Chapter 11

Retirement and Other

Tax-Deferred Plans
and Annuities

The income tax laws do not profess to

embody
perfect economic theory.
-- Oliver Wendell Holmes, Jr.

Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

LO #1 The Basics
Retirement plans are encouraged and receive tax
advantages.
Encourage saving for retirement or education
Generally, taxation is deferred (not eliminated)
Internal Revenue Code provides benefits to encourage
individuals to save for retirement or education.
Retirement plans include employer-sponsored plans
and individual-based plans.
Individuals can participate in retirement plans
sponsored by their employer or plans that the
individual sets up on their own
In general, retirement plans allow individuals to save for
retirement and not pay taxes on the money saved until
they retire
11-2

LO #1 The Basics
It is important to understand retirement
plan terminology
Annuity
Beneficiary
Contributions
Distributions
Donor
Tax-deferred retirement (or other) plan
Trustee

11-3

LO #1 The Basics
Tax-deferred does not mean tax-free.
Generally, untaxed contributions are taxed when
distributed. Previously-taxed contributions are not
taxed on distribution.
Contributions can provide a tax deduction to the
person/company that makes them.

The basic premise of most, but not all, retirement plans

is that contributions are made with money on which the
eventual recipient has not yet paid tax. These are pre-tax,
or untaxed, dollars. If this is the case, then when the
money is withdrawn, tax will be due.
Some retirement plans are funded with dollars that have
already been taxed. In this case, withdrawals are
generally not taxed.
11-4

LO #1 The Basics Concept Check 11-1

1. Tax-deferred retirement accounts are, essentially,

tax-free accounts.
False
2. The period in which accumulated assets are paid to
plan beneficiaries is known as the _________ period.
Distribution
3. A Keogh plan is an example of an individual-based
retirement plan.
False

11-5

LO #1 The Basics Concept Check 11-1

4. Two examples of employer-based retirement
plans are _____________ and ___________.
Pick any 2 of: qualified pension/profit-sharing,
401(k), 403(b), Keogh, SEP, SIMPLE
5. Distributions from pension plans are taxable
if the contributions were made using dollars
that were not previously taxed.
True

11-6

LO #2 Employer-Sponsored Retirement
Plans
Some retirement plans are established,
run, and are sponsored by an employer.
Six types of employer-sponsored
plans are include:
Qualified pension and profit-sharing plans
401(k) plans
403(b) plans
Keogh plans
Simplified Employee Pensions (SEP)
SIMPLE plans
11-7

LO #2 Employer-Sponsored Retirement
Plans
Employer sponsored plans provide benefits to
employers and employees
Employer gets immediate deduction for
contributions.
Employer contributions are not compensation to
employee.
Earnings from plan investments are not taxed
when earned.
Plan assets or earnings are not taxable to
employee until withdrawn.

In general, these plans provide the employer with a tax

deduction for the dollars contributed, the contributions
grow tax-free, and the contributions are not taxable to
the employee until withdrawn
11-8

LO #2 Employer-Sponsored Retirement
Plans
Two types of employer-sponsored plans:
Defined-contribution plans pre-establish the amount
of the contribution
The amount of the eventual distribution is not known
with certainty and will vary.
Defined-benefit plans pre-establish the amount of the
benefit
The amount of the contribution is not known with
certainty and will vary.
The key notion is that contributions will be invested
and will earn a return. We do not know, with certainty,
what that return will be. As a result, we can predetermine either the input (the contribution) or the
output (the distribution) but we cannot know both
11-9

LO #2 Employer-Sponsored Retirement
Plans
Qualified pension & profit-sharing
plans:
Nondiscriminatory, minimum vesting rules,
contributory or noncontributory
Additions to defined-contribution plan cant
exceed lower of $51K or 100% of
compensation
Additions to defined-benefit plan cant result
in benefits more than the lower of $205K or
100% of compensation
Qualified plans must meet certain nondiscrimination and vesting rules. There are
also dollar limits on either the amount of the
annual contribution or the annual benefit

11-10

LO #2 Employer-Sponsored Retirement
Plans
401(k) and Keogh plans are two types of
pension plans; both subject to certain
contribution limits
401(k) plans
Must meet nondiscrimination rules
Employee can elect to defer up to $17,500
(additional $5,500 if age 50 or over)

Keogh plans
For self-employed
Contribution limits generally the same as
qualified plans
11-11

LO #2 Employer-Sponsored Retirement
Plans
SEP and SIMPLE plans are two employer-sponsored
plans
Simplified Employee Pensions (SEP)
Employer creates and contributes to employee IRAs
Maximum contribution is lower of 25% of
compensation or $51,000.
SIMPLE plans
Employer creates IRA or 401(k) for employee
Employee contributes a % up to $12,000 (additional
$2,500 allowed if age 50 or over)
Employer makes matching contribution of 3% for all
employees or 2% for all eligible employees.
As with other plans, these are subject to certain rules
related to eligibility and contribution limits
11-12

LO #2 Employer-Sponsored Retirement
Plans Concept Check 11-2

1. Qualified pension plans are either defined-_______

plans or defined-_______ plans.
Benefit; contribution
2. Employees must make contributions to qualified
pension plans.
False
3. The maximum contribution to a 401(k) plan is
_______ for individuals under age 50.
$17,500

11-13

LO #2 Employer-Sponsored Retirement
Plans Concept Check 11-2
4. A Keogh plan can be used by selfemployed individuals.
True

5. A SIMPLE plan can be used by

employers with 100 or fewer employees
who also meet other requirements.
True

11-14

LO #3 Individual-Sponsored Retirement
Plans
An Individual Retirement Account is
one of the most common individualsponsored retirement plans
Traditional Individual Retirement
Account (IRA) and Roth IRA.
Contributions limited to smaller of
$5,500 or 100% of compensation. If age
50 or over, the dollar limit is $6,500.
11-15

LO #3 Individual-Sponsored Retirement
Plans
Individuals covered under an employer
plan
Deductible contribution amount begins to
phase out when AGI reaches $95K (married)
or $59K (others) and is fully phased out at
$115K and $69K, respectively.
Married filing separately, the phase out starts at
$0.

Can still make nondeductible contribution up

to the $5,500 or $6,500 limits
(cannot make a deductible IRA contribution if
their income exceeds certain AGI limits. Nondeductible contributions are always allowed.)

11-16

LO #3 Individual-Sponsored Retirement
Plans
Married taxpayers
If both employed and neither are covered under an
employer plan, then both spouses can make a
deductible IRA contribution up to the $ limits.
If only one spouse is employed and that person is
not covered under an employer plan, can
contribute up to the maximum for both persons.
If one spouse is covered under an employer plan,
and the other is not, the non-covered spouse can
contribute up to the dollar limits if AGI < $178,000.

11-17

LO #3 Individual-Sponsored Retirement
Plans
Roth IRA contributions are not
deductible but withdrawals are not
taxable(if the Roth has been active for at
least five years)
Contribution limits are the same as with
a traditional IRA (contributions are
made with pre-tax (or untaxed) dollars.
Distributions are fully taxed)
Phase out starts at $178K (MFJ), $112K
(single or HoH), $0 (MFS)
Phase out range is $10K MFJ, $15K others
11-18

LO #3 Individual-Sponsored Retirement
Plans
Traditional IRA vs Roth IRA;
contributions and distributions receive
different tax treatment
Contributions are deductible for traditional
IRA but not for Roth IRA
Distributions are taxable for traditional IRA
but not for Roth IRA

Taxpayers are trading off the nondeductibility of contributions against the

non-taxability of distributions.
11-19

LO #3 Individual-Sponsored Retirement
Plans Concept Check 11-3
1. Two types of individual-sponsored retirement plans are
______________ and ____________.
Traditional IRA and Roth IRA
2. A single individual, age 58, with wages of $30,000 can make a
tax-deductible contribution of up to $_______ to a traditional IRA.
$6,500

3. A married couple with earned income of $200,000 is ineligible to

make a deductible contribution to a traditional IRA. True or
false?
False
4. Generally, distributions from a Roth IRA are not taxable. True or
false?
True

11-20

LO #4 Tax-Deferred Nonretirement Plans

Coverdell Education Savings
Account (CESA) provide a taxadvantaged way to save for education
expenses
Has similar tax attributes to a Roth IRA:
Contributions not deductible (contributions
are made with after-tax dollars), account
grows tax-free, distributions are not
taxable if used exclusively to pay higher
education expenses of beneficiary.
Any person can establish and fund a CESA
for any person, him or herself included.
11-21

LO #4 Tax-Deferred Nonretirement Plans

CESA contributions limited to $2,000
per beneficiary. Multiple individuals can
contribute to a single CESA, but the total
contributions cannot exceed the $2,000
limit
From all sources combined

Contributions phased out when AGI of

contributor reaches $190K (MFJ), $95K
others.
Totally phased out at $30K or $15K above
those numbers, respectively.
11-22

LO #4 Tax-Deferred Nonretirement
Plans Concept Check 11-4
1. Contributions to Coverdell Education Savings
Accounts (CESAs) are not deductible. True or false?
True
2. The maximum annual contribution to a CESA is
$___________.
$2,000
3. Contributions to CESA accounts begin to be phasedout when AGI reaches $__________ for a single
taxpayer.
$95,000

11-23

LO #5 - Distributions
Generally, distributions are taxable if
retirement plan contributions were
deductible (are made with pre-tax or
previously untaxed dollars).
When some (but not all) contributions
were made with combination of
previously taxed & previously untaxed
dollars, then distributions will be
partially tax free and partially taxable.
Use simplified method.
11-24

LO #5 - Distributions
Simplified method. For cases where
retirement plan distributions are partially
taxable and partially non-taxable. The
method uses the life expectancy
Determine number of anticipated payments
using single life or dual life tables in text
Determine total contributions from
previously-taxed dollars.
Fraction: previously taxed $ / # payments
Fraction represents proportion of each
payment that will be tax-free.
11-25

LO #5 - Distributions
Other plans have required minimum
distributions (RMD) that must begin by April 1
of year following the year taxpayer reaches age
70.5.
RMD is based on life expectancy tables from
IRS (normally Table III in text)
Use these IRS tables to determine life
expectancy each year.
Most retirement plans have Required Minimum
Distributions. Roth IRA accounts are an
exception to the RMD rules. Generally,
distributions must begin no later than April 1 of
the year following the year the taxpayer reaches
age 70 .

11-26

LO #5 Distributions Concept
Check 11-5
1. A participant in a defined-benefit plan is only entitled to only a
stream of payments.
True
2. Distributions from qualified pension plans may be taxable,
nontaxable, or both.
True
3. The number of anticipated payments from a pension plan for a
single individual, age 68, is ______.
210
4. The number of anticipated payments from a pension plan for a
married couple ages 59 and 63 is ______.
310
5. Distributions are required from a traditional IRA.
True

11-27

LO #5 - Distributions
Roth IRA distributions are generally not
taxable:
Earnings are taxable if withdrawn prior to an
initial five-year holding period.
Coverdell Education Savings Account
(CESA) distributions are tax-free if used to pay
for qualified education expenses of beneficiary.
Cant use education expenses paid by CESA
also for American Opportunity/Hope or
lifetime learning credits (
Education expenses used as qualified
education expenses for CESA purposes
cannot be used again to determine education
tax credits=>the taxpayer cant double dip.
11-28

LO #5 - Distributions
Premature distributions generally subject to
10% penalty unless they are made subject to
one or more of the
exceptions apply. See page 11-17

Generally, taxpayers can transfer their

retirement assets from one plan to another.
That is called a rollover
Rollovers are generally tax-free. Rollovers to
a Roth IRA are taxable.
If rollover $ are distributed to the taxpayer, there is
a 60-day window to deposit $ in new plan.
Otherwise, the entire amount is taxable.
11-29

LO #5 Distributions Concept
Check 11-6
1. IRA distributions are taxable if funded with deductible
contributions.
True
2. Distributions are never required from a Roth IRA.
True
3. For an individual age 65, Roth IRA distributions are not taxable if
they have been held for at least five years.
True
4. Distributions from Coverdell Education Savings Accounts can be
used for any purpose once the beneficiary reaches age 30.
False

11-30

LO #6 - Annuities
An annuity is a series of payments
pursuant to a contract.
Normally, annuity payments are
partially taxable and partially tax-free
to recipient

11-31

LO #6 - Annuities
The tax-free component is based on the
cost of the annuity contract and expected
return
The cost of the annuity contract is the
amount the recipient paid for the contract.
The portion of the payments that is
represented by the cost of the contract is taxfree.
Cost of the annuity: amount the recipient paid
for the annuity contract. Payments from the
annuity are tax free to the extent of the
proportional share represented by amount paid

11-32

LO #6 - Annuities
To determine the tax free amount of
each payment, the taxpayer must calculate
the expected return on the contract
The expected return is the total amount
the recipient anticipates receiving over
the annuity contract.
For contracts that will last a specified amount
of time, the expected return is the periodic
payment the number of payments.
For contracts that will provide payments for
life, the recipient must refer to the life
expectancy tables to determine length of
time.
11-33

LO #6 Annuities Concept Check 11-7

1. An annuity is a ______ of payments under a ______.
Series; contract
2. Annuity payments are always the same amount each
period.
False
3. Annuity payments often have a taxable component
and a nontaxable component.
True

11-34