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2021 Qualified Charitable Distributions from IRAs

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“The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 changed the age for taking requirement minimum distributions (RMDs) to age 72.  Did it also change the age for making Qualified Charitable Distributions (QCDs)?”

 

ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare.  We bring Case of the Week to you to highlight the most relevant topics affecting your business. A recent call with a financial advisor from Alabama is representative of a common inquiry related to charitable giving.

Highlights of the Discussion

  • No, the SECURE Act did not change the eligibility age for making a QCD; it remains at 70½. So, any “eligible IRA owner or beneficiary” (defined below) can make a QCD up to $100,000 for 2021 by December 31, 2021.  The contributor must keep records to prove the amount of the QCD  (see Substantiation Requirements in IRS Publication 526, Charitable Contributions).
  • Those who make QCDs before reaching age 72 will not have the added benefit of counting them towards their RMDs, but the QCDs still will be excludable from taxable income and go towards supporting good causes. Because a QCD reduces taxable income, other potential benefits may result, for example, a person may be able to avoid paying higher Medicare premiums. Note that for those who make both QCDs and deductible IRA contributions[1] in the same year may need to limit the portion of a QCD that is excluded from income.
  • An eligible IRA owner or beneficiary for QCD purposes is a person who has attained age 70½ or older, and has assets in traditional IRAs, Roth IRAs, or “inactive” SEP IRAs or savings incentive match plans for employees (SIMPLE) IRAs. Inactive means there are no ongoing employer contributions to the SEP IRA or SIMPLE IRA. A SEP IRA or a SIMPLE IRA is treated as ongoing if the sponsoring employer makes an employer contribution for the plan year ending with or within the IRA owner’s taxable year in which the charitable contribution would be made (see IRS Notice 2007-7, Q&A 36).
  • A QCD is any otherwise taxable distribution (up to $100,000 per year) that an eligible person directly transfers to a “qualifying charitable organization.” QCDs were a temporary provision in the Pension Protection Act of 2006. After years of provisional annual extensions, the Protecting Americans from Tax Hikes Act of 2015 reinstated and made permanent QCDs for 2015 and beyond.
  • Generally, qualifying charitable organizations include those described in §170(b)(1)(A) of the Internal Revenue Code (IRC) (e.g., churches, educational organizations, hospitals and medical facilities, foundations, etc.) other than supporting organizations described in IRC § 509(a)(3) or donor advised funds that are described in IRC § 4966(d)(2). The IRS has a handy online tool Tax Exempt Organization Search, which can help taxpayers identify organizations eligible to receive tax-deductible charitable contributions. Note that a QCD contributor would not be entitled to an additional itemized tax deduction for a charitable contribution when making a QCD.
  • Where an individual has made nondeductible contributions to his or her traditional IRAs, a special rule treats amounts distributed to charities as coming first from taxable funds, instead of proportionately from taxable and nontaxable funds, as would be the case with regular distributions.
  • Be aware there are special IRS Form 1040 reporting instructions that apply to QCDs.
  • Section IX of IRS Notice 2007-7 contains additional compliance details regarding QCDs. For example, QCDs are not subject to federal tax withholding because an IRA owner that requests such a distribution is deemed to have elected out of withholding under IRC § 3405(a)(2) (see IRS Notice 2007-7 , Q&A 40).
  • There are other charitable giving options aside from QCDs. For example, the Consolidated Appropriations Act extended two temporary tax changes through the end of 2021 to encourage charitable giving by individuals (see Covid Tax Tip 2021-143). They include 1) a limited deduction (up to $600 for married couples) for charitable cash contributions for individuals who do not itemize deductions; and 2) a deduction of up to 100 percent of the taxpayer’s adjusted gross income for certain charitable cash contributions (if properly elected on their 2021 Form 1040 or Form 1040-SR) by those who itemize their deductions.
  • As one can see, the options for charitable giving are many and can be confusing, making consultation with a tax professional a recommended course of action.

Conclusion

Eligible traditional and Roth IRA owners and beneficiaries, including those with inactive SEP or SIMPLE IRAs, should be aware of the benefits of directing QCDs to their favorite charitable organizations.  Law changes and extensions have enhanced other giving options, making professional tax advice essential when making a gifting decision.

 

[1] The SECURE Act also eliminated the maximum age limit for making traditional IRA contributions.

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Privacy Notices and Retirement Plans

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“One of my clients who sponsors a 401(k) plan asked about the timing of sending a recordkeeper privacy notice to plan participants.  Does such a notice exist and, if so, when is the due date for delivery?”

ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare.  We bring Case of the Week to you to highlight the most relevant topics affecting your business.

A recent call with a financial advisor from Oklahoma is representative of a common inquiry related to 401(k) plan notices.

Highlights of the Discussion

At this time, there is no federal requirement for recordkeepers of qualified retirement plans to issue privacy notices to plan participants. However, a similar requirement could be coming down the pike as regulators become more concerned over retirement plan cybersecurity issues. In practice, research has found that some third-party administrators (TPAs) who administer both health plans [regulated by the Health Insurance Portability and Accountability Act of 1996 (HIPAA)] and retirement plans (regulated by the Employee Retirement Income Security Act of 1974 (ERISA)] have adopted similar security protection practices for both areas, including sending out Privacy Notices.[1]

As you may know, HIPAA is the federal law that resulted in the creation of national standards for the protection of sensitive patient health information from being disclosed without the patient’s consent or knowledge. The HIPAA Privacy Rule requires health plans and covered health care providers (“covered entities”) to distribute a notice that provides a user-friendly explanation of an individual’s rights with respect to their personal health information and the privacy practices of the covered entities. Covered health care entities must give the notice at enrollment and send a reminder at least once every three years explaining that individuals may request the notice at any time. The Privacy Notice must appear on the entity’s website and be posted in a conspicuous location as well.

With respect to qualified retirement plans, the Department of Labor currently has not created definitive cybersecurity rules or regulations. Instead, in April of 2021, it issued cybersecurity tips and best practices for plan sponsors, recordkeepers and participants:

  • Tips for Hiring a Service Provider: This piece helps plan sponsors and fiduciaries prudently select a service provider with strong cybersecurity practices and monitor their activities, as ERISA requires.
  • Cybersecurity Program Best Practices: This piece assists plan fiduciaries and record-keepers in their responsibilities to manage cybersecurity risks.
  • Online Security Tips: This piece offers plan participants and beneficiaries who check their accounts online basic rules to reduce the risk of fraud or loss.

Despite the lack of formal directives from the DOL, there is an understanding under DOL Regulation Section 2520.104b-1(c) and other pronouncements related to the electronic delivery of plan information that a plan sponsor must ensure the plan recordkeeping system it uses keeps participants’ personal information relating to their accounts and benefits confidential.

Conclusion

Currently, there is no HIPAA-like Privacy Notice required for retirement plan participants at this time. DOL regulators continue their conversations over what rules

[1] Advisory Council on Employee Welfare and Pension Benefit Plans, “Privacy and Security Issues Affecting Employee Benefit Plans, 2011

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Establishing a Solo 401(k) under the New Rules

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“My client is a sole proprietor and would like to set up a solo 401(k) plan for 2021. Are there any special considerations of which he needs to be aware?

ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business. A recent call with a financial advisor from Connecticut is representative of a common inquiry related to establishing a Solo 401(k) plan.

Highlights of the Discussion
• Yes, there are special considerations with respect to establishing and contributing to a solo 401(k) plan. For that reason, your client should work with his CPA, tax advisor and/or legal counsel to address all the issues.

• Three of the key consideration would include the following items, the

 Deadline for establishing the solo 401(k) plan,
 Deadline for making a salary deferral election, and
 Owner’s compensation for contribution purposes.

• In order to be able to make employee salary deferrals to the solo 401(k) for 2021, a sole proprietor would have to establish the solo 401(k) and execute a salary deferral election by December 31, 2021. Here’s why.

• Although the Setting Every Community Up for Retirement Enhancement (SECURE) Act, delayed the deadline for establishing a qualified retirement plan for a particular tax year until the business’s tax return due date, plus extensions, in practice, the delay only applies for facilitating the ability to make employer contributions (e.g., a profit-sharing contribution) for the prior year—not employee salary deferrals. Let’s take a look at an example.

EXAMPLE
The 2021 maximum contribution for an unincorporated business owner to a solo 401(k) plan with enough earned income could be as high as $58,000 (or $64,500 if he or she turns age 50 or older before the end of the year). Anthony, a 54-year-old sole proprietor who earns $400,000, would like to set up a solo 401(k) plan for 2021. If Anthony establishes the solo 401(k) by December 31, 2021, and executes a salary deferral election by the same date, his maximum contribution for 2021 would be $64,500.

If, under the new plan establishment rules, Anthony waits until sometime in 2022 before his extended tax filing deadline for 2021 (i.e., October 15, 2022) to establish a solo 401(k) for 2021, he could not make employee salary deferrals for 2021. Consequently, his maximum contribution in this scenario would be limited to $58,000 for 2021.

• In all cases, a salary deferral election must be made prior to the receipt of compensation Treasury Regulation (Treas. Reg.) 1.401(k)-1(a)(3)]. Pursuant to Treas. Reg. 1.401(k)-1(a)(6)(iii), for self-employed individuals (i.e., sole proprietors and partners), compensation is considered paid on the last day of the business owner’s taxable year (e.g., December 31, 2021 for 2021). Therefore, a self-employed person has until the end of his or her taxable year to execute a salary deferral election for “the plan.” Conservatively, that means the plan would have to be in place by December 31, 2021, as well to allow for the sole proprietor to make the salary deferral election.

• The definition of compensation for contribution purposes for an unincorporated business owner is unique IRC 401(c)(2)(A)(I). It takes into consideration earned income or net profits from the business but must be adjusted for self-employment taxes. Please refer to the worksheet for calculating contributions to a solo 401(k) plan for a self-employed individual in IRS Publication 560, Retirement Plans for Small Businesses

 

Conclusion
For self-employed individuals and their tax advisors, there are several special considerations with respect to setting up and contributing to solo 401(k) plans, including, but not limited to, the deadline for establishing a 401(k) plan, the deadline for making a salary deferral election, and the owner’s compensation for contribution purposes.

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“Disregarded Entities,” 403(b)s and 457(b)s

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“How are subsidiaries and affiliates of an employer eligible to sponsor a 403(b) plan treated for plan participation purposes?”

Highlights of the Discussion

Generally, in order to offer an IRC §403(b) plan, the sponsor must be an “eligible employer” [e.g., a public school, church, or IRC §501(c)(3) organization as defined under Treasury Regulation (Treas. Reg) §1.403(b)-2(b)(8)(i)]. If the eligible 403(b) sponsor has a subsidiary or other affiliate; it, too, must be an eligible employer, in and of itself, in order to allow its employees to participate in the 403(b) plan [Treas. Reg. §1.403(b)-2(b)(8)(ii)].  There is an exception, however, for “disregarded entities” under Treas. Reg. §301.7701-3(b)(ii), including certain limited liability companies (LLCs) as explained in Chief Counsel Memorandum 201634021.[1] Memoranda are not formal guidance, but they do provide insight into how the IRS interprets and applies its rules and regulations.

In general, an LLC with a single owner may elect to be classified as either an association by filing Form 8832, Entity Classification Election or to be disregarded as an entity separate from its owner pursuant to Treas. Reg. §301.7701-3(b)(ii). If an entity is a disregarded entity, its activities are treated as those of a sole proprietorship, branch, or division of the owner under Treas. Reg. §301.7701-2(a). Consequently, a disregarded entity is treated as a branch or division of the 403(b) plan sponsor and not as a subsidiary or affiliate. Therefore, the employees of a disregarded entity are treated as employees of the entity sponsoring the 403(b), and must be allowed to make elective deferrals in order to satisfy the universal availability rule under Treas. Reg. § 1.403(b)-5(b).

The IRS applies similar reasoning to a governmental or tax-exempt, single-member LLC with a disregarded entity that sponsors a 457(b) plan. The disregarded entity is treated as a branch or division of the governmental or tax-exempt organization, so the employees of the disregarded entity are treated as employees of the governmental or tax-exempt organization and may, but are not required to, participate in the 457(b) plan.

Conclusion

In most cases, if a 403(b) sponsor has a subsidiary or other affiliate; it, too, must be an eligible employer, on its own, in order to allow its employees to participate in the 403(b) plan. There is an exception for certain disregarded entities. Employees of a disregarded entity are treated as employees of the entity sponsoring the 403(b), and must be allowed to make elective deferrals in order to satisfy the universal availability rule.

 

[1] Note:  General Counsel Memoranda are prepared by Chief Counsel attorneys and are intended primarily for IRS internal use. They are similar to standard attorney opinions and indicate the reasoning behind revenue rulings, private letter rulings, and technical advice memoranda.

 

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Small Estate Affidavits and Retirement Plan Assets

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“One of my clients who sponsors a 401(k) plan asked me about a “small estate affidavit;” what is it and can it be used with retirement account assets?”

ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare.  We bring Case of the Week to you to highlight the most relevant topics affecting your business.

A recent call with a financial advisor from Minnesota is representative of a common inquiry related to retirement account beneficiaries.

Highlights of the Discussion

A small estate affidavit is a creature of state law. A small estate affidavit is a sworn written statement that authorizes someone to claim a decedent’s assets outside of the formal probate process when the estate is below a set value. Each state that authorizes the use of such documents sets forth the process and procedure for their use in state statute. For example, the governing Minnesota state statute for collection of personal property by affidavit is §524.3-1201 when the value of the estate does not exceed $75,000.

A small estate affidavit may come into play when a person dies “intestate,” that is, without a will (or named beneficiaries in the case of retirement plan assets.) Usually, the estate of a person who has died intestate goes through probate court to determine who will inherit the decedent’s assets. Use of a small estate affidavit can bypass the probate process.

When it comes to retirement plan assets, ERISA 3(8) allows participants to designate beneficiaries directly. The governing plan documents will outline the steps and forms necessary to properly assign beneficiaries of the plan. Federal law requires the spouse of a plan participant to be the beneficiary by default, unless he or she formally waives his or her right to the assets. If a participant fails to properly designate a beneficiary, or if no beneficiary so designated survives the participant, most plan documents specify the beneficiary shall be the surviving spouse, or if there is no surviving spouse, the deceased participant’s estate.

Whether a plan sponsor or plan administrator should honor a small estate affidavit is an important legal question. A “best practices approach” for plan sponsors could include the following steps.

  1. Review what the governing plan document says about the distribution of assets when no beneficiary is named, particularly with respect to the use of small estate affidavits.
  2. If the plan document is silent on small estate affidavits, determine if there are distribution administration policies in place that address the use of small estate affidavits.
  3. Absent plan document and distribution policy guidance, or if the guidance is unclear, seek the advice of an attorney and document the recommended course of action.
  4. Consider formally addressing the use of small estate affidavits within the plan’s distribution policies and/or plan document.

Conclusion

Plan administrators may encounter small estate affidavits when a deceased plan participant’s estate is small as determined by state law. Honoring a small estate affidavit is an important legal question for plan sponsors. The most prudent course of action would be to proceed with caution with the guidance of legal counsel.

 

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Hierarchy of Payroll Deductions

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An advisor asked, “I’ve run across the client situation where an individual’s paycheck is too small to handle all the mandatory deductions or withholdings (e.g., payroll taxes, health insurance premiums, FSA contributions, life insurance, garnishments for child support and taxes, repayment of qualified loans, union dues, elective deferrals to a 401(k) plan, etc.) Is there a hierarchy of deductions that a payroll department should follow?

ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare.  We bring Case of the Week to you to highlight the most relevant topics affecting your business. A recent call with a financial advisor from California is representative of a common inquiry related to withholding on payroll.

Highlights of the Discussion

First, check to see if the employer or payroll processor have a written policy. With respect to 401(k) salary deferrals, you could check the governing plan documents to see if there is a written policy (although few plans contain such information).

If no policy exists, it is best to put one in place. ERISA does not prescribe a hierarchy of withholding, neither is one specified in federal tax law. For guidance, it would be prudent to discuss the issue with a tax attorney. For reference, here’s one example of withholding order that applies to Federal civilian employees issued by the United States Office of Personnel Management.

Generally, payroll deductions are either mandatory or optional. Mandatory deductions would include those identified under federal, state, and local law. An employer is legally obligated to collect this money and remit it to the proper authority. Optional deductions, on the other hand, are voluntary, and an employee must provide written authorization to have such amounts withheld from a paycheck.  Notice that 401(k) salary deferrals are akin to Thrift Savings Plan deferrals and, therefore,  are considered “optional.”

Conclusion

If an employer does not have a policy regarding the hierarchy of payroll withholdings, a best practice is to put one in place with the help of a tax advisor, and apply it consistently.

 

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Is Congress Closing the Backdoor to Roth IRAs?

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An advisor asked: “Is Congress Closing the Backdoor to Roth IRAs?”

ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

A recent call with a financial advisor from California is representative of a common inquiry related to Roth conversions.

Highlights of the Discussion
Potentially, yes, as well as restricting other Roth conversion strategies. As part of the tentative measures to help fund the proposed $3.5 trillion budget reconciliation package (a.k.a., Build Back Better Act ), the House Ways and Means Committee has suggested, among other tactics, restricting “back-door Roth IRAs,” a popular tax-reduction strategy where individuals convert traditional IRA and/or retirement plan assets to Roth IRAs. If enacted as proposed, after-tax IRA and after-tax 401(k) plan conversions would be eliminated after 12/31/2021. For amounts other-than after-tax (i.e., pretax assets), traditional IRA and plan conversions for taxpayers who earn over the following taxable income thresholds would cease after 12/31/2031:

• Single taxpayers (or taxpayers married filing separately) with AGI over $400,000,
• Married taxpayers filing jointly with AGI over $450,000, and
• Heads of households with AGI over $425,000 (all indexed for inflation).

The buildup of Roth assets can be a source of tax-free income later if certain conditions are met. Ending Roth conversions using after-tax contributions in a defined contribution plan or IRA, and restricting Roth conversions of pre-tax plan or IRA assets would materially limit many taxpayers’ ability to accumulate Roth assets in a tax-free or tax-reduced manner.
You won’t find the phrase backdoor Roth IRA in the Internal Revenue Code or Treasury regulations. Nor is it a specific product, but the industry has known about the phenomena for years. A backdoor Roth IRA is merely a series of transactions or steps an individual can take to have a Roth IRA—regardless of income level. While initially poorly understood and lacking clear IRS guidance, so called “back-door Roth IRAs” have been legitimized over the years by the IRS.

The ability to make a 2021 Roth IRA contribution is phased out and eliminated for single tax filers with income between $125,000-$140,000; and for joint tax filers with income between $198,000-$208,000. Consequently, if a person earns too much, he or she cannot make a Roth IRA contribution directly (i.e., through the front door). But many can still take another route—by converting traditional IRA or qualified retirement plan assets, a transaction that has become known as the backdoor Roth IRA.

Congress repealed any income limitations for Roth IRA conversions in 2010. Consequently, regardless of income level, anyone could fund a Roth IRA through a conversion. For example, if a person exceeds the income limitation for contributions to a Roth IRA, he or she could contribute amounts (deductible or nondeductible) to a traditional IRA based on earned income and, shortly thereafter, convert the contribution from the traditional IRA to a Roth IRA. Similarly, a person with a 401(k)-plan account balance could convert eligible plan assets either in-plan to a designated Roth account (if one exists) or out-of-plan to a Roth IRA through a plan distribution. Assets that are taxable at the point of conversion would be included in the individual’s taxable income for the year. Going forward, earnings would accumulate tax-deferred and, potentially, would be tax-free upon distribution from the Roth IRA. Under the authority of IRS Notice 2014-54, a qualified plan participant can rollover pre-tax assets to a traditional IRA for a tax-free rollover and direct any after-tax assets to a Roth IRA for a tax-free Roth conversion.

Conclusion
Plan participants and IRA owners need to be aware that as part of the 2021 budget reconciliation process, the ability to convert assets to Roth assets may be sunsetting. If revenue-generating provisions of the Build Back Better Act are enacted as currently proposed, Roth conversions of after-tax IRA and after-tax 401(k) plan assets would be eliminated after 12/31/2021; and Roth conversions of pre-tax IRA and plan assets would cease after 12/31/2031.

Click here for an RLC webinar on the proposed changes.

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Cybersecurity and DOL Document Requests

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An advisor asked: “I understand the Department of Labor (DOL) is already checking the cybersecurity procedures of plans that are currently under audit. Do you have any insight into what the DOL’s auditors are requesting from plan sponsors with respect to cybersecurity policies?”

Highlights of the Discussion

Yes, we have a little insight. The DOL’s “Cybersecurity Document Requests” that we have seen, which have been given to at least some plans under audit, reveal the DOL has been asking for quite an extensive list of documentation, as represented below. Moreover, the DOL has noted that plan administrators should be aware that they may need to consult not only with the sponsor of the plan, but with the service providers of the plan to obtain all the documents requested, and if they are unable to produce the requested documents the plan administrator must specify the reasons why the documents are unavailable.

1. All policies, procedures, or guidelines relating to

• Data governance, classification and disposal.
• The implementation of access controls and identity management, including any use of multi-factor authentication.
• The processes for business continuity, disaster recovery, and incident response.
• The assessment of security risks.
• Data privacy.
• Management of vendors and third-party service providers, including notification protocols for cybersecurity events and the use of data for any purpose other than the direct performance of their duties.
• Cybersecurity awareness training.
• Encryption to protect all sensitive information transmitted, stored, or in transit.

2. All documents and communications relating to any past cybersecurity incidents.
3. All security risk assessment reports.
4. All security control audit reports, audit files, penetration test reports and supporting documents, and any other third-party cybersecurity analyses.
5. All documents and communications describing security reviews and independent security assessments of the assets or data of the plan stored in a cloud or managed by service providers.
6. All documents describing any secure system development life cycle (SDLC) program, including penetration testing, code review, and architecture analysis.
7. All documents describing security technical controls, including firewalls, antivirus software, and data backup.
8. All documents and communications from service providers relating to their cybersecurity capabilities and procedures.
9. All documents and communications from service providers regarding policies and procedures for collecting, storing, archiving, deleting, anonymizing, warehousing, and sharing data.
10. All documents and communications describing the permitted uses of data by the sponsor of the Plan or by any service providers of the Plan, including, but not limited to, all uses of data for the direct or indirect purpose of cross-selling or marketing products and services.

Most recently, the DOL on April 14, 2021, issued three cybersecurity directives nationwide for retirement plans:

• Tips for Hiring a Service Provider: This piece helps plan sponsors and fiduciaries prudently select a service provider with strong cybersecurity practices and monitor their activities, as ERISA requires.
• Cybersecurity Program Best Practices: This piece assists plan fiduciaries and record-keepers in their responsibilities to manage cybersecurity risks by following these 12 steps.
• Online Security Tips: This piece offers plan participants and beneficiaries who check their accounts online basic rules to reduce the risk of fraud or loss.

For more details, please see RLC’s previous Case of the Week: Cybersecurity and Retirement Plans-What’s the Latest?

Conclusion
The industry is still waiting for definitive cybersecurity rules for retirement plan administration. In the meantime, the best that concerned parties can do is make a good faith effort to adopt cybersecurity policies, following the series of guidelines, suggestions and best practices issued by the DOL, and document, document, document.

 

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Failed Rollovers

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An advisor asked:

“One of my clients took a distribution from his 401(k) plan and timely rolled it over to an IRA. All good—except that the IRA rollover contained an amount which should have been my client’s required minimum distribution (RMD) for the year. What happens to the RMD in the IRA?”

ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare.  We bring Case of the Week to you to highlight the most relevant topics affecting your business.

A recent call with a financial advisor from Massachusetts is representative of a common inquiry related to an invalid qualified-plan-to-IRA rollover.

Highlights of the Discussion

A rollover to an IRA could be a failed or invalid rollover under several circumstances, including if the rollover

  • Includes an RMD;
  • Is made after the 60-day time limit without a valid waiver or extension;
  • Violates the one-per-12-month IRA-to-IRA rollover rule (NA in this case since coming from a plan);
  • Does not meet the definition of an eligible rollover distribution.

Generally, the IRA owner has a few of options to correct the error pursuant to IRC Sec. 219(f)(6). Your client should seek the guidance of a professional tax advisor for his specific situation. Generally, under current rules,

  1. The IRA owner could leave the ineligible rollover amount in the IRA because the IRS deems such invalid rollovers to be regular IRA contributions for the year. (Of course, the individual, otherwise, would have to be eligible to make a regular IRA contribution for the year and the IRA administrator would need to correct the IRS reporting to reflect a regular IRA contribution).
  2. IRS Notice 87-16 allows an IRA owner to remove any current-year IRA contribution that is an eligible contribution without penalty by following the rules for removing excess contributions with net income attributable (NIA). These contributions must be removed by the tax return due date (including any extensions).
  3. If all or a portion of the invalid rollover amount exceeds the IRA owner’s regular contribution limit, the remaining rollover amount is treated as an excess contribution and will be subject to the six percent penalty tax if not timely removed (i.e., generally, October 15 of the year following the year the excess was created).
  4. Any remaining excess that is carried over in the IRA in subsequent years continues to be treated as a regular IRA contribution until the excess amount is eventually used up or removed.

Conclusion

When an invalid rollover contribution is made to an IRA during the year, the invalid rollover amount is deemed to be a regular IRA contribution for that taxable year. What happens next depends on whether the amount is an eligible contribution or an excess contribution.

See IRS Publication 590-A, Contributions to Individual Retirement Arrangements (IRAs) for more guidance.

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LLC Plan Establishment Deadline

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An advisor asked,

“I’m working with a limited liability company (LLC) that is interested in setting up a retirement plan.  What is the LLC’s deadline for establishing a plan?”

ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare.  We bring Case of the Week to you to highlight the most relevant topics affecting your business.

A recent call with a financial advisor from Texas is representative of a common inquiry related to setting up qualified retirement plans.

Highlights of the Discussion

Because this question deals with specific tax information, business owners should always seek the guidance of a tax professional for advice on their specific situations.  What follows is general information.

The short answer is it depends on whether the LLC is taxed as a corporation, a partnership or a sole proprietorship. For federal tax purposes, the IRS, typically, treats an LLC as a partnership that must file IRS Form 1065, U.S. Return of Partnership Income for the business.[1] There are exceptions to this rule, so a client should be encouraged to determine the exact nature of the business’s tax structure with a tax advisor. For example, a domestic LLC with at least two members is classified as a partnership for federal income tax purposes unless it files Form 8832, Entity Classification Election and elects to be treated as a corporation. A single-member LLC may choose to be taxed as either a corporation or as a sole proprietorship.

Once the LLC’s tax-filing status is determined, then we turn to the Setting Every Community Up for Retirement Enhancement (SECURE) Act, which gave businesses more time to set up plans for a particular tax year. Prior to the SECURE Act, a business that wanted a qualified retirement plan (e.g., 401(k), profit sharing, money purchase pension, defined benefit pension plan, etc.) for a particular tax year had to establish it by the last day of the business’s tax year. For example, a calendar year business had to sign documents to set up the plan by December 31 of the tax year in order to be able to contribute to and take a deduction for contributions.

Under the SECURE Act, for 2020 and later tax years, a business has until its tax filing deadline, plus extensions for a particular tax year to set up a plan. The plan establishment deadline is tied to the type of business entity and its associated tax filing deadline as illustrated below.

Tax Status Standard Filing Deadline Extended Filing Deadline
S-Corporation (or LLC taxed as S-Corp) March 15 September 15
Partnership (or LLC taxed as a partnership) March 15 September 15
C-Corporation (or LLC taxed as C-Corp) April 15 October 15
Sole Proprietorship (or LLC taxed as sole prop) April 15 October 15

[Note: Simplified employee pension (SEP) plans have historically followed the above schedule; and special set-up rules apply for safe harbor 401(k) plans.]

EXAMPLE:  The Limited is an LLC taxed as a partnership. Its standard tax filing deadline is March 15th of the year following the tax year in question. For the 2020 tax year, The Limited timely filed IRS Form 7004, Application for Automatic Extension of Time To File Certain Business Income Tax, Information, and Other Returns.  Consequently, it has an extended tax filing deadline of September 15, 2021, for its 2020 tax year. The owners of The Limited decide in August of 2021 they would like to set up a 401(k)/profit sharing plan for the business for 2020 and later years. The Limited has until September 15, 2021, to execute plan documents to set up the plan, effective for 2020. While The Limited would be able to make a profit sharing contribution on behalf of participants for 2020, participants can only make pre-tax employee salary deferrals and designated Roth contributions prospectively—meaning after they execute valid salary deferral elections for compensation yet to be received in 2021.

Conclusion

For many reasons, including determining the deadline to establish a qualified retirement plan, it is important to ascertain the federal tax-filing status of an LLC business. Under the SECURE Act, for 2020 and later tax years, a business has until its tax filing deadline, plus extensions to set up a plan.

 

[1] LLC Filing as a Corporation or Partnership

 

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