2014 Tax Changes: Goodbye IRA Charitable Rollovers

Editor's Note: The IRA Charitable Rollover was extended retroactively for the 2014 tax year on December 19, 2014, but has expired again as of January 1, 2015.

There are less than 2 months left in 2014, and if you are going to minimize your income tax liability you need to understand what changes were made in the tax law.

In this series, 2014 Tax Changes, I will give you an overview of the changes in the tax law that may affect you.  If you haven't already, feel free to read the first post in this series, Individual Mandate, discussing the Affordable Care Act's individual mandate that is now in effect, or the second post, Pease Limitation, discussing how your itemized deductions are being limited.

Goodbye IRA Charitable Rollovers

Through 2013, seniors who would otherwise have to take a "minimum required distribution" from their IRA and report that amount as income could instead rollover up to $100,000 to a charitable organization of their choice.

I am sure you are wondering why this was a tax benefit.  As you may already know, when you make a charitable contribution you are allowed to deduct the contribution as an itemized deduction.  Wouldn't this mean that the $100,000 of income from the minimum required distribution would, effectively, be netted against the charitable contribution itemized deduction so that there would not be any net increase in taxes?  Well, sometimes, but not always.

You have to remember that there are limits on the amount of charitable contributions that you are allowed to take.

First, you may only deduct, as a charitable contribution, up to 50% of your adjusted gross income.  That means if your only income is the minimum required distribution, then even if you give 100% of the distribution to your favorite charity you are only allowed to take up to half of that amount as a charitable deduction.  Yes, you will carry forward the excess contributions to the next year, but if your only income is from the IRA minimum required distributions and you are donating 100% of it to charity every year then you will never be able to take full advantage of the charitable deduction.

The second limitation is that not every senior takes itemized deductions.  I was using $100,000 as an example of the amount that may be distributed as part of an IRA's minimum required distribution, but in most cases this amount will be much less.  If, for example, a senior has $8,000 of minimum required distributions from his IRA and contributes 100% of it to a charity, then he would have $4,000 of itemized deductions.  Assuming that he did not have any other itemized deductions, despite making the charitable contribution he would not itemize his deductions and therefore would not receive any tax benefit from making the charitable contribution.

Finally, as you read about in my last post, the Pease Limitation, reduces the benefit of charitable contributions.  If you are affected by the Pease Limitation, the value of your charitable contribution deduction is limited.

The special rule that expired at the end of the 2013 eliminated these problems by ensuring that a senior that made a direct rollover of his/her IRA minimum required distributions to a qualified charitable organization would not pay any federal income taxes on the distribution because the distribution would not be recognized as income (and the contribution would not be allowed as a deduction).

Unfortunately, without this special tax rule seniors may pay more in taxes or will have to engage in different tax planning strategies.  And sadly this may also have an impact on the amount of charitable contributions made this year.

If you are interested in learning more about 2014 tax changes, please send me an e-mail.

Self-Directed IRAs

Did you know it is possible to hold real estate and business entities through an IRA?  You can if your IRA's custodian is open to having "nontraditional" investments.

What is a Self-Directed IRA?

A self-directed IRA is simply an IRA whose custodian permits a wide array of investments beyond bonds and securities and provides for maximum control by the account holder.  Self-directed IRAs can include any investment, other than life insurance and collectibles, that are not specifically prohibited by federal law.

As with all other IRAs, self-directed IRAs must comply with various rules and regulations, including a rule against "prohibited transactions".

What is a Prohibited Transaction?

There are several types of transactions that the federal government have determined to be improper if conducted with the IRA account holder, his or her beneficiaries, or any disqualified person.

Disqualified Persons

The Internal Revenue Code defines disqualified persons as:

1. A fiduciary of the plan (an IRA owner who exercises discretionary control over an IRA's investments is a fiduciary);
2. A person providing services to the plan;
3. An employer whose employees are covered by the plan;
4. An employee organization whose members are covered by the plan;
5. A direct or indirect owner of 50% or more of any entity that is described in numbers 3 or 4 above.
6. A family member of any of the above;
7. A corporation, partnership, trust, or estate that is more than 50% owned directed or indirectly by any person described in numbers 1 through 5 above;
8. An officer, director, 10% or more shareholder, or highly compensated employee (earning 10% or more of the employer's yearly wages) of a person described in numbers 3, 4, 5, or 7 above;
9. A 10% or more partner or joint venture of a person described in numbers 3,4, 5, or 7 above; or
10. Any disqualified person who is a disqualified person with respect to any plan to which a multiemployer plan trust is permitted to make payments under Section 4223 of ERISA.

Prohibited Transactions

There are several types of transactions that are prohibited if done between the self-directed IRA and a disqualified person.  Here are a few examples (this is by no means a comprehensive list):

• Selling property to or from the IRA;
• Lending money to or borrowing money from the IRA;
• Receiving unreasonable compensation for managing the IRA;
• Using the IRA as security for a loan; or
• Buying property for personal use with IRA funds.

What are the consequences if there is a prohibited transaction?

The penalties for engaging in a prohibited transaction are severe!  The Internal Revenue provides that if any prohibited transaction occurs, the account is no longer an IRA and it will be treated as if the assets within the account were distributed on the first day of the taxable year in which the prohibited transaction occurs.  This will trigger a 10% early withdrawal penalty, tax on the constructive distribution, and often an accuracy-related penalty for each of the tax years affected.

Let's look at an example.

In 2010, Mark decided to roll over all $2,000,000 from his 401(k) plan to a self-directed IRA.  On July 1, 2011, the IRA purchased a rental property for $400,000 and left the remaining assets invested in securities. The IRA then hired Mark to manage the property and agreed to pay him 10% of the total rents received. Mark managed the property until late 2013 when the IRA sold it for $450,000.  For the years 2011 through 2013, Mark reported his "management fee" as income, but did not report any of the rental income or the gain on the sale of the property because he knew that income earned by an IRA is tax-deferred.

In 2014, Mark received a notice from the IRS informing him that he was being audited for the tax years 2011, 2012, and 2013.  After its audit, the IRS concluded that the IRA's hiring of Mark and providing him compensation were prohibited transactions.  As a result, there was a deemed distribution of all of the IRA's assets on January 1, 2011 (not only the $400,000 used to purchase the rental property).  Mark was assessed the following penalties:

• Tax on $2,000,000+ deemed distributed to him on January 1, 2011 (plus penalties and interest);
• 10% early withdrawal penalty on the $2,000,000+ deemed distributed;
• 20% accuracy related penalty in 2011;
• Tax on the 2011, 2012, and 2013 rental income (plus penalties and interest)
• Tax on any interest, dividends, and capital gains from securities in 2011, 2012, and 2013 (plus penalties and interest);
• Tax on the capital gains from the sale of the rental property in 2013 (plus penalties and interest); and
• 20% accuracy related penalty in 2013.

It is not my intent to discourage anyone from using a self-directed IRA as an investment vehicle.  However, it is very important to understand that it can be very easy for someone to engage in a prohibited transaction and incur very severe penalties as a result.  Therefore, if you are thinking about utilizing a self-directed IRA, talk to a tax professional to ensure that everything is done properly.

If you have any questions about self-directed IRAs, please do not hesitate to contact me.

As always, I appreciate you leaving your feedback in the comments section below.

What is an IRA?

Everyone keeps telling you that you need to save for your retirement, but your company does not have a 401(k).  What are you supposed to do?  You can contribute to an Individual Retirement Account (IRA)!

 

The advice that everyone is giving you is right, you need to make sure you save for your own retirement.  One estimate projected that the Social Security trust fund will be exhausted by 2037 if not sooner.  I discussed this and provided advice for your retirement savings plan in Plan for Your Retirement: No One Else Will.

 

If your employer does not provide a company 401(k) plan, you will want to talk to your financial advisor about establishing an IRA.  But what is an IRA?

There are 2 basic types of IRAs:

 

1) Traditional IRA

 

Qualified contributions to a Traditional IRA help to reduce your taxes because they are tax-deductible.  Contributions to a Traditional IRA are one the few ways in which you can actually reduce your tax bill after the year ends.  The governments allows you to make a contribution up until April 15th of the following year, and to take the deduction in the preceding year.

 

The amount you are allowed to contribute to a Traditional IRA changes frequently as it is adjusted for inflation, but in 2013 you are allowed to make a contribution up to $5,500, or $6,500 if you are age 50 or over.

 

Once invested into a Traditional IRA, all of the funds grow without being taxed.  You will not be taxed until you withdraw the funds! 

 

There are a few basic requirements in order to make a contribution to a Traditional IRA:

• The contributor must be an individual (not a trust, company, etc.)
• You must be under the age of 70.5
• You must have sufficient earned income or compensation (at least as much as you contribute to your IRA)

 

Be careful though.  The ability to make a tax-deductible contribution phases out based upon whether or not your employer provides a company retirement plan, your tax filing status, and your income level. 

 

2) Roth IRA

 

The principal difference between Traditional IRAs and Roth IRAs are that with Traditional IRAs the contributions are tax-free while with Roth IRAs the distributions are tax-free.

 

In 2013, you are allowed to make a contribution up to $5,500 or $6,500 if you are age 50 or over.  However, the contribution limitation changes based upon your tax filing status and your income level.

 

Once invested into a Roth IRA, all the funds grow tax-free.  Furthermore, all of the distributions are tax-free provided that you are over the age of 59 1/2 and have had the Roth IRA account for at least 5 years.

 

Again, there are a few basic requirements in order to make a contribution to a Roth IRA:

• The contributor must be an individual (not a trust, company, etc.)
• You must have sufficient earned income or compensation (at least as much as you contribute to your IRA).

 

You will notice that unlike with Traditional IRAs, there is no age restriction on being able to contribute to a Roth IRA.

 

Of course these are only the 2 most basic types of IRAs.  You may want to discuss non-deductible IRAs, SEP IRAs, and SIMPLE IRAs with a financial advisor to determine what type of IRA makes the most sense for your situation.  If you need a referral to a great financial advisor, please do not hesitate to ask me.

 

If you have any tax questions that I can answer, please send me an e-mail.

 

Please feel free to leave your feedback below.

 

Plan for Your Retirement: No One Else Will

The Social Security trust fund will be exhausted by 2037.  This is according to one estimate provided by the Social Security Administration.

This means that it is up to you to provide for your retirement. But don't worry, you can make sure that you have a comfortable retirement if you follow two pieces of advice:

1) Start saving for your retirement early.  Start now.  I know, you have a lot of bills to pay and it will be decades until you retire.  You feel like you can start saving when you are more financially secure, and will just make up for starting later by saving more in the future.  This could work, but it comes at a cost.

For example, take Bill and his friend Bob.  Both are young men with a lot of bills, but Bill's family taught him to start saving for his retirement as soon as he could.  Both got hired to full-time jobs when they were 24 years old.  Bill looked at his expenses, and realized he could contribute $2,000 a year to his retirement at the end of every year.  He invested conservatively, and earned a steady 5% return without taxes every year.  At the age of 65, he had just under $270,000 saved.

Bob, on the other hand, did not set aside any money in his 20s or 30s.  It took Bob 20 years to feel financially secure enough to start contributing to his retirement account.  Bob, now 44 years old, wanted to catch up with Bill and decided to put  $7,000 a year into his retirement account at the end of every year.  Bob invested the same as Bill, and earned the same steady 5% return without taxes every year.  At the age of 65, he had just over $260,000 saved.

As you can see, in order to have between $260,000 and $270,000 in their retirement accounts, Bill only had to contribute $82,000 while Bob had to contribute $147,000 ($65,000 more).  This is all because Bill started saving at an early age.

That is the power of compounding investment returns.

2) Invest through a qualified retirement plan.  The IRS gives special tax treatment to certain types of retirement accounts including, but not limited to:

• 401(k)
• 403(b)
• Traditional IRA
• Roth IRA

There are different features and tax incentives attached to each of these types of retirement accounts, but they share one very important feature.  All the earnings grow tax-free.  Bob and Bill both had their money invested in a qualified retirement account, so all of the earnings grew tax-free.  If they decided to put their retirement savings in a normal investment account, they each would have had far less in their retirement accounts because they would have a significant amount taken out each year in taxes.

It is very rare for the government to allow you to invest your money without taxing it for decades, if ever.

These types of retirement accounts have another significant tax incentive.

Contributions to 401(k)s and 403(b)s reduce the amount of taxable wages you report on your tax return.  For example, if you earned $100,000 in a year, and you contributed $5,000 to your 401(k), your W-2 would only show $95,000 of gross wages.

Contributions to a Traditional IRA are deductible for the year of the contribution.  Thus, if you earned $100,000 during the year and contributed $5,000 to your Traditional IRA, you would take a deduction on your tax return for $5,000, leaving you with gross income of $95,000.

Assuming you are in a 25% federal tax bracket, you would save $1,250 in federal taxes for making a $5,000 contribution to your own retirement.

Distributions from a Roth IRA are tax-free.  This is delayed gratification, but if you expect to be in a higher income tax bracket when you retire or you think that tax rates will go up, you can choose to put your money into a Roth IRA and let it grow tax-free and then eventually take it out of your retirement account tax-free.

Please note that this is only a very brief overview of retirement plans.  I plan to discuss different aspects of retirement plans and the benefits to employers to sponsoring a 401(k) or 403(b) plan in future blog posts.

I strongly encourage you to talk to your financial advisor about setting up a retirement plan if you do not have one already.  If you need a referral to a financial advisor, I know a great financial advisor who would be happy to answer any of your questions.

I would love to get your feedback through comments below.  If you have a question that you would like to discuss with me privately, please do not hesitate to send me an e-mail.