Category Archives: IRA Issues

Few Changes Are Made to 2016 Benefit Plan Limits

On October 21, 2015 the IRS announced 2016 cost-of-living adjustments for annual contribution and other dollar limits affecting 401(k) and other retirement plans.   There are few changes to be noted, as the increase in the cost-of-living index stayed below many thresholds necessary to trigger adjustments. Citations below are to the Internal Revenue Code.

Limits That Remain the Same for 2016 Are As Follows:

–The annual Salary Deferral Limit for 401(k), 403(b), and most 457 plans, currently $18,000, stays the same.

–The age 50 and up catch-up limit, currently $6,000, also remains the same. For 2016 as in this year, the maximum plan deferral an individual age 50 or older may make is $24,000.

–Maximum total annual contributions to a 401(k) or other “defined contribution” plans under 415(c) remains at $53,000 ($59,000 for employees aged 50 and older).

–The maximum annual benefit under a defined benefit plan remained at $210,000.

–Maximum amount of compensation on which contributions may be based under 401(a)(17) remains at $265,000.

–The compensation threshold for determining a “highly compensated employee” remains unchanged at $120,000.

–The compensation dollar limit used to determine key employees in a top-heavy plan remains unchanged at $170,000.

–The compensation threshold for SEP participation remained the same at $600.

–The SIMPLE 401(k) and IRA contribution limit remained the same at $12,500.

–Traditional and Roth IRA contributions and catch-up amounts remain unchanged at $5,500 and $1,000, respectively.

–The Social Security Taxable Wage Base for 2016 remains at this year’s level, $118,500.

Limits That Changed for 2016 Are As Follows:

  • The deductibility of IRA contributions made by someone who is not covered by an employer’s retirement plan but is married to someone who is, phases out if their joint income is between $184,000 and $194,000, up from $183,000 and $193,000.
  • The deductibility of contributions to a Roth IRA phases out over the following adjusted gross income ranges:
    • $184,000 to $194,000 for married couples filing jointly, also up from $183,000 and $193,000;
    • $117,000 to $132,000 for singles and heads of households, up from $116,000 to $131,000.
  • The retirement savings contribution tax credit (saver’s credit) for low and moderate-income workers is limited to those whose adjusted gross income does not exceed:
    • $61,500 for married couples filing jointly, up from $61,000;
    • $46,125 for heads of households, up from $45,750; and
    • $30,750 for married filing separately and for singles, up from $30,500.

 

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IRS Announces Increased 2015 Retirement Plan Contribution Limits

On October 23, 2014 the IRS announced 2015 cost-of-living adjustments for annual contribution and other dollar limits affecting 401(k) and other retirement plans.   A 1.7% rise in the September CPI-U over 2013 triggered $500 increases to the annual maximum salary deferral limit for 401(k) plans, and the catch-up limit for individuals age 50 or older. Citations below are to the Internal Revenue Code.

Limits That Increase for 2015 Are As Follows:

–The annual Salary Deferral Limit for 401(k), 403(b), and most 457 plans, currently $17,500, increases $500 to $18,000.

–The age 50 and up catch-up limit also increases $500, to $6,000 total. This means that the maximum plan deferral an individual age 50 or older in 2015 may make is $24,000.

–Maximum total annual contributions to a 401(k) or other “defined contribution” plans under 415(c) increased from $52,000 to $53,000 ($59,000 for employees aged 50 and older).

–Maximum amount of compensation on which contributions may be based under 401(a)(17) increased from $260,000 to $265,000.

–The compensation threshold for determining a “highly compensated employee” increased from $115,000 to $120,000.

–The compensation threshold for SEP participation increased from $550 to $600.

–The SIMPLE 401(k) and IRA contribution limit increased $500 to $12,500.

–The Social Security Taxable Wage Base for 2015 increased from $117,000 to $118,500.

Limits That Stayed The Same for 2015 Are As Follows:

–Traditional and Roth IRA contributions and catch-up amounts remain unchanged at $5,500 and $1,000, respectively.

–The compensation dollar limit used to determine key employees in a top-heavy plan remains unchanged at $170,000.

–The maximum annual benefit under a defined benefit plan remained at $210,000.

 

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IRS Announces 2014 Benefit Limits

On October 31, 2013 the IRS announced 2014 cost-of-living adjustments for annual contribution and other dollar limits affecting 401(k) and other retirement plans.  The announcement had been delayed until the September 2013 Consumer Price Index for Urban Consumers (CPI-U) was available, which in turn was delayed by the government shutdown over the budget and debt ceiling debate.   A modest 1.2% rise in the September CPI-U over 2013 left a number of the dollar limits unchanged for 2014, although a few limits have increased (citations are to the Internal Revenue Code).
Some limits that did not change for 2014 are as follows:
–Salary Deferral Limit for 401(k), 403(b), and 457 plans remains unchanged at $17,500. The age 50 and up catch-up limit also remains unchanged at $5,500 for a total contribution limit of $23,000.
–The compensation threshold for “highly compensated employee” remained at $115,000 for a second year in a row.
–Traditional and Roth IRA contributions and catch-up amounts remain unchanged at $5,500 and $1,000, respectively.
–SIMPLE 401(k) and IRA contribution limits remain at $12,000.
Limits that did increase are as follows:
–Maximum total contribution to a 401(k) or other “defined contribution” plans under 415(c) increased from $51,000 to $52,000 ($57,500 for employees aged 50 and older).
–Maximum amount of compensation on which contributions may be based under 401(1)(17) increased from $255,000 to $260,000.
–Maximum annual benefit under a defined benefit plan increased from $205,000 to $210,000.
–Social Security Taxable Wage Base increased from $113,700 to $117,000.
–The dollar limit defining “key employee” in a top-heavy plan increased from $165,000 to $170,000.

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Reality Check on IRA Investments in Real Estate

Multiple times each year I am asked by prospective clients whether, and how, they can invest traditional IRA assets in real estate.  In this time of distressed real estate and very low interest rates, many investors have maxed out on their after-tax investments in real estate, and their IRA account balances beckon as a new source of investment capital.  If these folks look online, they will find many sources of purported “advice” on how to get rich through IRA investments in real estate.  Unfortunately, the information available online usually obscures or overlooks altogether some significant practical and tax hurdles to making IRA investments in real estate work from both the technical/legal and “return on investment” perspectives.

Below I summarize those obstacles.  They are not barriers, per se, but prospective investors should assess them carefully, preferably in consultation with their attorneys, CPAs, or other tax advisors, before committing IRA assets to an investment in real property.    Failure to steer clear of them could result in immediate taxation of the entire IRA account – including conventional investments.

  1. Understand How the IRS Views Your IRA

A very important concept that much of the online marketing around IRAs overlooks is that, from the perspective of the IRS:

  • the IRA is solely meant to provide a source of retirement income and is not a ready source of capital for an investment opportunity; and
  • You are a fiduciary with regard to your IRA account.

The IRS applies a term – prohibited transaction or “PT” – to any use of IRA assets for personal gain other than preservation of a retirement income stream.  The prohibited transaction rules disallow a number of specific transactions, such as selling real estate to or buying it from your IRA, or personal or immediate family member use of real estate owned by an IRA, but they also generally prohibit “self-dealing” which is defined to include any act of a fiduciary (i.e., you) by which IRA income or assets are used for the fiduciary’s own interest.   Examples of self-dealing could include purchase of real estate built on speculation by a son in law, purchase of real estate adjoining your own property or that of a family member in order to control how the property is used and who lives there, or , outside the real estate context, use of IRA assets alongside personal assets in order to meet a minimum investment account threshold.

If your IRA investment in real estate constitutes a prohibited transaction of any stripe, the total account balance of the IRA will be treated as if it were distributed to you on the first of the year in which the investment is made, and thus included in your taxable income for that year.  If you are under age 59 ½, you also may have to pay an early distribution penalty equal to 10% of the prohibited investment.

Even if the purchase transaction satisfies PT rules, management of the IRA-owned real estate can also trigger violations, as is discussed in section 4, below.

  1. Analyze the Tax Consequences:  Income Tax Rates, versus Capital Gains (plus deductions)

Investing IRA assets in real estate means that gains on your investment  –  when realized through sale of the real estate and distributed from the IRA – will be taxed at regular income tax rates, rather than the lower capital gains rates that apply to after-tax real estate investments.  Also, during the time that your IRA holds the real estate, depreciation and the many deductions for property expenses claimed on Schedules C or E will not apply as they would to after-tax real property investments.

  1. Pay Cash – Avoid Unrelated Debt Financed Income

Your IRA must pay cash for the real estate, otherwise tax will be owed on “unrelated debt financed income” under Internal Revenue Code Section 514 if the leveraged property generates income (such as rents) or if it is sold for a profit while the mortgage is still outstanding (or within 12 months of paying it off).   The IRA trustee or custodian must pay the tax.

In determining how much your IRA can afford to pay for a parcel of real estate, you must arrange ahead of time, preferably with the help of a CPA or other tax advisor, to maintain liquid investments in the IRA to pay off certain recurrent costs and expenses, and for other reasons outlined in 5 – 7, below.

  1. Follow Correct Procedures (the Natalie Choate 4-Step Test)

As mentioned, the IRS views you as a fiduciary with regard to your own IRA.  Because the PT rules prohibit an IRA fiduciary from engaging in business transactions with the IRA itself, you will need to use third parties both to purchase the real estate, and to manage the real estate.  Natalie Choate, a nationally recognized authority on the estate planning aspects of IRAs and qualified retirement plans, specifically recommends the following four steps:

  • Find a specialized IRA  custodian.  Not all IRA custodians are well versed in the intricacies of the prohibited transaction rules, and how real estate investments may trigger violations.  You will want to find a bank custodian who has experience in this area.  Work through trusted contacts such as your CPA or other tax advisor until you have found the right match.
  • Custodian engages in purchase transaction, not you.  The PT rules require that the IRA custodian, not you as IRA fiduciary, uses your IRA assets to purchase the real estate.  You cannot buy the real estate and transfer it to your IRA, or sell it to your IRA.  The latter transaction would be a PT; the transfer would not work because generally only cash may be contributed to an IRA.
  • The Custodian engages a third party property manager. This step is recommended if your real estate has residential tenants or commercial tenants in anything other than a “triple net” lease requiring that they assume costs the landlord otherwise would pay.  The property manager, not you, should run the property (e.g., make repairs, collect rent, pay expenses and property taxes, etc.) and send the IRA custodian a check each month that is net of all such costs.  This arrangement makes it unlikely that you will intermingle your personal assets with the IRA assets, for instance by directly hiring a painter or gardener, or by paying a bill associated with the IRA owned property.
  •  No family use or sweat equity.  For the same reasons that a third party property manager is recommended, you must avoid any personal use of the IRA-owned real estate, or use by direct family members.  Even use by extended family members or family friends could comprise a “self-dealing” type of PT as described above.  You must also resist the urge to work on the property yourself, show apartments, or have family members fill any of these roles.  Ideally, your property manager will anticipate and take care of such needs on an arms-length basis, without involving you.
  1. Set Aside Liquid IRA Investments for Required Minimum Distributions

When you reach age 70 ½, the IRS requires that you begin taking annual minimum required distributions from your traditional (i.e., non-Roth) IRA.  If you have multiple traditional IRAs, you can choose one from which to take distributions, but you must pool all IRA account balances together to determine the minimum required amount you must withdraw each year.  Failure to timely take out a sufficient amount could result in a 50% tax, based on what you should have withdrawn.  Needless to say, minimum required distributions are most easily made from liquid IRA investments – stock that can be sold, money market accounts, etc.  Before investing IRA assets in real estate, make sure that you preserve sufficient liquid IRA investments from which to take required minimum distributions.  You CPA or other tax advisor can help you do some advance planning in this regard, to determine the principal amount you should set aside for this purpose, and income you can expect it to generate.

Failure to preserve liquid investments for this purpose will make it very hard to take minimum required distributions.  You might have to distribute fractional interests in the IRA-owned real estate, which would be an expensive process (both in determining the value of the fractional interests, and in documenting the interest transfer).

  1. Set Aside Liquid IRA Investments for Annual Valuations of the RE Investment

Most reputable IRA custodians will require annual valuations of real estate investments or other non-traditional investments (privately held stock, etc.)  The valuation may cost several thousand dollars, possibly more.  The IRA must pay for this expense; you cannot use personal funds.  Before committing IRA assets to the real estate purchase, you need to determine how much in liquid IRA investments you need to aside in order to pay this recurrent expense from either the liquid investments themselves and/or anticipated investment income they generate.

  1. Set Aside Liquid IRA Investments for Property Taxes, Expenses, Insurance Improvements, Management Fees

As mentioned, your third party property manager will be using IRA funds to pay property taxes, maintenance and other expenses, insurance, improvements, and will also draw on the IRA to pay its own management fees.  Before committing IRA assets to the real estate purchase, you will need to determine how much in liquid IRA investments you need to set aside in order to pay these expenses from the investments themselves and/or anticipated investment income they generate.  Some amounts will be predictable and recurring; others, such as large repairs (roof replacement, etc.) are not predictable and you will have to use good judgment in estimating a set-aside.

Bottom line, IRA investments in real estate can be done, but there are many rules that must be followed to avoid disqualification of the IRA and immediate taxation of the entire IRA account. The availability of required minimum distribution amounts, the loss of capital gains treatment, and the self-dealing restrictions, generally make an IRA investment in real property unsuitable and problematical at best.  For investors who are still “game,” some advance financial and tax planning strongly is advised both before the transaction occurs, during the life of the real estate investment, and well in advance of any minimum required distribution start date.

Finally, you will note that this post does not discuss strategies using business entities within an IRA, such as IRA-owned single member limited liability companies (“LLCs”).   Often marketed as “checkbook control” IRAs, these arrangements raise a host of compliance issues over and above the ones discussed below.  The Groom Law Group has an excellent article debunking this and a number of other questionable IRA strategies that you can read here.

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Treasury Department Issues Guidance Easing Access to Lifetime Payout Options

On February 2, 2012 the Treasury Department issued guidance aimed at easing employee access to lifetime payout options from 401(k) and other defined contribution plans (IRAs and IRA-based arrangements are exempt) A link to the related fact sheet is here, and proposed regulations and a Treasury/IRS ruling will follow with more details. (An advance copy of the proposed regulation is available here.)

The Department’s fact sheet outlines the reason for the initiative – the “longevity risk” that results from increased life spans and the prevalence of lump-sum retirement plan distributions in the post-defined benefit plan era. Through a request for public comments, the Department gathered data and studied ways in which current provisions of the Internal Revenue Code discourage plan participants from choosing life annuity and other incremental payout options. The guidance package outlines both the regulatory barriers that they identified, and their proposals to make lifetime income options more accessible and popular among plan participants. The proposed changes are as follows:

1) To correct the “all or nothing” choice between a lump sum or an annuity payout, proposed regulations will simplify the manner of calculating a distribution that is part lump sum, part annuity, so that plans are more likely to offer this blended form of distribution;
2) To address retirees’ fears of outliving required minimum distribution payments that generally must begin at age 70 ½, proposed regulations would allow use of up to 25% of an IRA or 401(k) account balance (or $100,000, if less) to purchase a “longevity annuity” that will begin payment by age 85.
3) To expand access to cost-effective annuity forms of payout under the relatively few remaining defined benefit pension plan, a Treasury/IRS ruling will explain permit full or partial rollovers from a 401(k) plan, to a defined benefit pension plan sponsored by the same employer, in exchange for an immediate annuity from that plan.
4) To aid employers and third party administrators who are unsure of how spousal consent rules work in relation to deferred annuities, including longevity annuities, a Treasury/IRS ruling will identify plan and annuity terms that will automatically protect spousal rights without requiring spousal consent before the annuity begins, shifting the spousal consent compliance to the insurer issuing the annuity. (Many if not most 401(k) plans have opted out of rules requiring spousal consent under ERISA, however many investment providers in community property states require spousal consent to any loans or distributions.)

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DOL Disallows IRA Promissory Note Investment

Last week, the Department of Labor issued Advisory Opinion 2011-04A finding that it would be a “prohibited transaction” (“PT”) for an IRA to purchase a promissory note and deed of trust from a bank where the IRA owner and his spouse were indebted under the note, and where the IRA owner’s family trust held title to the real property at issue.

This ruling is important because the Department of Labor concluded that the proposed arrangement would be an impermissible extension of credit from the IRA to the IRA owners, even though the owners simply intended to move the existing loan over from a bank to the IRA without thereafter refinancing or otherwise taking any action that would constitute a new loan from the IRA. Also significant is that the Department of Labor classified the proposed transaction as prohibited self dealing, for reasons explained below.

The Advisory Opinion involved an IRA that the owner opened over twenty years ago. The owner was the sole account holder and his wife was the sole beneficiary. In 1993 the owners bought an eight-unit apartment building in San Diego for $200,000, financed with a loan from Chase Bank that was secured by a first deed of trust on the property, and evidenced in the form of a promissory note. Title to the property was held in the name of the owners’ family trust. The owners were the trustees and sole beneficiaries of the family trust.

What the owners proposed to do was to have the IRA purchase the promissory note and deed of trust from Chase Bank. Chase Bank would assign the note and deed over to the IRA, or more precisely to another bank serving as IRA custodian, and the owners would make all subsequent payments on the note to the IRA custodian, which in addition to receiving payments would otherwise enforce the promissory note.

The owners’ request for an advisory opinion specifically pointed out that “the transaction [was] structured to avoid any new loan or other extension of credit between the IRA and the [owners], as would occur if they refinanced the loan under different terms using the IRA as a new lender.”

This language refers to one type of prohibited “party in interest” transaction – the direct or indirect lending of money or other extension of credit between a plan (here, the IRA) and a disqualified person or persons (here, the IRA owners). ERISA and the Internal Revenue Code (“Code”) describe four other types of specific prohibited transactions as well as several general categories of prohibited “self dealing” with IRA/plan assets by a fiduciary. Of relevance here are (a) the transfer of plan assets or income to, or use of them by or for the benefit of, a disqualified person; and (b) dealing with plan assets or income for the fiduciary’s own personal account. These are set forth in Code Section 4975(c)(1)(D) and (E), respectively.

The Department of Labor analysis first identified the IRA owner as a fiduciary with regard to the IRA due to his sole discretion over IRA investments. As a fiduciary he was a “disqualified person” as that term is defined in Code Section 4975(e)(2), as were his family members (including his wife) and his family trust, as he and his wife (now both fiduciaries and disqualified persons) together owned more than 50% of the trust. (The DOL has express authority to interpret Section 4975 of the Code and also interprets parallel provisions of ERISA governing prohibited transactions.)

Then, the Department of Labor rejected the notion that simply “moving” the loan over from Chase Bank to the IRA was not a prohibited extension of credit from the IRA to the IRA owners. First, it cited Department policy that a loan is a transaction that “continued from the time it is made until all amounts due are paid,” and that the parties must be examined throughout that time for indicia of a prohibited relationship. On that basis the Department found that a prohibited extension of credit would occur as soon as the IRA acquired the note from Chase Bank, and that the IRA’s holding of the note would constitute another prohibited extension of credit so long as the IRA owners or any other disqualified persons made payments on the note.

The Department of Labor went on to determine that the transfer to and holding of the loan by the IRA would also constitute prohibited self dealing if the transaction was part of an agreement, arrangement or understanding by the IRA owner, as the IRA’s fiduciary, “to benefit himself or persons in which he has an interest that affects his best judgment as a fiduciary (e.g., the Family Trust.)” Noting that this was “generally an inherently factual question,” the Department observed that the proposed purchase of the note by the IRA from Chase Bank would be one in which the IRA owner “would have an understanding, as a fiduciary, that the assets of the IRA are being used to create a prohibited transaction (i.e., an ongoing debtor-creditor relationship between the IRA and disqualified persons) once the IRA acquires the Note.” It therefore concluded that, under those circumstances, the IRA’s purchase of the note would be a separate, self-dealing prohibited transaction under Code Section 4975(c)(1)(D) and (E).

This Advisory Opinion is a good example of how a proposed IRA investment that had been structured with an attorney’s advice and approved by a very reputable bank custodian could still be found to be three different types of prohibited transaction, once under the scrutiny of a government agency. Simply put, this is an area of the law where even the cautious can come to grief. Seeking a tax advisor’s opinion, if not agency approval, is advised before proceeding with any unorthodox IRA investment.

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