Lesson 6.2: Qualified Accounts

Lesson 6.2: Qualified Accounts

• Most people invest to prepare for retirement.

• The government established special account types designed for retirement savings.

• These accounts qualify for tax-deferred savings for retirement and are called qualified accounts.

• Some require sponsorship by an employer, and others do not.

• All are designed to encourage people to save money for their retirement.

LO 6.e Recall contribution and distribution rules for traditional and Roth IRA accounts.

Individual Retirement Accounts (IRAs)

• Individual retirement accounts (IRAs) were created as a way of encouraging people to save for retirement.

• All employed individuals, regardless of whether they are covered by a qualified corporate retirement plan, may open and contribute to an IRA.

• IRAs are not considered qualified plans by the IRS. Qualified plans require an employer sponsor.

• However, IRA plans have many of the same rules and restrictions (particularly on distributions) as qualified plans.

• It is easier to think of them as a self-sponsored qualified plan, but technically they are not "qualified."

• Contributions may be made for a tax year as late as the first filing deadline in the following year, normally April 15.

• IRA plans allow the earnings in the account to grow tax deferred.

• Individuals making a contribution to an IRA can take a tax deduction for the amount of the contribution if certain criteria are met.

• If an individual is not actively participating in other qualified plans, such as an employer's 401(k) plan, the full amount of the contribution to the IRA is deductible.

• For an individual covered by another qualified plan, the portion deductible is determined by that person's income level.

• The tax deduction gradually phases out as the taxpayer's adjusted gross income (AGI) climbs.

• The exact income levels above which tax-deductible contributions are prohibited is not critical for testing purposes because these levels are, by law, raised each year.

• However, contributions may still be made because the earnings on these contributions are still tax deferred.

• There are two types of IRAs: traditional and Roth.

• Contributions to IRAs are made out of earned income (salary, wages, tips, etc.), rather than ordinary income (earned income plus dividends, interest, capital gains, etc.).

• There is no age limit for making IRA contributions.

• The concepts around contributions are tested, but the annual dollar limit is not. This number may change annually, so it is not included on the exam as a test point.

Traditional IRAs

Contributions

• An eligible individual may make contributions up to a maximum dollar amount (this amount can change from year to year as determined by the tax code), provided that the contribution does not exceed earned income for the year.

• The dollar cap is increased by a catch-up amount for individuals age 50 and older. Currently, the catch-up amount is $1,000$.

Investments

• Within an IRA, investments can be made in stocks, bonds, investment company securities, U.S.-minted gold and silver coins, and many other securities.

• There are, however, certain investments that are considered ineligible for use in an IRA.

• Collectibles (e.g., antiques, gems, rare coins, works of art, stamps) are not acceptable IRA investments.

• Life insurance contracts may not be purchased in an IRA.

• Although life insurance is not allowed within IRAs, annuities are allowed. However, FINRA has expressed concern about the suitability of a tax-favored product (like an annuity) within a tax-favored account.

• The following is a partial list of investments generally considered appropriate for IRAs:

  • Stocks

  • Bonds

  • Mutual funds

  • Unit investment trusts (UITs)

  • Government securities

  • U.S. government-issued gold and silver coins

• Certain investment practices are also considered inappropriate for IRAs or any other retirement plan:

  • Short sales of stock

  • Speculative option strategies

  • Tax-exempt municipal securities

  • Margin account trading

• However, covered call writing is permissible because it is a conservative way to generate investment income.

Rollover

• A rollover is when a customer withdraws and takes possession of IRA assets and then returns the assets back to an IRA (or other qualified account) within 60 calendar days.

• As long as the customer successfully completes the rollover, there are no tax implications for the withdrawal.

• A person is allowed to perform one rollover per rolling year, not per IRA and not per calendar year.

• Rollovers have a time limit of 60 calendar days, not two months.

Transfer

• A customer may transfer IRA assets from one IRA account to another IRA account. This is sometimes called a custodian-to-custodian transfer.

• There is no limit on the number of times a customer may do a transfer.

• If a customer moves money from an employer plan—such as a 401(k) to an IRA, this is sometimes called a direct rollover. Be careful; this activity is actually a transfer and not a rollover.

Withdrawals

• Distributions may begin without penalty after age 59½ and are generally added to ordinary income for tax purposes.

• Distributions before age 59½ are subject to a 10% penalty, as well as regular income tax.

• There are exceptions to the penalty (but not the taxes) if the distribution is due to:

  • death of the owner;

  • disability of the owner;

  • a first-time homebuyer's purchase of a principal residence (up to $10,000$);

  • education expenses for the taxpayer, spouse, child, or grandchild;

  • medical premiums for unemployed individuals; or

  • medical expenses in excess of defined AGI limits.

Required Minimum Distributions

• Called RMDs, these distributions are required beginning in the year the account owner turns 72 and annually by December 31 thereafter.

• The amount of the RMD is based on the account values as of the end of the previous year.

• If an investor has more than one account that has RMDs, the total of all the accounts is used to determine the amount.

• The account holder may choose which account (or accounts) to take the distribution from.

EXAMPLE

• A taxpayer is 75 years old and has three traditional IRAs: one at a bank, one at an insurance company, and the third at a BD. The total of the RMDs from the accounts is $20,000$. The taxpayer could take all $20,000$ from one of the accounts or could take from all three accounts in any combination desired as long as the total withdrawn is $20,000$.

• The first RMD may be delayed until April 1 of the year after the account holder turns 72. If the RMD is delayed this way, there will need to be a second distribution by December 31 of that same year.

• If an account holder fails to take the RMD by the required date, the difference between any amount that was withdrawn and the RMD will be subject to a 50% penalty.

Roth IRAs

• Introduced in 1997 as part of the Taxpayer Relief Act, the Roth IRA (named after its principal sponsor, Senator William Roth) is a variation on the traditional IRA.

Contributions

• Contribution rules for Roth IRAs are the same as for traditional IRAS. It might be better to say that the two types have a combined limit.

• The limit to IRA contributions is for all contributions to all IRAs in a year. A customer cannot contribute the maximum in both a traditional and a Roth IRA. As with traditional IRAs, the contribution must come from earned income.

EXAMPLE

• If the annual maximum contribution for IRAs is $6,000$, an investor could contribute $4,000$ to a traditional IRA and $2,000$ to a Roth IRA, for a total contribution to all IRAs of $6,000$.

• However, it is important to note that contributions to a Roth IRA are not deductible from current income for tax purposes.

• An additional limitation is that an investor's eligibility to contribute to a Roth IRA is phased out at higher income limits, eventually falling to zero. The income figure is not tested, but the concept may be.

• There is no age limit for contributions to a Roth IRA, though remember that contributions must be from earned income.

Investments

• The investment limitations for a Roth IRA are essentially the same as for a traditional IRA.

Rollover

• The rollover rules are the same for traditional and Roth IRAs. Remember that only one is allowed per rolling year per person. You cannot do a rollover in a traditional and another in a Roth.

Transfer

• The rules are the same as for traditional IRAs, but the transfer from a Roth account must be to a Roth account.

Withdrawals

• Distributions are where the Roth shines. Distributions of the cost basis are always tax free.

• Qualified distributions of income or gains in the account are also tax free.

• Nonqualified distributions of income or gains from the account are taxed as ordinary income and subject to a 10% penalty.

For a Distribution to Be Qualified

• For a distribution to be qualified, the account holder must have held a Roth IRA for at least five years before the distribution and the account holder must be age 59½ or older.

• Exceptions to the age limit are as follows:

  • Death (no penalty for the beneficiary)

  • Disability of the account owner

  • A first-time home purchase (up to $10,000$)

• There is no RMD rule for Roth IRAs. Account holders can leave the money in their accounts until they die.

Suitability

• Roth IRAs are considered a good way to save for retirement for those who are younger (more years of growth that may be tax free) and those in lower income tax brackets (for whom the current deduction has little value).

• Anyone who may not deduct a contribution to a traditional IRA would be better off putting money in a Roth IRA.

• Excess contributions to an IRA will result in a penalty. If a customer contributes more to an IRA than legally allowed, the customer will incur a 6% penalty based on the amount of the excess contribution every year until the excess amount is withdrawn.

LO 6.f Differentiate defined benefit and defined contribution plans.

• There are a number of qualified retirement savings plans that require sponsorship by an employer and so are only available to employees.

• They are broadly divided into two types: defined benefit plans and defined contribution plans.

Defined Benefit Plans (Traditional Pension Plans)

• As is evident in the name, a defined benefit plan defines within the plan document the benefit it will pay to retirees. It is often called a pension plan.

• The plan will determine a benefit that retirees receive based on years of service, age, and salary at the time of retirement. The plan will replace a portion of the preretirement income.

EXAMPLE

• Rick & Ty's Furniture Stores have a pension plan that pays a benefit calculated as follows.

• Employees may begin collecting as early as age 60.

• Employees will receive an income equal to 2% per year of service of the average salary of the last five years of service. The maximum benefit is 70%.

• Joe, a truck driver for the company, retires at age 65. Joe has worked for R&T since he was 25 years old-a total of 40 years. His average annual salary over the last five years was $60,000$.

• 40 years × 2% = 80% (this exceeds the maximum benefit, so his number will be 70%)

• 70% of $60,000$ is $42,000$ a year. He will receive monthly payments equal to $42,000$ a year for the rest of his life.

• Employers will use the services of an outside firm to determine how much the company needs to contribute to the plan to have sufficient assets to meet the defined benefit payments.

• Employers are required to make the payments as defined in the plan. This places the investment risk on the company, and many companies are moving away from these types of plans.

• Pension plans from private employers pay a fixed benefit. Once the employee begins to collect benefits, the amount will not change. The beneficiary takes on purchasing power risk. Pensions from government agencies often include a cost-of-living adjustment (COLA).

Defined Contribution Plans

• As the name indicates, defined contribution plans define the amount that may be contributed to the plan.

• Employees in these plans will normally have a balance that they may invest in a mix of securities as defined within the plan.

• At retirement or when changing employers, employees may take possession of the assets in their account, often transferring the assets to an IRA for distribution during retirement.

• Employers may be required to contribute to the plan depending on the type of plan and the specifics of a particular plan.

• Here is a partial list of defined contribution plans:

  • 401(k) plans

  • 403(b) plans

  • Profit-sharing plans

  • Money purchase plans

  • SIMPLE plans

• These, among other defined contribution plans, are more popular than pensions today because the investing risk is carried by the employee. The liability for the employer is much smaller.

• Also, the assets in these plans are transportable between employer plans, making them a better choice for a mobile workforce that changes employers several times over an active career.

Knowledge Check 6.2

Question 1

• In order to contribute to both a traditional IRA and a Roth IRA in the same year, a customer must have sufficient earned income.

Question 2

• Chris Perez began contributing $3,000$ a year to a Roth IRA account 10 years ago when he was 50 years old. The account value today has grown to $60,000$. He withdraws $5,000$ from the account. Perez will owe taxes on none of the withdrawal.