Tax FAQs
By: Tax Hotline
Summer 2022 (Vol. 40, No. 2)
Q: I pay my twelve-year-old son a small wage to do odd jobs for me. He washes company vehicles, picks up trash and is an errand boy. Can he use his earned income to open a ROTH IRA?
A: Minors generally cannot open brokerage accounts in their own name until age 18. As such, it requires an adult to serve as custodian. A Roth IRA for minors is also known as a custodial account Roth IRA or a Roth IRA for Kids. No matter which name it uses, the benefits are the same as a regular Roth IRA.
Here’s how it works: The custodian opens and maintains control of the minor child’s Roth IRA. Decisions about contributions, investments, and distributions are also controlled by the custodian, who receives account statements as well. As the custodian, parents should remember that while they control and maintain the account, it belongs to the minor child. As such, the accounts funds must be used for the benefit of the minor. Generally, assets must be transferred to a new account in the minor’s name when they reach either 18 or 21, depending on the state.
A minor can only contribute to a Roth IRA if they have earned income from a job or earnings from self-employment such as babysitting, pet sitting, or mowing lawns. As a reminder, self-employment earnings of $400 or more may be subject to self-employment taxes such as Medicare and Social Security. Most minors won’t be required to file a tax return; however, they should keep a written log of hours worked in case the IRS contacts them with questions later.
For 2022, the maximum contribution to a Roth IRA is the lesser of $6,000 or the total of the child’s earned income. For example, if your child earns $3,000 this year, the maximum contribution is $3,000 (not $6,000). Parents can add funds to their child’s account as long as the total contribution amount (child and parent) does not exceed the amount of earned income your child made this year. Using the example above, if the child earned $3,000 but only wanted to contribute $1,500 to their Roth IRA, the parent could contribute an additional $1,500. Contributions can be withdrawn penalty and tax-free at any time - you don’t need to wait until age 59 1/2. Even if your child makes a one-time contribution today, the earlier they start saving, the more time their money has to grow, thanks to the power of compounding.
Q: For the past five years, my current employer took a set percentage of my pretax salary and put it into my 401(k) plan. I have accepted a job with a different employer and will be leaving in 2 months. What are the options for the money in my 401(k) plan?
A: This is a very important question because making the wrong move could cost you thousands of dollars or more in taxes and lower returns. The answer may differ depending on your specific circumstances, but the general rule of thumb says don’t take the cash-out option. You have 60 days to decide whether to roll it over or leave it in the account. Resist the temptation to cash out. The worst thing an employee can do when leaving a job is to withdraw the money from their 401(k) plans and put it in their bank account. Here’s why:
If you decide to have your distribution paid to you, the plan administrator will withhold 20 percent of your total for federal income taxes, so if you had $100,000 in your account and wanted to cash it out, you’re already down to $80,000. Furthermore, if you’re younger than 59 1/2, you’ll face a 10 percent penalty for early withdrawal come tax time. Now you’re down another 10 percent from the top line to $70,000.
If you separate from service during or after the year you reach age 55 (age 50 for public safety employees of a state, or political subdivision of a state, in a governmental defined benefit plan), there is an exception to the 10 percent early withdrawal tax penalty. This applies to 401(k) plans only. IRA, SEP, SIMPLE IRA, and SARSEP Plans do not qualify for the exception. In addition, because distributions are taxed as ordinary income, at the end of the year, you’ll have to pay the difference between your tax bracket and the 20 percent already taken out. For example, if you’re in the 32 percent tax bracket, you’ll still owe 12 percent, or $12,000. This lowers the amount of your cash distribution to $58,000. But that’s not all. You also might have to pay state and local taxes. Between taxes and penalties, you could end up with little over half of what you had saved up, short-changing your retirement savings significantly.
What are the alternatives? If your new job offers a retirement plan, the easiest course of action is to roll your account into the new plan before the 60-day period ends. This is known as a “rollover” and is relatively painless to do.
Contact The 401(k) plan administrator at your previous job should have all of the forms you need. The best way to roll funds over from an old 401(k) plan to a new one is to use a direct transfer. With the direct transfer, you never receive a check, you avoid all of the taxes and penalties mentioned above, and your savings will continue to grow tax-deferred until you retire.
One word of caution: Many employers require that you work a minimum period of time before you can participate in a 401(k). If that is the case, one solution is to keep your money in your former employer’s 401(k) plan until the new one is available. Then you can roll it over into the new plan. Most plans let former employees leave their assets for several months in the old plan.
60-Day Rollover Period. If you have your former employer make the distribution check out to you, the Internal Revenue Service considers this a cash distribution. Your check will have 20 percent taken out automatically from your vested amount for federal income tax. But don’t panic. You have 60 days to roll over the lump sum (including the 20 percent) to your new employer’s plan or into a rollover individual retirement account (IRA). Then you won’t owe the additional taxes or the 10 percent early withdrawal penalty.
If you’re not happy with the fund choices your new employer offers, you might opt for a rollover IRA instead of your company’s plan. You can then choose from hundreds of funds and have more control over your money. But again, to avoid the withholding hassle, use direct rollovers.
Leave It with your former employer. If your vested account balance in your 401(k) is more than $5,000, you can usually leave it with your former employer’s retirement plan. Your lump sum will keep growing tax-deferred until you retire. However, if you can’t leave the money in your former employer’s 401(k) and your new job doesn’t have a 401(k), your best bet is a direct rollover into an IRA. The same applies if you’ve decided to go into business for yourself. Once you turn 59 1/2, you can begin withdrawals from your IRA without penalty, and your withdrawals are taxed as ordinary income. The IRS “Rule of 55” allows you to withdraw funds from your 401(k) or 403(b) without a penalty at age 55 or older.
With both a 401(k) and an IRA, you must begin taking required minimum distributions (RMDs) when you reach age 72, whether you’re working or not.
Q: Can you explain “Small Employer Health Reimbursement Arrangements”?
A: Small employer HRAs or QSEHRAs (Qualified Small Employer Health Reimbursement Arrangements) allow small businesses without group health plans to set aside money, tax-free, for employees to use toward medical expenses - including the cost of buying health insurance. Here’s what small business owners need to know about QSEHRAs.
Included in the 21st Century Cures Act enacted by Congress on December 13, 2016, was a provision for QSEHRAs, which permit an eligible employer to provide a qualified small employer health reimbursement arrangement (QSEHRA), which is not a group health plan and thus is not subject to the requirements that apply to group health plans.
QSEHRAs must meet several criteria such as:
- The arrangement is funded solely by an eligible employer, and no salary reduction contributions may be made under the arrangement.
- The arrangement generally is provided on the same terms to all eligible employees of the employer;
- The arrangement provides, after the employee provides proof of coverage, for the payment or reimbursement of medical expenses incurred by the employee or the employee’s family members; and the amount of the payments and reimbursements for any year do not exceed inflation-adjusted amounts for payments and reimbursements of expenses. For 2022, the maximum dollar amount for employee-only arrangements is $5,450. The maximum dollar amount for arrangements that provide for payments and reimbursements for expenses of family members is $11,050.
Any small employer from a startup to a nonprofit that doesn’t offer a group health plan is able to set up a QSEHRA as long as they meet certain rules. Small employers are defined as an employer that is not an applicable large employer (ALE). An applicable large employer is defined as one that employs more than 50 full-time workers, including full-time equivalent employees, on average.
If a small employer currently offers a group health plan but wants to set up a QSEHRA, the group health plan must be canceled before the QSEHRA will start. One of the most important rules is that in order for employees to participate in a QSEHRA, they must have health insurance that meets minimum essential coverage.