Tax

Avoiding Penalties on Early Withdrawals from IRAs

More than half of Millennials and Gen Xers have already or are planning to, withdraw money from their retirement plans to cover unexpected expenses such as medical bills, educational expenses, or buying a house, according to a recent PwC Employee Financial Wellness Survey (April 2017). Most notably, the survey also found that this trend is on the rise for both Millennials and Gen Xers, increasing 14 and 6 percent, respectively, from 2016 to 2017.

Background

When retirement plans such as the 401(k) were introduced, company pensions were still the norm and this “new” retirement savings vehicle was meant to be a supplement to the pension. Fast forward to today, however, and the retirement landscape has changed dramatically. Very few companies offer pensions anymore and most people rely entirely on whatever savings they’ve accumulated in their retirement account, along with social security) to get them through their golden years. In fact, for many people, retirement accounts are their most significant source of savings.

Because retirement plans such as the 401(k), tax-sheltered annuity plans under section 403(b) for employees of public schools or tax-exempt organizations, and Individual Retirement Accounts (IRAs) were created to help you save money for your retirement years, withdrawals before retirement age (59 1/2) are discouraged. As such, the IRS imposes a penalty of 10 percent for early withdrawals taken from qualified retirement plans before age 59 1/2.

Minimizing Early Withdrawal Penalties

While you should always think carefully about taking money out of your retirement plan before you’ve reached retirement age, there may be times when you need access to those funds. The downside is that you’ll be faced with an IRS penalty on the withdrawal unless you meet one of the exceptions listed below.

For instance, if you withdraw cash from your IRA to pay off credit card debt you will be liable for the 10 percent penalty when you file your tax return. Furthermore, that money is also considered taxable income by the IRS. In other words, you don’t want to get into the habit of treating your retirement fund like a cash cow but instead, should focus on building cash reserves in an emergency fund.

That being said, if an early withdrawal is unavoidable because you are suddenly unemployed, disabled, or have outstanding medical expenses, IRS provisions allow a number of exceptions that may be used to minimize or avoid the tax penalty.

  1. Beneficiary of a deceased IRA owner. If you are the beneficiary of a deceased IRA owner, you do not have to pay the 10 percent penalty on distributions taken before age 59 1/2 unless you inherit a traditional IRA from your deceased spouse and elect to treat it as your own. In this case, any distribution you later receive before you reach age 59 1/2 may be subject to the 10 percent additional tax.
  2. Totally and permanently disabled. Distributions made because you are totally and permanently disabled are exempt from the early withdrawal penalty. You are considered disabled if you can furnish proof that you cannot do any substantial gainful activity because of your physical or mental condition. A physician must determine that your condition can be expected to result in death or to be of long, continued, and indefinite duration.
  3. Distributions for qualified higher education expenses.Distributions for qualified higher education expenses are also exempt, provided they are not paid through tax-free distributions from a Coverdell education savings account, scholarships and fellowships, Pell grants, employer-provided educational assistance, and Veterans’ educational assistance. Qualified higher education expenses include tuition, fees, books, supplies, and equipment required for the enrollment or attendance of a student at an eligible educational institution, as well as expenses incurred by special needs students in connection with their enrollment or attendance. If the individual is at least a half-time student, room and board are qualified higher education expenses. This exception applies to expenses incurred by you, your spouse, children and grandchildren.
  4. Distributions due to an IRS levy of the qualified plan. This exception applies if the IRS takes money directly out of your 401(k) plan to satisfy an IRS levy (tax debt).
  5. Distributions that are not more than the cost of your medical insurance. Even if you are under age 59 1/2, you may not have to pay the 10 percent additional tax on distributions during the year that is not more than the amount you paid during the year for medical insurance for yourself, your spouse, and your dependents. You will not have to pay the tax on these amounts if all of the following conditions apply: you lost your job, you received unemployment compensation paid under any federal or state law for 12 consecutive weeks because you lost your job, you receive the distributions during either the year you received the unemployment compensation or the following year, you receive the distributions no later than 60 days after you have been reemployed.
  6. Distributions to qualified reservists. Generally, these are distributions made to individuals called to active duty after September 11, 2001, for a period greater than 179 days or for an indefinite period because you are a member of a reserve component such as the Army National Guard. Distributions taken during the active duty period are not subject to the 10 percent penalty.
  7. Distributions in the form of an annuity. You can take the money as part of a series of substantially equal periodic payments over your estimated lifespan or the joint lives of you and your designated beneficiary. These payments must be made at least annually and payments are based on IRS life expectancy tables. If payments are from a qualified employee plan, they must begin after you have left the job. The payments must be made at least once each year until age 59 1/2, or for five years, whichever period is longer.
  8. Medical expenses. If you have out-of-pocket medical expenses that exceed 10 percent of your adjusted gross income, you can withdraw funds from a retirement account to pay those expenses without paying a penalty.

    Example: If you had an adjusted gross income of $100,000 for tax year 2017 and medical expenses of $12,500, you could withdraw as much as $2,500 from your pension or IRA without incurring the 10 percent penalty tax. You do not have to itemize your deductions to take advantage of this exception.

  9. Buy, build, or rebuild a first home. An IRA distribution used to buy, build, or rebuild a first home also escapes the penalty; however, you need to understand the government’s definition of a “first time” home buyer. In this case, it’s defined as someone who hasn’t owned a home for the last two years prior to the date of the new acquisition. You could have owned five prior houses, but if you haven’t owned one in at least two years, you qualify.

    The first-time homeowner can be yourself, your spouse, your or your spouse’s child or grandchild, parent or another relative. The “date of acquisition” is the day you sign the contract for the purchase of an existing house or the day construction of your new principal residence begins. The amount withdrawn for the purchase of a home must be used within 120 days of withdrawal and the maximum lifetime withdrawal exemption is $10,000. If both you and your spouse are first-time home buyers, each of you can receive distributions up to $10,000 for a first home without having to pay the 10 percent penalty.

Questions about Early Withdrawals?

Before withdrawing funds from a retirement account please call the office and speak to a tax professional. While you may be able to minimize or avoid the 10 percent penalty tax using one of the exceptions listed above, remember that you are still liable for any regular income tax that’s owed on the funds that you’ve withdrawn–and you may be liable for more tax than you realize when you file your tax return next spring.

SIMPLE IRA Plans for Small Business

Of all the retirement plans available to small business owners, the SIMPLE IRA plan (Savings Incentive Match PLan for Employees) is the easiest to set up and the least expensive to manage. The catch is that you’ll need to set it up by October 1st. Here’s what you need to know.

What is a SIMPLE IRA Plan?

SIMPLE IRA Plans are intended to encourage small business employers to offer retirement coverage to their employees. Self-employed business owners are able to contribute both as employee and employer, with both contributions made from self-employment earnings. In addition, if living expenses are covered by your day job (or your spouse’s job), you would be free to put all of your sideline earnings, up to the ceiling, into SIMPLE IRA plan retirement investments.

How does a SIMPLE IRA Plan Work?

A SIMPLE IRA plan is easier to set up and operate than most other plans in that contributions go into an IRA you set up. Requirements for reporting to the IRS and other agencies are minimal as well. Your plan’s custodian, typically an investment institution, has the reporting duties and the process for figuring the deductible contribution is a bit easier than with other plans.

SIMPLE IRA plans calculate contributions in two steps:

1. Employee out-of-salary contribution
The limit on this “elective deferral” is $12,500 in 2017, after which it can rise further with the cost of living.

Catch-up. Owner-employees age 50 or older can make an additional $3,000 deductible “catch-up” contribution (for a total of $15,500) as an employee in 2017.

2. Employer “matching” contribution
The employer match equals a maximum of three percent of employee’s earnings.

Example An owner-employee age 50 or over in 2017 with self-employment earnings of $40,000 could contribute and deduct $12,500 as employee plus an additional $3,000 employee catch up contribution, plus a $1,200 (3 percent of $40,000) employer match, for a total of $16,700.

Are there any Downsides to SIMPLE IRA Plans?

Because investments are through an IRA you must work through a financial institution acting, which acts as the trustee or custodian. As such, you are not in direct control and will generally have fewer investment options than if you were your own trustee, as is the case with a 401(k).

You also cannot set up the SIMPLE IRA plan after the calendar year ends and still be able to take advantage of the tax benefits on that year’s tax return, as is allowed with Simplified Employee Pension Plans, or SEPs. Generally, to make a SIMPLE IRA plan effective for a year, it must be set up by October 1 of that year. A later date is allowed only when the business is started after October 1 and the SIMPLE IRA plan must be set up as soon as it is administratively feasible.

Furthermore, once self-employment earnings become significant however, other retirement plans may be more advantageous than a SIMPLE IRA retirement plan.

Example If you are under 50 with $50,000 of self-employment earnings in 2017, you could contribute $12,500 as employee to your SIMPLE IRA plan plus an additional 3 percent of $50,000 as an employer contribution, for a total of $14,000. In contrast, a 401(k) plan would allow a $31,000 contribution.With $100,000 of earnings, the total for a SIMPLE IRA Plan would be $15,500 and $43,500 for a 401(k).

If the SIMPLE IRA plan is set up for a sideline business and you’re already vested in a 401(k) in another business or as an employee the total amount you can put into the SIMPLE IRA plan and the 401(k) combined (in 2017) can’t be more than $18,000 or $23,500 if catch-up contributions are made to the 401(k) by someone age 50 or over. So, someone under age 50 who puts $9,000 in her 401(k) can’t put more than $9,000 in her SIMPLE IRA plan for 2017. The same limit applies if you have a SIMPLE IRA plan while also contributing as an employee to a 403(b) annuity (typically for government employees and teachers in public and private schools).

How to Get Started Setting up a SIMPLE IRA Plan

You can set up a SIMPLE IRA plan account on your own; however, most people turn to financial institutions. SIMPLE IRA Plans are offered by the same financial institutions that offer any other IRAs and 401(k) plans.

You can expect the institution to give you a plan document and an adoption agreement. In the adoption agreement, you will choose an “effective date,” which is the start date for payments out of salary or business earnings. Again, that date can’t be later than October 1 of the year you adopt the plan, except for a business formed after October 1.

Another key document is the Salary Reduction Agreement, which briefly describes how money goes into your SIMPLE IRA plan. You need such an agreement even if you pay yourself business profits rather than salary. Printed guidance on operating the SIMPLE IRA plan may also be provided. You will also be establishing a SIMPLE IRA plan account for yourself as participant.

Ready to Explore Retirement Plan Options for your Small Business?

SIMPLE IRA Plans are an excellent choice for home-based businesses and ideal for full-time employees or homemakers who make a modest income from a sideline business and work well for small business owners who don’t want to spend a lot of time and pay high administration fees associated with more complex retirement plans.

If you are a business owner interested in discussing retirement plan options for your small business, don’t hesitate to contact the office today.

Scam Alerts: Hurricane Charities and Ransomware

While The IRS, state tax agencies and numerous people in the tax and accounting industry are working together to warn tax professionals and their clients about phishing scams, they are still all too common. Here’s what you need to know about the two most recent scams: fake charities that take advantage of people’s generosity during times of natural disasters and IRS/FBI-themed ransomware.

Fake Charity Scams Relating to Hurricane Harvey

With Houston still reeling from the devastating effects of Hurricane Harvey, many people are wondering how they can help. One of the best ways to do this is by donating to a charity that helps victims affected by natural disasters. Unfortunately, however, due to the prevalence of tax scams, taxpayers need to make sure the organization they donate to is not a fake charity set up by unscrupulous criminals looking to make a fast buck or get people’s personal information.

How the Fake Charity Scam Works

These types of fraudulent schemes usually involve contact by telephone, social media, email or in-person solicitations. Criminals typically send emails that steer recipients to bogus websites that appear to be affiliated with legitimate charitable causes. These sites frequently mimic the sites of, or use names similar to, legitimate charities, or claim to be affiliated with legitimate charities in order to persuade people to send money or provide personal financial information that can be used to steal identities or financial resources.

What to Watch out for

Follow these tips if you want to make a disaster-related charitable donation but avoid falling victim to scam artists:

  • Donate to recognized charities. IRS.gov has the tools people need to quickly and easily check the status of charitable organizations.
  • Be wary of charities with names that are similar to familiar or nationally known organizations. Some phony charities use names or websites that sound or look like those of respected, legitimate organizations. The IRS website at IRS.gov has a search feature, “Exempt Organizations Select Check” which people can use to find qualified charities; donations to these charities may be tax-deductible.
  • Don’t give out personal financial information–such as Social Security numbers or credit card and bank account numbers and passwords–to anyone who solicits a contribution. Scam artists may use this information to steal a donor’s identity and money.
  • Never give or send cash. For security and tax record purposes, contribute by check or credit card or another way that provides documentation of the donation.
  • Consult IRS Publication 526, Charitable Contributions, available on IRS.gov. This free booklet describes the tax rules that apply to making legitimate tax-deductible donations. Among other things, it also provides complete details on what records to keep.

Taxpayers suspecting fraud by email should visit IRS.gov and search for the keywords “Report Phishing.” More information about tax scams and schemes may be found at IRS.gov using the keywords “scams and schemes.” Details on available relief can be found on the disaster relief page on IRS.gov as well.

Don’t hesitate to call the office if you have any questions or concerns or believe you have been a victim of a fake charity scam.

IRS/FBI-Themed Ransomware Scams

There’s also a new phishing scheme that impersonates the IRS and the FBI as part of a ransomware scam to take computer data hostage. The scam email uses the emblems of both the IRS and the Federal Bureau of Investigation. It tries to entice users to select a “here” link to download a fake FBI questionnaire. Instead, the link downloads a certain type of malware called ransomware that prevents users from accessing data stored on their device unless they pay money to the scammers.

What to do if you are a Victim of a Ransomeware Scam

Do not pay a ransom. Paying it further encourages the criminals, and frequently the scammers won’t provide the decryption key even after a ransom is paid. Victims should immediately report any ransomware attempt or attack to the FBI at the Internet Crime Complaint Center (www.IC3.gov). Forward any IRS-themed scams to phishing@irs.gov. For more information about IRS Tax Scams and Consumer Alerts visit the IRS website

People should stay vigilant against email scams that try to impersonate the IRS and other agencies that try to lure you into clicking a link or opening an attachment. As a reminder, the IRS does not use email, text messages or social media to discuss personal tax issues, such as those involving bills or refunds.

If you believe you’ve been a victim of a ransomware scam or any other IRS-related scam, please call the office for assistance.

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