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Ed Slott's Free IRA Update

May 2008

Volume 1, Number 5


In This Issue

  • Focus on Plan
  • Question of the
  • News, Rulings and Other Updates
  • Retirement
    Planning Tip
  • Ed Slott's IRA
    Advisor - May Issue



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May Focus: Plan Loans

An increasing number of plan participants are taking loans from their qualified plan accounts such as 401(k)s, profit sharing plans, pension plans and their 403(b) accounts. This has brought the question of whether it makes good financial sense to take loans from these plans to the forefront of the minds of financial professionals and participants alike. But like most decisions about retirement plan assets, the answer depends on the specific facts and circumstances that apply to the participant.

When making the decision to take a loan from a retirement account, the following are some of the points that should be considered:

  • The purpose of the loan: If the loan is being used towards the down payment of a home, or to prevent foreclosure on a home, the loan may make good financial sense. Of course, the foreclosure issue can be viewed from two points. (1) It may help the participant to keep the home and the equity that has accrued. (2) On the other hand, if the same issues that caused the foreclosure to come about still exist, it could result in just throwing good money after bad, thus increasing the amount the participant will lose.

If the loan is being used to pay off credit card balances, the loss of tax-deferred earnings vs the interest that would be repaid on the credit card balances should be compared. Using a qualified plan loan to pay off credit card balances, only to have those card balances increased again afterwards, will result in the participant being worse off. They will have an additional loan to repay and a reduction in their plan balance at the same time resulting in a loss of earnings.

  • The ability to repay the loan. If circumstances arise that result in the participant's inability to repay the loan, the outstanding loan balance could be treated as a taxable distribution. This would cause the participant to not only permanently lose the benefit of tax-deferred growth on the amount, but to be stuck with a tax-bill based on the outstanding loan amount and possible early distribution penalties.
  • Change of jobs may mean a distribution: Most plan sponsors require participants who leave their employment to repay outstanding loan amounts shortly after termination of employment. For those who are unable to pony-up the cash to pay the outstanding loan balance, the outstanding loan balance could be treated as a taxable distribution. Again, this amount could be subject to income tax and the early distribution penalty. If the amount is offset against the participant's account balance, the participant has 60-days to rollover the amount to an IRA or other eligible retirement plan so that the amount is not taxable.

Some argue that taking a loan is a double negative as (1) the amount disbursed as a loan no longer has the benefit of accruing tax-deferred earnings in the account, and (2), the loan repayments are made with funds that are already taxed and those amounts will be taxed again when withdrawn from the account. But the truth of the matter is that loans do not result in a double negative in all circumstances. For instance, if the amount is used towards the purchase of a home and the property significantly increases in value, the return on investment in the property can offset or (even) negate the negative impact of loss of tax-deferred growth and repaying with already taxed dollars. For some, the intrinsic value of the loan far outweighs any negative financial impact.

Now that money is cheap participants should explore other loan options before leaning on their retirement savings. For those who have no option but to take loans from their retirement accounts, loan repayments should be made as quickly as possible so as to restore the amount to the plan. At a minimum, participants must pay at least what is required under the amortization schedule so as to prevent the amount from being treated as a distribution.

Explanations of the rules that govern IRAs are usually provided in Ed Slott's IRA Advisor Newsletter. If you are not already a subscriber and want to get an idea of what the newsletter includes, you can preview past issues before subscribing.
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Question of the Month

Question: An individual submitted a request for a distribution of $10,000 and elected to have 5% withheld for federal taxes. However, the custodian withheld 10% and insists that 10% is the minimum amount they can withhold. Is that true?

Answer: It depends. The withholding requirements depend on whether the amount is a periodic payment, non-periodic payment, and if the amount is a rollover eligible distribution from a qualified plan (such as a 401(k), profit sharing or pension plan), 403(b) or 457(b) plan.

For this purpose, periodic payments are defined as payments from a pension plan that are spread out over more than one year (periodic payments). Non-periodic payments are ad-hoc one-time distributions or distributions paid within one-year.

For periodic payments from a pension or annuity, the withholding amount is calculated using the same method that is used to determine withholding salaries and wages, and the participant would simply instruct the payer on how much to withhold.

For non-periodic payments, the following applies:

  • If the account is a Traditional, SEP or SIMPLE IRA, the amount withheld for federal tax must be zero, or any amount that is at least 10%. If the IRA owner elects to have federal taxes withheld and indicates an amount less than 10% of the gross distribution amount, the custodian is required to increase the amount to 10%.
  • If the account is a qualified plan (such as a 401(k), profit sharing or pension plan), 403(b) or 457(b) plan, the following withholding rules apply:
    • If the amount is rollover eligible, and is processed as a direct rollover to an eligible retirement plan, no withholding applies
    • If the amount is rollover eligible, and is paid to the participant, instead of being processed as a direct rollover, the payer is required to withhold at least 20% for federal taxes.
    • If the amount is not rollover eligible, the IRA withholding rules apply, which means the minimum withholding amount is 10%, unless the participant elects zero withholding.

Rollover eligible distributions are defined in IRS Publication 575, available
at www.irs.gov.

Bear in mind that some payers also perform withholding for state taxes. The withholding rules for states are different from the withholding rules for federal tax; further, the withholding rules vary among states. For instance, a state rule may require withholding only if federal taxes are withheld, one may require withholding only if requested by the participant or IRA owner, some have different withholding rules for IRAs and qualified plans, and the withholding percentages differ.

Special rules apply to amounts that are sent overseas. These are explained in IRS Publication 515, available at www.irs.gov

News, Rulings and Other Updates

  • TC Memo 2008-93: Issues (1) Whether a 2002 distribution of $25,000 from a Simplified Employee Pension Individual Retirement Account (SEP-IRA) is includable in the SEP-IRA owner’s taxable income and (2) whether the 10 percent early distribution penalty applies to the distribution.

Highlights: SEP-IRA owner made a withdrawal of $25,000 from his SEP-IRA and deposited the amount into his company's account. Within 60-days, he instructed his bookkeeper to send a check for the amount to his broker to be deposited as a rollover contribution to his IRA. The broker did not receive the funds. The SEP-IRA owner did not include the amount in income, because he thought the rollover was completed within the 60-day period. He stated that he was unaware that the rollover was not completed, until he received a notice from the IRS. He further stated that when he contacted the IRS (via telephone) for information about how to handle the matter, he was not provided with information about the IRS’ ability to extend the 60-day period, and was given incorrect information.

The tax court ruled that the amount was includable in income and subject to the 10% early distribution penalty. Part of their reasoning was that he should have noticed that the amount was not taken from the company's account balance.

  • PLR 200814029: The IRS extended the 60-day rollover period, for an individual who failed to meet the 60-day deadline, due to mental impairment. They ruled that the mental impairment adversely affected her ability to make sound financial decisions and to understand the consequences of her actions.

Facts/Highlights: Submitted medical documentation indicated that the IRA owner began to receive treatment for an irreversible neurological disease two years before the distribution was made from the IRA. This disease affected her ability to understand the rollover rules for a matured certificate of deposit (CD), as explained by her financial institution. The amount was not used for any purpose, other than the distribution and subsequent rollover. The rollover, minus her required minimum distribution (RMD) amount, was completed after the 60-day deadline.

Reminder: A PLR cannot be cited as precedence or legal reference.

May's Retirement Planning Tip
When restorative payments are sent to IRAs, be sure to have the IRA custodian treat the amounts as non-reportable transactions. That is, they should not be reported on IRS Form 5498 as any type of contribution.

Restorative Payments Defined: For this purpose, restorative payments are amounts paid to the IRA to restore the IRA balance to what it (by estimation) would have been, had the action from which the restorative payment resulted did not occur. Examples include a broker or financial institution being required to reimburse an IRA for mismanagement of the IRA.

If you send restorative payments to IRA custodians, include as much of the related documentation as possible, so as to prove that the funds belong to the IRA. In addition, attach a note explaining the source and include specific instructions to treat the amount as a non-reportable credit to the IRA. Leave nothing to chance, and do not assume that the person who will handle the deposit is familiar with these requirements.

Highlights from Ed Slott's IRA Advisor Newsletter - May 2008 Issue

The May 2008 issue of Ed Slott's IRA Advisor is now available online. The areas covered include the following:

  • How A Stretch IRA was Saved—Even When RMDs were Missed. In this piece, we discussed the following:
    • Facts of the private letter ruling that was issued by the IRS on the case discussed
    • The background and basic information
    • The 50% excess accumulation penalty
    • Payment of penalty no longer required with the filing of Form 5329
    • The 5-Year rule
    • Designated beneficiary
    • Why the PLR was requested
    • Why the 50% excess accumulation penalty was paid
    • Advisor action plan for similar scenarios
  • IRA Investment Insights: In this piece, this month's guest IRA expert, Harry S. Dent, Jr., Harvard MBA of the HS Dent Foundation in Tampa, FL, discussed:
    • Investing for the long haul
    • Investment demographics
    • The boomer impact
    • Boomers and bonds
    • Commodities investing
    • Stocks and funds
    • Rebalancing the portfolio, and he provides
    • An advisor action plan

Be sure to review the May issue and post your questions on our message board at http://www.irahelp.com/phpBB/index.php?area=, where some of the best experts in the retirement field gather to discuss technical issues.

To view current and past issues of the IRA Advisor, click the link below to access our "Subscribers Only" section of our website:
http://irahelp.com/newsletter.php?area=a (for America Online users)

If you do not already subscribe to Ed Slott's IRA Advisor Newsletter, you may do so by clicking here and providing the required information, or by calling 800-663-1340. Each issue is 8 full pages of must-have tax information. Individuals who subscribe to the online version of the Ed Slott's IRA Advisor Newsletter, receive access to back issues at no additional cost.

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