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What Is A Non-Deductible Traditional IRA?

Many people make too much money to contribute to an Roth. You can get around this problem. High earners can still take advantage of the Roth IRA by contributing to a nondeductible IRA and then converting to a Roth. A nondeductible IRA is simply a traditional IRA for which there is no tax deduction, and it is available to almost everyone with wages or self-employment income.

A non-deductible Traditional IRA is a Traditional IRA that consists of non-deductible contributions. In both Roth IRA and non-deductible Traditional IRA, contributions are non-deductible, meaning that you fund them with after-tax money. The major difference comes from the way earnings are taxed. Earnings are taxed as ordinary income if you withdraw them from a non-deductible Traditional IRA. In contrast, earnings are tax free if you withdraw them from a Roth IRA.

You make non-deductible contributions to a Traditional IRA by setting up and sending money to an IRA custodian of your choice. You do not need to notify the IRA custodian that you are making non-deductible contributions. However, you do need to notify IRS that you have made non-deductible contributions to a Traditional IRA with Form 8606 Nondeductible IRAs when you file your tax return. It is your responsibility to keep track of the basis, the amount of non-deductible contributions, in your Traditional IRA. You can then convert this non-deductible Traditional IRA to a Roth IRA but make sure you get professionals help.

Remember that the IRS treats all of your (but not your spouse’s) non-Roth IRAs as one giant IRA. When you make non-deductible contributions to a Traditional IRA, you’ll have the basis, the amount of non-deductible contributions, reported on Form 8606. When you convert a part or all of your Traditional IRA to a Roth IRA, the conversion amount must contain the non-deductible portion proportionally. For example, if 5% of your non-Roth IRA are non-deductible contributions, then 5% of the conversion amount must be non-deductible contributions, and the rest must come from the deductible contributions, including earnings and rollover contributions. Notice that you cannot just convert the non-deductible part to a Roth IRA.

There are a couple of ways to work around this problem. The proportionate allocation rule does not apply to rollovers from an IRA to a QRP (Qualified Retirement Plan like a 401k) or 403b plan. Instead, a distribution that is rolled from and IRA to a QRP or 403b plan is deemed to come entirely out of the taxable portion of the IRA. This exception is necessary because the nontaxable portion of an IRA cannot be rolled into a QRP or 403b plan. You might therefore consider a rollover from your Traditional and non-traditional IRA back to a 401k or if you qualify as a self-employed business owner who can open a solo 401k, you might rollover your Traditional and non-traditional IRA to a solo 401k.

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Contributions and Deductions

The Internal Revenue Code for the 401k plans (IRC Section 401k) is different than that for IRAs (which uses IRC 408).  The  IRS establishes maximum amounts that people can invest into 401k plans each year and the money inside a 401k plan benefits from the same kind of tax deferral that the IRS affords to funds invested in individual retirement accounts. IRS guidelines provide restrictions based on both dollar amounts and in some cases on  percentage of income.

Looking at history, the United States Revenue Act of 1978 included an amendment to Section 401k of the IRS tax code. The measure allowed employers to pay a portion of each employees pay into a tax-deferred compensation plan. In the beginning these plans were not synonymous with retirement accounts, but by 1980  a few companies drew up proposals to establish 401k retirement plans.  Many companies since then have reduced or discontinued defined benefit retirement plans because 401k plans are less expensive to operate.  As of 2011, the IRS allows taxpayers to contribute $16,500 into 401k plans and $22,000 for employees who are over the age of 50. Contributions to SIMPLE plans for business employers with less than 100 employees and no other plan in place,  have maximums of $11,500 and individuals over the age of 50 can invest $14,000. The IRS uses cost-of living calculations to change annual contribution limits.

Employers can match employee contributions without reducing the employee’s eligibility for salary deferral.  Most companies cap matching contributions at 50 percent of the amount invested by the employee. Other companies impose an overall maximum contribution equal to say 6 percent of the employees annual salary. The IRS allows employers to match contributions of only up to 3 percent in SIMPLE plans.  The IRS allows people to make annual contributions of up to $5,000 to Roth individual retirement accounts or $6,000 for people over the age of 50.  Roth IRA contributions do not impact 401k contributions or vice versa.  The IRS allows some people who participate in 401k plans to also make contributions to traditional IRA plans. As of 2011, single people earning less than $56,000 or married couples earning less than $90,000 can get a full deduction in a traditional IRA and still are able to deduct the $16,500 for their 401k accounts.  For higher earner their are phase out amounts and it is best to consult your CPA to determine their eligibility to participate in both plans.

The IRS uses contribution amounts when assessing tax deductions rather than account values. If you invest $16,500 and your investment falls in value to $8,000 during the same year, you cannot make additional contributions to bring your 401k back to the maximum. If you invest too much in a 401k plan, you must withdraw excess funds before April 15 following the calender year in which you invested. Over-the-limit contributions left in 401k accounts are subject to double taxation whic is never a good thing.


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Hardship Withdrawal From 401k

You know the times are tough when people are robbing money from their 401(k) accounts early and using the hardship withdrawal rules to give them access to needed cash. The lingering high unemployment rate and slew of home foreclosures have been major factors. Companies with retirement plans are reporting a rise in the number of workers who are withdrawing money early.

I read nearly 7% of 401k account holders made a withdrawal and about 20 percent of the withdrawals were for hardships. Just to put that in perspective, before the 2008 economic downturn, about 5 percent of workers withdrew money from their account each year. There has been an increase in hardship withdrawals in the past two years and the most frequently cited reason for hardship withdrawals last year was to avoid a home eviction or foreclosure. The lender are on track to take back around 800,000 homes this year. Even though that is down from last years numbers of around one million, that is still a painfully high number.

Most people who make withdrawals under hardship have to pay taxes and a 10 percent penalty on the money taken out which can be expensive and therefore it should be viewed as a last resort. I think is is normal for someone to want to save their home and avoid foreclosure BUT most of the time these delay tactics only result in a temporary delay and end up in foreclosure. This is a poor use of the retirement money you now, even more so, desperately need. Removing money from a retirement account permanently reduces the savings and diminishes what it can earn over time. If you are in such a situation, you really need to talk to an experienced professional who understands the 401k rules and foreclosure and bankruptcy laws as well.

The Internal Revenue Service makes it clear the worker must have exhausted other financial resources first before taking a hardship withdrawal. That includes bank loans and tapping the assets of a spouse. Workers must also have already exhausted any other distribution and loan possibility with their employer’s retirement plan. The IRS classifies six expenses as hardships and most plans follow these guidelines. They include certain medical expenses, the cost of buying a family’s principal home, college costs, payments necessary to avoid eviction or foreclosure, burial expenses, and certain expenses for the repair of damage to the employee’s principal residence. Of course, the IRS has made exceptions on occasion to some of the hardship withdrawal rules. For example, victims of some hurricanes have been given a break. So if you have experienced a natural disaster you should inquire about whether there’s an exception for your situation.

The process is that an employee will need to contact the person in his company responsible for managing the 401k program. There will be an application process during which the worker will have to demonstrate the hardship. The worker also will need to demonstrate that other borrowing and resources have been tapped and the withdrawal is the last resort.

One thing to thing about is that once that money is taken out you will no longer experience that money working for you over time. It is a lost opportunity for example if the market starts to skyrocket and your money is no longer in the game. Many times you will be prohibited from contributing more money to the account for six months after taking the withdrawal which only hurts you further. A 401(k) loan should only be used as a temporary stop gap to get help in tough financial times and when you feel like you have some job security because a high percentage of workers with loans who lose their jobs default on the loan. Remember, it should be noted that a 401(k) loan is usually due within 60 days of job termination and when it’s not repaid, the money is treated as an early withdrawal and taxes and the 10 percent penalty must be paid.


How A Company Bankruptcy Affects Your 401K

In today’s uncertain times, people are asking questions concerning the security of their retirement savings plan like a 401k at their workplace.   But there’s good news. Your 401(k) account cannot be taken to pay for company debts.  The questions come from a lack of understanding of how 401k are structured and how they work.  It is really not that complicated and hopefully after reading this article, you will understand how these qualified plans work.

The first thing you have to understand is that YOU own the 401k (at least the funds that are vested).  The funds that are not vested just means that some portion of the account may have some strings attached.  Investopedia defines vested as ” the lawful right of an individual or entity to gain access to tangible or intangible property now or in the future. A vested interest is an entitled benefit, which can be conveyed to a separate party. There is usually a vesting period before the claimant can gain access to the asset or property.  Due to the right of ownership, the benefit cannot be taken away.  Typically any money that you contribute yourself is fully vested from the moment you put it into the plan. Employer matching contributions, however, may have some vesting requirements.  A common one is that an additional percentage of the company contribution is vested for every year that you work for the employer. The company’s portion is not fully vested until the conditions are met.  So any money that you’ve contributed is fully yours. And any portion of the company’s contributed that is vested also belongs to you. You own it.

The other thing that needs to be understood is what the “plan administrator”.   The administrator oversees the plan for you. The administrator will collect contributions from you and your employer, invest and distribute them per your instructions and the law, and keep track of the funds and provide reports to you and when appropriate to the IRS.  Chances are that you’ll never meet the administrator in person. You’re much more likely to talk by phone or to use forms available in your human resources department to send instructions to them.  Remember, they do not own your account.  They just service it for you.  For that service they charge a fee.

The other thing which needs to be discussed is the investments within the account.  The administrator will have a number of investment choices available for you.  Typically, they have stocks, mutual funds and some safer options like bonds, U.S. Treasury bills or maybe CDs.  Many plans include the employer’s common stock if it’s publicly traded.  Naturally, the company is happy to have employees invest in it.  But that can be dangerous.  If the company struggles, not only could you lose your job, any shares in company stock could lose most of their value.  If the company goes downhill so will the value of the company stock and therefore your 401k value.  This is the biggest danger to your account.  Just remember, your 401k account cannot be used to pay company debts.  In order to protect yourself, it is wise to limit the amount of company stock you have in your retirement account.  If you get shares of the company as the company’s contribution, then find out from the plan administrator when you’re allowed to sell those shares.  Then sell them and reinvest the money in something else.  There is one other risk if your employer goes out of business.  A bankrupt company could leave an “orphaned” plan.  That’s when the company and the administrator have abandoned the plan.  That would severely restrict your ability to get at your money or change investment options.

You can go to the Department Of Labor  and has a FAQ page on abandon plans (go to http://www.dol.gov/ebsa/faqs/faq-abplanreg.html).  In short a custodian will be appointed and the funds distributed to you, so you can reinvest it. If your employer has declared bankruptcy, take immediate action. Contact the plan administrator. During the winding-down period that accompanies bankruptcies, the administrator may still be able to respond to your instructions. Once you get your money reinvest it.  I suggest setting up a self directed IRA or a solo 401k.   DO NOT spend the money since the tax penalty is high.

In summary, if your company does declare bankruptcy, your savings could be in jeopardy because of falling company stock value (if you own company stock) or your inability to get out of your investments and control your account.  The company’s creditors will not be able to get at your 401k savings, so that is not an issue.