Archive for August, 2015|Monthly archive page

Back to Basics Part XXI – Form 5329 – Penalties on Retirement Accounts

Originally published in the Cedar Street Times

August 21, 2015

The official name for Form 5329 is “Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts.”  In other words, “penalties on incorrect contributions to or withdrawals out of retirement accounts, education accounts, and medical accounts.”

Most people are familiar with the fact that retirement accounts such as 401(k)s, 457 plans, IRAs, Roth IRAs, SIMPLE IRAs, SEP IRAs, etc. have limits on the amount of money you can contribute each year.  They also limit your ability to withdraw money from those accounts until you are generally 59.5 years old, or meet one of a handful of limited exceptions.

Most people are also familiar with fact that you MUST begin taking distributions by the time you reach 70.5 years old (with a few exceptions such as for Roth IRAs, certain employees that have not yet retired from their job, or non-spouse inherited IRAs).  You can delay the distribution in the year you turn 70.5 until April 1st of the following year, but if you do that, then you have to take two distributions that year.  IRS instructions are often very poorly worded on this particular matter, and often people misunderstand this important point.

Education savings accounts such as 529 plans or Coverdell ESAs as well as tax favored medical spending accounts such as HSAs and Archer MSAs also have annual contribution limits.  In addition, you must use the funds for qualified education or medical expenses, respectively.

If you fail to follow the rules, either by accident or out of necessity, you will generally incur penalties, which are calculated using Form 5329 for most of these infractions.

So, how much are the penalties?  If you over-contribute to a retirement plan, education account, or medical spending account there is a six percent penalty on excess contributions if you do not withdraw the excess contribution (plus any related investment earnings)  within six months of the original due date of the return, excluding extensions (so by October 15 for almost everybody).  Any earnings generated by the over-contribution will be treated as distributions of cash to you in the tax year the correcting withdrawal actually occurs.  The rules governing distributions (discussed later) will apply and you may be subject to penalties on that portion.    The custodian of the account will calculate the related earnings that need to be pulled out of the account when you inform them of the need to withdraw funds.

If you over-contribute for multiple years in a row before realizing it, the penalty compounds.  So you would file a Form 5329 for each of the past years (no 1040X needed) and pay six percent on the excess contributions for the year of the 5329 you are filing, plus any prior excess contributions that still had not been taken out.  In other words, you pay six percent every year on the excess contribution until you take it out.  Interest would also be assessed on top of the penalties.

If you fail to take a Required Minimum Distribution (RMD), the penalty is 50 percent of the amount that was supposed to be taken out, but was not.  Unlike the six percent over-contribution penalty that applies every year until you take the funds out, the 50 percent penalty only applies once.  But you would need to withdraw the funds and file a 5329 for each past year you failed to take an RMD.  Interest would also be assessed on top of the penalties.  Fortunately, the IRS has been pretty lenient with the steep 50 percent penalty, and you can often get them to waive the penalty for reasonable cause once you withdraw the money.

Early distributions for all retirement accounts that do not qualify for an exception are subject to a ten percent penalty, (plus inclusion as taxable income for the portion related to original contributions for which you received a tax deduction as well as on any earnings generated while in the account).  SIMPLE IRAs have a special rule that increases the penalty to 25 percent if the date of your first contribution to the SIMPLE IRA was less than two years ago.

Distributions from education savings accounts for nonqualified purposes are subject to a ten percent penalty.

Distributions from medical spending accounts that are not used for qualified purposes are generally subject to a 20 percent penalty.  These 20 percent penalties, however, are calculated on different forms (8889 for HSAs and 8853 for MSAs).  With HSAs when you reach 65, you can use the money for whatever purpose you want, without penalty.  You can also rollover an MSA into an HSA.

Regarding the Form 5329 itself, the first two parts deal with distribution penalties for retirement accounts and education accounts (health account distribution penalties are calculated on other forms).  The third through seventh parts deal with excess contribution penalties for each different type of account.  The final section, part VIII, deals with penalties on RMDs not distributed.

If you have questions about other schedules or forms in your tax returns, prior articles in our Back to Basics series on personal tax returns are republished on my website at www.tlongcpa.com/blog .

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

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Back to Basics – Part XX – Form 4952 – Investment Interest Expense

Originally published in the Cedar Street Times

August 7, 2015

Today is my brother, Justin’s, birthday, and I know just what to get him.  We were both avid baseball card collectors from the time we were seven and eight years old on up through our middle school years.  Once, we even put on a “Kids Baseball Card Show” to buy, sell, and trade cards.  We went around advertising the show with flyers on telephone polls all over the local neighborhoods, and secured the neighborhood pool clubhouse facility to host our show.  It was a great success!

At the conclusion of my baseball card collecting career I had amassed over 10,000 cards with albums full of rookie cards and great players at the time.  One of my most prized cards was a 1954 Topps Willie Mays.  I remember wondering, how much money have I invested in all these cards over the years?  Would I be able to retire after selling the cards years later?  The Beckett Baseball Card Monthly price guide certainly made me think so based on the prices they listed and the rapid rates of increase.  Old cards from the 1940s – 1960s were worth hundreds or even thousands of dollars each.

A few years after my interest in card collecting waned, a mass of new brands flooded the markets.  That combined with other problems in baseball at the time sent the card market into an unrecoverable nose dive.  Over 20 years later, most cards are still worth a tiny fraction of their peak.

Although my desire was primarily the personal fun of collecting, there were many adult investors that had serious money in cards.  As with any investment bubble, I am sure there were collectors mortgaging their homes, running up credit card debt and borrowing from family in order to get a piece of the action.

As I reflect on that now, I see there would have been an opportunity for these people to take advantage of today’s topic – Form 4952 – Investment Interest Expense Deduction.   If you have questions about other schedules or forms in your tax returns, prior articles in our Back to Basics series on personal tax returns are republished on my website at www.tlongcpa.com/blog .

Investment interest expense is reported on Schedule A as an itemized deduction and is essentially interest paid on debt used to buy property that produces or hopefully will produce income at some point.  It doesn’t include interest expense incurred in your trade or business, or for passive activities like most rental properties.  These types of interest get reported elsewhere.  So, borrowing money to buy investments such as stocks, bonds, or annuities would qualify.  Many financial companies offer margin loans.  The interest on these loans would certainly qualify as investment interest expense if the proceeds were used to buy more stocks and bonds.  Borrowing money to buy the right to royalty income or to buy property held for investment gain, such as vacant land, art, or even baseball cards would also qualify, among other things.

Due to passive activity rules which limit or even eliminate current deductions on passive rental activities such as a home you rent out, many people would like to be able to deduct the interest as investment interest instead.  However, interest on passive activities is specifically excluded from being classified as investment interest expense.  The interest on vacant land can usually escape this clause, even if small amounts of rent are collected since the rent is incidental to the paramount investment purpose of appreciation.  To be considered incidental, the principal purpose must be to realize gain from appreciation AND the gross rents received for the year must be less than two percent of the lesser of the property’s unadjusted basis or its fair market value.

The rub with investment interest expense is that it is only deductible to the extent that you have investment income!  If you have no investment income, you can’t deduct the expense, and it gets suspended until a year you actually do have investment income.  So what qualifies as investment income?  Well, all of the things we just discussed for which you borrowed  money and can deduct as investment interest expense – so interest, dividends, gains from property held for investment, etc.  Prior to being applied against investment interest expense, the investment income figure is reduced by other investment expenses that you may have reported on Schedule A – such as investment advisory fees, safe deposit boxes, investment subscriptions, etc.

By default, your net capital gains (meaning net long-term capital gains in excess of net short-term capital losses) as well as qualified dividends are not included in investment income.  This is done because both of these already get taxed at favorable lower capital gains rates, so the thinking is, “Why would you want to waste a deduction to offset income that is already getting a lower capital gains rate, when you could instead use it to offset ordinary income taxed at higher rates ?”  The answer is that sometimes you may not be able to ever foresee having much ordinary investment income taxable at higher rates.  And instead of just suspending the deduction and getting n0 current tax benefit, you elect to include your net capital gains and qualified dividends as investment income and use the deduction to help wipe that income out, thus saving you current taxes.

The Form 4952 itself is a rather simple form – only a half page in length.  Part I is a summary of the gross investment interest expense including any current interest and past interest that was carried over.  Part II helps you calculate the net investment income  from interest dividends, gains, capital gains, less investment expenses from Schedule A.  Part III compares parts I and II and calculates the investment interest expense that will be currently deductible, as well as the part that is being suspended to the future if there is not enough investment income to absorb the expenses.

As for the card collecting Justin and I did, I sure am glad we didn’t go into debt buying baseball cards and having to file 4952s! Now about that gift – how about a box of wax packs or a factory sealed set – I know just where to get them…

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.