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Generally, you must include in income amounts you pay into a retirement plan through payroll deductions. You recover your contributions tax free when you retire and receive benefits from the plan. See Publication 575 for information about the tax treatment of retirement plan benefits.
Employer's contributions to qualified plan. Your employer's contributions to a qualified retirement plan for you are not included in income at the time contributed. (Your employer can tell you whether your retirement plan is qualified.) However, the cost of life insurance coverage included in the plan may have to be included. See Group-Term Life Insurance, earlier, under Fringe Benefits.
Employer's contributions to nonqualified plan. If your employer pays into a nonqualified plan for you, you generally must include the contributions in your income as wages for the tax year in which the contributions are made. However, if your interest in the plan is subject to a substantial risk of forfeiture (you have a good chance of losing it) at the time of the contribution, you do not have to include the value of your interest in your income until it is no longer subject to a substantial risk of forfeiture.
If you are covered by certain kinds of retirement plans, you can choose to have part of your compensation contributed by your employer to a retirement fund, rather than have it paid to you. The amount you set aside (called an elective deferral) is treated as an employer contribution to a qualified plan. It is not included in wages subject to income tax at the time contributed. However, it is included in wages subject to social security and Medicare taxes.
Elective deferrals include elective contributions to the following retirement plans.
Limit on deferrals. For 2001, you generally should not have deferred more than a total of $10,500 for all qualified plans by which you are covered. This amount may be further limited if you are a highly compensated employee. The amount deferred by a highly compensated employee as a percentage of pay can be no more than 125% of the average deferral percentage (ADP) of all eligible nonhighly compensated employees. Your employer or plan administrator can probably tell you the amount of the deferral limit under this ADP test and whether it applies to you.
Your employer or plan administrator should apply the proper annual limit when figuring your plan contributions. However, you are responsible for monitoring the total you defer to ensure that the limit is not exceeded.
Under new law, the general limit on elective deferrals for 2002 is $11,000. This amount will increase by $1,000 each year until it reaches $15,000 in 2006. In addition, beginning in 2002, you generally can make an additional elective deferral if you are age 50 or older. For more information, see Publication 553, Highlights of 2001 Tax Changes.
Special limit for deferrals under SIMPLE plans. If you are a participant in a SIMPLE plan, you generally should not have deferred more than $6,500 in 2001. Amounts you defer under a SIMPLE plan count toward the general limit ($10,500 for 2001) and may affect the amount you can defer under other elective deferral plans.
Under new law, the special limit on elective deferrals for SIMPLE plans for 2002 is $7,000. This amount will increase by $1,000 each year until it reaches $10,000 in 2005.
Special limit for deferrals under section 457 plans. If you are a participant in a section 457 plan (a deferred compensation plan for employees of state or local governments or tax-exempt organizations), you should generally have deferred no more than 1/3 of your compensation, up to $8,500 in 2001. Your plan may also allow a special catch-up limit of up to $15,000 for each of your last 3 years of service before reaching normal retirement age. Amounts you defer under other elective deferral plans may affect your limits under section 457 plans. Amounts you defer under section 457 plans may affect the amount you can defer in tax-sheltered annuities under the special limit discussed next.
Under new law, beginning in 2002, the special limit on elective deferrals for section 457 plans no longer applies. Deferrals under these plans are subject to the general limit for elective deferrals ($11,000 for 2002). The special catch-up limit in the last 3 years before retirement is twice the general limit amount (twice $11,000 for 2002, or $22,000). Also, beginning in 2002, deferrals under section 457 plans are no longer coordinated with other plans in applying the deferral limit.
Special limit for tax-sheltered annuities. If you are a participant in a tax-sheltered annuity plan with at least 15 years of service at an educational organization, a hospital, a home health service agency, a health and welfare service agency, a church, or a convention or association of churches (or associated organization), the limit on elective deferrals to the plan is the general limit ($10,500 for 2001) plus the lesser of the following amounts.
Reporting by employer. Your employer generally should not include elective deferrals in your wages in box 1 of Form W-2. Instead, your employer should mark the Retirement plan checkbox in box 13 and show the total amount deferred in box 12.
Section 501(c)(18)(D) contributions. Wages shown in box 1 of your Form W-2 should not have been reduced for contributions you made to a section 501(c)(18)(D) retirement plan. The amount you contributed should be identified with code "H" in box 12. You may deduct the amount deferred subject to the limits that apply. Include your deduction in the total on line 32 (Form 1040). Enter the amount and "501(c)(18)" on the dotted line next to line 32.
Excess deferrals. If your deferrals exceed the annual limit, you must notify your plan by the date required by the plan. If the plan permits, the excess amount will be distributed to you. If you participate in more than one plan, you can have the excess paid out of any of the plans that permit these distributions. You must notify each plan by the date required by that plan of the amount to be paid from that particular plan. The plan must then pay you the amount of the excess, along with any income earned on that amount, by April 15 of the following year.
You must include the excess deferral in your income for the year of the deferral. File Form 1040 to add the excess deferral amount to your wages on line 7. Do not use Form 1040A or Form 1040EZ to report excess deferral amounts.
Excess not distributed. If you do not take out the excess amount, you cannot include it in the cost of the contract even though you included it in your income. Therefore, you are taxed twice on the excess deferral left in the plan--once when you contribute it, and again when you receive it as a distribution.
Excess distributed to you. If you take out the excess after the year of the deferral and you receive the corrective distribution by April 15 of the following year, do not include it in income again in the year you receive it. If you receive it later, you must include it in income in both the year of the deferral and the year you receive it. Any income on the excess deferral taken out is taxable in the tax year in which you take it out. If you take out part of the excess deferral and the income on it, allocate the distribution proportionately between the excess deferral and the income.
You should receive a Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., for the year in which the excess deferral is distributed to you. Use the following rules to report a corrective distribution shown on Form 1099-R for 2001.
Report a loss on a corrective distribution of an excess deferral in the year the excess amount (reduced by the loss) is distributed to you. Include the loss as a negative amount on line 21 (Form 1040) and identify it as "Loss on Excess Deferral Distribution."
Even though a corrective
distribution of excess deferrals is reported on Form 1099-R, it is not
otherwise treated as a distribution from the plan. It cannot be rolled over into another
plan, and it is not subject to the additional tax on early distributions.
If you are a highly compensated employee, the total of your elective deferrals and other contributions made for you for any year under a section 401(k) plan or SARSEP can be, as a percentage of pay, no more than 125% of the average deferral percentage (ADP) of all eligible nonhighly compensated employees.
If the total contributed to the plan is more than the amount allowed under the ADP test, the excess contributions must be either distributed to you or recharacterized as after-tax employee contributions by treating them as distributed to you and then contributed by you to the plan. You must include the excess contributions in your income as wages on line 7 of Form 1040. You cannot use Form 1040A or Form 1040EZ to report excess contribution amounts.
If you receive excess contributions from a 401(k) plan and any income earned on the contributions within 2 1/2 months after the close of the plan year, you must include them in your income in the year of the contribution. If you receive them later, or receive less than $100 excess contributions, include the excess contributions and earnings in your income in the year distributed. If the excess contributions are recharacterized, you must include them in income in the year a corrective distribution would have occurred. For a SARSEP, the employer must notify you by March 15 following the year in which excess contributions are made that you must withdraw the excess and earnings. You must include the excess contributions in your income in the year of the contribution (or the year of the notification if less than $100) and include the earnings in your income in the year withdrawn.
You should receive a Form 1099-R for the year in which the excess contributions are distributed to you (or are recharacterized). Add excess contributions or earnings shown on Form 1099-R for 2001 to your wages on your 2001 tax return if code "8" is in box 7. If code "P" or "D" is in box 7, you may have to file an amended 2000 or 1999 return on Form 1040X to add the excess contributions or earnings to your wages in the year of the contribution.
Even though a corrective
distribution of excess contributions is reported on Form 1099-R, it is not
otherwise treated as a distribution from the plan. It cannot be rolled over into another
plan, and it is not subject to the additional tax on early distributions.
The amount contributed in 2001 to a defined contribution plan is generally limited to the lesser of 25% of your compensation or $35,000. Under certain circumstances, contributions that exceed these limits (excess annual additions) may be corrected by a distribution of your elective deferrals or a return of your after-tax contributions and earnings from these contributions.
Under new law, the dollar limit on contributions to a defined contribution plan for 2002 is $40,000.
A corrective payment of excess annual additions consisting of elective deferrals or earnings from your after-tax contributions is fully taxable in the year paid. A corrective payment consisting of your after-tax contributions is not taxable.
If you received a corrective payment of excess annual additions, you should receive a separate Form 1099-R for the year of the payment with the code "E" in box 7. Report the total payment shown in box 1 of Form 1099-R on line 16a of Form 1040 or line 12a of Form 1040A. Report the taxable amount shown in box 2a of Form 1099-R on line 16b of Form 1040 or line 12b of Form 1040A.
Even though a corrective
distribution of excess annual additions is reported on Form 1099-R, it is not
otherwise treated as a distribution from the plan. It cannot be rolled over into another
plan, and it is not subject to the additional tax on early distributions.
If you receive a nonstatutory option to buy or sell stock or other property as payment for your services, you will usually have income either when you receive the option or when you exercise the option (use it to buy or sell the stock or other property). However, if your option is a statutory stock option (defined later), you usually will not have any income until you sell or exchange your stock. Your employer can tell you which kind of option you hold.
If you are granted a nonstatutory stock option, the amount of income to include and the time to include it depend on whether the fair market value of the option can be readily determined. The fair market value of an option can be readily determined if it is actively traded on an established market.
The fair market value of an option that is not traded on an established market can be readily determined only if all of the following conditions exist.
The option privilege for an option to buy is the opportunity to benefit during the option's exercise period from any increase in the value of property subject to the option without risking any capital. For example, if during the exercise period the fair market value of stock subject to an option is greater than the option's exercise price, a profit may be realized by exercising the option and immediately selling the stock at its higher value. The option privilege for an option to sell is the opportunity to benefit during the exercise period from a decrease in the value of the property subject to the option.
Option with readily determined value. If you receive a nonstatutory stock option that has a readily determined fair market value at the time it is granted to you, the option is treated like other property received as compensation. See Restricted Property, later, for rules on how much income to include and when to include it. However, the rule described in that discussion for choosing to include the value of property in your income for the year of the transfer does not apply to a nonstatutory option.
Option without readily determined value. If the fair market value of the option is not readily determined at the time it is granted to you (even if it is determined later), you do not have income until you transfer or exercise the option. When you exercise this kind of option, the restricted property rules apply to the property received. The amount to include in your income is the difference between the amount you pay for the property and its fair market value when it becomes substantially vested. Your basis in the property you acquire under the option is the amount you pay for it plus any amount you must include in your gross income under this rule. For more information on restricted property, see Restricted Property, later.
If you transferred this kind of option in an arm's-length transaction, you must include in your income the money or other property you received for the transfer, as if you had exercised the option.
There are two kinds of statutory stock options.
For either kind of option, you must be an employee of the company granting the option, or a related company, at all times beginning with the date the option is granted, until 3 months before you exercise the option (for an incentive stock option, 1 year before if you are disabled). Also, the option must be nontransferable except at death. If you do not meet the employment requirements, or you receive a transferable option, your option is a nonstatutory stock option. See Nonstatutory Stock Options, earlier in this discussion.
If you receive a statutory stock option, do not include any amount in your income either when the option is granted or when you exercise it. You have taxable income or deductible loss when you sell the stock that you bought by exercising the option. Your income or loss is the difference between the amount you paid for the stock (the option price) and the amount you receive when you sell it. You generally treat this amount as capital gain or loss and report it on Schedule D (Form 1040), Capital Gains and Losses, for the year of the sale.
However, you may have ordinary income for the year that you sell the stock in either of the following situations.
Report your ordinary income as wages on line 7, Form 1040, for the year of the sale.
Incentive stock options (ISOs). If you sell stock acquired by exercising an ISO and meet the holding period requirement, your gain or loss from the sale is capital gain or loss.
If you do not meet the holding period requirement and you have a gain from the sale, the gain is ordinary income up to the amount by which the stock's fair market value when you exercised the option exceeded the option price. Any excess gain is capital gain. If you have a loss from the sale, it is a capital loss and you do not have any ordinary income.
Example. Your employer, X Corporation, granted you an ISO on March 11, 1999, to buy 100 shares of X Corporation stock at $10 a share, its fair market value at the time. You exercised the option on January 19, 2000, when the stock was selling on the open market for $12 a share. On January 25, 2001, you sold the stock for $15 a share. Although you held the stock for more than a year, less than 2 years had passed from the time you were granted the option. In 2001, you must report the difference between the option price ($10) and the value of the stock when you exercised the option ($12) as wages. The rest of your gain is capital gain, figured as follows:
| Selling price ($15 × 100 shares) | $ 1,500 |
| Purchase price ($10 × 100 shares) | -1,000 |
| Gain | $ 500 |
| Amount reported as wages [($12 × 100 shares) - $1,000] | - 200 |
| Amount reported as capital gain | $ 300 |
Alternative minimum tax (AMT). For the AMT, you must treat stock acquired through the exercise of an ISO as if no special treatment applied. This means that, when your rights in the stock are transferable and no longer subject to a substantial risk of forfeiture, you must include as an adjustment in figuring alternative minimum taxable income the amount by which the fair market value of the stock exceeds the option price. Enter this adjustment on line 10 of Form 6251, Alternative Minimum Tax--Individuals. Increase your AMT basis in any stock you acquire by exercising the ISO by the amount of the adjustment. However, no adjustment is required if you dispose of the stock in the same year you exercise the option.
See Restricted Property, later, for more information.
Your AMT basis in stock
acquired through an ISO is likely to differ from your regular tax basis. Therefore, keep
adequate records for both the AMT and regular tax so that you can figure your adjusted
gain or loss.
Example. The facts are the same as in the previous example. On January 19, 2001, when the stock was selling on the open market for $14 a share, your rights to the stock first became transferable. You include $400 ($1,400 value when your rights first became transferable minus $1,000 purchase price) as an adjustment on line 10 of Form 6251.
Employee stock purchase plan. If you sold stock acquired by exercising an option granted under an employee stock purchase plan, determine your ordinary income and your capital gain or loss as follows.
Option granted at discount. If you meet the holding period requirement and you have a gain from the sale, the gain is ordinary income up to the amount by which the stock's fair market value when the option was granted exceeded the option price. Any excess gain is capital gain. If you have a loss from the sale, it is a capital loss, and you do not have any ordinary income.
Example. Your employer, Y Corporation, granted you an option under its employee stock purchase plan to buy 100 shares of stock of Y Corporation for $20 a share at a time when the stock had a value of $22 a share. Eighteen months later, when the value of the stock was $23 a share, you exercised the option, and 14 months after that you sold your stock for $30 a share. In the year of sale, you must report as wages the difference between the option price ($20) and the value at the time the option was granted ($22). The rest of your gain ($8) is capital gain, figured as follows:
| Selling price ($30 × 100 shares) | $ 3,000 |
| Purchase price (option price) ($20 × 100 shares) | -2,000 |
| Gain | $ 1,000 |
| Amount reported as wages [($22 × 100 shares) - $2,000] | - 200 |
| Amount reported as capital gain | $ 800 |
Holding period requirement not met. If you do not meet the holding period requirement, your ordinary income is the amount by which the stock's fair market value when you exercised the option exceeded the option price. This ordinary income is not limited to your gain from the sale of the stock. Increase your basis in the stock by the amount of this ordinary income. The difference between your increased basis and the selling price of the stock is a capital gain or loss.
Example. The facts are the same as in the previous example, except that you sold the stock only 6 months after you exercised the option. Because you did not hold the stock long enough, you must report $300 as wages and $700 as capital gain, figured as follows:
| Selling price ($30 × 100 shares) | $3,000 |
| Purchase price (option price) ($20 × 100 shares) | -2,000 |
| Gain | $1,000 |
| Amount reported as wages [($23 × 100 shares) - $2,000] | - 300 |
| Amount reported as capital gain [$3,000 - ($2,000 + $300)] | $700 |
Generally, if you receive property for your services, you must include its fair market value in your income in the year you receive the property. However, if you receive stock or other property that has certain restrictions that affect its value, you do not include the value of the property in your income until it has been substantially vested. (You can choose to include the value of the property in your income in the year it is transferred to you, as discussed later, rather than the year it is substantially vested.)
Until the property becomes substantially vested, it is owned by the person who makes the transfer to you, usually your employer. However, any income from the property, or the right to use the property, is included in your income as wages in the year you receive the income or have the right to use the property.
When the property becomes substantially vested, you must include its fair market value, minus any amount you paid for it, in your income for that year.
Example. Your employer, the RST Corporation, sells you 100 shares of its stock at $10 a share. At the time of the sale the fair market value of the stock is $100 a share. Under the terms of the sale, the stock is under a substantial risk of forfeiture (you have a good chance of losing it) for a 5-year period. Because your stock is not substantially vested when it is transferred, you do not include any amount in your income in the year you buy it. At the end of the 5-year period, the fair market value of the stock is $200 a share. You must include $19,000 in your income [100 shares × ($200 fair market value - $10 you paid)]. Dividends paid by the RST Corporation on your 100 shares of stock are taxable to you as wages during the period the stock can be forfeited.
Substantially vested. Property is substantially vested when:
Transferable property. Property is transferable if you can sell, assign, or pledge your interest in the property to any person (other than the transferor), and if the person receiving your interest in the property is not required to give up the property, or its value, if the substantial risk of forfeiture occurs.
Substantial risk of forfeiture. A substantial risk of forfeiture exists if the rights in the property transferred depend on the future performance (or refraining from performance) of substantial services by any person, or the occurrence of a certain condition related to the transfer.
Example. The Spin Corporation transfers to you as compensation for services 100 shares of its corporate stock for $100 a share. Under the terms of the transfer, you must resell the stock to the corporation at $100 a share if you leave your job for any reason within 3 years from the date of transfer. Because you must perform substantial services over a period of time and you must resell the stock to the corporation at $100 a share (regardless of its value) if you do not perform the services, your rights to the stock are subject to a substantial risk of forfeiture.
Choosing to include in income for year of transfer. You can choose to include the value of the property at the time of transfer (minus any amount you paid for the property) in your income for the year it is transferred. If you make this choice, the substantial vesting rules do not apply and, generally, any later appreciation in value is not included in your compensation when the property becomes substantially vested. Your basis for figuring gain or loss when you sell the property is the amount you paid for it plus the amount you included in income as compensation.
If you make this
choice, you cannot revoke it without the consent of the Internal Revenue Service. Consent
will be given only if you were under a mistake of fact as to the underlying transaction.
If you forfeit the property after you have included its value in income, your loss is the amount you paid for the property minus any amount you realized on the forfeiture.
How to make the choice. You make the choice by filing a written statement with the Internal Revenue Service center where you file your return. You must file this statement no later than 30 days after the date the property was transferred. A copy of the statement must be attached to your tax return for the year the property was transferred. You also must give a copy of this statement to the person for whom you performed the services and, if someone other than you received the property, to that person.
You must sign the statement and indicate on it that you are making the choice under section 83(b) of the Internal Revenue Code. The statement must contain all of the following information.
Dividends received on restricted stock. Dividends you receive on restricted stock are extra compensation to you. Your employer should include these payments on your Form W-2. If they are also reported on a Form 1099-DIV, Dividends and Distributions, you should list them on Schedule B (Form 1040), Interest and Ordinary Dividends, with a statement that you have included them as wages. Do not include them in the total dividends received.
Stock you chose to include in your income. Dividends you receive on restricted stock you chose to include in your income in the year transferred are treated the same as any other dividends. You should receive a Form 1099-DIV showing these dividends. Do not include the dividends in your wages on your return. Report them as dividends.
Sale of property not substantially vested. These rules apply to the sale or other disposition of property that you did not choose to include in your income in the year transferred and that is not substantially vested.
If you sell or otherwise dispose of the property in an arm's-length transaction, include in your income as compensation for the year of sale the amount realized minus the amount you paid for the property. If you exchange the property in an arm's-length transaction for other property that is not substantially vested, treat the new property as if it were substituted for the exchanged property.
If you sell the property in a transaction that is not at arm's length, include in your income as compensation for the year of sale the total of any money you received and the fair market value of any substantially vested property you received on the sale. In addition, you will have to report income when the original property becomes substantially vested, as if you still held it. Report as compensation its fair market value minus the total of the amount you paid for the property and the amount included in your income from the earlier sale.
Example. In 1998, you paid your employer $50 for a share of stock that had a fair market value of $100 and was subject to forfeiture until 2001. In 2000, you sold the stock to your spouse for $10 in a transaction not at arm's length. You had wage income of $10 from this transaction. In 2001, when the stock had a fair market value of $120, it became substantially vested. For 2001, you must report additional wage income of $60, figured as follows:
| Fair market value of stock at time of substantial vesting | $120 | |
| Minus: Amount paid for stock | $50 | |
| Minus: Compensation previously included in income from sale to spouse | 10 | -60 |
| Additional income | $60 |
Inherited property not substantially vested. If you inherit property not substantially vested at the time of the decedent's death, any income you receive from the property is considered income in respect of a decedent and is taxed according to the rules for restricted property received for services. For information about income in respect of a decedent, get Publication 559.