Archive for the ‘529 plan’ Tag

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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Losses on 401(k)s, IRAs, and 529 Plans

Originally published in the Pacific Grove Hometown Bulletin

September 21, 2011

 

The stock market seems like a pinball these days bumping off financial forecasts and being paddled by fiscal policy promises.  Unable to stomach some of the lows over the past few years more than a few people gave up the game and pulled money out of investments seeking the “security” of cash.   Others may have felt they had no choice, and cashed out their retirement savings to live on; some realizing they contributed more money to the plan than they got back!  Perhaps this happened to your retirement or education savings accounts, or will happen at some point.  But can you get a tax deduction for the loss in value you have incurred?

Well, it depends.  The chief determining factor is whether or not you have basis in your account.  Basis in a retirement or education account is created if you make contributions for which you receive no tax deduction when contributed.  For example – Roth-IRA contributions are not deductible when they are made, so the original contribution amount each year adds to your basis.  Education savings through section 529 plans and Coverdell Education Savings Accounts are the same way.   Many employers now offer a Roth contribution option within a 401(k) plan.  These contributions also create basis.

Traditional 401(k), SEP IRAs, SIMPLE IRAs, and traditional IRA contributions provide you with an immediate tax deduction, so they provide no basis.  However, if you were over a certain income threshold and tried to make traditional IRA contributions, you may have been allowed to contribute to the account, but prohibited from taking the deduction.  This is termed a “nondeductible IRA contribution;” it would have created basis; and it is tracked on Form 8606 in your tax returns.

If it is determined you do have basis, and for a strategic reason (or by necessity) you end up liquidating the IRA (all IRAs of the same type must be liquidated for this to work), and the value of the IRA is less than your basis in the account, then you are eligible to take the loss as a miscellaneous itemized deduction subject to the two percent threshold.  If you have more than one section 529 plan, the calculation is a little different.

Liquidating your retirement accounts to get a possible tax deduction is not typically an advisable course of action for many reasons, and you would want to discuss this with your tax professional and investment advisor first.  However, sometimes, this can be a strategic move.  More often, it will have been done out of perceived necessity or by accident.  If it happens, however, you certainly want to make your tax professional aware of your losses and take the deduction if you are eligible.

Two quick examples:  1) Melissa, a parent, starts a 529 account (only has one) and contributes $10,000 towards her child’s future education.  A year later, the investments have fallen, and the account is only worth $6,000.  Melissa could liquidate the account and take a $4,000 loss on Schedule A.  Then she could start a new 529 plan putting the $6,000 back into the plan.  Melissa has just harvested a $4,000 loss. 2) Joseph opened his first Roth-IRA three years ago and contributed $14,000 over the three years.  He received some bum advice from a friend and invested most of it in a penny stock mail-order belly-dancer business that went belly-up.  Joseph’s account is now only worth $1,000.  He could liquidate his Roth-IRA and take a $13,000 loss on Schedule A.

There may be other circumstances and specific rules that affect you, and you should consult with a qualified tax professional regarding your tax situation.  Prior articles are republished on my website at www.tlongcpa.com/blog.

IRS Circular 230 Notice: To the extent this article concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law.

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950. He can be reached at 831-333-1041.