Employer Retirement Plans with Income Annuities

In the private sector, employers have been moving away from traditional pensions, known as defined benefit plans. These plans, funded by employer contributions, often pay long-time employees (and usually those employees’ spouses) lifelong regular cash flow.

Instead, many companies now provide defined contribution plans, such as 401(k)s, which are funded largely by workers’ salary deferrals. The actual retirement benefit will vary, depending on how the chosen investments perform.

National security

Last year, the Treasury Department and the IRS took steps to encourage the use of substitute traditional pensions by retirees. Deferred income annuities (DIAs), which are mainly held in IRAs, were given favorable tax treatment, if certain requirements are met. Later in 2014, the Treasury and IRS issued Notice 2014-66, which made it more likely that target date funds, mainly held in 401(k) plans, will purchase DIAs, which can offer pension-like cash flow to retirees.

Setting the date

Target date funds offer a predetermined asset allocation that gradually becomes less aggressive and more conservative, as its target date approaches.

Example 1: 
Fawn Grant, age 50, plans to retire in her mid-60s. She invests her 401(k) contribution in a 2030 target date fund. Now, that fund has a balanced mix of equities, for appreciation potential, and fixed income, for stability and cash flow.

            

As this fund approaches its 2030 target date, its asset mix will shift to fewer equities and more fixed income. Many plan participants like the idea of having professional investment strategists automatically make these asset allocation decisions.

Enter deferred annuities

Notice 2014-66 clarifies that target date funds in employer sponsored retirement plans can hold DIAs. A DIA is purchased today; the resulting income stream will not begin until years later. The longer the time between the investment and the start of annuity payments, the greater the amount of periodic cash flow an annuitant will receive.

Example 2: 
Hugh Jordan purchases a DIA at age 55. If Hugh defers lifelong income payments until age 65, he will get more monthly income than he would get by starting immediately. Hugh will get even larger annuity payments by waiting until age 70, or age 75.

The recent federal notice explains that target date funds offered through employer plans will be able to include DIAs among their fixed-income holdings for participants who are nearing retirement age. If those DIAs meet certain criteria, some technical issues won’t arise.

Similarly, target date funds are considered qualified default investment alternatives (QDIAs), which helps to explain their popularity in 401(k) plans. Employers who make the proper explanation can use QDIAs for the contributions of employees who neglect to make investment choices, while the employers generally avoid liability for any investment losses.

How 401(k) pensions might work

Here is an example of how DIAs could provide lifetime income from a target date fund offered by an employer-sponsored retirement plan. Such funds might be limited to participants of similar ages. A 2033 target date fund, for instance, might be available only to employees born in 1967, 1968, or 1969. In 2033, those employees will be 66, 65, or 64.

Beginning in 2023, when the fund participants are 56, 55, or 54, the target date fund can begin to purchase DIAs as part of its fixed income allocation. For the next 10 years, the fund will purchase more and more DIAs, increasing the allocation to such annuities. In 2033, the fund’s target date, the fund will dissolve.

At this point, the participants will learn what their DIA options are. They can start to receive lifetime income right away, or they can wait until a later time to start, in order to increase the annuity payments. Other assets of the now-dissolved target date fund, besides the DIAs, can be reinvested elsewhere in the company retirement plan.

The federal notice provides one example, so not all target date funds holding DIAs inside company plans will look exactly like that. However they’re structured, the idea is to provide employees with predictable cash flow after retirement through income annuities.

Withdrawal Rules

·         It’s possible for target date funds in defined contribution plans to hold deferred income annuities and satisfy nondiscrimination requirements.

·         Among other conditions, the deferred annuities cannot provide a guaranteed lifetime withdrawal benefit (GLWB) or a guaranteed minimum withdrawal benefit (GMWB).

·         With a GLWB, the participant is guaranteed to receive a specified lifetime stream of income, regardless of the investment performance of the account, while still retaining access to the funds in the account.

·         A GMWB is similar to a GLWB, but a stream of income is guaranteed for a specified period rather than for the lifetime of the contract owner or annuitant.

·         The Treasury Dept. and the IRS are considering whether to provide guidance relating to GLWB and GMWB features in defined contribution plans.     

Renting Vs. Buying a Home

Should you buy or rent your home? This decision can include financial as well as nonfinancial factors. Even if the nonfinancial aspects are extremely important, you should not overlook the financial side.

Crucial ratio

One key to choosing between buying or renting is to determine the annual rent-to-purchase price ratio in the housing market you’re considering. The higher this ratio, the greater the advantage of buying a home.

            

Example 1: Art Smith is considering buying a home that is priced at $200,000. He can rent a comparable home in the same neighborhood for $800 a month, which is $9,600 a year. The rent-to-purchase ratio is $9,600 to $200,000, or 4.8%.

            

Example 2: In a different area of the U.S., Beth Jones also is eyeing a $200,000 home. A comparable home would rent for $1,200 a month. Thus, the rent-to-price ratio for Beth is $14,400 to $200,000, or 7.2% a month.

            

A recent study from Morningstar’s HelloWallet unit indicates that renting might be a better choice when the rent-to-price ratio is below 5%, while buying may be preferable if that ratio is over 7%. That is, the more you’ll have to pay to rent a desirable home, relative to home prices, the greater the chance that the numbers will favor a purchase. 

Assuming the rent-to-purchase price ratio is favorable, young taxpayers with relatively low early career incomes might do well to rent rather than buy a home. The same may be true for relocating retirees who have modest incomes after they stop working.

Conversely, high-income taxpayers might enjoy considerable tax savings from home ownership, assuming they are comfortable with the purchase price. Today’s low interest rates make financing a home purchase appealing, and the leverage can add to any profits from home price appreciation.

Thinking about taxes

Homeowners may enjoy multiple tax benefits that are not available to renters. Mortgage interest and property tax payments generally are tax-deductible. Moreover, profits on a sale of a home often enjoy an exemption from capital gains tax. Assuming the home was owned and occupied at least two of the preceding five years, up to $250,000 of gains are untaxed ($500,000 for married couples filing a joint tax return).

Of course, there is no way for a home buyer to know if a home eventually will be sold at a profit. What’s more, the deductions for mortgage interest may not generate any actual tax savings. That’s because those savings are available only to taxpayers who itemize deductions. Homeowners who take the standard deduction get no tax benefit from their mortgage interest or property tax deductions.

            

Example 3: Craig and Diane Emerson bought a house for $200,000, taking out a $160,000 mortgage. At a 4% mortgage rate, their interest payments this year are $6,400 (4% of $160,000). The Emersons also pay $4,000 in state and local taxes and make $2,000 in charitable donations, for a total of $12,400 in possible itemized deductions.

            

In 2015, the standard deduction is $6,300 for single filers and $12,600 for married couples filing jointly. (Taxpayers who are blind or at least age 65 have higher standard deductions.) Thus, the Emersons will choose the standard deduction and get no tax benefit from paying mortgage interest or property taxes.

Tax bracket truths

Now, what happens if the Emersons had $14,200 in itemized deductions instead of $12,400? If so, they would itemize and deduct their mortgage interest and property tax payments. In this scenario, $14,200 of itemized deductions is $1,600 greater than the standard deduction for couples, so the Emersons’ net tax deduction from home ownership would be $1,600. Assuming an effective marginal income tax rate of 20%, that $1,600 in net deductions would save them $320 in tax this year.

            

Example 4: Assume the same financial information as in example 3, but assume the Emersons have a higher income and, thus, have an effective marginal tax rate of 40%. Then that same $1,600 in net tax deductions from home ownership would save the Emersons $640 in tax. With a higher income, owning a home saves more tax.

           

             

Other issues

The decision about whether to rent or buy a home involves more than the purchase price, rental rates, and tax savings. Buying a house means saving up a great deal of cash for a down payment and putting that cash into an illiquid asset. Renting may leave you with more easily accessible cash, but will that cash be invested wisely or spent imprudently? It’s also important to decide if the responsibility of home ownership is for you.

           

Nevertheless, financial concerns are vital to residential decisions.

When Workers Are Independent Contractors

As business owners know all too well, hiring an employee costs more than just paying a salary. 

Employers generally provide benefits to employees, which can be expensive. Moreover, employers must pay a share of Medicare, Social Security, and state unemployment taxes.

            

None of the above applies when your company hires an independent contractor—a publicist to get your company’s name in the news, for example, or a freelance website designer. You pay these people the agreed-upon amount and let them worry about funding their retirement or handling payroll tax. If that’s the case, why not just use a group of independent contractors to work for your company and do with few or even no employees?

Defining the difference

The answer is that the IRS is well aware of the advantages of using contractors. Therefore, the IRS has established rules governing how independent contractors are classified, as opposed to employees. Drilling down, the major difference is a matter of control.

            

Hiring an independent contractor to do a specific task is fine. You tell the contractor what you want done, and you pay for results. However, if you tell the worker how and when and where the work is to be done, you risk having that worker re-cast as an employee by the IRS.

           

In some cases, common sense will apply. If that freelancer works on your website while doing other paying jobs for other companies, chances are the IRS will go along with independent contractor classification. On the other hand, if you have a person who works from home as a freelancer but works only on your website, does it more or less full time, and takes direction from your IT people, you may have a difficult time treating him or her as a contractor.

If you have been misclassifying employees as contractors, the penalties can be steep. Our office can discuss your workers with you, letting you know how to proceed in order to legitimately treat them as independent contractors.

Accumulated Assets in C-Corps

Owners of regular C corporations face double taxation. The company’s profits are subject to the corporate income tax. 

If some of those profits are paid to the owner and other shareholders, as nondeductible dividends, the same dollars will be taxed again, on the recipients’ personal tax returns.

    

Double taxation might not have been a major concern when the highest tax rate on qualified dividends was only 15%, as it had been for most of this century. However, recent legislation boosted the dividend tax rate to 20% for some taxpayers; high-income taxpayers also may owe the 3.8% Medicare surtax as well as some indirect taxes on dividends they receive. Therefore, business owners may prefer to retain earnings in the company, rather than pay out double taxed dividends.

     

Example 1:

Craig Taylor owns 100% of CT Corp. The company’s profits this year are $400,000, on which CT Corp. pays income tax. Rather than pay himself a dividend, which would be taxed at an effective rate of 25% in this scenario, counting all the various taxes that would be triggered, Craig decides to keep the money inside CT Corp.

Cash crunch

However, CT Corp. might run into a tax problem: the accumulated earnings tax (AET).

Retained earnings over $250,000 are subject to this tax ($150,000 for personal service corporations, such as professional practices). Thus, if CT Corp. had $200,000 in retained earnings from prior years, this year’s $400,000 makes the total $600,000, which is $350,000 over the $250,000 limit. CT Corp. would owe tax on the $350,000 overage: $70,000, at the current 20% AET rate.

     

In practice, the AET is not a certainty. The IRS might investigate when CT Corp. reports retained earnings over $250,000 on its corporate income tax return, but it’s possible that it won’t owe the AET, if the company has a good reason for the large accumulation.

Forward thinking

Earnings in excess of $250,000 will be permitted if the company can show that it had a reasonable need for holding onto cash and other liquid assets. That need could be to provide funding for a specific plan related to the company’s business, such as buying expensive equipment or expanding into a new territory.

Solid proof

In order to retain earnings over $250,000, yet avoid the AET, a corporation must be able to show that there really was a plan in place to use the money, and that the reasons for the retention go beyond tax avoidance. Ideally, corporate minutes or other documentation, such as emails, will include a discussion of, for example, the company’s intent to upgrade its information technology with an expensive new system.

    

No matter how well you can show that a plan was in place as a reason for accumulating excess assets, you’ll also need to show that the plan has since been executed, or is in some stage of progress.

 What’s more, court decisions have approved the concept that C corporations can cite working capital as a reason for accumulating earnings over $250,000. Our office can help you determine an acceptable level of working capital for your company, which might raise its permissible level of accumulated earnings.

Simple solution

Regardless of your needs for working capital, there are basic steps you can take to avoid or limit the AET. For instance, you can pay some dividends to shareholders each year, even if that generates double taxation. A company that retains excess earnings while never paying out dividends may be especially vulnerable to IRS scrutiny and assessment of the AET.

    

Longevity Annuities

Deferred income annuities (DIAs) recently have become popular. New regulations from the U.S. Treasury Department may increase their appeal, opening the way for so-called “longevity” annuities inside IRAs and employer retirement plans.

Later rather than sooner

With a DIA, you pay an insurance company now in return for a predetermined amount of cash flow in the future.

            

Example 1:

Grace Palmer is age 55, planning to retire at 65. She buys an income annuity now for $100,000. Depending on the specific features Grace requests, if she starts to receive payments immediately, she might get around $400 a month ($4,800 a year) as long as she lives.

           

Instead, Grace agrees to wait until she retires at 65 to start payments. In return for giving up her money for 10 years, with no return, Grace might get lifelong annual payouts of $800 a month. (Exact amounts will depend on the contract terms and the annuity issuer.)

Even later

Certain DIAs are known as longevity annuities. They begin paying out late in life, so they appeal to people who are concerned about running short of money if they live into their late 80s or 90s or beyond.

            

Example 2: 

Instead of starting her DIA payouts at 65, Grace asks for them to begin at 75 or later. Such a delay could increase her payouts to $2,000 a month or more, as her remaining life expectancy would be limited. Grace enters into this arrangement to assure herself that she’ll have substantial cash flow if she lives until an advanced age.

Solving the distribution dilemma

Until recently, such longevity annuities were impractical for retirement accounts because required minimum distributions (RMDs) typically start after age 70½. Seniors would have to take RMDs on the annuity value even though no cash would be coming from the annuity.

            

Example 3: 

Suppose Henry Adams had bought a longevity annuity inside his IRA to begin payments at age 80. At age 70½, when Henry has $500,000 in his IRA, the annuity issuer values the contract at $100,000. Under prior rules, Henry would have had to take RMDs based on a $500,000 value even though he had only $400,000 currently available. Henry would have been required to withdraw (and pay tax on) a relatively large amount, even if he doesn’t need all the money he’ll withdraw.

This unfavorable tax treatment would continue, year after year, as long as Henry waited for his longevity annuity. Thus, longevity annuities were not attractive for retirement accounts and few people bought them in their IRA.

This situation is about to change. In July 2014, the Treasury Department issued final regulations on qualified longevity annuity contracts (QLACs). If annuities meet certain conditions, they will be considered QLACs. That way, the account value won’t count for RMD calculations.

Pros and cons

Some insurance companies are working on QLACs that are expected to appear in 2015. QLACs might appeal to seniors who are likely to live well beyond normal life expectancy and who are concerned about running short of money. In addition, individuals who would like to trim their RMDs and, thus, leave more to heirs, may consider buying QLACs. The regulations permit QLACs to have a return of premium feature, which would pay beneficiaries the amount invested yet not paid out in annuity payments by the time the annuity purchaser dies.

            

On the downside, QLACs will not be permitted to have any liquidity features for the buyer. If a taxpayer invests $100,000 in a QLAC, all she can get in return will be her annuity payments.

Rules for QLACs

·         No more than 25% of an individual’s total IRA money can be invested in qualified longevity contracts (QLACs).

·         For this purpose, SEP IRAs and SIMPLE IRAs are included. Roth IRAs don’t count because there is no reason to hold a QLAC in a Roth IRA, where the owner never has required minimum distributions. 

·         The 25% limit also applies to each employer plan.

·         Counting all QLACs in all plans, an investor cannot invest more than $125,000. That ceiling will increase with inflation.

·         QLAC payouts must begin no later than age 85, although they can begin earlier.