investment in contract before 08/14/82
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Penalty Exceptions—Disability Exception
• Disability is defined as unable to engage in substantial gainful activity because of any medically determined physical or mental impairment that can be expected to result in death or be of long-continued and indefinite duration.
• Substantially gainful activity refers to the activity or a comparable activity in which the individual customarily engaged in prior to the disability.
• In order to qualify for the disability exception, the taxpayer must be able to furnish proof of the disability.
• Although the IRS has not prescribed in what form or matter the proof must be furnished, attaching to the return a physician’s statement describing the medical condition resulting in the disability is always a good idea.
Penalty Exceptions—Substantially Equal Periodic Payments
• To qualify under the substantially equal periodic payments provision, the
distribution must be part of a series of substantially equal periodic payments made at least annually for the life expectancy of the account owner or the joint life
expectancies of the account owner and their beneficiary.
• The payments may be altered (or stopped completely) after the later of:
• The date the employee turns age 59½, or
• The close of the five-year period beginning with the date the initial payment was received.
Penalty Exceptions—Substantially Equal Periodic Payments
• Modifications of the payment result in the 10% penalty being retroactively applied.
• The penalty is calculated on all current and previous distributions that were received before the taxpayer turned 59½.
• The taxpayer must pay interest on the penalty beginning with the tax year the penalty would have been payable and ending on the actual date of payment.
• The payment is considered modified if after the date the payment starts, any of the following happen:
• There is any addition to the account other than gains or losses.
• Any nontaxable transfer of a portion of the account balance to another account.
• A rollover by the taxpayer of an amount received that is not taxable.
Penalty Exceptions—Substantially Equal Periodic Payments
• Stopping the payment or taking an extra payment.
• Changing the payment frequency (i.e., from annual to monthly payments).
• There is no modification to the payment and therefore no recapture of the penalty if the account is depleted prior to the required age or five-year time period or the modification is “by reason of death or disability” [IRC Dec. 72(t)(4)(A)].
Penalty Exceptions—Substantially Equal Periodic Payments
• Three calculations qualify (other methods may be allowed but require an IRS PLR).
• Minimum Required Distribution Method – produces the smallest payment. Results in the exact amount required, not the minimum. The account is annually revalued.
• Fixed Annuity Factor Method – the account is amortized at an interest rate that is reasonable over the number of years equal to life expectancy.
• Fixed Annuitization Method – Produces the largest payment. The account balance is divided by an annuity factor using a mortality factor and a “reasonable interest rate."
Penalty Exceptions—Substantially Equal Periodic Payments
• Fixed Annuity Method Example: Assume a reasonable rate of 4.5% that is 120% of the applicable federal mid-term rate.
• Ron calculates an annual payment using his remaining life expectancy of 34.2 years which will yield a fixed annual payment of $28,917.
• Fixed Annuitization Method Example: This calculation is typically done by an actuary and is based on the actuarial present value of an annuity of one dollar a year payable over the life of a 50-year old.
• The annuity factor of 17.462 is calculated based on the mortality table in Appendix B of Rev. Rul. 2002-62 and an interest rate of 4.5%. The annual distribution is calculated at $28,634 ($500,000/17.462).
Penalty Exceptions—Substantially Equal Periodic Payments
• Rev. Rul. 2002-62 and notice 2004-15 allow a one-time change from either the amortization method or the annuitization method.
• A reasonable rate of interest for either the amortization or annuitization methods cannot be more than 120% of the federal mid-term rates for either of the two months immediately preceding the month in which the distribution begins.
• Distributions taken to the extent of deductible medical expenses.
• The participant does not have to itemize their deductions but expenses must exceed AGI threshold amount for medical expenses.
• While there is no requirement that the proceeds be traced to payment of the qualified medical expenses, it is crucial to take the distribution in the year that the qualifying medical expenses are paid.
Penalty Exceptions—Federal Levy Exception
• Payments from an account due to a federal levy are exempt from the penalty tax.
• However, if a taxpayer voluntarily withdraws funds from their IRA or qualified account, the penalty is still assessed.
• Qualified reservist distributions from an IRA or qualified plan are exempt from the 10% penalty.
• A qualified reservist is one called to duty after September 11, 2001 for a period of 179 days or more.
• A qualified distribution occurs after the call of duty and before the end of duty.
• Reservists have two years to re-contribute all or part of these distributions in the period following the end of duty.
Penalty Exceptions—Separation from Service at Age 55 (50 for Public Safety Employees)
• Does Not Apply to IRAs or SEPs.
• Employee must separate from service.
• Public safety employees include police, firefighters, emergency medical service personnel for a state or political subdivision.
• Withdrawals up to the amount paid for deductible medical and long-term insurance costs are exempt from penalty if unemployment benefits have been received for at least 12 consecutive weeks.
• Also applies to self-employed individuals who otherwise would have qualified for unemployment benefits.
Penalty Exceptions—First-Time Homebuyer Exception (IRA Only)
• Up to $10,000 of cumulative lifetime withdrawals used for home buying costs for a first-time homebuyer who is either the taxpayer, taxpayer’s spouse, child,
grandchild, ancestor or spouse’s ancestor.
• Funds must be used within 120 days of receipt for cost to acquire, construct or reconstruct principal residence.
• If acquisition is delayed or cancelled, the funds can be rolled back into an IRA within 120 days of receipt rather than the normal 60-day rule.
• First-time home buyer is defined as not having had an ownership interest in a
• Withdrawals from IRAs to the extent they do not exceed the qualified higher education expenses of the taxpayer, spouse, child, stepchild or grandchild.
• Qualified higher education expenses include tuition, fees, books, supplies, equipment required for enrollment, and room and board (if student is at least a half-time student) at a post secondary institution.
• Includes graduate school.
• Withdrawals must occur in the same tax year as the higher educational expenses.
Penalty Exceptions—Self-funding of a Business by Use of Funds in a Retirement Plan (ROBS)
• Encouraged by third party administrators to use retirement funds as capital.
• The “owner” moves their retirement funds into a qualified plan sponsored by the closely held C corporation.
• The qualified plan buys the C corporation stock giving the business a cash infusion.
Plan (ROBS)
• The IRS has warned on numerous occasions that many of these plans are potentially abusive arrangements.
• While there are some success stories, most ROBS businesses either failed or were on the road to failure with high rates of bankruptcy (both personal and business), liens (personal and business) and corporate dissolutions.
Recent Court Cases
• Brandon Clark and Heidi Heffron-Clark, 7th US Circuit Court of Appeals, Nos. 12-1241 and 12-1255
• Heidi inherited $300,000 from her mother.
• In 2011 bankruptcy judge rules creditors could go after inherited IRA.
• District court reversed this ruling.
• The Appeals court reversed District court ruling.
• Inherited IRAs differ from other IRAs in three ways:
• A beneficiary of an inherited IRA cannot make contributions to the account.
• A beneficiary of an inherited IRA cannot roll the IRA into another retirement plan.
• Distributions from an inherited IRA must begin within a year or be entirely distributed within five years.
Revenue Ruling 2013-17
• Registered Domestic Partnerships, Civil Unions, or Other Similar Formal Relationships not Denominated as Marriage
• For federal tax purposes, the term “marriage” does not include registered domestic partnerships, civil unions, or other similar form relationships recognized under state law that are not denominated as marriage under that state’s law.
• This applies regardless of whether individuals who have entered into such relationship are of opposite sex or the same sex.
• Example: Brad and Angelina enter into a civil union in their home state of Illinois.
• For federal tax purposes, Brad and Angelina will not be considered married.
• This may differ from how Illinois treats civil unions.