10 tax facts for retirees

March 19, 2014 at 10:12 AM

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Let's suppose you have a boomer client that has recently retired. (Most likely, you have more than one.) Now, let's say that this client pays premiums on an LTCI policy and has recently purchased an existing immediate annuity contract. They come to you, wanting to know what this means for their tax filing. Are their LTCI premiums deductible as medical expenses? How will they be taxed for the annuity purchase? Luckily, you've read this article, and so you know the answer to these and eight other questions your retired clients may ask.

1. Are premiums paid for a qualified long-term care insurance contract deductible as medical expenses?

Amounts paid for any qualified long-term care insurance contract or for qualified long-term care services generally are included in the definition of medical care and, thus, are eligible for income tax deduction, subject to certain limitations. Amounts paid for the medical care of a taxpayer, the taxpayer's spouse, or the taxpayer's dependents are deductible subject to the 10 percent adjusted gross income floor. The 10 percent floor is effective for tax years beginning after 2012, but the 7.5 percent floor remains effective for senior citizens aged 65 and older (and their spouses) through 2016.

The deduction for eligible long-term care premiums that are paid during any taxable year for a qualified long-term care insurance contract as defined in IRC Section 7702B(b) is subject to an additional dollar amount limit that increases with the age of the insured individual. In 2014, for persons age forty or less, the limit is $370. For ages forty-one through fifty, the limit is $700. For ages fifty-one through sixty, the limit is $1,400. For ages sixty-one through seventy, the limit is $3,720. For those over age seventy, the limit is $4,660. The age is the individual's attained age before the close of the taxable year. The limits are indexed annually.

For tax years beginning after 2009, an annuity contract, life insurance policy, or long-term care insurance policy, may be exchanged for a(nother) qualified long-term care insurance contract without taxation.

An amount paid for qualified long-term care services as defined in IRC Section 7702B(c) will not be treated as paid for medical care if a service is provided by an individual's spouse or a relative unless the service is provided by a licensed professional. A relative generally is any individual who can be considered a dependent under the IRC.

In addition, a service may not be provided by a corporation or partnership that is related to an individual within the meaning of IRC Sections 267(b) or 707(b).

2. Are benefits received under a qualified long-term care insurance contract taxable income?

A qualified long-term care insurance contract is treated as an accident and health insurance contract. Thus, amounts (other than dividends or premium refunds) received under such a contract are treated as amounts received for personal injuries and sickness and are treated as reimbursement for expenses actually incurred for medical care. Since amounts received for personal injuries and sickness are generally not includable in gross income, benefits received under qualified long-term care insurance are generally not taxable.

But there is a limit on the amount of qualified long-term care benefits that may be excluded from income. Generally, if the total periodic payments received under all qualified long-term care insurance contracts (and any periodic payments received as an accelerated death benefit under IRC Section 101(g)) exceed a per diem limitation, the excess must be included in income (without regard to IRC Section 72). If the insured is terminally ill when a payment treated under IRC Section 101(g) is received, the payment is not taken into account for this purpose.

If payments exceed the greater of $330 per day (in 2014; $320 for 2013 and $310 for 2012, adjusted annually for inflation) or the actual amount of qualified long-term care expenses incurred, the excess payment amounts are taxable as income when benefits are paid. Notably, this "per diem" rule will not apply, regardless of payment size, if the payments are fully allocable to the reimbursement of the insured's long-term care insurance expenses. However, payments in excess of reimbursements may become taxable to the extent they exceed the per diem limitation as calculated above.

3. How is the purchaser of an existing immediate annuity contract taxed?

If the purchaser receives lifetime proceeds under the contract, the purchaser is taxed in the same way as an original owner would be taxed, but with the following differences. The purchaser's cost basis is the consideration the purchaser paid for the contract, plus any premiums the purchaser paid after the purchase and less any excludable dividends and unrepaid excludable loans received by the purchaser after the purchase.

If the contract is purchased after payments commence under a life income or installment option, a new exclusion ratio must be determined, based on the purchaser's cost and expected return computed as of the purchaser's annuity starting date. The purchaser's annuity starting date is the beginning of the first period for which the purchaser receives an annuity payment under the contract.

4. What is the tax treatment for an annuity with a long-term care rider?

Under the Pension Protection Act, annuities issued after December 31, 2009 may include a qualified long-term care insurance rider. Under these rules, inclusion of the rider will not trigger taxable distributions as premiums are deducted from cash value for long-term care premiums, although such charges will reduce investment in the contract. In addition, all long-term care benefits paid under the rider will be tax-free and are excludable from the recipient's gross income (and not reduce investment in the contract).

In a private letter ruling, the IRS analyzed the federal income tax treatment of a particular company's long-term care insurance rider to be offered with certain annuity contracts by an insurance company with respect to taxable years beginning after December 31, 2009, and ruled that the rider will constitute a qualified long-term care insurance contract.

5. Is the full gain on a deferred annuity or retirement income contract taxable in the year the contract matures?

If the contract provides for automatic settlement under an annuity option, the lump sum proceeds are not constructively received in the year of maturity. The annuity payments (whether life income or installment) are taxed under the regular annuity rules. In computing the exclusion ratio for the payments, the amount to be used as the investment in the contract is premium cost, not the maturity value.

Of course, if the contract owner takes a one sum settlement at maturity, he or she must include the gain in gross income for the year in which he or she receives the payment.

6. Who qualifies for the tax credit for the elderly and the permanently and totally disabled and how is the credit computed?

The credit is available to taxpayers age 65 or older, or those who are under age 65, retired on disability, and were considered permanently and totally disabled when they retired.

"An individual is permanently and totally disabled if he is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or which has lasted or can be expected to last for a continuous period of not less than 12 months. An individual shall not be considered to be permanently and totally disabled unless he furnishes proof of the existence thereof in such form and manner, and at such times, as the Secretary may require."

The credit equals 15% of an individual's IRC Section 22 amount for the taxable year, but may not exceed the amount of tax. This IRC Section 22 base amount is $5,000 for a single taxpayer or married taxpayers filing jointly if only one spouse qualifies for the credit; $7,500 for married taxpayers filing jointly if both qualify; and $3,750 for a married taxpayer filing separately. Married taxpayers must file a joint return to claim the credit, unless they lived apart for the entire taxable year.

This base figure is limited for individuals under age 65 to the amount of the disability income (taxable amount an individual receives under an employer plan as wages or payments in lieu of wages for the period he is absent from work on account of permanent and total disability) received during the taxable year. (Proof of continuing permanent and total disability may be required.) For married taxpayers who are both qualified and who file jointly, the base figure cannot exceed the total of both spouses' disability income if both are under age 65 or if only one is under age 65, the sum of $5,000 plus the disability income of the spouse who is under 65.

The base figure (or the amount of disability income in the case of individuals under age 65, if lower) is reduced dollar-for-dollar by one-half of adjusted gross income in excess of $7,500 (single taxpayers), $10,000 (joint return), or $5,000 (married filing separately). A reduction is also made for Social Security and railroad retirement benefits that are excluded from gross income, and certain other tax-exempt income.

7. Are contributions to, and postretirement payments from, a deferred compensation account balance or nonaccount balance plan subject to FICA and FUTA taxes?

Yes.

There are two timing rules for the treatment of deferred compensation amounts under the Federal Insurance Contributions Act ("FICA") and the Federal Unemployment Tax Act ("FUTA"): (1) the "general timing rule," and (2) the "special timing rule."

The general timing rule provides that amounts taxable as wages generally are taxed when paid or "constructively received."

The special timing rule applies to amounts deferred by an employee under any deferred compensation plan of an employer covered by FICA. The special timing rule applies to voluntary salary, commission and bonus reduction plans, employer-paid supplemental plans, funded and unfunded plans, private plans, and eligible or ineligible Section 457 plans. It does not apply to excess (golden) parachute payments.

Section 409A has not changed the application or calculation of employment taxes. Under these rules, vested nonqualified plan contributions (and the earnings on them) generally are taxable for employment tax purposes (compared with income tax purposes) when they are contributed (as in the case of most voluntary salary/bonus deferral plans) or when they are vested (as in the case of an employer-paid supplemental plan with risks of forfeiture on the benefits).

General Timing Rule

Under the general timing rule, an employee's "amount deferred" is considered to be "wages" for FICA purposes at the later of the date when the services are performed or the employee's rights to such amount are no longer subject to a Section 3121 "substantial risk of forfeiture" governing the timing of the imposition of FICA taxes on compensation.

Similar rules apply for FUTA (federal unemployment tax) purposes, although the taxable wage base for FUTA purposes is substantially smaller ($7,000).

Where an amount deferred cannot be readily calculated by the last day of the year, employers may choose between two alternative methods: the estimated method and the lag method.

Under the estimated method, the employer treats a reasonably estimated amount as wages paid on the last day of the calendar year. If the employer underestimates, it may treat the shortfall as wages in the first year (or in the first quarter of the second year). If the employer overestimates, it may claim a refund or credit.

Under the lag method, the employer may calculate the end-of-year amount deferred on any date in the first quarter of the next calendar year. The amount deferred will be treated as wages paid and received on that date, and the amount deferred that otherwise would have been taken into account on the last day of the year must be increased by income through the date on which the amount is taken into account.

Special Timing (Nonduplication) Rule

The "special timing" (nonduplication) rule is designed to prevent double taxation once an amount is treated as wages. Under this rule, any amount (and any income attributable to it) will not again be treated as wages for FICA or FUTA purposes in any later year. A deferred amount is treated as taken into account for FICA and FUTA purposes when it is included in computing the amount of wages, but only to the extent that any additional tax for the year resulting from the inclusion actually is paid before the expiration of the period of limitation for the year. A failure to take a deferred amount into account subjects it (and any income attributable thereto) to inclusion when actually or constructively paid.

8. Can an employer make post-retirement contributions to a tax sheltered annuity on behalf of a retired employee?

Yes, but time limits apply.

Under the IRC, the term "includable compensation" means compensation earned by the employee for the most recent period, ending not later than the close of the taxable year for which the limitation is being determined, that constitutes a full year of service and that precedes the taxable year by no more than five years.

A former employee is deemed to have monthly includible compensation for the period through the end of the taxable year in which the employee ceases to be an employee and through the end of each of the next five taxable years. The amount of the monthly includable compensation is equal to one-twelfth of the former employee's includable compensation during the former employee's most recent year of service. Accordingly, non-elective employer contributions for a former employee must not exceed the IRC Section 415(c) limit up to the lesser of the dollar amount in IRC Section 415(c) or the former employee's annual includable compensation based on the former employee's average monthly compensation during his or her most recent year of service.

9. What is the effect of failure to make timely distributions from a tax sheltered annuity?

If an amount distributed from a tax sheltered annuity is not taken by the participant, or is less than the required minimum distribution, an excise tax equal to 50% of the shortfall is generally levied against the individual (not the plan). However, the tax may be waived if the payee establishes to the satisfaction of the IRS that the shortfall was due to reasonable error, and that reasonable steps are being taken to remedy the shortfall. Generally, the excise tax will be waived automatically in the case of a beneficiary who receives the entire benefit to which he is entitled under the 5-year rule.

Planning Point: RMDs from Section 403(a) and 403(b) defined contribution plans were waived for calendar year 2009 only. Also, the five year rule is determined without regard to 2009. A person who received a RMD for 2009 (including a distribution for 2009 made as late as April 1, 2010) had until the later of 60 days of receiving the RMD or November 30, 2009, to roll over the RMD to an IRA or other retirement plan (assuming the rollover would otherwise qualify).

The minimum distribution requirements will not be treated as violated and, thus, the 50% excise tax will not apply where a shortfall occurs because assets are invested in a contract issued by an insurance company in state insurer delinquency proceedings. To the extent that a distribution otherwise required under IRC Section 401(a)(9) is not made during the state insurer delinquency proceedings, this amount and any additional amount accrued during this period will be treated as though it is not vested.

10. Are payments received under a tax sheltered annuity taxable income to the employee?

Yes, except to the extent the amounts are a recovery of the employee's investment in the contract including the amount of a defaulted loan or to the extent the employee rolls over an eligible distribution to another tax sheltered annuity, a qualified retirement plan, an eligible governmental 457 plan, or a traditional individual retirement plan.

Where an annuity contract without life insurance protection is used for funding, all payments received normally are taxable in full as ordinary income to the employee. This is the result regardless of whether contributions were made by the employer as additional compensation to the employee, were derived from a reduction in the employee's salary, or were paid in part by deductible voluntary employee contributions. Because salary reduction contributions have not been previously taxed to the employee, where they have come within the overall limit, they cannot be treated as a cost basis for the contract.

In some instances, however, the employee will have a cost basis for the contract. An employee's cost basis consists of any nondeductible contributions the employee has paid and any portion of the contributions made by the employer on which the employee has paid tax, except that excess salary reduction amounts not distributed from the plan by April 15 of the year following the contribution are not included in basis even though they were included in income.

Where a life insurance policy is used, the sum of the annual one year term costs that have been taxed to the employee are included in the employee's cost basis

Similarly, any portion of an employer's premiums that have been included in an employee's gross income because they exceeded the employee's overall limit are included in the employee's cost basis. The amount of any policy loans included in income as a taxable distribution also would constitute part of the employee's cost basis.

Once a loan is deemed distributed under IRC Section 72(p), the interest that accrues thereafter on that loan is not included in income for purposes of determining the amount that is taxable under IRC Section 72. In addition, neither the income that results from the deemed distribution nor the interest that accrues thereafter increases the participant's investment or cost basis in the contract under IRC Section 72. To the extent that a participant repays by cash any portion of a loan that has been deemed distributed, the participant acquires a tax basis in the contract in the same manner as if the repayments were after-tax contributions.

If an employee takes an account balance in a single lump sum cash payment, the full amount received will be ordinary income to the employee in the year of receipt unless the employee has a cost basis, with a few limited exceptions. If the employee has a cost basis, the amount in excess of the cost basis will be ordinary income.

Amounts received before the annuity starting date, that is, an in-service distribution, by an employee who has a cost basis are taxed under a rule that provides for pro rata recovery of cost. An employee excludes that portion of the distribution that bears the same ratio to the total distribution as the employee's investment in the contract bears to the total value of the employee's accrued benefit as of the date of the distribution. Amounts received prior to July 2, 1986 were taxed under a cost recovery rule permitting recovery of basis before taxing any of the distribution as interest.

The annuity starting date is the first day of the first period for which an amount is received as an annuity under a contract. If a plan on May 5, 1986 permitted in-service withdrawal of employee contributions, the pro rata recovery rules do not apply to investment in the contract prior to 1987. Instead, investment in the contract prior to 1987 will be recovered first and the pro rata recovery rules will apply only to the extent that amounts received before the annuity starting date, when added to all other amounts previously received under the contract after 1986, exceed the employee's investment in the contract as of December 31, 1986.

Where the 403(b) annuity contract or custodial account is solely liable for the payment of investment expenses, the direct payment of investment advisor fees from a participant's annuity or account is not treated as a distribution. Likewise, where an annuity contract consists of different subaccounts for which a financial advisor provides asset allocation advice, if the annuity contract expenses are assessed directly against the contract value itself, those payments then are expenses of the contract itself and, therefore, are not distributions from the contract includable in the annuity contract owner's gross income. Furthermore, assessing expenses against a contract in this manner does not cause the contract to lose its qualified status under IRC Section 403(b).

Withholding

With respect to distributions other than eligible rollover distributions, amounts will be withheld from periodic payments at the rates applicable to wage payments and from other distributions at a 10 percent rate. An employee may elect not to have income tax withheld from these payments. Tax will not be withheld on amounts distributed that it is reasonable to believe will not be includable in income.

Any eligible rollover distribution made after December 31, 1992 is subject to mandatory income tax withholding at the rate of 20 percent unless the distributee elects to have the distribution paid by means of a direct rollover. This mandatory withholding applies even if the employee's employment terminated prior to January 1, 1993, and even if the eligible rollover distribution is part of a series of payments that began before January 1, 1993. For distributions after 1992 but before October 19, 1995, slightly different rules may be applicable under temporary regulations.

For more tax planning coverage, visit: www.LifeHealthPro.com/taxplanning

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