pension income

When Distributions from Retirement Accounts Are Required

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Deductible contributions to IRAs and qualified plans are beneficial because they allow taxpayers to reduce their taxable income by the amount of the contributions.  The earnings within the retirement accounts are not subject to tax as long as the earnings remain in the retirement account.  However, the IRS doesn’t allow the party to last forever.  Eventually, taxpayers are subject to the minimum distribution rules that require taxpayers to withdraw funds from retirement plans and pay tax on the distributed amounts.  The rules discussed in this post apply to traditional IRAs and qualified plans.  These rules apply to Roth IRAs only after the owner’s death (i.e., the rules require beneficiaries of inherited Roth IRAs to receive minimum distributions; the original owners of Roth IRAs have no such requirement).

What Do the Minimum Required Distributions Rules Require?

Basically, these rules require the retirement account owner to distribute the balances in retirement accounts over her remaining life expectancy.  These rules require a minimum amount that must be distributed and taxed; the account owner is free to withdraw additional amounts from the retirement accounts.  Each year’s distribution is calculated independently.  No credit may be taken in the current year for prior year distributions that exceeded the required amount.

If an account owner withdraws less than the minimum required distribution, he is subject to a 50% penalty for the shortfall.

Example:  Terry’s minimum required distribution is $10,000.  She only withdraws $6,000.  She is subject to a 50% penalty on the $4,000 shortfall, which amounts to a $2,000 penalty.  Not good.

When Do Minimum Required Distributions Take Effect?

Minimum required distributions for IRAs are required starting April 1 of the year after the taxpayer reaches age 70½.  Generally, for participants of qualified plans, the minimum distribution rules take effect April 1 of the year following the year that the participant retires.  However, when the qualified plan participant owns more than 5% of the employer, the minimum required distributions are required in the year after the participant reaches age 70½ even if the participant isn’t retired.

An account owner reaches age 70½ six months after her 70th birthday.

Example:  John owns an IRA and turns 70 on January 16, 2012.  John therefore turns 70½ on July 16, 2012.  Minimum required distributions are required to be taken by April 1, 2013 (the year after he reaches age 70½).

The distribution required to be taken by April 1, 2013 is for 2012.  The distribution required for 2013 must be taken by December 31, 2013.  Therefore, if John waits until April 1, 2013 to take his first distribution, he will have to take two distributions during 2013 (one for 2012 and one for 2013).  The two distributions can bump John into a higher tax bracket, affect deductions and credits that are sensitive to income, and cause more of his Social Security income to be subject to tax.  John may be better off taking his 2012 distribution during 2012 rather than waiting until April 1, 2013.

How Is the Amount of the Minimum Required Distribution Calculated?

The simple answer is that the IRA trustee is required to report the minimum required distribution to IRA owners, or calculate it for them, by January 31 of the year the distribution is required.  However, it is the account owner’s responsibility to ensure that the calculated amount is correct.

The not so simple answer is that the minimum required distribution is calculated based on the account owner’s age at the end of the distribution year and based on the account balance at the end of the prior year.  Distributions are based on prior year balances because they are more readily determined than current year balances.

Example:  Jean turns 81 in 2012.  Her life expectancy is based on her age during 2012 (age 81).  Her life expectancy is 17.9 years.  She has two IRAs.  At December 31, 2011, IRA-1 has a balance of $100,000 and IRA-2 has a balance of $80,000.  Her minimum required distribution for 2012 for IRA-1 is $5,587 ($100,000 divided by 17.9) and her minimum required distribution for IRA-2 is $4,469 ($80,000 divided by 17.9).  The total required distributions of $10,056 can be withdrawn from one or both accounts.  

Only amounts that an individual owns as the IRA owner may be aggregated.  Amounts in IRAs that an individual holds as a beneficiary of the same decedent may be aggregated, but such amounts may not be aggregated with amounts held in IRAs that the individual holds as the IRA owner or as the beneficiary of another decedent.

For qualified plans, minimum required distributions must be calculated and distributed for each account–aggregation is not allowed for qualified plan accounts.

Buzzkill Disclaimer: This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230.

Michigan Pension Tax-Updated

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Historically, Michigan allowed an exemption for pension income.  For those with private pensions (e.g., 401k plan from GM or an Individual Retirement Account), the State allowed a $45,842 exemption in 2011 ($91,684 for joint filers) from taxable income.  For public pensions (i.e., government pensions), the exemption was unlimited—there was no tax on public pension income regardless of amount.

While the pension tax was working its way through the legislative process, the original plan was to subject seniors’ entire pension income to Michigan’s 4.35% income tax.  This caused a bit of a stir.  The pension tax, in its final form, applies different tax rules to three brackets.

The brackets are:

  • Those born before 1946
  • Those born between 1946 and 1952
  • Those born after 1952

On a joint return, it is the year of birth of the older spouse that controls the tax treatment of both spouses’ pensions.

BORN BEFORE 1946

Those born before 1946 will see no change in how their pension income is taxed.  For 2012, private pension income up to $47,309 is exempt for single filers and $94,618 for joint filers.  Public pensions are exempt regardless of amount.  Social Security income is fully exempt from Michigan tax.  Seems simple so far, but wait…

BORN BETWEEN 1946 AND 1952

Phase 1: Before the Taxpayer Reaches Age 67

If a taxpayer is born between 1946 and 1952 and is under 67 years old, the exemption amounts are changed to $20,000 for a single return and $40,000 for a joint return regardless of whether the income is from a private or public pension.  Social Security income is exempt.  Railroad pension income is exempt.  Military pension income is exempt.

Phase 2: After the Taxpayer Reaches Age 67

If a taxpayer is born between 1946 and 1952 and is 67 years old or older, the exemption amounts remain at $20,000/$40,000 but apply to both pension and non-pension income.  This provision helps seniors with low pension income because they now have a large exemption that can apply to non-pension income such as wages or business profit.

Social Security income is fully exempt from Michigan tax.  Social Security income recipients are still eligible to use the $20,000/$40,000 exemption amounts to other types of income.

Recipients of railroad pension income and military pension income have a choice.  They can either:

  • take an unlimited tax exemption for railroad pension income or military pension income OR
  • claim the $20,000/$40,000 exemption amounts

When the law originally passed, the $20,000/$40,000 exemption amounts were completely phased out if Household Resources exceed $75,000 on a single return or $150,000 on a joint return.  However, this phaseout has been ruled unconstitutional by the Michigan Supreme Court because it constitutes a graduated tax.  Michigan’s Constitution requires the state to have a flat income tax.

Born after 1952

Phase 1: Before the Taxpayer Reaches Age 67

If a taxpayer is born after 1952 and is under 67 years old, the new law eliminates any exemption of private or public pension.  Social Security income, Railroad Pension income, and Military pension income are still exempt from Michigan tax.  There is no $20,000/$40,000 exemption available to offset any form of income.

Phase 2: After the Taxpayer Reaches Age 67

If a taxpayer is born after 1952 and is 67 years old or older, the new law allows the $20,000/$40,000 exemption for ALL types of income—public and private pensions, non-retirement income, and Social Security income.

Under this provision, Social Security income, Railroad Pension income, and Military Pension income has to be sheltered by the $20,000/$40,000 exemption amounts.

ALTERNATIVELY:  taxpayers may elect to waive the $20,000/$40,000 exemption amounts and instead claim an unlimited exemption for Social Security income, Railroad Pension income, and Military Pension income.

Example:  It is 2020, John is 67 years old and he was born in 1953.  John has $15,000 in Social Security Income and $30,000 in private pension income.  John is married so he is entitled to a $40,000 exemption.  John must use $15,000 of his exemption to shelter his Social Security income.  John has a $25,000 remaining exemption to shelter his $30,000 pension income.  John will pay tax on the remaining $5,000 pension income.

Under the alternative, John would waive the $40,000 exemption amount and fully exempt his Social Security income.  However, this  would increase John’s taxes.  His Social Security income of $15,000 would be exempt, but he must now pay tax on his $30,000 private pension income.

Basically, taxpayers would be better off claiming the $20,000/$40,000 exemption unless their Social Security income, Military Pension income, and Railroad Pension income are greater than the $20,000/$40,000 exemption amount.

If John was born in 1952, his Social Security income would be exempt from tax without having to use his $40,000 exemption.  Thus, his full $40,000 exemption would fully shelter his $30,000 pension income.

Tax simplification!!!

Stay tuned for more updates.

Buzzkill Disclaimer: This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230.

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