Life and Death Planning for Retirement Benefits

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Life and Death Planning for Retirement Benefits

for a six percent penalty ($17,700) on the $295,000 excess contribution. Assume she withdraws the excess contribution and income thereon in early 2011. Here is how she will report these transactions on her tax return: $300,000 distribution from the inherited 401(k) plan in 2010 (this is includible in her income in 2010, but is not subject to the 10% penalty because the penalty does not apply to death benefits; see ¶ 9.4.01 ); additional income of $12,000 (the earnings on the contribution) reportable in 2010 and subject to the 10% penalty in 2010 (see “D” above); and $5,000 contribution to her own IRA for 2010. Armande Example: Armande, age 45, is eligible to contribute $5,000 to a traditional IRA in 2010. By mistake he contributes $9,000. He has made an excess contribution of $4,000. By the time he discovers this error, in early 2011, the $4,000 excess contribution has already generated $3,000 of “net income attributable thereto” ( ¶ 5.6.02 ) due to Armande’s spectacular investment success. To avoid a six percent excess contribution penalty for 2010 ($240), he would have to withdraw the $4,000 excess contribution and the $3,000 of “earnings” thereon ...but the earnings would be subject to income tax and to the 10 percent penalty on “early distributions” (see “D” above) because Armande is under age 59½. So he would have to pay a $300 penalty to avoid a $240 penalty! He decides to pay the excess contributions penalty of $240 for 2010, leave the excess contribution in the IRA, and treat the 2010 excess contribution as part of his $5,000 “regular” IRA contribution for 2011. In 2011 he is eligible to contribute up to $5,000 to an IRA from his compensation income, so the $4,000 excess contribution carried over from 2010 will “absorb” most of his 2011 contribution. 2.2 If the Participant Has After-tax Money in the Plan or IRA This ¶ 2.2 explains how to determine how much basis (after-tax money) a participant or beneficiary has in a traditional qualified retirement plan (QRP) or IRA, how much of such basis is deemed included in any particular distribution, and what happens if a distribution that includes some basis is rolled over to more than one plan or IRA or is only partly rolled over . See the “Road Map” in ¶ 2.2.01 . To answer the same questions with respect to a Roth IRA (or designated Roth account (DRAC)), see ¶ 5.2.06 (or ¶ 5.7.05 ). For treatment of return of basis under the minimum distribution rules, see ¶ 1.2.02 (D). For the effect of UBTI on basis, see ¶ 8.2.01 . For what happens if the total combined value of the participant’s IRAs is less than the amount of his basis, see ¶ 8.1.02 . 2.2.01 Road Map: Tax-free distribution of participant’s “basis” A retirement plan distribution is nontaxable to the extent it represents the recovery of the participant’s “investment in the contract.” § 72(b)(2) . The “ investment in the contract ” is the money in the plan that the participant has already paid income tax on. For ease of reference, it is usually called the participant’s “ basis ” or “ after-tax money ” in the plan or IRA. There is no double taxation; the participant is not taxed again when he takes that after-tax money out of the plan or IRA. The pretax money is the money inside the plan or IRA that has not yet been subjected to income tax. Unfortunately, there is no quick easy way to explain the rules that govern after-tax money in a plan or IRA. There is a general rule with numerous exceptions, and there are different rules (and different exceptions) for plans than for IRAs. Here is your Road Map for Tracking Basis: