The ‘Disaster Fund’
Imagine you have a mutual fund, rental property, or other asset that you have grown slowly, reserving it for LTC if that need ever strikes you. You selected the investment product to be low risk and therefore low return. You passed up annuities or LTC policies because these have potential surrender charges, and even though that expires in eight to a dozen years, you just disliked the idea in favor of more liquid assets. Of course, realty is the least liquid, costing commissions to sell off and market value loss in recessions or under pressured sale conditions. This market loss happens to bond funds, too, if interest rates rise. Now, imagine liquidating the fund or asset and paying capital gains taxes. Maybe your income tax bracket is low and the capital gain tax rate is zero; maybe tax law has changed and this bites you bigger than you thought. While it grew and paid dividends or modest rent, you used that money for upkeep and property taxes, or the mutual fund dividends bought you additional shares. You paid income taxes on those earnings. But contrast this with an income annuity that doubled as an LTC policy. Had that been the case, you would have paid no taxes along the way (deferred). If your eventual need was for income, then you could arrange for tax-advantaged income; if the need became LTC, then the money out would be entirely tax-free. In essence, you had a Tier 4 cash reserve for long-term (possibly very late in life) needs, but you sacrificed quite a bit in tax by using a vehicle that makes you pay Uncle Sam every single year: a non-LTC annuity hybrid policy, like a CD or mutual fund. So, after ten years or so of holding this CD or other non-LTC annuity, you realize that there was a cost for perceived liquidity. Ouch. And you thought avoiding surrender charge potentials was worth it! If you are wise enough to have a fund for long-term care or other late-in-life disaster, bravo! But the smartest vehicle for that purpose is the only one that is tax-deferred (tax-free for LTC use) and that loses its surrender charge over time to become fully liquid. These are guaranteed as to return and immune to interest rate fluctuations, rental market busts, etc. These are not available for IRA or qualified plan money, unless you take money out to become nonqualified money in a year when your income tax rate is quite low (some counterbalancing of loss or a dip in your income). Today, the rates in these combo annuity-LTC policies are around 2%.
Recap
There are two ways to take money from a tax-deferred, nonqualified annuity that has a long-term care rider: For income taken up to your actual LTC costs, both income taxes and penalties are permanently waived. No other investment is treated this way in the tax code.
For ordinary income needs taken from any non-qual annuity (combo annuity-LTC or otherwise), income is subject to ordinary income taxation. If you’re older than 59.5, you will not have the tax penalty under any circumstances. If you annuitize (exchange principal for maximum income), then the IRS automatically has the annuity company report the favored calculation, called the exclusion ratio, for you: Your basis is divided by your expected remaining years of life according to the IRS mortality table or the annuity company’s (if better at the time). That ratio is the part of your annuity income that is not subject to tax until you have recovered all of your basis. This is much better than the non-annuitization (withdrawals) method of taxation.
Most people do not want to give up access to their annuity principal. This is especially so when they recall that their lifetime guarantee of withdrawals rider guarantees income even when the principal is exhausted. As long as you take only what the rider guarantees, and don’t exhaust principal by taking more, it will pay lifelong. Extra withdrawals reduce income by the proportion of the excess taken to the remaining principal. The big secret is that the income from such riders is only about five percentage points less than the income from annuitizing! Unfortunately, the income tax treatment while receiving withdrawals is like any other account (CD, net rental income, whatever: earnings are recognized first). So while withdrawing income rather than taking it via annuitization, you pay income tax on all payments received, at least to the extent that you have earnings in the annuity. But at least you had a safe return above bank rates, and surrender penalties permanently go away with time and are waived anyway up to the annuity carrier’s penalty-free withdrawal privilege, which is usually 10% (taking 10% annually will exhaust the account, obviously, but at least there is no account-based penalty up to this limit).
What if you must take money from an IRA, 457 plan, or a qualified plan? I hope you never have to take retirement money prior to actual retirement. But if you must, there is a tax privilege (tax-free plan loans) for two of these three, and a tax penalty mitigation for all three. Please notice that I distinguish between income taxation and the tax penalty for early withdrawals. The following options do not exist for former employees who keep their assets at their old employer plan.
IRA Plan Loan
No plan loans. Sorry. Remember also that SIMPLE and SARSEP plans (IRA-like small business retirement plans) are treated as IRAs, not as qualified retirement plans or 457 plans (larger employer plans).
Employers can make their plans and hardship withdrawals more restrictive than the following, and even offer no such provisions. But most follow the IRS corridors.457 and Qualified Plan Loans
You may take a loan of up to the lesser of 50% of what you’re vested to in your plan (vested mans what you’d keep if you left the employer) or $50,000. This limit is the total at any given time, not counting market corrections while the loan is outstanding. You must pay this back over no longer than five years, and you must pay the reasonable interest rate set by the plan trustees (interest gets added to your account, not the plan administrators; nice!). Any loan outstanding on the day you are no longer a plan participant (if you leave employment) will be reported to the IRS as a distribution (subject to penalty if you are under 59.5).
A new employer can accept the loan balance transfer if it accepted the transfer on or before the employee’s last day at the former employer, but most plans do not allow for this. So check with your new employer well before you leap.
Tax Penalty Waived for Hardship Withdrawals
On IRAs and other plans, death and permanent disability is cause for penalty waiver; not income recognition waiver. IRAs do allow for this waiver for higher education expenses being withdrawn and paid to the institution within thirty days of the withdrawal; oddly, this waiver does not exist for 457 and qualified plans. There is a “first home buyer” exception (up to $10,000 withdrawn) that is only available to IRAs as well. But remember, retirement savings are so you can have a home and eat regularly when you finally retire! The following are never IRA waivers, only 457 and qualified retirement plans:
• If you are laid off or opt to retire and are at least age 55 (50 for most public entity plans like municipal workers), then you will be treated as if you were 59.5.
•If you can show that you had unreimbursed medical expenses that are over 7.5% of your adjusted gross income (10% if under age 65 in the year of the withdrawal).
• If you are a reservist or National Guardsman/woman called by federal order (i.e., not for domestic disaster relief) to active military duty (regardless of duration), there is no penalty.
Individual 401(k) Plans
If you want to manage your retirement money personally (so you think you’re a money manager, eh?) and the account is large, then consider the Indy-k. Most people pick this simply to be able to get at their cash more easily (see withdrawals and loans above). However, use a discount brokerage to keep the costs down; the admin fees associated with IRS and Department of Labor regulations compliance are at least $1,500 annually, plus about $300 per employee. Any employee must be added to the plan, and you must have a company-paid contribution of at least 5% of pay within the vesting time (maximum delay is five years at 20% vesting yearly). Otherwise, your plan will definitely get audited and likely found discriminatory (the owner loses deductibility of his or her own new contributions and the sky begins to fall. Just don’t go there!).
Buying or Starting a Business With an IRA (Not 401(k))
Want to contribute directly to the growth of share price, perhaps as you leave an old employer? There are no pass-through entities allowed, like S-corporations, partnerships, or sole proprietorships; C-corps and limited liability companies only. Don’t let lineal relatives invest in the entity (that’s parents, children, spouses; siblings are allowed). Because the IRS thinks it’s too capitalist for you to set your own salary or pay out bunches of benefits to yourself, you cannot have a controlling interest in the voting stock, nor control whoever or whatever owns stock besides you (you cannot own or control more than 50% of the voting stock). If you’ve got that entrepreneurial fever and you don’t mind getting audited often, then this strategy is for you! Trustee costs are high (around 1.5% sometimes) because of verification and reporting; have a second IRA for other assets that are not company stock, or else the administration costs will be applicable to all your IRA assets.
Employer Stock in a Qualified Retirement Plan
Whether your retirement plan is an Employee Stock Ownership Plan (ESOP) or a 401(k), the stock may be distributed, upon a “triggering event,” to a taxable brokerage account and treated more favorably than ordinary income taxation would allow. Allowable triggering events are:
• Death
• Termination of the employer plan without trustees transferring assets to a new plan
• Separation from service at age 55 or later
•Exercise of an in-service distribution by a current employee, if the plan allows in-service distributions and the stock is not restricted
Any of the above must be the case. But also all qualified retirement plans the employee has must distribute all assets in the current tax year. In addition, no plan loans are allowed to be outstanding and there may be no withdrawals of the stock itself. If these restrictions are in place, then the owner may initiate a special tax privilege: The stock that the employer and the employee purchased for the account may be distributed to a nonqualified trading account, typically liquidated but not required to be liquidated.
Next, the cost of that stock is subtracted from its value at distribution. The cost is taxed at ordinary income tax rates (plus a 10% penalty if applicable per rules in my previous section). The value above this cost is taxed at capital gains rates as they exist at the time of the distribution. It can then be placed in a Roth, spent, or used in any way the owner desires. If the stock is not sold immediately, any extra gain after the distribution gets accounted for separately and will be subject to later capital gains rates on that subsequent appreciation, once actually sold. An heir may execute this as if he or she were the decedent. Capital gains rates can be quite low, compared to ordinary income tax, and this option is almost always the best choice.
This tax treatment will likely exist as long as we have an income tax system because it encourages buying employer stock and so enhances capital formation, which is essential to the economy. Even if we change to a different taxation system, employee stock ownership will still have to be favored to encourage capital formation.
This excerpt is taken from “The Secrets of Successful Financial Planning: Inside Tips From an Expert,” by Dan Gallagher. To read other articles of this book, click here. To buy this book, click here.
