Archive for the ‘59.5’ Tag

Back to Basics Part XXVI – Form 8606 – Nondeductible IRAs

Originally published in the Cedar Street Times

October 30, 2015

If you have traditional or Roth IRAs, you owe it to yourself to understand what is meant by having “basis in your IRA.”  This is especially important for people that have switched tax preparers over the years or prepared returns themselves, as they may not have transferred or tracked the amounts properly from year-to-year, or preparer-to-preparer.  Failure to understand this concept could result in oversights that cost you thousands or tens of thousands of dollars in tax when you start withdrawing and using the money from those accounts.

Having basis in your IRA means that you have made a contribution to your IRA at some point over the years for which you did not receive a tax deduction when you made the contribution.  Since you did not get a tax deduction when you contributed the money, you should not have to pay tax when you withdraw the money.  Roth contributions, by nature, are those for which you receive no tax deduction when you put the money in, so all contributions create basis.  With traditional IRAs, you create basis when contributing if your income is too high and you are therefore disallowed from taking the tax deduction.  Having high income would not prohibit you from making the contribution to the account, but you would just not be allowed to take the tax deduction on the tax returns.

If you are unfamiliar with the related calculations and forms and do not review them carefully or discuss them with your return preparer (or just plain have no interest in doing so!), you could easily assume you are getting a deduction when you are not.  Financial advisors generally have no idea if you have basis in your IRAs because they do not typically obtain copies of your tax returns and verify the deductions each year – it is just not part of their job description.  Basis to them generally means, what did you pay for the stock, bond, or mutual fund (a different concept of basis relevant for regular brokerage accounts).

And you do not really need a lot of income to be phased out from the deduction; it is not just a problem for the rich.  For tax year 2015, people filing single or head of household that also contributed to a retirement plan through their work during the year (even if a trivial amount) or were eligible for a pension, are allowed to take the deduction in full until they reach only $61,000 of income.  Then the deduction starts to phase out and is completely phased out once they have $71,000 of income.  For married couples filing jointly, the combined income (of both spouses) phase out range is only $98,000 to $118,000 when determining the deductibility of a contribution when both spouses participates in a work plan.  In situations where one spouse participates in a work plan, and the other does not, the phaseout range for the deductibility of the contribution by the spouse that does not participate in a work plan is a combined income (of both spouses) of $181,000 – $191,000.  If neither spouses participates in a work plan during the year, there is no income phase out for the deduction that year.

The other way people get basis in their IRAs is if they are inherited.  Since IRAs do not get a step-up in basis upon the death of a decedent, you receive the basis the decedent had in the IRA (if any).  So it becomes very important to make sure you know what this is and hopefully have some documentation supporting it.

When you start withdrawing money out of your IRAs, the tax preparer determines the tax free portion of your withdrawal by dividing your total historical IRA basis by the total year-end values of all your SEP, SIMPLE and Traditional IRAs and multiplying that ratio by your IRA withdrawal amount.  If you or your past preparer(s) did not carefully track and pass this basis number on over the years, then your current preparer will generally assume there is no basis.  As such you have just set yourself up to be double taxed – once when the money was put in and you did not get the deduction and now again, when you take the distributions.

Sadly, I regularly see new clients come through my doors whose basis is missing, drastically lower than it should be, or at least suspect of being low; the client often has no idea why it even matters, has not kept records, and has changed investment advisors and tax preparers several times.  It becomes time consuming and expensive to recreate, if it can be done at all, or is even noticed in the first place.  Unless a nondeductible contribution is made during the year, the Form 8606 used to track the nondeductible contributions, is not filed and therefore not part of the return you may hand to your new preparer.  That individual has to have the presence of mind to ask about these carryovers.  I see these problems mostly with do-it-yourself and discount tax service chains.  Those options certainly have a right place and serve a need, but as a consumer, you need to understand the more you have at stake, the more detrimental is a mistake.

As mentioned before, with Roth IRAs, basis is created with every contribution.  What becomes important to track with Roth IRAs is the total amount of direct contributions made to the Roth versus Roth conversions and rollovers from traditional IRAs.  If you take any distributions before reaching age 59 1/2, or are over 59 1/2 but have had a Roth IRA for less than five years, these amounts become critical in order to calculate if a portion of your distribution is taxable.  There is a specific ordering method for withdrawals which is favorable.  As with traditional IRAs, Roth IRA basis is often forgotten about over the years.

The Form 8606 – Nondeductible IRAs does several things: 1)  it is used to calculate and track nondeductible contributions to traditional IRAs, 2) it is used to calculate the taxability of SEP, SIMPLE, and traditional IRA distributions when there is basis, 3) it is used to calculate the tax on Roth conversions, and 4) it is used to calculate the any possible tax on Roth distributions.  Part I of the is used for items 1) and 2) above.  Part II of the form is used 3), above and part III of the form is used to calculate item 4).

The instructions to the form also explain how to handle recharacterizations – this is where you  contribute money to an IRA and then later for that same tax year decide you want to “recharacterize” it as a contribution to a Roth IRA instead, or vice versa – it’s like a “do-over.”  In addition the instructions explain how to handle excess contributions or a return of contributions made during the year.

Even though the taxing authorities have theoretically received all your 8606s since 1987 when nondeductible IRAs were first permitted, I have never seen them point out to a taxpayer that he had basis in the past that was overlooked.  In fact, in the instructions to the form the IRS puts the burden on the taxpayer to retain the supporting documents from inception of your IRAs until your retirement accounts are fully distributed (plus at least three years for audit possibilities).

They ask that for the purpose of proving your basis in IRAs, you keep the first page of all 1040s, keep all Form 8606s,  keep all Form 5498s from your custodian showing the amounts contributed each year, as well as all 1099-Rs showing any distributions.  Now you know why, when people ask me how long I suggest keeping tax returns, I say, “Forever.”  I actually have scans of every one of my personal tax returns dating back to when I was 16, mowing greens, raking bunkers, and driving tractors in the summer for a golf course.

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, Inc. 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.

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.