NEWS AND RESOURCES

Financial Planning for December 1999

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Tax Traps in Retirement and How to Avoid Them
If you plan to retire in the year 2000, or even 2001, you'll be faced with a number of options and a bewildering array of tax consequences. Avoid costly mistakes by learning the tax rules now, well before your eligible for a payout from your company's plan.

IRS penalties for not handling your retirement nest egg properly can be substantial. Some of the biggest tax traps are the easiest to avoid, if you know what to do.

1. Distributions too late.
You must begin taking distributions from your IRA by April 1 of the year after the calendar year in which you turn age 70 ˝. If you don't, the IRS will take 50% of the amount you should have taken as a penalty. Participants in other types of plans, however, can wait until later retirement to start receiving payouts, unless they also own 5% of the firm.

Prevent the IRS from taking your hard-earned retirement money by taking the proper distribution at the proper time. The amount you are suppose to take: An annual distribution calculated to deplete your retirement account over your life expectancy or the expectancy of a beneficiary you designate.

2. Distributions too early.
If you take money out of your retirement plan before you reach age 59 ˝ you may be subject to an additional 10% tax on the distribution. Consult your tax advisor for details. This is on top of the regular tax you'll have to pay from being forced to include the distribution in your taxable income.

Avoid this trap.
Leave your money in the plan even if you have to look elsewhere for funds you need now. In some cases, employees can borrow from retirement plans when the money is needed for a specific reason, such as medical care.

3. Taking a distribution by mistake.
When you leave a company you may be given the option to receive the balance of your retirement account.

Warning

If the plan provides an option for you to take the distribution, do tax-planning with the distribution. You might transfer the distribution into an IRA, put it into your new employer's plan if allowed or keep it in the former employer's plan. This full distribution will be taxed if you keep it, and the IRS may impose a 10% penalty.

Tax-trap avoider.
If you receive a distribution, roll it into the plan at your new job or into your own Individual Retirement Account.

4. Failing to contribute to a retirement plan.
If you are employed by someone else or you are self-employed, retirement plans defer taxes in two ways…


  • The amount that you contribute is subtracted from your taxable income for the year for which the contribution is made. The contribution isn't taxed until withdrawal at retirement.
  • Tax on the earnings in your account are deferred until withdrawal.

Avoid this trap
Make the maximum contribution to every type of retirement plan that you are eligible for. Don't miss out on the double benefit.

5. Extending the time to make your contribution.
You can extend the time to make your contribution. You have until your tax return is due on April 15 to make your IRA contributions for the prior tax year.

If you are an individual or a small company, the due date for your Keogh or SEP plan contribution is extended for as long as you have extended the time to file your tax return. This may give you up to the extended due date of your return to complete your contribution for the prior tax year. (But the Keogh plan must have been set up before year end.)

Even better.

You will have had the use of the money up until this extended due date while you were waiting to make the contribution.

6. Not making your maximum contribution.
Every type of self-employed retirement plan has a formula to calculate the maximum allowable contribution. The formulas can be complex and tedious.

Avoid this tax trap.
Take the time to understand the rules and make the proper calculations. Or, retain an accountant to do it for you.

7. Taking a loan that is not allowed.
Self-employed business owners, S corporation shareholders and certain partners are not allowed to borrow against their retirement plans. Loans between the plan and its other participants must meet certain specific rules before a loan is allowed.

Tax-trap avoider
If you are in a plan that allows you to take a loan, make sure you adhere to its requirements to avoid any additional taxes.

8. Not contributing on behalf of your employees.
Self-employed business owners often make the mistake of contributing to a plan that covers themselves only. They don't realize that they are also required to make contributions for all eligible employees each year.

Additional rule

The plan must be in writing and it must set be set up by the last day of the calendar year for which you are making the contribution. You need not make the actual contribution until the due date of your return, plus extensions.

Eligible employees

Full-time employees who have reached age 21 and have worked for you for at least one year. Amount: The contribution formula for employees is the same formula that you use for yourself.
Example: If you contribute 10% of your salary, then you must contribute 10% of your employees' salary on their behalf.
Penalty: If these employee contributions have not been made, the IRS will declare the plan "discriminatory," and it could be disqualified as a tax deduction. Your contributions won't be deductible, and the amounts would then be taxed as current income.

9. Investing in prohibited transactions.
Self-employed people must be extremely careful when deciding where to invest their retirement plans.

Prohibited investments:

A plan that involves a sale, exchange or lease of property between the owner and the plan may constitute a prohibited transaction. Consult your tax advisor before undertaking such a transaction.

10. Not contributing the maximum amount to your 401(k) plan.
You are allowed to contribute 25 percent of your salary up to $10,000 during 1998. The contribution to the plan is tax-deductible. The income from your 401(k) is tax-deferred.

Special bonus:

Your employer may have a program where it matches all, or a portion, of the amount you contributed to your company's plan as soon as you are eligible.

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