No Personal Use

This is a thorny question, because there are lots of restrictions around this sort of purchase with an IRA account.  First of all, you need to understand that you cannot use the real estate personally, if it is owned by your IRA.  Specifically, you, your spouse, heirs, and any other linear relatives can not use such a piece of real estate while your IRA owns it.  That factor in itself should answer the question for a lot of folks.

So, for example you could not – purchase a home in a sunny clime and use it for your own purposes two months out of the year (allowing your family members to stay there, in addition to your own two weeks during the winter, for example) and then rent it out the rest of the year.  The IRS disallows such use, and will consider your real estate investment to have been distributed, and therefore fully taxable as ordinary income.

On the other hand, if you owned such a home and rented it out for a profit, this could still be owned by your IRA.

Additional Issues

If you’re still reading, you must be determined to try this anyhow, so here are some additional issues that you need to deal with… If you use a mortgage (actually a special type of mortgage called a non-recourse loan) to purchase the property, regardless of how it is used, the income from the property will be considered Unrelated Business Taxable Income (UBTI) and therefore taxable in the current year.  This particular wrinkle has caused many IRA real estate investors to lose the qualification on their money and owe tax on the entire account.

In addition to the UBTI issue, there are more restrictions:  you cannot provide services to your IRA, such as sweat equity in fixing up the old fixer-upper or managing the property yourself (you would have to use a third-party manager); you also cannot sell a piece of property that you own to your IRA (or purchase it from a relative); any income from the property must be deposited in the IRA account, and all expenses associated with the property must be paid by the IRA account.  If your IRA account doesn’t have enough cash on hand to pay insurance and property taxes, for example, you might have to either sell the property or distribute it to yourself in order to make sure those payments are made – otherwise if you paid the expense yourself the IRA could become immediately taxable to you.

Distribution

Lastly, as you decide that you’re going to now occupy the home, you have to distribute the property from the IRA – making the entire then-current value of the home subject to ordinary income tax.  So if you purchased a home in a depressed area (think Florida coast, for example) at $100,000, and then five years later when you want to move into the home when it is valued at $200,000 – you have to pay ordinary income tax on the entire $200,000 in one year.  If you had very little other income for the year, the ordinary income tax (federal only) would amount to $56,000 (using 2010 tax rates).

Bottom Line

If there is a piece of property that you could not otherwise purchase, using IRA funds might not be a bad way to go.  I would suggest a couple of things though: 1) you should purchase the property outright if you can, to avoid the whole UBTI issue; 2) you should plan your income in the year of distribution, so that you limit the ordinary income tax hit; 3) hire an experienced “Self-Directed IRA” trustee to help you through the process.  Because this process can be so very complicated and fraught with error, it will pay off for you to get someone on your side that has handled these transactions successfully in the past.

However, in my opinion, using the IRA to own property that you eventually will occupy is an enormous headache that you could probably do without.  If you really want to own real estate in your IRA as an investment, look at rental property or commercial property – perhaps in a REIT.  Owning real estate outside an IRA is a big enough headache, and when you add all of the additional restrictions to the process, I can’t imagine that it would be worthwhile.

Here’s a better idea:  wait until you’re ready to retire, then find that property that you want, and use distributions from your IRA to fund a mortgage on the property (or if you really want to, distribute the funds and buy it outright without a loan).  You’ll have far less headaches, and the outcome will be very similar.  Good luck!

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How File and Suspend Works and Why It’s Important

Any worker can establish a benefit amount by applying at any time after age 62 – but he or she doesn’t have to continue receiving that benefit.  The worker can immediately suspend the receipt of benefits, so that seemingly the application is moot.  However, what this has done is establish a “base” for the worker’s spouse to begin receiving benefits based upon that amount.

Here’s an example:

A worker is at Full Retirement Age (FRA), and his or her spouse is the same age.  Since the spouse of the worker has a much lower benefit available based on his or her own record, and as such is looking forward to utilizing the primary wage earner’s earnings record to receive the Spousal Benefit.

At the same time, the couple prefers to delay receiving the primary wage earner’s benefit as long as possible, to age 70, in order to receive the maximum increases (see here for more details).  In order to achieve both goals, the primary wage earner applies for benefits at FRA, and then immediately suspends receiving the benefit.  This establishes the amount that the lower-wage earning spouse can begin receiving in Spousal Benefits, while at the same time allows the primary wage earning spouse’s record to continue increasing in value until he or she reaches age 70, the maximum age to delay.

How To Do It

The mechanics of this option did not become available until 2000, and as such (believe it or not) sometimes the Social Security Administration (SSA) personnel are not aware of this option.  It is still not available to be applied for online (as are most other benefit options) so you need to visit your local SSA office to complete the process.

In order to ensure that the SSA personnel are clear about what you’re doing, you should download the Social Security Legislative Bulletin 106-20 (available at this link) which explains the provision fully.  The provision is part of the Senior Citizens’ Freedom to Work Act of 2000 – and the third bullet point of the Bulletin is what you want to point out as proof that you can pull this number.

Soon enough, SSA personnel are going to get this one straight as more and more folks do this maneuver, so be patient with them, and download the bulletin and take it with you to make sure you get what you’re asking for.

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Like all tax provisions, this is one that you have to pay particular attention to the details, otherwise you could miss out on the credit.  Following are seven facts that the IRS wants you to know about claiming the credit (IRS Tax Tip 2010-27).

Seven Important Facts About Claiming the First-Time Homebuyer Credit

1. You must buy – or enter into a binding contract to buy – a principal residence located in the United States on or before April 30, 2010.  If you have entered into a binding contract before April 30, 2010, you must close on the home purchase before June 30, 2010.
2. To be considered a first-time homebuyer, you and your spouse – if you are married – must not have jointly or separately owned another principal residence during the three years prior to the date of purchase.
3. To be considered a long-time resident homebuyer you and your spouse – if you are married – must have lived in the same principal residence for any consecutive five-year period during the eight-year period that ended on the date the new home is purchased.  Additionally, your settlement date must be after November 6, 2009.
4. The maximum credit for a first-time homebuyer is $8,000.  The maximum credit for a long-time resident homebuyer is $6,500.
5. You must file a paper return and attach Form 5405, “First-Time Homebuyer Credit and Repayment of the Credit” with additional documents (detailed below) to verify the purchase.  Therefore, if you claim the credit you will not be able to file electronically.
6. New homebuyers must attach a copy of a properly executed settlement statement used to complete such a purchase.   Buyers of a newly constructed home, where a settlement statement is not commonly available, must attach a copy of the dated certificate of occupancy.  Mobile home purchasers who are unable to get a settlement statement must attach a copy of the retail sales contract.
7. If you are a long-time resident claiming the credit, the IRS recommends that you also attach any documentation covering the five-consecutive-year period, including Form 1098, “Mortgage Interest Statement” or a substitute mortgage interest statement, property tax records or homeowner’s insurance records.

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For most assets that you own, when you pass away, your last will and testament determines who will receive the assets.  You may want to make sure that your daughter gets the heirloom china set, and you son receives the antique car, among other things – so you direct these wishes through your will.

If you don’t have a will, the state, through the probate process, will determine how your assets are to be distributed.  Generally this is to your living heirs in order from your surviving spouse to your children and then grandchildren; but it’s different in each state, so it really makes a lot of sense to set up even a simple will to make sure everything goes to the people you want it to.

But your IRA doesn’t go through the direction of your will or the probate process, as long as you’ve properly assigned a beneficiary or a group of beneficiaries.  The great thing about this is that, since the assignment is generally cut-and-dried (i.e., beneficiaries are named specifically, so there are no questions), your heirs can immediately access the funds in the IRA account if the need should arise.  See the article here to find out more about proper choices for beneficiaries of an IRA.

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The Social Security Survivor Benefit

When a primary wage earner dies, the Social Security system has a way to help care for the surviving spouse.  The Survivor Benefit is generally equal to the primary wage earner’s retirement benefit – this benefit replaces other spousal retirement benefits (the one that is equal to 50% of the primary wage earner’s benefit, available while the primary wage earner is living – see here for more detail).

The mechanics of the Social Security Survivor Benefit can apply to widows or widowers at various ages, depending upon the circumstances, as well as to the children and/or parents of the primary worker.  We’ll cover each sort of individual in turn…

Widows and Widowers

When the primary wage earner dies, the surviving spouse is entitled to receive a retirement benefit based on the primary wage earner’s retirement benefit.  Of course, if the surviving spouse’s retirement benefit based upon his or her own record is equal to or more than the deceased spouse’s benefit, the surviving spouse will continue to receive his or her own retirement benefit.

If the surviving spouse elects to begin receiving survivor benefits before Full Retirement Age (FRA), the benefit is subject to actuarial reduction.  Since a surviving spouse is eligible to begin receiving early benefits at age 60 (instead of age 62 for regular or spousal benefits), the “usual” age table is changed by 2 years.  Whereas FRA for regular or spousal benefits for those born between 1943 and 1954 is age 66, for a survivor benefit, FRA for those born between 1945 and 1956 is age 66.  (See this article for the FRA ages and this article actuarial adjustments.  Adjust the ages and years by 2 for Survivor Benefit.)  If the surviving spouse is disabled, early benefits may be received any time after age 50, with the actuarial reduction assuming benefits begin at age 60 (no further reduction, in other words).

In addition to the benefit mentioned above, there is a Survivor Benefit available to a younger spouse if there are children under age 16 that the surviving spouse is caring for, or a child of any age who has become disabled before age 22.  This Survivor Benefit is equal to 75% of the FRA benefit of the deceased spouse – and only lasts until the child reaches age 16.  At the same time, each child under age 18 will receive a Survivor Benefit (more on this later) until age 18.

It should be noted that there is no increase in benefits by delaying receipt of benefits after FRA, so a widow or widower should begin receiving Survivor Benefits at FRA and no later.

It should also be noted that divorced spouses who survive a deceased worker are also eligible for the Survivor Benefit.

Children

Any child under age 18 (19 if attending school) who survives a deceased worker that has earned the maximum credits is eligible to receive a Survivor Benefit equal to the actuarially reduced amount of the FRA of the deceased parent.  This amount is 75% of the FRA benefit of the surviving child’s parent, and this benefit will be payable until the child reaches age 18 (or 19).

In addition to the children of the deceased worker, this benefit can be available to step-children, grandchildren, step-grandchildren, or adopted children of the deceased worker, if the deceased worker provided 1/2 or more support to the child.

Surviving Parents Over Age 62

In the event that the deceased worker had provided more than 1/2 of the support of one or more older parents (over age 62), the surviving parents are eligible to receive a Survivor Benefit as well.  This Survivor Benefit is based on the age of the surviving parent, and actuarial reductions apply to these benefits if received before FRA of the survivor.

Family Maximum

For the whole family of the deceased wage earner, that is, surviving children under 18, spouse and parents, there is a maximum benefit amount that applies – equal to between 150% and 180% of the deceased worker’s basic benefit (the calculation is complicated, using the bend point formulas).  The Social Security website has a calculator to help you understand this amount.

Bear in mind that any Survivor Benefit received by a surviving divorced spouse to not count toward this family maximum.

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IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).

Among the options for Section 529 plans are two types of account:  savings and prepaid tuition.  Following is a brief explanation of the two types of account.

Savings-Type 529 Plan

The savings type of 529 plan works much like an IRA or 401(k): contributions are made and the amounts contributed to the plan are allocated among various sorts of investment options, mostly mutual funds or derivatives of mutual funds.  Over time, assuming that you’ve made appropriate allocation choices and the investments grow, the balance of the account will in turn grow, increasing the amount of funds available to pay for college expenses.  Growth in the account is tax-free when used for qualified higher education expenses (QHEE).

As with any investing activity there are risks to investing in these plans – similar to the risks you face in your IRA or 401(k) plan.  It’s possible that your account could lose value at any given point in time (like late 2008, for example) but prudent investment choices, appropriate time-orientation, and risk management can help to assure that your account will grow over time – but there are no guarantees.

Prepaid Tuition 529 Plan

On the other hand, the prepaid tuition type of plan is set up quite differently from any other type of account.  Instead of a savings account, in this case you’re purchasing discounted “units” or semesters of education – which, backed by the sponsoring state, are guaranteed to be traded for equivalent semesters of public college education (in the sponsoring state) when the student reaches college age.

If the student chooses to attend a non-public school or a school in another state, the programs guarantee that the equivalent of the then-current tuition cost will be available to pay the college of choice, even though the cost at that school will be different from the state universities in the sponsoring state.

Just as with the savings-type of plan, growth in the account is tax-free if used for QHEE – and in either type of plan if you choose not to use the account proceeds for education, you can withdraw the value and pay tax and a penalty on the growth.

The Downside to Prepaid Tuition

So, with all the market volatility, you’d think that the prepaid plan is the way to go – after all, this type is guaranteed!  Unfortunately, that guarantee by the sponsoring state is only as good as the state’s finances; these days, for many states, finances are currently listed under the heading of “Deplorable”.  When you couple the finances of the state with the dramatic increases in tuition costs we’ve seen in recent years, someone is bound to take a hit.  Guess who “someone” is?

Many prepaid tuition plans were forced to bar adding new participants to their plans after the dot-com bubble burst several years ago, since poor market returns and higher tuition rates were causing the plans to lose money far too quickly to make up reserve balances.  Now, similar situations abound, and the states backing the plans may or may not have the funds to help shore things up.  As a result, new fees have sprouted for many plans – along with large increases in the discounted costs for new credits being purchased, which chokes off the new money coming into the plans.

According to a recent article in the Wall Street Journal, all across the nation prepaid tuition plans are operating in the red – seems that the market volatility does have an impact on these plans after all, just a little more subtle and after the fact.  And it’s up to the state to determine if their promises are worth keeping… and here in Illinois we don’t have that much faith in our state government. Your mileage may vary.

For my money, it just makes far more sense to use the savings-type of 529 plan: a plan that you can understand, can follow the balance, and perceive how and why fluctuations occur.  With those plans, you know what you have in the account, day in and day out.  With the prepaid plans, especially given the poor fiscal conditions of the states guaranteeing things, it’s all in question, in my opinion.

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Don’t get me wrong – this article doesn’t suggest that the tax consequences should drive your choice of beneficiary(s).  Rather, the assumption here is that you have several beneficiaries to choose from, and other classes of assets that you can direct toward heirs that aren’t as able as others to take advantage of the tax-favorable provisions.

Following are the benefits and consequences of some of the major groupings of choices that you might make for beneficiary(s) of your IRA.

Age

Younger Individual

If you choose a young individual as the beneficiary of your IRA, your heir will be able to take advantage of long-term tax deferral using the method that provides for payout over the life expectancy of the beneficiary.  By doing so, the tax-deferred status of the account can remain in force for a considerably long time (consider a 2-year-old heir, providing for 80+ years of potential tax deferral).

Older Individual

If you choose an older individual as the beneficiary of your IRA, this heir can also take advantage of the life expectancy payout method – but the payout period will be much less (due to the age of the beneficiary).  Therefore the tax-deferral benefit will be considerably less for the older individual versus the younger individual.

Spouse (any age)

Directly

If you leave your IRA directly to your spouse by name, he or she can elect to treat the inherited IRA as his or her own IRA.  This means that your spouse will be able to defer distributions from the account until he or she reaches age 70½, and then use the Uniform Life Table for distributions.  As you know, the ULT is much more favorable than the Single Lifetime Table, which is the one required to be used by owners of inherited IRAs.  Your spouse can also name his or her own beneficiary for any amounts remaining in the IRA at his or her death – which provides for additional deferral in the account.

In Trust

If instead, you decide to leave your IRA to your spouse via a trust (even a look-through trust), you remove the possibility for your spouse to assume ownership of the trust (as described above).  By doing so, the account must be treated as an inherited IRA, subject to the immediate Required Minimum Distributions from the account, regardless of the age of your spouse.  Further deferral of taxes is limited in many cases, since if the spouse is younger than 70½ he or she has to take distributions now rather than delaying until age 70½.  In addition, your spouse will be required to use the less-favorable Single Lifetime Table for the distributions; your spouse also cannot name his or her own beneficiary for the account for further deferral after his or her death.

Now, if the spouse is the sole beneficiary of the trust, the account can be treated as if it were directly inherited by your spouse, as in effect the look-through trust becomes a conduit trust.  With a conduit trust, the effect is the same as naming your spouse the sole beneficiary of the account – so the same rules apply as when you leave the account directly to your spouse.  The only difference is that you’ve spent extra money drafting the trust agreement.

Other Beneficiary Options

Group (versus Individual)

Leaving your IRA to a group of people instead of one person, this can introduce quite a bit of complexity to the situation.  Where possible you could split your IRA into separate accounts and direct each account to an individual beneficiary, saving your beneficiaries a lot of extra headaches at your passing.  If this is not possible or you would prefer not to split your account your heirs can do it later – it’s just a lot of extra paperwork for them that you could have handled for them in advance.  See this article for additional information on splitting inherited IRAs.

Charity

As tax-exempt entities, charities do not have to pay tax on any donations.  So if you choose to name a charity as beneficiary of your IRA, there are no tax consequences on an asset that would otherwise be fully subject to ordinary income tax.  This can be a very tax efficient way to provide charitable bequests – leaving your more tax-favorable assets to non-charity recipients.

Your Estate

If you choose to leave your IRA assets to your estate – either intentionally by naming your estate as beneficiary, or unintentionally by not naming a beneficiary or by naming a non-look-through trust as your beneficiary – tax deferral benefits are lost. Estates and non-look-through trusts have no life expectancy, therefore there is no life expectancy payout option.  This is not to say that there are no good reasons to choose your estate as beneficiary of your IRA – but that’s a topic for another post…

Bottom Line

As I mentioned before, you should not cause the tax code to be the determining factor when choosing a beneficiary.  You should leave your assets to whomever you wish.  You can, however, use the information on this page to help guide your process of choosing a beneficiary, making tax-efficient choices.  Making thoughtful decisions about this process can ease the tax burden for your heirs.

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Social Security Credit

Generally speaking, a quarter of Social Security credit is earned for each $1,120 earned (in 2010).  This amount is indexed each year – for example, the amount of earnings for a credit in 2009 was $1,090.  So if a worker earns at least $4,480 in 2010, four quarters of credit are earned with the Social Security system.

Minimum Credits

If you become disabled before age 62, disability benefits may be available to you if you have at least six quarters of credits earned.  Of course, these benefits will be reduced from the maximum, based upon how many credits you happen to have earned.

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Whatever the reason, you’re short the documents that you need in order to prepare your tax return.  So what do you do?

What Do You Do?

Your employer is required to send your W2 earnings statement to you by February 1 for the prior year’s earnings. But sometimes things go awry, and you don’t receive the form. There are four steps to follow to retrieve the required information…

1. Contact your employer – inquire if and when the W2 forms were mailed out.  It’s possible that the postal service returned it to your employer due to an incorrect or incomplete address.  Even if it hasn’t been returned, your employer should be able to produce a new copy of the form and send it out to you.
2. Contact the IRS – the IRS receives a copy of all W2 forms filed.  Wait until after February 16, and then you can call the taxpayer assistance line at 800-829-1040.  Make sure you have as much information about the earnings as possible – including your employer’s name and address, your dates of employment, and an estimate of your earnings (you can get this from your end-of-year pay stub).  The IRS should be able to produce the appropriate information for you or direct you to the steps you need to take.
3. File your return – on time if you can, or with a timely filed extension request, even if you have not received the W2.  If you have taken the first two steps and still have not received the form by April 15, use Form 4852, “Substitute for Form W2, Wage and Tax Statement”.  Attach Form 4852 to your return, using your last pay stub to estimate your earnings and withholding taxes.  Keep in mind that using Form 4852 may delay any refund due to additional processing required.
4. File an amended return – if you happen to receive your W2 after you’ve filed using Form 4852 and the W2 includes different information than you used to prepare your return.  Use Form 1040X to file this amended return, within 3 years of the original return deadline.

You can find the forms mentioned above on the IRS website, along with the original text of this IRS Tax Tip, #2010-28.

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Let’s look at the definition from the IRS…

Definition

Only Eligible Rollover Distributions, or ERDs, can be rolled over, according to the IRS.  The definition that is given is really an anti-definition, explaining that any normally taxable distribution is eligible for rollover unless it fits the exceptions listed.

An ERD is defined as – a distribution that is eligible to be rolled over to an eligible retirement plan. Eligible rollover distributions include a participant’s balance in a qualified plan, 401(k), 403(b) or 457 plan, except for certain amounts that include the following:

• Any of a series of substantially equal periodic payments (SOSEPP) paid at least once a year over:
  • The participant’s  lifetime or life expectancy,
  • The joint lives or life expectancies of the participant and his/her beneficiary, or
  • A period of 10 years or more,
• A required minimum distribution,
• Hardship distributions,
• Corrective distributions of excess contributions or excess deferrals, and any income allocable to the excess, or of excess annual additions and any allocable gains,
• A loan treated as a distribution because it does not satisfy certain requirements either when made or later (such as upon default), unless the participant’s accrued benefits are reduced (offset) to repay the loan
• Dividends on employer securities, and
• The cost of life insurance coverage.

So, as long as the distribution plan that you set up doesn’t fit any of the requirements above and has a payout period of 10 years or less, your distributions can be considered ERDs, and therefore rolled over into an IRA or other retirement plan.

Understand that these distributions will be subject to mandatory 20% withholding if paid out to you.  Plus, you must complete the rollover within 60 days when it’s not done by trustee-to-trustee (or direct) rollover.

Whenever possible, you would want to set up these payments as direct rollovers into your IRA (or other QRP) to avoid this withholding requirement and 60-day limit.  If this can’t be done, you should make up the 20% withheld difference from other savings as you rollover the distributions in order to avoid tax and penalties.

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IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).