009 2010
Und 50 3 3 3 4 4 4 5 5 5
Age 50+ 3.5 3.5 3.5 4.5 5 5 5 5 5
The new law also permits IRA treatment for voluntary contributions to certain employer sponsored retirement plans (“Deemed IRAs”).
Increased Elective Deferrals
In 2002 the maximum deferral permitted under 401(k) plans as well as 403(b) tax-sheltered annuities and Salary Reduction SEPs and 457 Plans, will be $11,000, and this will be increased annually by $1,000 each year until 2006. The maximum will be indexed thereafter. There are “catch up” provisions here too. SIMPLE plan limits and catch-ups are different, but were also increased.
There have always been special limits for 403(b) plans and “457 Plans” (non-qualified plans for those employed by non-profit organizations and governments). Under the new law there are no more “exclusion allowances” and the same limits apply to deferrals under 457 as to 401(k) plans beginning next year.
However Section 457 plans have a special catch-up provision---in the three years prior to retirement, the applicable dollar limit is twice what it otherwise would be (in lieu of any other catch-up provision). In addition, the limit on 457 plans is over and above any 401(k) or 4403(b) plan. Currently the amounts going into those plans offset the amount that could otherwise be contributed to a 457 plans.
October 22, 2001
House Ways & Means Committee Approves Economic Stimulus Package
On October 12, in an atmosphere of haste and uncertainty, the House Ways and Means Committee approved an economic stimulus bill (H.R. 3090) by a party-line vote of 23-14. The bill seeks to give the economy an immediate $100 billion boost in tax relief for 2002. In addition, it provides new spending to supplement unemployment benefits and health care for displaced workers.
Key provisions of importance to NAIFA members would:
· Permit quicker withdrawal from IRA's by displaced workers for health insurance expenses without penalty;
· Extend the Archer medical savings accounts (MSAs) for an additional year through 2003;
· Allow for 30 percent bonus depreciation in the first year of certain qualified capital investments placed in service through 2005;
· Provide a temporary increase in expensing to $35,000 from 2002 to 2003;
· Provide $3 billion in block grants to states in order to assist in providing health care coverage for displaced workers, which could be used to supplement COBRA premiums;
· Provide for a permanent extension of the exemption under Subpart F for active financing overseas income.
The Bush administration signaled tepid support for the Ways & Means bill scheduled for full House action next week. The tax cuts in the bill exceeded the Administration's target goal. President Bush had called for tax relief and new expenditures totaling $60 billion to $75 billion for 2002, mostly devoted to tax cuts. Members of the Senate Finance Committee and staff have indicated to NAIFA that it could be two to three weeks before the Senate considers its version of the economic stimulus package. The Senate is expected to pass a package that is closer to what is supported by the Administration.
Anthrax Disrupts Capitol Hill
The discovery of anthrax within the halls of Congress brought nearly all congressional activity to a halt last week. On October 15, the office of Senate Majority Leader Tom Daschle (D-SD) received a letter containing anthrax. In the wake of this revelation, hundreds of Congressional staffers and visitors lined up to be tested for anthrax exposure. While dozens of Senate staff and Capitol police officers tested positive for exposure, no one on Capitol Hill has been infected with the disease.
In the days following this discovery, House and Senate leaders took different approaches to ensure the safety of lawmakers and staff in the face of this crisis. House Speaker Dennis Hastert (R-IL), in coordination with House Minority Leader Dick Gephardt (D-MO), announced that the House would adjourn for a week - October 17 through October 23. However, Senate Majority Leader Daschle, in conjunction with Senate Minority Leader Trent Lott (R-MS), decided the Senate would remain in session with votes through October 18. Nevertheless, despite the differing floor schedules, both House and Senate leaders ordered the unprecedented immediate closure of all congressional office buildings until October 23 to allow for further testing.
As a result, consideration of several issues of importance to NAIFA were postponed. These include a House Financial Services subcommittee hearing scheduled for October 18 on the availability of terrorism reinsurance following the attacks of September 11, 2001. In addition, deliberation of the economic stimulus package (H.R. 3090) by the full House has been rescheduled for October 24.
NAIFA/AALU Split Dollar Efforts Continue
As has been previously reported, the Internal Revenue Service (IRS) issued Notice 2001-10 seeking to change the way split dollar life insurance arrangements are taxed. NAIFA believes this Notice, if allowed to go into effect, would curtail the future use of split dollar. Moreover, it would raise troubling uncertainty among hundreds of thousands of small and large businesses and their employees with respect to existing plans.
Finding an alternative split dollar tax regime acceptable to agents remains a high priority for NAIFA and AALU. To date, NAIFA and AALU have held numerous meetings with senior officials at the Treasury Department and IRS. Recently, it appeared an approach under which split dollar would be taxed through section 7872 rules - characterizing split dollar arrangements as interest free loans - was gaining ground within the Administration, particularly within the IRS. If implemented, this would be a dramatic departure from the way that split dollar arrangements have been taxed for over 30 years.
In response, NAIFA and AALU submitted joint comments on September 17, 2001, emphasizing the need to grandfather existing split dollar arrangements, as well as suggesting an alternative approach for new arrangements. Taxpayers could elect to either be taxed under section 7872 or under a regime in which employees would be taxed -- in the event of a pre-death withdrawal -- on the entire equity in a life insurance contract accumulated during the existence of a split dollar arrangement. Treasury officials are giving careful attention to this new approach and remain committed to providing final split dollar guidance in the very near future. It is hoped that a final rule will be published by year's end.
Financial Services Anti-Fraud Bill Cleared for House Floor Action
NAIFA-backed legislation to fight financial fraud by creating a "functional" anti-fraud network is now set to move to the full House for consideration. The Financial Services Antifraud Network Act of 2001 (H.R. 1408) - sponsored by Financial Services Committee Chairman Mike Oxley (R-OH) and Representative Mike Rogers (R-MI) - was approved by the House Judiciary Committee on October 10, 2001. This legislation would enable the sharing of information among more than 250 state, local, and federal agencies to assist regulators and law enforcement officials in pinning down elusive perpetrators of fraud. H.R. 1408 would benefit NAIFA members by streamlining background checks for all insurance and securities licensing. It would also accelerate the passage of reciprocity laws in the states pursuant to the NARAB provisions in the Gramm-Leach-Bliley Act. As previously reported in the Political Frontline, H.R. 1408 passed the Financial Services Committee by an overwhelming bipartisan vote of 20-1 on June 13. The bill is now ready for full House consideration.
NAIFA Political Frontline is published by the NAIFA Government Affairs Department for use by NAIFA legislative contacts and state and local leaders. For more information, contact:
David A. Winston
Morris R. Goff
Danielle F. Waterfield
Lucy B. Coburn
Mary Ann Plumb
July 18, 2002
IRS OFFERS GUST “NON-AMENDERS” OPPORTUNITY TO CORRECT QUALIFIED PLANS
Employers had until February 28, 2002 either to adopt a prototype plan or volume submitter plan of a sponsor or practioner that had timely filed its plan with IRS for GUST or to certify jointly with the sponsor or practioner an intent to adopt the sponsor’s or practioner’s GUST approved plan Otherwise, the employer would have needed, by the date, to adopt a GUST restated plan document.
The IRS considers plans maintained by employer that did not meet this deadline to be GUST NON-AMENDERS. In Revenue Procedure 2002-35, the IRS offers employers an opportunity to correct this non-amender qualification defect by:
1-Amending the plan for GUST
2- Filing for a letter of determination by September 3, 2002 via form 5300 or 5307, including the phrase “REV. PROC 2002-35” in bold on the top of the form; and
3-Paying a fee in addition to the standard filing fee based upon the following schedule:
Numbers of participants Fee
(Per Form 5300 of form 5307)
1001 or more-$10,000
Please note that if you adopted or certified your intent to adopt a HARTFORD PROTOTYPE plan document on or before February 28, 2002, you are eligible for the extended remedial amendment period and will not be considered a non-amender. The Hartford will provide you with a GUST document for your adoption later this year.
If the Hartford provided you with a plan document and you would like assistance with this non-amender program please contact your Hartford Plan Manager.
CONGRESS CONSIDERS CHANGES TO RETIREMENT PLAN RULES FOLLOWING ENRON
The House of Representatives has passed the Pension Security Act of 2002 in response to issues raised in the bankruptcy of Enron. The Senate has its own “Enron” bills. While it is too soon to tell what form final legislation, if any, will take, here is a brief summary of the key provisions included in the House passed bill:
1-Participants must receive a thirty-day (30) advance notice of transaction suspension periods or “blackouts”;
2-Participants must receive quarterly benefit statements that include:
A-Total accrued benefit as well as the vested benefit;
B-The value of investments allocated to a participant’s account;
C-Any investment transfer limitation or restriction.
D-An explanation of the importance of diversification. The Department of Labor is directed to provide guidance and model notices.
3-A ban on sales of stock by key executives during the transaction suspension periods;
4-Clarification of employer fiduciary liability during transaction suspension period;
5-New diversification rights for participant including the ability to diversify out of employer stock: immediately for employee deferrals, and after three years for employer contribution. Plans may provide not greater than either a three (3) year-of-service cliff schedule or a 3 year rolling period based upon the age of contribution;
6-Allows for pre-tax salary reductions to pay for retirement planning services; and
7-Includes changes to rules that currently prohibit certain persons from providing investment advice.
8-The bill also includes pension reforms excluded from EGTRRA for procedural reasons (including flexibility in the nondiscrimination, coverage and separate line of business rules and reform of the suspension-of-benefits notice regime) and additional short-term relief for 2001 from the pension effects of 30-year Treasury bond rates.
IRA Minimum Distribution Changes 2002
July 18, 2002
IRS ISSUES FINAL MINIMUM DISTRIBUTION REGULATIONS
The IRS has finalized the minimum required distribution regulations proposed last year. These final regulations include the following changes:
1-The mortality tables used to determine life expectancy have been updated to reflect more current life expectancies.
2-Final determination of a decedent’s beneficiaries is now made by September 30th (previously December 31st) of the calendar year following the year of death.
Beneficiaries that disclaim or receive their benefit prior to this date will not be considered beneficiaries under the regulations for remaining benefit
3-In calculating a minimum required distribution, a beneficiary’s age is taken into account if the beneficiary is the individual’s spouse who is 10 or more years younger than the individual. For the purpose of this rule, marital status is determined as of January 1st of each calendar year.
4-Contributions and distributions made after December 31st of a calendar year may be disregarded for purposes of determining the December 31st balance used to calculate the minimum required distribution for the following year. However, certain add-back rules are retained for rollovers and recharacterized IRA conversions that are not in any account as of December 31 of a year.
5-The balance at the end of the first distribution calendar year is no longer reduced by a distribution made by April 1 of the following next calendar year to determine that calendar year’s minimum amount, e. g., the balance on December 31, 2002 is not reduced by the MRD payment made by April 1, 2002 when determining the MRD for 2003
6-If IRA benefits are transferred, the transferor IRA is not required to retain the minimum required distribution and may now transfer the entire balance to the new IRA.
The final regulations apply for determining minimum distribution required for the 2003 and later calendars years. These regulations may be used for the 2002 calendar year, as may the 2001 proposed regulations or the 1987 proposed regulations.
In Revenue Procedure 2002-29, the IRS required qualified plans to be amended by the close of the 2003 plan year to reflect the final regulations. The Revenue Procedure includes a model amendment that sponsors of qualified plans may use for this purpose.
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