Category: Income Tax Planning

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Annuities Charitable Remainder Trust HECM Reverse Mortgage Income Tax Planning Medicare Retirement Income Planning Reverse Mortgage Roth IRA Social Security

6 Proven Retirement Income Planning Strategies Beginning at Age 62

This article was originally published in, and has been reprinted with permission from, Retirement Daily.

When you contemplate your life, you can usually pinpoint pivotal moments that changed the trajectory of who you are today. Often times, there are one or more magical moments that you will never forget.

In the retirement planning world, age 62 is that moment. Until then, you accumulate assets for some unspecified future date when you will transition from working full time to perhaps part time, and then, in most cases, fully retire. Your primary source of income, i.e., employment, will eventually come to a grinding halt.

Beginning at age 62, several things will begin to quickly unfold that will require you to change your retirement planning mindset from asset to income accumulation. You will need to figure out how to convert the assets that you worked hard to save into a predictable income stream beginning on a specified date, or within a range of dates, that will enable you to match your projected financial needs in retirement. Furthermore, you will need to develop various strategies for creating after-tax retirement income in order to optimize the longevity of your assets for the rest of your life. Needless to say, this is no small task.

This article provides an overview of six proven strategies that can be implemented beginning at age 62 that are at the core of the transition from retirement asset to retirement income planning. Strategies #4 and #5 should be considered before age 62 whenever possible and strategy #6 when applicable. Most important, all potential strategies should be evaluated as part of a holistic retirement income plan.

Strategy #1:  Defer Social Security Start Date

You can start your Social Security retirement benefits as early as age 62 or as late as age 70. Unless you’re no longer working and have no other sources of income or you have a life-threatening illness, it generally isn’t advisable to start receiving Social Security at age 62. This is due to the fact that benefits may be 30 percent less than what they would be at your full retirement age which is between 66 and 67 depending upon the year you were born.

Your Social Security benefits will increase by 8% per year plus cost-of-living adjustments for each year that you defer your start date between full retirement age and age 70. Social Security can be used to insure your, and, if married, your spouse’s longevity risk.

The decision regarding when to begin receiving Social Security retirement benefits should be carefully analyzed, especially if you’re married. In addition to locking in the amount of your benefit, you are also potentially establishing the amount of your spouse’s monthly payment in the event that you die first.

Strategy #2:  Gain Unrestricted Access to Home Equity

As discussed in my 5 Key Financial Metrics When Evaluating a HECM Reverse Mortgage article, housing wealth, although it represents about one half of an average household’s net worth, is often ignored as a retirement income planning tool. There are numerous strategies that can be used to provide readily available tax-free liquidity to pay for planned and unforeseen expenses throughout retirement by monetizing a portion of the equity in one’s home.

Several of the strategies can be used in conjunction with home equity conversion mortgages, or HECMs, the most popular reverse mortgage program. You can qualify for a HECM beginning at age 62. All homeowners age 62 or older with or without a mortgage should evaluate a potential HECM for its ability to provide unrestricted access to an increasing tax-free line of credit without the downsides of a home equity line of credit, or HELOC.

When implemented early and used strategically to unlock illiquid home equity, a HECM reverse mortgage can be used to increase after-tax cash flow at opportune times throughout retirement while providing peace of mind.

Strategy #3:  Reduce Medicare Part B and D Premiums

Medicare Part B and D premiums are determined using modified adjusted gross income (MAGI) from your federal income tax return two years prior to the current year. Assuming you enroll in Medicare when you become eligible at age 65, your MAGI from two years prior, or age 63, will determine your Medicare premiums at 65. 2021 Medicare Part B monthly premiums range from $148.50 to $504.90 per person depending upon tax filing status and 2019 MAGI

Medicare Part B and D premium planning should begin at age 62 when you’re one year away from having your income determine your premiums when you turn 65. You should incorporate the Medicare income brackets into your income tax projections every year for the rest of your life to determine the amount of your projected Medicare Part B and D monthly premiums. Using this information, you can develop strategies to reduce your projected MAGI and associated premiums.

You need to always keep in mind when planning Medicare premium reduction strategies that it’s a year-by-year proposition given the fact that premiums are determined using your MAGI from two years prior to the current year. If your income in a particular year is projected to experience an unusual spike that’s attributable to a one-time or infrequent event that will otherwise optimize your projected after-tax retirement income for several years, it will usually make sense to pay the increased Medicare Part B and D premiums in that year. Examples include a sizable strategic or market-sensitive Roth IRA conversion or an unusual increase in a business owner’s income that will enable a larger qualified business income (QBI) deduction that will result in a large amount of income tax savings.

Strategy #4:  Roth IRA Conversion Window of Opportunity

A multi-year, or staged, Roth IRA conversion strategy is a great example of a retirement income planning technique that should ideally be implemented beginning 20 years before retirement. A ten-year window of opportunity begins at age 62 for doing a Roth IRA conversion, creating a greater sense of urgency for implementing this strategy. This corresponds to the ten years prior to the age 72 commencement of lifetime annual required minimum distributions, or RMDs, from retirement plans.

Roth IRA conversions beginning at age 62 will reduce your annual RMDs for the rest of your life. This can, in turn, potentially reduce your annual taxable income, Medicare Part B and D premiums, taxable Social Security benefits, and net investment income tax. To the extent that this occurs, this will increase after-tax retirement income and contribute to the overall goal of optimizing asset longevity. Reduced RMDs also reduce the survivor’s exposure to the widow(er)’s income tax penalty for couples.

Reduced RMDs can also reduce the value of taxable retirement plan accounts at death and, in turn, reduce taxable income for non-spouse beneficiaries. Given the fact that most non-spouse beneficiaries are subject to a 10-year payout rule for taking distributions from retirement plans and IRA accounts, a reduction in the value of taxable accounts will often result in less tax liability for children and other non-spouse beneficiaries.

Per Strategy #3, taxable income from Roth IRA conversions needs to be balanced against potential higher Medicare Part B and D premiums beginning at age 63. The reduction in RMDs and associated lifetime income tax savings beginning at age 72 can more than offset increased Medicare Part B and D premiums between age 63 and 72 if done strategically.

Strategy #5:  Lock in Sustainable and Potentially Tax-Favored Lifetime Income

The fifth strategy – locking in sustainable and potentially tax-favored lifetime income, has gained in popularity as a result of the virtual demise of corporate pension plans. Besides Social Security, opportunities for receiving a sustainable lifetime income stream with built-in longevity insurance to reduce the risks associated with the stock market have dwindled in the private sector.

Immediate and deferred fixed income annuities are a natural fit for filling this gap in a holistic retirement income plan beginning at any age. Purchase of fixed income annuities takes on more urgency at age 62 due to the fact that the income start date for the majority of fixed income annuities will occur by age 72, leaving less time for deferred growth and increased lifetime income. The income start date is subject to the RMD rules when purchases are made from qualified accounts and traditional IRAs.

Income optimization is the appropriate benchmark that should be used when evaluating fixed income annuities for inclusion in a retirement income plan. The goal is to design a comprehensive strategy that uses the least amount of assets to purchase the greatest amount of sustainable after-tax lifetime income that’s projected to pay for expenses not covered by Social Security, pensions, and distributions from investment and other assets.

Fixed income annuities come in three flavors:  single premium immediate annuities (SPIAs), deferred income annuities (DIAs), and fixed index annuities (FIAs) with income riders. SPIAs and DIAs enjoy a unique income tax advantage when purchased in a nonqualified, or nonretirement account.

Unlike FIAs with income riders that distribute ordinary income that’s fully taxable, SPIAs and DIAs are annuitized. Periodic payments include income and a return of premium, or investment. When held in a nonqualified account, the return of premium portion of each payment, which can be 50% or greater, is nontaxable. Once 100% of one’s investment has been received, future payments are fully taxable.

Strategy #6:  Achieve Sizable Tax Savings and Tax-Favored Lifetime Income When Selling Highly Appreciated Nonretirement Assets

The sixth strategy, although it can be used by anyone at any time, tends to be implemented by individuals in their 60’s. Generally speaking, they’re the ones with highly appreciated nonretirement assets who are looking for a tax-favored lifetime income exit plan. This includes real estate, investment securities, and businesses.

This strategy is designed to reduce or eliminate income tax liability attributable to the capital gain that owners will realize from the sale of the highly appreciated asset by transferring a portion, or all, of the ownership of the asset from one or more individuals to a charitable remainder trust, or CRT, prior to the sale while providing tax-favored lifetime income. A CRT, which is a tax-exempt trust, is a long-standing IRS-blessed strategy when properly structured.

There are six benefits associated with a CRT:

  1. The capital gain on the sale of assets owned by a CRT is exempt from taxation.
  2. CRT funding creates a sizable income tax deduction equal to the projected remainder interest of the CRT that will eventually pass to one or more charities.
  3. The proceeds from the sale of CRT assets can be reinvested to provide a lifetime income stream for the beneficiaries.
  4. Most of a CRT’s annual income will be taxed at favorable long-term capital gains tax rates.
  5. A CRT is an excellent philanthropic tool since the remainder interest of the assets will be distributed to one or more chosen charities following the death of the surviving lifetime income beneficiaries.
  6. CRT assets avoid estate tax.

Six Proven Strategies

The six strategies that are highlighted in this article are proven strategies for creating and optimizing after-tax retirement income that can individually and collectively prolong the longevity of one’s assets in retirement. Each strategy can be implemented beginning at age 62 as part of a holistic retirement income plan.

Deferring Social Security start date (strategy #1) is a time-sensitive strategy. Once you start receiving Social Security, with some limited exceptions, it’s an irrevocable decision that, with the exception of potential cost of living adjustments, will lock in the amount of your periodic and lifetime payments and can also affect your spouse’s payments.

Gaining unrestricted access to home equity (strategy #2) through a HECM reverse mortgage should be implemented at age 62, the qualifying age, whenever possible to optimize the growth of, and after-tax distributions from, the credit line. Planning for reducing Medicare Part B and D premiums (strategy #3), which is an annual strategy, should be implemented beginning at age 62 since income from your federal income tax return beginning at age 63 will be used to determine your Medicare Part B and D premiums when you’re 65.

Roth IRA Conversions (strategy #4) and locking in sustainable and potentially tax-favored income (strategy #5) should be considered before age 62 whenever possible since there’s no restriction on the start date and earlier vs. later implementation can optimize after-tax lifetime income in retirement.

Achieving sizable tax savings and tax-favored lifetime income when selling highly appreciated nonretirement assets (strategy #6) is dependent upon (a) owning highly appreciated assets such as real estate, investment securities, or a business and (b) a desire to sell those assets.

Let the magic begin!

Categories
HECM Reverse Mortgage Income Tax Planning Retirement Income Planning Reverse Mortgage

5 Key Financial Metrics When Evaluating a HECM Reverse Mortgage

Home loan / reverse mortgage or transforming assets into cash concept : House model, US dollar notes on a simple balance scale, depicts a homeowner or a borrower turns properties / residence into cash

This article was originally published in, and has been reprinted with permission from, Retirement Daily.

Housing wealth, although it represents about one half of an average household’s net worth, is often ignored as a retirement income planning tool. There are numerous strategies that can be used to provide readily available tax-free liquidity to pay for planned and unforeseen expenses throughout retirement by monetizing a portion of the equity in one’s home.

Several of the strategies are offered by home equity conversion mortgages, or HECMs, which is the most popular reverse mortgage program and is offered and insured by the Federal Housing Administration (FHA). You can qualify for a HECM beginning at age 62.

If you aren’t familiar with HECMs or simply need a refresher, I recommend that you read my June 10, 2020 Retirement Daily article, Not Your Father’s Reverse Mortgage. The biggest change since I wrote the article is an increase in FHA’s HECM lending limit from $765,600 in 2020 to $822,375 in 2021.

HECM Unlocks Home Equity Without the Downsides of a HELOC

A HECM is designed to unlock home equity for homeowners as needed through a readily available credit line without the downsides of a home equity line of credit, or HELOC. These include access for a specified number of years – typically ten, required minimum monthly payments, lender can freeze or cancel the loan, home is subject to foreclosure if minimum payments aren’t paid, and a requirement to repay the loan in full even if the borrower owes more than the home is worth. Perhaps most important, you may not qualify for a HELOC when you’re retired if your sources of income for repayment are limited.

All homeowners with or without a mortgage should evaluate a potential HECM beginning at age 62 since this is the eligible age. An evaluation should be done whenever contemplating refinancing or purchasing a new home or planning for other major financial changes. Whatever the situation, a HECM can increase cash flow, reduce expenses, and increase retirement savings.

The HECM Pentathlon

There are five key financial metrics that should be analyzed individually and collectively when considering a HECM. Just like a track and field pentathlon, you don’t need to score high in every event to win the gold medal. You may bask in glory after finishing low in the shot put, excelling in the 800 meters and 60-meter hurdles, and performing in the 75th percentile in the high jump and long jump.

Side-by-side projections of existing or potential refinancing of forward, or traditional, mortgages with one or more HECM scenarios applying each of the five metrics for the next 20 years should be prepared. This will enable you to evaluate the pros and cons of a HECM in your situation.

The remainder of this article will use three hypothetical scenarios to illustrate each of the five financial metrics. Please refer to Hypothetical Scenario List of Assumptions below for a list of assumptions used in the various scenarios.

Please keep in mind that the “Mortgage” scenario in each illustration refers to a forward, or traditional, mortgage. Please also note that the assumed increasing interest rates that are used to calculate accrued interest on projected HECM loan and credit line balances are greater than FHA’s “expected,” or initial, interest rate that’s required to be illustrated for the life of a loan on a projected amortization schedule when applying for a HECM.

Metric #1:  Projected Mortgage Balance

Most people entering retirement who own a home still have a mortgage, home equity loan, or outstanding HELOC balance. Many of these won’t be paid off for 10 to 20 years. Even if you have a minimal or no mortgage balance, you should consider a HECM if access to tax-free liquidity is or will be important to you during retirement.

There are two primary advantages of a HECM over a forward, or traditional, mortgage: (a) no required loan payments and (b) ongoing access to a tax-free line of credit that increases by the loan interest rate and elective payments.

  • Traditional mortgage balance of $300,572, with assumed monthly payments of $1,600, is paid down over 20 years, with a projected balance of $21,985 at age 82.
  • HECM #1 balance of $325,572, which assumes no payments, increases to a projected balance of $807,340 at age 82.
  • HECM #2 balance of $325,572, with assumed monthly payments of $1,600, is paid down over 20 years, with a projected balance of $124,749 at age 82.

Winner:  Traditional mortgage by approximately $103,000 over HECM #2 and $785,000 over HECM #1

Metric #2:  Projected Savings

Whenever you’re making mortgage payments, whether it’s on a traditional mortgage or electively on a HECM, you’re decreasing the amount that you could otherwise be saving. Likewise, when you don’t make payments on a HECM, which is what most people do, you have the opportunity to save money that would otherwise be used to make mortgage payments.

  • Required traditional mortgage monthly payments of $1,600 reduces savings by $19,200 a year, or a total of $384,000 over 20 years.
  • HECM #1, which assumes no payments over the first 20 years, results in annual savings of $19,200, or a total of $384,000 over 20 years.
  • Elective HECM #2 monthly payments of $1,600 produces the same result as a traditional mortgage, i.e., annual savings reduction of $19,200, with a total of $384,000 over 20 years.

Winner:  HECM #1 by $768,000 over traditional mortgage and HECM #2

Metric #3:  Projected Net Worth

Projected net worth as it relates to the evaluation of a HECM is equal to the total of the projected mortgage or HECM balance, projected savings balance, and projected home value each year. The projected mortgage or HECM balance needs to be shown as a negative amount since loans reduce net worth.

  • Traditional mortgage projected net worth increases from $599,428 to $1,566,026 at the end of 20 years.
  • HECM #1 projected net worth, which assumes no payments, increases from $574,428 to $1,548,671 after 20 years.
  • HECM #2, projected net worth, which assumes monthly payments of $1,600 totaling $384,000, increases from $574,428 to $1,463,262 after 20 years.

Winner:  Traditional mortgage by approximately $17,000 over HECM #1 and $103,000 over HECM #2

Metric #4:  Projected Line of Credit

As previously stated, one of the primary advantages of a HECM over a forward, or traditional, mortgage is ongoing access to a tax-free line of credit. Once again, the line of credit increases by the loan interest rate and elective payments.

As discussed in the “Reverse Mortgages No Longer a Program of Last Resort” section in my Not Your Father’s Reverse Mortgage article, research by Dr. Wade Pfau has shown that applying for a HECM earlier and using the HECM line of credit strategically throughout retirement can potentially increase retirement spending and provide for a larger legacy.

Both HECMs in the hypothetical scenario are illustrated with no credit line advances for the first 20 years to keep the illustrations simple. This results in a projected increasing line of credit for the duration of the illustration. Any advances from the credit line would reduce the projected line of credit balance.

  • Traditional mortgage has no line of credit.
  • HECM #1 projected line of credit, which assumes no payments, grows by the assumed interest rate, which begins at 2% and increases gradually to 5.5% in years 17 to 20, causing it to grow from $86,188 to $213,725 at the end of 20 years.
  • HECM #2 projected line of credit, in addition to growing by the assumed interest rate, also increases by the monthly payments of $1,600, resulting in a tenfold increase from $86,188 to $895,316 after 20 years.

Winner:  HECM #2 by approximately $681,000 over HECM #1 and $895,000 over the traditional mortgage

Metric #5:  Projected Liquidity

Metrics #4 – projected line of credit and #5 – projected liquidity, when evaluated together, are the most compelling criterion favoring the use of a HECM as a retirement income planning tool for prolonging the longevity of retirement assets.

Projected liquidity is equal to the total of projected savings (metric #2) plus projected line of credit (metric #4). The ability to readily access funds from savings as a result of not making mortgage payments and/or from a readily available tax-free credit line during one’s retirement years, especially when alternative sources of income may be scarce or nonexistent, distinguishes HECMs as a unique planning solution.

Illustration #5 – Projected Liquidity

  • Since there is no credit line available with a traditional mortgage, projected liquidity decreases by the amount of projected savings which is -$19,200 per year, or -$384,000 after 20 years.
  • HECM #1 savings is projected to increase by $19,200 per year as a result of no credit line payments, or a total of $384,000 after 20 years. The credit line is projected to increase from $86,188 to $213,725 during the same period. Combining the two results in projected liquidity of $597,725 at the end of year 20.
  • HECM #2’s monthly payments of $1,600, or $19,200 a year reduce projected savings by $384,000 after 20 years. The credit line, however, is projected to increase from $86,188 to $895,316 during the same period, resulting in projected liquidity of $511,316 at the end of year 20.

Winner:  HECM #1 by approximately $87,000 over HECM #2 and $982,000 over the traditional mortgage

Illustration HECM Pentathlon Overall Winner

As stated in the beginning of the “HECM Pentathlon” section, there are five key financial metrics that should be analyzed individually and collectively when considering a HECM. Just like a track and field pentathlon, the overall winner is determined by the highest total score for all five events.

Assuming that a score of 5 points is assigned for 1st place, 3 points for 2nd, and 1 point for 3rd, the overall winner of the Illustration HECM Pentathlon with a total score of 17 points is HECM #1. (The crowd goes wild!) Traditional mortgage and HECM #2 tie for 2nd place with a total score of 13 points each.

Illustration HECM Pentathlon 1st Place – HECM #1 demonstrates the importance of analyzing all five metrics together. If you focus only on the mortgage balance, which is projected to increase from $326,000 to $807,000 in 20 years, you would never choose HECM #1. When you factor in projected savings and liquidity, both of which finished in 1st place, together with projected net worth and credit line, with both finishing in 2nd place, you have your HECM pentathlon overall winner.

Caution:  It isn’t prudent to select a winner based on score alone in the HECM Pentathlon. This is a starting point and may not be the best option for you. If, for example, your priority is to have the highest line of credit with a large amount of liquidity 20 years from now to pay for potential long-term care expenses using tax-free funds, HECM #2 would be your clear choice provided that you’re comfortable with continuing to pay $1,600 per month for 20 years despite the fact that there’s no payment requirement with a HECM. As a reminder, assuming you remain in your home, you were planning on doing this anyway with your existing mortgage.

Per Illustration HECM Pentathlon 2nd Place – HECM #2, by continuing to pay $1,600 per month, or a total of $384,000 over 20 years, HECM #2 credit line balance is projected to be $895,000 in 20 years, or $681,000 greater than projected HECM #1 balance of $214,000. Projected HECM #2 liquidity is projected to be $511,000, or only $87,000 less than HECM #1 projected liquidity of $598,000. HECM #2 net worth is projected to be $1.463 million, or only $86,000 less than HECM #1 projected net worth of $1.549 million.

The fact that HECM #2 mortgage balance is projected to be $125,000, or $103,000 greater than the projected balance of $22,000 of your current traditional mortgage should be less of a concern, especially when you consider the fact that there’s no line of credit and your liquidity is projected to be -$384,000 in 20 years if you keep your current mortgage.

A HECM Isn’t for Everyone

Despite the fact that a HECM is a wonderful tool for unlocking home equity, it isn’t a good solution in every situation. One example would be if you’re planning on selling your home in the next five years. The initial costs associated with a HECM would generally not be justified in this case. You could, however, potentially use a HECM for purchase strategy when you sell your home if you buy a replacement home if that makes financial sense.

Also, individuals who (a) are focused only on paying off their traditional mortgage, (b) have already paid off their mortgage and are unwilling to borrow against their home, or (c) are unable to justify the value of having ready access to an increasing tax-free credit line during their retirement years relative to the initial costs aren’t good candidates for a HECM reverse mortgage.

Summary

A HECM can furnish you with a one-of-a-kind tool to unlock illiquid home equity, providing unfettered access to tax-free funds when you’re likely to need them the most, i.e., in your retirement years, without the downsides associated with a HELOC. The combination of no required loan payments and ongoing access to a tax-free line of credit that increases by the loan interest rate and elective payments is unique.

This article introduces a process for analyzing a potential HECM in any situation. The process includes five financial metrics that can, and should be, used individually and collectively to analyze the pros and cons of unlocking home equity. The inclusion of projected credit line advances to pay for one or more strategic outlays, e.g., projected long-term care expenses, would complete the analysis.

When the value of a HECM as a retirement income planning solution is understood, implemented early in retirement, and used strategically to unlock illiquid home equity, a HECM reverse mortgage can be used to increase after-tax cash flow at opportune times throughout retirement while providing peace of mind.

Categories
Annuities Deferred Income Annuities Income Tax Planning Retirement Income Planning

Nonqualified Fixed Income Annuities: A Timeless Tax and Retirement Income Planning Opportunity

Fixed Income Annuities: A Timeless Tax and Retirement Income Planning Opportunity

This article was originally published in, and has been reprinted with permission from, Retirement Daily.

President Biden’s American Families Plan includes proposed increases in the top marginal income tax rate from 37% to 39.6% and the top long-term capital gains tax rate from 23.8% to 43.4% for households with income over $1 million. Both changes would negatively impact investment returns for affected individuals.

Stock market-based investment strategies, with their exposure to higher ordinary and long-term capital gains tax rates are being reevaluated by investors and financial advisers alike. One strategy that is attracting more attention that will be virtually unscathed by the proposed tax increase is longevity insurance, more commonly known as fixed income annuities.

Three Types of Fixed Income Annuities

Fixed income annuities provide sustainable lifetime or term certain income and, as such, are well suited for retirement income planning. There are three types of fixed income annuities:  single-premium immediate annuities (SPIAs), deferred income annuities (DIAs), and fixed index annuities (FIAs) with income riders.

Each of the three types of fixed income annuities serve a different purpose within a retirement income plan. Two of the three options, SPIAs and DIAs, are tax-favored when purchased in a nonqualified, or nonretirement, account. This makes them an excellent choice for those in higher tax brackets who are seeking to maximize after-tax sustainable income.

SPIAs can be an appropriate retirement income planning solution if you are retiring soon or are retired and have an immediate need for sustainable income. Income distributions can be as frequent as monthly or as infrequent as annually (depending on the options available from the insurer), as long as the first benefit is paid within one year of the contract’s purchase date.

DIAs are a better fit than SPIAs in most retirement income planning scenarios due to their deferred income start date. Deferral of your income start date increases the amount of your periodic income payment since the insurance company will be making payments to you for a shorter period of time assuming a lifetime payout.

100% of income distributions from FIAs with income riders are taxed as ordinary income whether they are in a retirement or nonretirement account. While their flexible income start date and potential death benefit are attractive features, income tax savings is not a strong suit of FIAs with income riders.

DIAs and SPIAs Unique Income Tax Advantage

DIAs and SPIAs enjoy a unique income tax advantage when they are purchased in a nonretirement account. Unlike FIAs with income riders that distribute ordinary income that reduces the accumulation value of the annuity contract, DIAs and SPIAs are annuitized.

The annuitization period is defined by the contract and is either a defined term, e.g., 10 years, or lifetime. Lifetime DIAs and SPIAs provide for an optional minimum payout period or lump sum payable to the annuitant’s beneficiaries to guarantee a minimum total payout.

The income tax advantage of DIAs and SPIAs is attributable to the allocation of each annuitized payment between income and a return of premium. The portion that is deemed to be a return of premium is your cost, or basis, and is nontaxable. Annuitization is analogous to amortization of a mortgage. When you make a mortgage payment, each payment is allocated between deductible interest and nondeductible principal.

In the case of a DIA or SPIA, the amount of each payment that is considered to be a nontaxable return of premium is calculated by applying an “exclusion ratio” to each monthly payment. The exclusion ratio is actuarially calculated by dividing the investment in an annuity contract by the total expected lifetime payments.

SPIA Tax Savings Illustration

To illustrate the income tax advantage of nonretirement DIAs and SPIAs, suppose you are a woman, and you purchase a SPIA for $100,000 when you are 65 years old. Let us further assume that the insurance company determines that you have a 22-year life expectancy, and they will pay you $475 a month for the rest of your life. Your lifetime payments are expected to total $125,400 ($475 x 12 x 22).

Your exclusion ratio is calculated by dividing your premium, or investment, of $100,000 by your expected lifetime payments of $125,400. The result is that 79.75%, or $379, of each of your monthly payments of $475 will be nontaxable for the first 22 years. 20.25%, or $96, of each  monthly payment will be taxable. Even though your annual payments will total $5,700, the insurance company will report taxable income of only $1,154 for the initial 22 years.

What happens if you survive your 22-year life expectancy? You will continue to receive monthly payments of $475 for the rest of your life, however, 100% of your monthly payments will be taxable as ordinary income. This makes sense since your nontaxable payments for the first 22 years will have totaled $100,000 which is equal to your original investment.

Nonretirement DIAs and SPIAs Can Optimize After-Tax Retirement Income

DIAs and SPIAs, like all fixed income annuities, provide sustainable lifetime income. When purchased in a nonretirement account, they distinguish themselves further as a retirement income planning solution since their after-tax income is predictable.

Income tax rates have minimal impact on the amount of after-tax income from DIAs and SPIAs due to their exclusion ratio. Furthermore, any increase in marginal income tax rates will not affect most annuitants’ after-tax periodic payments until cost basis has been recovered. As illustrated, this will not occur until the annuitant survives her life expectancy beginning on the annuity purchase date.

The ability to optimize after-tax income from nonretirement DIAs and SPIAs can also result in spillover income tax and other savings. This includes the potential reduction of taxable Social Security benefits, reduced exposure to the 3.8% net investment income tax, increased potential deductibility of medical expenses, and the opportunity to reduce marginal income tax rates and Medicare Part B premiums. Each of these things individually and collectively can result in additional increased after-tax retirement income for the duration of retirement.

Nonretirement fixed income annuities, with their sustainable lifetime income and tax-favored status, offer a timeless tax and retirement income planning opportunity.

Categories
Charitable Remainder Trust Estate Planning Income Tax Planning

Reduce Capital Gains Tax on the Sale of Your Business

Businessmen making handshake with his partner in cafe - business etiquette, congratulation, merger and acquisition concepts

This article was originally published in, and has been reprinted with permission from, Retirement Daily.

Located at the end of President Biden’s American Families Plan released on April 28th is the administration’s wealth redistribution plan titled “Tax Reform That Rewards Work – Not Wealth.” The section begins with the statement that the goal is to reverse provisions of the Tax Cuts and Jobs Act of 2017 and reform the tax code “…so that the wealthy have to play by the same rules as everyone else.”

Proposed Lifetime and Death Capital Gains Tax Rate of 43.4%

The American Families Plan would increase the top marginal income tax rate from 37% to 39.6%. In addition, the proposed top rate of 39.6% would replace the current long-term capital gains tax rate of 20% for households with income over $1 million. While income at this level is not the norm (539,000 income tax returns were filed in 2019 with 2018 adjusted gross income of more than $1 million, representing 0.4% of 141 million total returns filed), it is not unusual for business owners to cross the $1 million threshold when they sell a business.

Long-term capital gains tax rates for households with income over $1 million would almost double under President Biden’s plan, increasing 19.6% from 23.8% to 43.4% when you include the net investment income tax of 3.8%. Let us not forget about state income tax. Add on 13.3% if you live in California for a total marginal tax rate of 56.7% on all income, including long-term capital gains.

The proposed legislation would also eliminate the step-up in basis on unrealized gains exceeding $1 million at death. The step-up in basis allows individuals with appreciated assets to avoid income taxation on the appreciated value when they die. Unrealized gains exceeding $1 million at death would be taxed at a 43.4% rate unless the appreciated assets are donated to charity.

Eliminate Capital Gains on Business Sales with a CRT

Lifetime charitable giving has historically benefited individuals with highly appreciated non retirement assets such as real estate, investment portfolios, and businesses. Many savvy business owners who are planning on selling their business and want to reduce or eliminate income tax liability attributable to the capital gain that they will realize from the sale can use a long-standing IRS-blessed strategy called a charitable remainder trust, or CRT. A properly designed and administered CRT managed by an experienced investment advisor who specializes in CRTS and is familiar with their four-tier payout scheme can be used as the cornerstone of a successful business owner’s retirement income plan.

A CRT is a tax-exempt trust. The initial and one of the most important benefits of a CRT is that the gain on the sale of assets owned by a CRT is exempt from taxation. This includes ownership of a business interest.

Tax Proposal Creates Sense of Urgency for Implementation of CRT Business Sale Strategy

The proposed long-term capital gain tax rate increase of 19.6% has created a sense of urgency for business owners who are thinking about selling their businesses in the near future. The CRT strategy will increase in popularity with the proposed tax law changes. It will likely result in the acceleration of the sale of many businesses to avoid the increased tax liability attributable to long-term capital gains exceeding $1 million from the sale if the proposed changes are enacted.

It is important to keep in mind that the proposed tax legislation that’s part of the American Families Plan is in its early stages. The long-term capital gains tax rate increase of 19.6% and elimination of the step-up in basis at death are major departures from long-term fixtures of the income tax law, and, as such, are controversial and subject to modification.

Having said this, given the reality that one of the overriding goals of the current administration is redistribution of wealth as evidenced by the fact that the American Families Plan was released on the 98th day of the new administration, successful business owners have a lot at stake and need to act quickly before the proposed legislation or some form of it is enacted. Furthermore, business owners and others adversely affected by the proposed legislation need to keep in mind that any tax legislation that is enacted, whether it is in 2021 or 2022, could have an effective date as of the date of enactment or even a retroactive date.

CRT Funding Creates a Current Income Tax Deduction

When the CRT income beneficiary(ies) die, the remainder interest in the CRT is transferred to one or more charitable organizations specified in the CRT document. This creates a second income tax benefit to the business owner, i.e., a charitable contribution deduction, that can be used to offset otherwise taxable income.

The deduction, which is taken in the year that the business interest is transferred to the CRT, is the present value of the projected remainder interest of the CRT that will pass to one or more charities. The amount of the deduction can be hundreds of thousands of dollars or more depending upon the value of the business interest being transferred to the CRT and the age of the business owner and spouse if married. The allowable charitable deduction is limited to 30% of adjusted gross income, with excess amounts carried forward for five years.

CRT Lifetime Income Stream is Tax-Favored

The third income tax benefit enjoyed by a business owner who sells part or all of his/her business interest using a CRT is favorable taxation of CRT income. The net proceeds from the sale of a business interest owned by a CRT are reinvested by the CRT to provide a lifetime income stream to a designated beneficiary who is generally the business owner and his/her spouse if married.

The periodic income payment is calculated using either a fixed dollar amount if it is a charitable remainder annuity trust (CRAT) or a fixed percentage of the annually redetermined net fair market value of trust assets for a charitable remainder unitrust (CRUT). The taxation of CRT income, which is reported annually on Schedule K-1, is driven by the character of the income being distributed, taxed in the following order under a four-tier payout scheme:  ordinary income, capital gains, tax free income, and principal.

Most of a CRT’s annual income will be taxed as long-term capital gains at a current top federal tax rate of 23.8% since the origin of a CRT from the sale of a business is untaxed long-term capital gains. CRT income classified as long-term capital gains will continue to enjoy favorable tax treatment if President Biden’s proposal is enacted provided that total taxable income in a given year is less than $1 million.

Potential CRT Income Tax Savings – Current Income Tax Law

In summary, income tax savings attributable to establishing and funding a CRT in connection with the sale of business includes three components:  elimination of the capital gain from the sale of the business, a sizable charitable contribution deduction, and favorable income tax treatment of CRT lifetime income distributions.

The latter benefit is threatened if the administration’s tax proposal is enacted and taxable income in a particular year exceeds $1 million. When this occurs, it generally happens in the year of sale. It could extend to future years if the business is sold on an installment sale basis depending upon the selling price and the amounts received in subsequent years.

The easiest way to illustrate the initial and ongoing income tax savings from a CRT is with an example. The example applies current income tax law and includes the following eight assumptions:

  • Sale of business on June 30, 2021 with long-term capital gain of $5 million
  • Reinvestment of net proceeds of business if sold outright with a return of 5% split 50/50 between qualified and nonqualified dividend income
  • Reinvestment of net proceeds of business if sold by CRT with annual distributions of 5% of prior year’s December 31st CRT value split 75/25 between long term capital gains and dividend income, with the latter split 50/50 between qualified and nonqualified dividend income
  • Other ordinary income of $200,000
  • Standard deduction with outright sale
  • Married filing joint tax status
  • Ages 63 and 59
  • California resident

Cases #1 and #2 – Outright Sale of Business

The purpose of Case #1 is to calculate the income tax liability attributable to the long-term capital gain of $5 million from the sale of the business. Per the illustration, federal income tax would be $1.143 million, or 22.86% of the gain. California tax would be $623,000, or 12.46% of the gain, for total income tax liability of $1.766 million, or 35.32% of the gain.

Case #2 includes investment income of $81,000 and other ordinary income of $200,000, increasing taxable income from $4.975 million to $5.256 million. Total income tax liability increases from $1.766 million to $1.908 million, or 36.13% of total adjusted gross income.

Case #3 – Sale of 100% of Business by CRT

Case #3 assumes that 100% of the ownership of the business is transferred to a CRT prior to the June 30, 2021 assumed closing date. This would result in the following:

  • Long-term capital gain of $0
  • Charitable contribution deduction of $1.422 million with allowable deduction of $97,500 in 2021, $135,000 in 2022, and the balance of $1,189,500 carried forward for four years
  • Total projected 2021 income tax liability of $52,000 or $1.856 million less than Case #2 tax liability of $1.908 million
  • Reinvestable net after-tax proceeds of $4.9 million, or $1.8 million greater than Case #2 of $3.1 million.
  • Annual investment income of 5% of the CRT value of $5 million, or $250,000, which is $88,000 greater than the projected annual investment income of $162,000 from the net after-tax proceeds from an outright sale
  • $218,750, or 87.5%, of CRT investment income of $250,000 taxed at a 23.8% capital gains tax rate vs. $80,846, or 50%, of non-CRT investment income of $162,000 taxed at a 23.8% capital gains tax rate
  • Total projected 2022 income tax liability of $75,000, or $18,000 less than Case #2 projected liability of $93,000

Enactment of the American Families Plan would result in additional federal income tax liability of 19.6% of $5 million, or $980,000, for an outright sale. Without a CRT, reinvestable net after-tax proceeds of $3.1 million would be reduced to $2.1 million, or 42.2%, of the long-term capital gain of $5 million.

CRT Assets Avoid Estate Taxation

Did I mention that there is another tax bill that Senator Bernie Sanders and the White House formally proposed on March 25th called the “For the 99.5% Act?” This proposal would reduce the federal gift and estate tax exemption of $11.7 million per individual to $3.5 million effective January 1, 2022. The “For the 99.5% Act” would also increase the estate tax rate from 40% to 45% on taxable estates exceeding $3.5 million, 50% on estates above $10 million, and 65% for estates over $1 billion.

A CRT is an excellent estate planning strategy for reducing estate tax. CRT assets avoid estate tax since the remainder of the CRT passes to charity at death, and, as such, it is excludable from one’s taxable estate. In the preceding example, the remainder value of the $5 million of assets transferred to the CRT would be excluded from the husband and wife’s estate.

Retirement Income Planning Essential When Evaluating CRT Strategy

A CRT is a powerful planning strategy that can be used as the cornerstone of a successful business owner’s retirement income plan. It offers the opportunity for sizable initial and ongoing income tax savings, increased sustainable lifetime tax-favored income, elimination of estate tax on CRT assets, and, last, but not least, a philanthropic/legacy component, i.e., the distribution of the remainder of the CRT to one or more chosen charities.

There are many situations where individuals who have used this strategy have accumulated a larger estate that has been distributed to their heirs than they would have without a CRT. This can occur when a CRT is combined with an irrevocable life insurance trust that purchases life insurance on the life of the business owner and his/her spouse if married using a portion of the income tax savings from implementing the CRT.

The CRT strategy, while it offers several significant benefits for business owners considering selling a business and for their families, is not for everyone. The implementation of a CRT generally should not be an all or nothing situation whereby 100% of the ownership of a business is transferred to a CRT.

It is important to strike a balance between CRT vs. individual ownership, weighing the pluses and minuses of each in a particular situation within the context of a holistic retirement income plan. Paying some income tax is not necessarily a bad thing – especially if you can do so at a federal tax rate of 23.8% vs. 43.4%.

Categories
Income Tax Planning Retirement Income Planning

RMDs Required Again in 2021

RMDs Required Again in 2021

This article was originally published in, and has been reprinted with permission from, Retirement Daily.

2020 was an eventful year for required minimum distributions, commonly referred to as RMDs. There were two pieces of legislation that were effective in 2020 that produced three noteworthy changes affecting RMDs.

RMD Background

Before discussing the changes, some RMD background is in order. IRAs were enacted as part of the Employee Retirement Income Security Act (ERISA) in 1974. ERISA required IRA and retirement plan account owners to take taxable lifetime annual distributions from their accounts beginning at age 70-1/2 to offset tax savings received from making deductible contributions.

The annual RMD for plan participants and IRA owners is calculated by dividing the value of each account on December 31st of the previous year by a life expectancy factor for the current year from IRS’ Uniform Lifetime Table. All RMD’s must be distributed by December 31st each year. There is an exception for the initial withdrawal which must be taken by April 1st of the year following the year in which you turn 72, which was previously age 70-1/2.

Failure to take RMDs by the specified due date results in a 50% penalty on the shortfall. The penalty can be waived by IRS for good cause if appropriate steps are taken to correct the error in a timely manner.

RMD Beginning Age Increased to 72

The required beginning age was April 1st of the year following the year in which you turned 70-1/2 until 2020. The first legislative change, the SECURE Act, increased the RMD age from 70-1/2 to 72 for anyone reaching age 70-1/2 after December 31, 2019 for 2020 RMDs.

July 1, 1949 is the key date for determining whether you were required to take your initial RMD by April 1st of the year following the year that you turned age 70-1/2 or 72. Here are the rules:

  • Anyone born before July 1, 1949 was subject to the age 70-1/2 RMD rule.
  • Anyone born July 1, 1949 or later qualifies for the age 72 RMD rule.

10-Year Payout Rule

In addition to increasing the RMD age from 70-1/2 to 72, the SECURE Act eliminated the RMD regime for many retirement and IRA account beneficiaries who inherit accounts for deaths after December 31, 2019. These individuals are subject to a 10-year payout rule effective January 1, 2020.

There are five classes of “eligible designated beneficiaries,” or “EDBs,” who continue to be subject to the RMD rules instead of the 10-year payout rule. These include:

  1. Surviving spouses
  2. Minor children up to the age of majority, excluding grandchildren
  3. Disabled individuals who qualify under strict IRS rules
  4. Chronically ill individuals
  5. Individuals not more than ten years younger than the IRA owner

All other individuals, or “non-eligible designated beneficiaries,” or “NEDBs,” are subject to a 10-year rule whereby they must empty their accounts by the end of the tenth year after death. Examples of NEDBs include children after reaching the age of majority and grandchildren. Failure to empty accounts by the end of the tenth year following death results in a 50% penalty on any remaining balances.

RMDs Waived in 2020

The second legislative change that affected RMDs in 2020, although temporary, attracted the most attention. The Coronavirus Aid, Relief, and Economic Security Act, or CARES Act, which was signed into law on March 27, 2020 waived RMDs in 2020. I speculated about this possibility in my March 16, 2020 blog post.

The waiver included the following three types of RMDs:

  • 2019 RMDs due by April 1, 2020 for anyone born before July 1, 1949 who delayed their initial RMD
  • 2020 RMDs from company plans and IRAs
  • 2020 RMDs for company plan, IRA, and Roth IRA beneficiaries not subject to the 10-year payout rule

IRS allowed individuals who took RMDs in the beginning of the year to return them to their retirement and IRA accounts up until August 31, 2020. This presented an opportunity to roll over, or convert, distributions to a Roth IRA rather than return them to their originating accounts.

RMD Vacation is Over

2020 was an unprecedented and confusing year for most people, including company retirement plan and IRA account owners and beneficiaries impacted by the RMD rule changes. The beginning age was increased from 70-1/2 to 72, the RMD regime was replaced by a new 10-year payout rule for many beneficiaries, and RMDs were waived. If this was not a wake-up call for the need for holistic retirement income planning, I don’t know what is.

Anyone who is a retirement plan or IRA account owner or eligible designated beneficiary needs to add distribution of RMDs to their 2021 to-do list if they have not done so already. If you did not take distributions from your retirement plan and IRA accounts in 2020, you may be surprised that the amount of your 2021 RMDs is greater than in 2019, requiring you to pay more income tax in 2021 than you did in 2019.

Given the fact that 2021 RMDs are calculated using December 31, 2020 account values, larger 2021 RMDs are a distinct possibility assuming you did not take distributions in 2020. Furthermore, this is more likely if you have an equity-based portfolio that benefited from favorable 2019 and 2020 stock market performance if you did not liquidate your equity holdings during the Covid-19 selloff.

You also need to start planning for how and when you will take distributions if you are subject to the 10-year payout rule since you don’t have the luxury of taking pre-determined RMDs using a generous IRS life expectancy table. Distribution timing is key, especially since income tax rates may increase before the scheduled 2025 sunsetting of many provisions of current tax law. It is critical that you work with your financial advisors to optimize the timing and amounts of your after-tax distributions and avoid a potential 50% penalty if you don’t empty your accounts within ten years.

Welcome to 2021! Your RMD vacation is over.

Categories
Income Tax Planning Retirement Income Planning Roth IRA

Six Stealth Taxes That Can Derail Your Retirement

Greedy Leprechaun on the pile of money with thumb up - finance concept isolated on white

This article was originally published in, and has been reprinted with permission from, Retirement Daily.

The goal of retirement income planning is to optimize the longevity of your after-tax retirement income to pay for your projected inflation-adjusted expenses. In addition to having adequate retirement assets, there are two ways to achieve this goal: (a) maximize income and (b) minimize income tax liability.

There are six stealth taxes that can increase your income tax liability and reduce your lifetime after-tax retirement income. All of them, except for one, have been in existence for several years. A couple are difficult to avoid due to their low-income thresholds. Although several taxes may not kick in until retirement, planning for each of them should begin long before and continue throughout retirement.

Stealth Tax #1:  10-Year Payout Rule

Let’s start with the new kid on the block – the 10-year payout rule. This was created by the SECURE Act and is generally effective for deaths after December 31, 2019. It applies to beneficiaries of retirement plans and IRA accounts.

Surviving spouses, minor children who are not grandchildren, and other “eligible designated beneficiaries” are unaffected by the 10-year payout rule. They can continue to take distributions from retirement plans and IRA accounts over their lifetime using the required minimum distribution, or RMD, rules.

Children after reaching the age of majority and grandchildren are classified as “non-eligible designated beneficiaries.” They are no longer required to take RMDs from their retirement and IRA accounts. They are instead subject to the new 10-year payout rule whereby they must empty these accounts by the end of the tenth year after death.

Distributions can be taken evenly over ten years or in random years so long as there’s no balance remaining in any retirement or IRA accounts by the end of the tenth year after death of the individual from whom you inherited the accounts.

Two potential types of stealth taxes have been created by the 10-year payout rule. The first type comes in the form of accelerated and potentially increased income tax liability compared to the RMD rules. The second type is a potential penalty assessed by IRS as an “additional tax on excess accumulations” of 50% plus interest on the balance of funds remaining in any retirement plan or IRA accounts at the end of the tenth year.

Stealth Tax #2:  Social Security

Taxation of Social Security benefits, which began in 1984, is one of the stealth taxes that is difficult to avoid due to its low-income threshold. The threshold, which is referred to as “combined income,” is the total of adjusted gross income, nontaxable interest, and half of your Social Security benefits.

Single individuals with combined income of $25,000 to $34,000 are taxed on up to 50% of benefits, and up to 85% on amounts above $34,000. Joint return filers with combined income of $32,000 to $44,000 are taxed on up to 50% of benefits, and up to 85% on amounts exceeding $44,000. Unlike other income-sensitive thresholds, Social Security combined income amounts have never been increased for inflation.

Taxation of Social Security benefits is often a double stealth tax. The inclusion of up to 85% of benefits in taxable income, in addition to potentially increasing tax liability, can also increase marginal and long-term capital gains tax rates. Other potential fallouts include increased Medicare Part B and D premiums, increased exposure to net investment income tax, and increased widow/widower’s income tax.

Stealth Tax #3:  Increased Medicare Part B and D Premiums

Medicare Part B and D premiums are determined using modified adjusted gross income (MAGI) from your federal income tax return two years prior to the current year. Assuming you enroll in Medicare at age 65, you will want to project and track your MAGI every year beginning at age 63.

Monthly premiums begin at $148.50. An Income Related Monthly Adjustment Amount (IRMAA) is added to this amount if your income is greater than $88,000 for single taxpayers and $176,000 for joint tax filers. Monthly premiums can be as high as $504.90 for those in the top income threshold, resulting in increased annual Medicare premiums of as much as $4,276.80 per person or $8,553.60 per couple.

Medicare Part B and Part D monthly premiums can increase significantly in a particular year because of an unusually large amount of income two years prior to the current year. This can include taxable gains from the sale of a residence or rental property or income from a sizable Roth IRA conversion.

Stealth Tax #4:  Net Investment Income Tax

The net investment income tax has gone under the radar for a lot of taxpayers since its introduction in 2013. The tax is a surtax that is generally paid by high income taxpayers with significant investment income.

Single taxpayers with investment income and MAGI greater than $200,000 and married filing joint taxpayers with MAGI more than $250,000 are subject to a surtax of 3.8% on net investment income. This includes capital gains, interest, dividends, rental income, royalties, and nonqualified annuity income.

The net investment income tax effectively increases the 15% and 20% long-term capital gains tax rate by 3.8% for higher income taxpayers.

Stealth Tax #5:  Widow(er)’s Income Tax Penalty

Stealth tax #5, the widow(er)’s income tax, is the stealthiest of all stealth taxes since most people aren’t aware of it, it’s the most difficult to plan for, and it can potentially increase tax liability significantly each year going forward once it applies.

Unfortunately, the income tax law is not kind to surviving spouses who don’t remarry. A widow or widower who has the same, or even less, income than the couple enjoyed will often be subject to higher federal, and potentially, state, income tax liability. This results from the transition from the use of married filing joint tax rates to single tax rates and a standard deduction of 50% of the married filing joint amount of $25,100, or $12,550, beginning in the year following the year of death of one’s spouse.

Stealth Tax #6:  $10,000 Limitation on Personal Income Tax Deductions

Unlike the first five stealth taxes that directly increase income tax or Medicare premiums in the case of stealth tax #3, stealth tax #6 indirectly achieves the same result. The $10,000 limitation on the personal income tax deduction accomplishes this by eliminating a potentially large amount of one’s overall tax deductions for those affected by it. This has translated to reduced itemized deductions of tens of thousands of dollars or more in many cases since 2018.

This change, combined with the doubling of the standard deduction and reduced mortgage interest deductions, has reduced the percentage of taxpayers itemizing their deductions from approximately 31% in 2017 prior to the enactment of the Tax Cuts and Jobs Act to approximately 14% in 2019.

Stealth Tax Planning Opportunity:  Staged Roth IRA Conversions

Although there are various retirement income planning strategies that can be implemented to address each of the six stealth taxes discussed in this article, there is one strategy that can reduce income tax liability attributable to the first five. The strategy to which I am referring and have espoused for many years, is a staged, or multi-year Roth IRA conversion plan.

The current low historic income tax rates that will expire after 2025 and potentially sooner provide a window of opportunity for Roth IRA conversions that many of us may never see again in our lifetime. If you’re in your 50’s or 60’s and you have traditional 401(k) plans, SEP-IRAs, and traditional IRAs, why wait until age 72 when the value of your plans has potentially doubled, and tax rates are potentially higher to pay income tax on your distributions?

When you do a Roth IRA conversion, or a series of Roth IRA conversions using a staged Roth IRA conversion plan, you eliminate taxation on the future growth of converted assets, reduce required minimum distributions (RMDs) beginning at age 72, and reduce dependency on taxable assets in retirement. This, in turn, allows you to reduce your exposure to the first five stealth taxes throughout your retirement years as follows:

  • Reduce the value of taxable assets impacted by the 10-year payout rule
  • Decrease the Social Security “combined income” threshold, potentially decreasing your percentage of taxable Social Security benefits
  • Decrease modified adjusted gross income (MAGI) which can potentially reduce your Medicare Part B and D premiums beginning at age 65
  • Potentially decrease your net investment income tax since this is calculated using MAGI
  • Reduce the value of taxable retirement assets and your exposure to the widow(er)’s income tax liability if you’re married

Look Beyond Current Income Tax Rates When Planning for Retirement

The six stealth taxes discussed in this article can impact the success of your retirement in various stages of your life beginning long before you retire and continuing throughout your retirement. It behooves you to not get lulled into a false sense of security by today’s low federal income tax rates since they are scheduled to sunset after 2025 and this may occur sooner. While it is difficult, if not impossible, to predict future rates, it is better to err on the conservative side when planning for a long-term event like retirement that may not begin for many years.

Furthermore, it is crucial to look beyond rates to understand how stealth taxes can potentially derail your retirement. None of them is likely to be eliminated since each is responsible for billions of dollars of annual tax revenue. On the contrary, additional stealth taxes will be imposed as part of future tax legislation based on historical precedent. This is likely given the out-of-control federal deficit and the fact that stealth taxes are confusing and often fly under the radar – hence their name.

Categories
401(k) Plans Income Tax Planning

Carve Out Your 401(k) Company Stock for Favorable NUA Tax Treatment

Carve Out Your 401(k) Company Stock for Favorable NUA Tax Treatment

This article was originally published in, and has been reprinted with permission from, Retirement Daily.

Distributions from a traditional 401(k) plan are generally taxable as ordinary income at your regular income tax rates. This includes pre-tax contributions plus earnings. If your traditional 401(k) plan is rolled over to a traditional IRA, the same rule applies when you withdraw funds from your IRA.

Company Stock NUA Exception

There’s an exception to this rule for highly appreciated company stock held in a 401(k) plan. Appreciation is the difference between current value and the cost of the shares when they were put in the plan.

Although you can roll over company stock from your 401(k) plan to an IRA, it generally isn’t advisable to do so if the stock is highly appreciated. This is due to the tax break on net unrealized appreciation (NUA) of company stock.

Under the NUA exception, you can withdraw your highly appreciated stock from your 401(k) plan, transferring it to a taxable brokerage account without the market value of the stock being subject to taxation. The net unrealized appreciation, or NUA, is taxable at favorable federal long-term capital gains tax rates when you sell the stock. Only the original cost of the stock will be subject to regular tax rates in the year of distribution if you meet two tests.

NUA Test #1 – Triggering Event

There are two tests governing when you can apply the NUA exception. Test #1 is that the distribution must occur after any one of the following four triggering events:

  • Age 59-1/2
  • Separation from service (not for self-employed)
  • Disability (only for self-employed)
  • Death

Once one of the four triggering events occurs, the NUA exception applies in the year of the qualifying event and in any subsequent year subject to compliance with test #2.

NUA Test #2 – Lump-Sum Distribution

After the occurrence of one of the four triggering events, you must take a lump-sum distribution from your 401(k) plan. To qualify as a lump-sum distribution, (a) the distribution must occur in one tax year and (b) your 401(k) balance must be zero by the end of that year.

NUA Example

Let’s assume that Tom works for Tesla, he has a traditional 401(k) plan, and Tesla stock is one of the holdings in Tom’s plan. Let’s further assume that Tom left Tesla last year to go work for a startup (triggering event #2). Tom initiated and completed a lump-sum distribution from his plan in the current year. As part of the process, he transferred 100% of his Tesla stock to a nonretirement brokerage account.

The fair market value of Tom’s Tesla stock on August 12th, the date of distribution, is $1 million. His cost basis is $100,000, resulting in net unrealized appreciation, or NUA, of $900,000. Tom would pay ordinary income tax at his regular tax rates on his cost basis of $100,000 in the year of distribution.

The NUA of $900,000 will be taxed at favorable long-term capital gains tax rates when the stock is sold. This is true even if Tom sells the stock the day after the distribution. Had Tom instead transferred his Tesla stock to a traditional IRA, Tom, and potentially his heirs would be taxed at ordinary tax rates on all distributions from Tom’s IRA.

Let’s suppose that Tom decides to sell his Tesla stock 20 days later on September 1st after it has increased in value to $1.2 million. Tom’s capital gain would be the difference between the current value of $1.2 million and his cost basis of $100,000, or $1.1 million, taxed as follows:

  • Long-term capital gain on the NUA of $900,000 taxed at favorable long-term capital gains tax rates
  • Short-term capital gain on the additional appreciation of $200,000 since the date of distribution taxed at ordinary income tax rates since the stock was sold less than a year from the date of distribution

Complying with the NUA Exception

As previously stated, there are strict rules governing when you can apply the NUA exception. Failure to comply with the rules will result in ordinary income vs. favorable long-term capital gain tax treatment on the unrealized appreciation of company stock held in a 401(k) plan.

There are ten things to keep in mind to avoid unpleasant surprises, several of which have been addressed in various IRS private letter rulings:

  1. Do not transfer highly appreciated company stock to an IRA. The NUA tax break will be lost forever if this is done.
  2. You cannot leave any funds in the company plan. All 401(k) plan funds must be distributed in one tax year.
  3. If the 401(k) plan consists of employer securities and other assets such as cash and mutual funds, the other assets can and generally should be transferred to an IRA account. This will enable you to zero out your 401(k) balance without current year taxation on the plan’s other assets and receive favorable NUA taxation treatment on the distribution of the highly appreciated company stock. This will occur so long as the transfer of the other assets is completed by the end of the same year that the employer securities are distributed.
  4. A NUA transaction may take several weeks to complete from the time the employer makes the distribution of stock to the time that the transfer agent issues new shares. It’s a good idea to never start the process after Thanksgiving. It’s better to wait until the beginning of the following year. This will enable you to complete the distribution in one year.
  5. Don’t sell the company stock in your 401(k) plan too quickly. Once you sell the shares, they’re no longer eligible for the NUA tax break. Keep in mind that most companies aren’t like Enron.
  6. Confirm that there have been no deemed loan distributions from your 401(k) plan. A deemed distribution occurs when there’s a default on a loan from a plan. If this occurs, the entire outstanding balance of the loan is treated as a taxable distribution and the transaction won’t qualify for favorable NUA taxation.
  7. Keep track of the cost basis of the company stock in your 401(k) plan. While the basis of company shares isn’t affected, this can be tricky if there are mergers, acquisitions, spin-offs, and corporate reorganizations.
  8. Make sure that beneficiaries are made aware of your NUA, including the cost basis of your company stock, since death is one of the four NUA triggering events. If you have a 401(k) plan with highly appreciated stock in your plan when you die, your beneficiary(ies) can claim the NUA tax break on a lump-sum distribution. The distribution can be taken in any year after you die so long as it is completed in one tax year. There are other tax rules that come into play in this situation that are beyond the scope of this article.
  9. Confirm that your employer will first transfer the plan’s other assets directly to the IRA custodian as a trustee-to-trustee transfer and then distribute the NUA shares to you via an in-kind transfer to your nonretirement brokerage account in one tax year, leaving nothing in the account. This will avoid IRS’ mandatory 20% federal income tax withholding requirement on distributions from a qualified plan.
  10. Be aware that brokerage firms generally don’t assign a special designation to NUA stock on monthly investment and annual tax reporting statements. It’s up to you, your financial advisors, and potentially your beneficiaries to keep track of NUA stock. This is necessary to claim the proper income tax treatment when NUA stock is sold, i.e., allocation of capital gains between short- vs. long-term.

Other NUA Benefits

In addition to favorable long-term capital gains tax treatment on NUA, there are several other benefits that can be realized from engaging in a NUA transaction. These include the following:

  • Except for cost basis, highly appreciated stock held in a 401(k) plan won’t be taxable at ordinary income tax rates in the future.
  • Today’s current low tax rates can be locked in before rates are likely to increase. This includes ordinary income tax on the cost basis of company stock and long-term capital gains tax rates on NUA.
  • The company stock that’s distributed won’t be subject to required minimum distributions, or RMDs.
  • There are no limitations on how or when the company stock can be used as there would be if the stock is continued to be held in a 401(k) plan.
  • Non-spouse beneficiaries won’t be affected by the repeal of the stretch IRA rules and associated 10-year distribution requirement on the distributed company stock.
  • All beneficiaries can use the NUA tax break to the extent that it wasn’t used during the owner’s lifetime.

When Taking Company Stock Isn’t a Good Idea

Taking a distribution of company stock from a 401(k) plan and complying with the NUA rules can result in significant income tax savings and other benefits when the stock is highly appreciated, i.e., its fair market value significantly exceeds its cost basis. Likewise, NUA transactions should be avoided whenever there’s either a high cost basis or the stock isn’t highly appreciated.

Let’s suppose that Tom in our example worked for General Electric instead of Tesla. He began purchasing GE stock in his 401(k) plan in 2000 when the price was $55. With a few exceptions, the price has steadily declined with a current price of $10 per share. The current value of Tom’s stock is $100,000 with a cost basis of $400,000. Tom wouldn’t be a good candidate for a NUA transaction given the unrealized loss of $300,000.

Recommendations

The NUA tax break is a valuable strategy that shouldn’t be overlooked. The income tax savings and other benefits can be substantial in the right situation. It’s important to keep in mind that a NUA transaction can be pursued by your beneficiaries if it isn’t done during your lifetime.

If you have highly appreciated company stock in your 401(k) plan, you and your financial advisors should periodically explore and plan for a NUA transaction as a possibility even if you haven’t experienced one of the four triggering events. This includes being aware of the various triggering events, the lump-sum distribution requirement, and analyzing the various compliance requirements beginning with keeping track of the cost basis of your stock.

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Income Tax Planning Roth IRA

Keep Your Eye on QBI Before You Rothify

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This article was originally published in, and has been reprinted with permission from, Retirement Daily.

As stated in the introduction to my last Retirement Daily article, “Should You do a Roth IRA Conversion After Age 62?,” Roth IRA conversions are an excellent tool for optimizing after-tax income throughout retirement when done strategically as part of a holistic retirement income plan. The timing and amount of Roth IRA conversions needs to be carefully analyzed as part of a multi-year, or staged, Roth IRA conversion plan.

The article makes a case for accelerating the execution of a Roth IRA conversion plan given the backdrop of current historical low federal income tax rates and wide tax brackets favoring higher conversion amounts through 2025. While this strategy often makes sense, there are situations where reduced income tax savings can offset potential long-term benefits otherwise achievable with larger conversion amounts in a particular year.

Watch Out for the QBI Minefield

One situation where income tax savings can be reduced or eliminated by income from Roth IRA conversions comes into play with eligible owners of pass-through entities. If you’re an owner of a profitable sole proprietorship, Subchapter S corporation, or partnership, you’re probably familiar with the qualified business income, or QBI, deduction that became an important part of income tax law beginning in 2018.

The QBI, or Internal Revenue Code Section 199A, deduction provides owners of these types of entities with a tax deduction of the lesser of (a) 20% of the individual’s qualified business income or (b) 20% of taxable income minus net capital gains. The QBI deduction is a special deduction that’s unaffected by above-the-line deductions, itemized deductions, or the standard deduction. Like current favorable income tax rates and wide tax brackets, the deduction is scheduled to sunset after 2025.

Service Business QBI Income Limitations

The QBI deduction is potentially reduced or eliminated by income limitations for individuals who fall under the category “specified service trade or business” (SSTB). This includes a trade or business involving the performance of services in 11 specified fields:  health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investment and investment management, trading, and dealing in certain assets or any trade or business where the principal asset is the reputation or skill of one or more of its employees.

The income limitations for SSTB individuals in 2020 range from $163,300 to $213,300 for single filers and $326,600 to $426,600 for joint filers. Income limitations are essentially taxable income before the QBI deduction. The QBI deduction phases out beginning at the lower respective income levels and is eliminated at the top thresholds.

There’s potentially a lot at stake if you can keep your taxable income below the applicable income thresholds. Maximum QBI deductions are currently $32,660 ($163,300 x 20%) for single individuals and double this amount, or $65,320 ($326,600 x 20%), for joint filers.

QBI Roth IRA Conversion Example

This brings us to our question du jour:  How can a Roth IRA conversion reduce or eliminate a QBI deduction and associated income tax savings? The best way to illustrate this is with a multiple-case example.

In our example, we have two individuals, Jim and Sheila, who are both attorneys unrelated to each other with identical employment income of $351,400. Jim is an associate attorney who receives a W-2. Sheila is a general partner in a law firm and receives a K-1 reporting her share of the firm’s income. Jim and Sheila take the standard deduction of $24,800 and use married filing joint tax status.

Case #1 – Jim: W-2 of $351,400

Jim receives a W-2 in the amount of $351,400. As an employee, Jim isn’t entitled to the QBI deduction. His taxable income is $326,600. Jim’s federal income tax liability, including Medicare tax on high-income taxpayers of $913, is $67,456.

Case #2 – Sheila:  K-1 of $351,400

Sheila receives a K-1 in the amount of $351,400. As an owner of her law firm, Sheila is entitled to a QBI deduction in the amount of $65,320. Her taxable income is $261,280. Sheila’s federal income tax liability is $50,866, or $16,590 less than Jim’s federal tax of $67,456.

Case #3 – Sheila:  K-1 of $351,400 and Roth IRA Conversion of $50,000

The facts in Case #3 are identical to those in Case #2 with one difference. On March 23rd, after the Dow Jones declined 38.4% from its all-time high of 29,569 on February 12th to a year-to-date low of 18,214, and knowing that Sheila and her husband are paying federal income tax at a historically low rate, Sheila did a Roth IRA conversion in the amount of $50,000.

Sheila’s QBI deduction decreased from $65,320 in Case #2 to $17,570 as a result of the QBI limitation on specified service trade or business individuals, increasing her taxable income from $261,280 to $359,030. This increased Sheila’s federal marginal tax rate from 24% to 32% and her federal income tax liability from $50,866 to $76,921. The difference of $26,055 represents a 51% increase.

Don’t Disqualify Your QBI Deduction with Excess Roth IRA Conversions

What appeared to be a timely move on Sheila’s part, i.e., doing a sizable Roth IRA conversion following a 38% decline in the stock market, with associated elimination of income tax liability on future appreciation of her conversion while in a historically low tax bracket, proved to be ill-advised, at least in the short run.

$48,000, or 73%, of Sheila’s otherwise allowable QBI deduction was eliminated by doing a Roth IRA conversion of $50,000, resulting in an increase in taxable income of $98,000. The increase in Sheila’s income tax liability of 51% significantly exceeded her marginal tax rate of 24% without the conversion and 32% with the conversion.

In Sheila’s defense, it’s possible that when she did her conversion on March 23rd, her projected 2020 K-1 income may have been much less than $351,400, resulting in a higher projected QBI deduction.

Illustrate Multiple What-If Scenarios

If you’re a profitable service business owner, you should balance the strategy of accelerating income to take advantage of low tax rates in effect through 2025 against the potential phaseout and loss of the QBI deduction. This especially applies to large Roth IRA conversions that can’t be offset with losses and other deductions such as a rental property passive loss carry forward when the property is sold.

Although I didn’t illustrate it, there are situations where it makes sense to increase taxable income in order to increase the QBI deduction and reduce federal income tax liability. The lesson to be learned is that it’s important to do income tax planning using multiple what-if scenarios to minimize tax liability and increase the longevity of after-tax retirement income. This applies to QBI as well as other complicated tax planning situations.

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Income Tax Planning Retirement Plan

Don’t Qualify for Cornavirus-Related Distributions? There’s Always 72(t)

This article was originally published in, and has been reprinted with permission from, Retirement Daily.

One of the provisions of the CARES Act that was enacted in late March 2020 provides income tax breaks for individuals affected by COVID-19 who take “coronavirus-related distributions,” or CRDs, from a company plan or from an IRA in 2020. Company plans aren’t required to offer CRDs.

Tax Breaks for Coronavirus-Related Distributions

If a distribution qualifies as a CRD, the recipient is entitled to the following three tax breaks on up to $100,000 of retirement plan distributions:

  • The 10% penalty is waived.
  • Tax on the distribution is due, however, it can be spread evenly over three years.
  • The funds distributed can be repaid over the three-year period to a company plan or IRA with a refund of taxes paid.

Affected individuals who qualify for CRDs fall into three categories as follows:

  • You are diagnosed with the virus SARS-CoV-2 or with COVID-19 by a test approved by the Centers for Disease Control and Prevention.
  • Your spouse or dependent is diagnosed with the virus by an approved test.
  • You experience “adverse financial consequences” as a result of being quarantined, being furloughed or laid off or having work hours reduced, being unable to work due to lack of childcare, or closing or reducing hours of your business.

IRS Notice 2020-50 provides additional guidance and clarification regarding adverse financial consequences that can qualify affected individuals for CRDs.

Section 72(t) Relief

Although the “adverse financial consequences” criteria for individuals is fairly broad, if you, your spouse, or dependent aren’t diagnosed with the virus SARS-CoV-2 or with COVID-19, it’s possible that you may not qualify for the CRD tax break.

If this is the case, there’s another strategy that you can use to avoid the 10% federal penalty and a potential state penalty on premature distributions from retirement plans. It works for individuals who are less than 59-1/2 who own an IRA or have a company plan and employment has been terminated with that company.

The strategy, which is commonly referred to as “72(t)” for the IRS Code section that created it, requires you to commit to a plan of withdrawals, or “substantially equal periodic payments,” or SEPPs. The 72(t) strategy has been blessed by IRS since 1989 when it was added to the Internal Revenue Code.

Section 72(t) Requirements

To take advantage of Section 72(t), payments are required to be distributed from a retirement plan using an annuitization method that:

  • Must continue for the longer of five years or until age 59-1/2,
  • Must be distributed at least annually using either a calendar or fiscal year depending upon the annuitization method chosen,
  • Must be substantially equal with no change in the payment formula and no stoppage of payments unless the account owner becomes disabled or dies,
  • Can be calculated using either a single or joint life and cannot be changed.

Section 72(t) Annuitization Methods

There are three annuitization methods authorized by IRS, however, other distribution methods can be used if they satisfy the SEPP requirement. The three authorized methods are as follows:

  1. Minimum distribution
  2. Amortization
  3. Annuity factor

The minimum distribution method will generally result in the lowest payment. The amortization and annuity factor methods generally produce larger distributions since both allow you to use a “reasonable” interest rate to calculate the payments.

While it’s possible to make a one-time irrevocable change from either the amortization or annuity factor method to the minimum distribution method, you are otherwise locked into the method that you choose when you establish your 72(t) plan. The choice of a specific method will depend upon your retirement income planning needs.

Section 72(t) Plan Modification Consequences

The most important consideration when deciding whether to implement a 72(t) plan is your ability to stick to it. A minimum commitment of five years from the date of establishment of a plan, or until age 59-1/2, if longer, is required. Assuming you’re 45 when you set up your plan, you would need to maintain it for 14 years until you turn 59-1/2.

The consequences of not sticking to a 72(t) plan can be expensive. This is because the 10% federal and applicable state premature distribution penalty and interest will be applied retroactively to all distributions taken before age 59-1/2 in the year in which a plan modification occurs.

There are several types of Section 72(t) modifications. These include missed distributions, reduced distributions, excess distributions, and changes in the account balance to calculate the distribution amount other than by regular gains and losses. In addition, funds cannot be added to the 72(t) account, including contributions or rollover of distributions.

As an example, let’s assume that Tom began his 72(t) plan when he was 45, he is now 57, and he has taken allowable distributions totaling $220,000 from his 72(t) IRA account over the last 12 years. Suppose that his calculated 72(t) distribution amount at age 58 is $23,000, however, Tom takes $40,000 since he needs extra money for home improvements. Tom has modified his 72(t) plan by taking excess distributions of $17,000. He will be assessed a federal penalty of 10% of $260,000 (prior year distributions of $220,000 + current year distribution of $40,000), or $26,000, plus any applicable state penalty and interest in addition to current year tax liability on his distribution of $40,000.

72(t) Planning

In addition to assessing your ability to stick to a 72(t) plan, it’s important to decide on the amount of funds that you want to commit to your plan at the outset. This requires projections of the 72(t) plan account balance over the duration of the plan life and continuing throughout retirement using various distribution methods.

Since the financial consequences of a 72(t) plan modification can be significant, you should only transfer enough funds to a 72(t) IRA account that will meet your projected annual needs for the duration of the plan using your selected distribution method. Any excess funds should remain in a separate IRA account.

Short-Term Solutions

While tax breaks are available for Coronavirus-Related Distributions (CRDs) and 72(t) distributions, both are short-term solutions resulting in premature distributions from company plans or IRAs. Premature distributions disrupt tax-deferred growth of taxable retirement plans. Both strategies require payment of income tax although it can be spread over three years with CRDs. Furthermore, funds withdrawn won’t be available for retirement when they may be needed the most.

Categories
Income Tax Planning IRA

You Have 10 Years to Empty Your Beneficiary IRAs If You Aren’t an EDB

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If you own or are the beneficiary of a retirement account or IRA, you’re probably familiar with the term, “required minimum distribution,” or “RMD.” Simply stated, this is the IRS rule that requires you to take minimum distributions from your retirement and IRA accounts each year beginning on a specified date. The amount of each annual distribution is calculated using the value of the accounts on December 31st of the prior year and an age factor from an IRS life expectancy table.

The RMD regime as it applies to IRAs is often referred to as the “stretch IRA” since it allows designated, or named, IRA beneficiaries to take, or stretch, distributions over their life expectancy. The stretch IRA was eliminated on January 1st for many individuals with the enactment of the SECURE Act.

If you are the beneficiary of a retirement or IRA account that you inherited after 2019, you need to familiarize yourself with the new rules in order to determine the applicable time frame for taking distributions from your account. Noncompliance can result in IRS assessment of an onerous penalty and interest in addition to income tax.

New 10-Year Payout Rule

Under the SECURE Act, most retirement and IRA account beneficiaries who inherit retirement and IRA accounts beginning in 2020 are subject to a new 10-year payout rule. The effective date for this rule is generally for deaths after December 31, 2019. Beneficiaries who are affected by this rule are no longer required to take RMDs from these accounts.

The 10-year payout rule requires retirement and IRA account beneficiaries to empty their accounts by the end of the tenth year after the employee or IRA owner’s death. The rule applies to defined contribution plans, including 401(k), 403(b) and 457(b) plans and traditional and Roth IRAs. It doesn’t apply to defined benefit plans.

Eligible Designated Beneficiaries Exempt from 10-Year Payout Rule

The SECURE Act created three new classes of beneficiaries. The three classes are used to determine the length of time over which each class must take distributions from their retirement and IRA accounts.

“Eligible designated beneficiaries,” or “EDBs,” are exempt from the 10-year rule. The stretch IRA still applies to these individuals since they take distributions using the RMD rules. EDB status is determined at the date of the owner’s, or plan participant’s, death and cannot be changed.

There are five classes of eligible designated beneficiaries, or “EDBs,” as follows:

  1. Surviving spouses
  2. Minor children up to the age of majority, excluding grandchildren
  3. Disabled individuals who qualify under strict IRS rules
  4. Chronically ill individuals
  5. Individuals not more than ten years younger than the IRA owner

In addition to the foregoing five classes, any designated beneficiary who inherited their retirement account or IRA before 2020 also qualifies as an EDB. These individuals are grandfathered under the pre-2020 stretch IRA rules.

Once EDBs no longer qualify as EDBs, e.g., minor child attaining the age of majority, or die, the 10-year rule is applied to them or to their beneficiaries.

Non-Eligible Designated Beneficiaries Subject to 10-Year Payout Rule

The second class of beneficiaries created by the SECURE Act are “non-eligible designated beneficiaries,” or “NEDBs.” These are designated, or named, beneficiaries who do not qualify as EDBs. Examples include children after reaching the age of majority, grandchildren, and some “look-through trusts,” a discussion of which is beyond the scope of this post.

NEDBs are no longer required to take RMDs from their retirement and IRA accounts. They are instead subject to the new 10-year rule whereby they must empty their accounts by the end of the tenth year after death.

Non-Designated Beneficiaries Continue to Follow Prior Law

Whereas EDBs and NEDBs are generally people, the third class of beneficiaries, “non-designated beneficiaries,” or “NDBs,” are entities. This includes estates, charities, or non-qualifying, i.e., “non-look-through” trusts.

The distribution rules for NDBs are unchanged. They are based on whether the IRA owner or plan participant dies before or after the owner’s “required beginning date,” or “RBD.” The RBD is generally April 1st after the year of the 72nd birthday.

If the owner dies before the RBD, the account must be withdrawn by the end of the fifth year after death. This is known as the 5-year rule. If the owner dies after the RBD, RMDs must be taken over the deceased IRA owner or plan participant’s remaining single life expectancy.

Distribution Shortfall Penalty

Whether you’re an EDB or NEDB or an NDB entity, the IRS penalty for shortfalls in meeting applicable distribution requirements is severe. The amount of the penalty, which is referred to by IRS as the “additional tax on excess accumulations,” is 50% of the shortfall. While a penalty waiver request can be submitted to IRS, it’s obviously better to avoid this situation.

The timing of potential penalties for eligible designated beneficiaries, or EDBs, continues to be determined and calculated based on annual RMDs since the stretch IRA rules still apply. The 50% penalty is relatively easy to avoid for EDBs since their distributions can be automatically calculated and distributed by financial institutions on the same day each year.

The 50% penalty for distribution shortfalls for non-eligible designated beneficiaries, or NEDBs, is more problematic. NEDBs are subject to the new 10-year rule that requires them to empty their accounts by the end of the tenth year after death.

Given what’s at stake, it’s imperative for NEDBs to track the 10-year rule as it pertains to each of their IRA and retirement plan accounts. This includes Roth IRA and Roth 401(k) plan beneficiary accounts. While distributions from the latter accounts are exempt from taxation, distribution shortfalls are subject to the 50% penalty.

Required Minimum Distributions Waived in 2020

Eligible designated beneficiaries, including surviving spouses and minor children, are exempt from the 10-year payout rule and must take distributions using the RMD rules. The good news is that the CARES Act which was signed on March 27th waives required minimum distributions, or RMDs, for 2020. The waiver applies to inherited traditional and Roth IRAs.

Which Type of Beneficiary Are You?

As strange as it seems, if you are the beneficiary of a retirement plan or IRA account that you inherited after 2019, you must first determine which of the three classes of beneficiaries you fall into in order to determine the required time frame for taking distributions from your account. This can be tricky and will likely require the assistance of a professional advisor who is familiar with the applicable rules.

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Income Tax Planning IRA Retirement Income Planning Roth IRA

Contribute Your 2020 RMD to a Roth IRA

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Less than four weeks ago on March 27th, President Trump signed the Coronavirus Aid, Relief, and Economic Security (CARES) Act. This 880-page legislation includes four pages that waive required minimum distributions, or RMDs, for 2020 for traditional IRAs, workplace retirement plans, and inherited traditional and Roth IRAs.

As was the case in 2009 when RMDs were also waived, if this wasn’t done in 2020, many individuals, especially older ones, would be upset that they would be forced to sell deflated assets to satisfy their RMD and avoid a 50% penalty.

What if you have already taken your 2020 RMD, a portion of your RMD, or IRA or other retirement plan distributions greater than your RMD? You have three options, with #2 and #3 inapplicable to distributions from inherited traditional and Roth IRAs:

  1. Keep
  2. Return
  3. Contribute to a Roth IRA

Let’s examine the pros and cons of each of the three options.

Keep

If you have already taken distributions from taxable retirement accounts, including RMDs, you can simply keep them. If you took a distribution before February 1st, this is your only option.

Any distributions that you keep are subject to ordinary income tax to the extent that the distribution exceeds your basis. Basis includes a pro-rata amount of nondeductible contributions in the case of an IRA and after-tax contributions if the distribution came from a 401(k).

Options #2 and #3 generally aren’t viable planning strategies for retirees who depend on RMDs to cover basic expenses. Although the amount changes from year to year, it’s a systematic payout and, as such, is comparable to a structured distribution from a variable annuity.

Return

As discussed in my April 6th post, 2020 Required Minimum Distributions Waived, the CARES Act applies the “60-day rollover rule” to determine if you can return your RMD to your Traditional IRA or other retirement plan account. Under this rule, you can rollover, or return, your distribution to the account from which it came within 60 days from the date that you received it provided that you haven’t done any other rollovers within the previous 365 days.

It’s critical to review all IRA and retirement plan transactions within the previous 365 days to determine if any other rollovers have occurred. If there was another rollover, the return of your 2020 distribution will be taxable and will be subject to a potential 10% early distribution penalty and a 6% per year excess accumulation penalty if it isn’t timely removed from the account.

On April 9th, IRS released Notice 2020-23, one of the sections of which supersedes the 60-day rollover rule, indirectly extending the 2020 RMD waiver to distributions taken between February 1, 2020 and May 15, 2020 to July 15th. As noted in the “Keep It” section, if you took distributions before February 1st, your only choice is to keep it and include it in your 2020 gross income.

The advantage of rolling over, or returning, distributions to IRAs or other retirement plan accounts is that they won’t be subject to taxation in 2020. Distributions that are rolled over, or returned, to IRAs will continue to enjoy tax-deferred growth provided that there have been no other rollovers within the previous 365 days.

Potential disadvantages of returning distributions to retirement plans outnumber those of keeping them depending upon one’s situation. They include the following:

  • Increased RMDs in subsequent years
  • Increased income tax liability in subsequent years due to increased RMDs
  • Potential increased Medicare Part B Premiums and taxable Social Security due to increased RMDs
  • Increased exposure to likely higher income tax rates for you and your heirs beginning in 2026 when current tax rates expire or potentially sooner depending upon results of the upcoming presidential election
  • Increased exposure to increased income tax liability in future years for surviving spouses due to the widow(er)’s penalty
  • Increased exposure to 10-year vs. lifetime distribution requirement and associated potential increased income tax liability for non-minor children, grandchildren, and other nonspouses who inherit traditional IRAs and other retirement plans resulting from the SECURE Act that went into effect on January 1st

Contribute to a Roth IRA

When most people think about doing a Roth IRA conversion, they expect to transfer assets directly from a traditional IRA account to a Roth IRA account. Furthermore, while it’s possible to do a transfer between accounts located at different financial institutions, most transfers are done within the same financial institution.

There’s another way to do a Roth IRA conversion that can be used to leverage its benefits in light of the waiver of 2020 RMDs. It’s a strategy that’s been part of the income tax law since the Taxpayer Relief Act of 1997 which created the Roth IRA. If you receive a distribution from a traditional IRA, you can contribute, or roll it over, to a Roth IRA within 60 days after the distribution as a Roth IRA conversion.

The once-per-year rule discussed in the “Return” section doesn’t apply to rollovers to Roth IRAs. Furthermore, the 60-day rollover time frame has been extended to July 15th for 2020 Roth IRA conversions of distributions taken from IRAs and other retirement plans between February 1st and May 15th by IRS Notice 2020-23.

There are many advantages of employing this strategy, the first several of which are mirror images of the disadvantages of returning distributions to retirement plans discussed in the previous section. The advantages of contributing or rolling over 2020 distributions to a Roth IRA include the following:

  • Reduced RMDs in subsequent years
  • Reduced income tax liability in subsequent years due to reduced RMDs
  • Potential reduced Medicare Part B Premiums and taxable Social Security due to reduced RMDs
  • Reduced exposure to likely higher income tax rates for you and your heirs beginning in 2026 when current tax rates expire or potentially sooner depending upon results of the upcoming presidential election
  • Reduced exposure to increased income tax liability in future years for surviving spouses due to the widow(er)’s penalty
  • Reduced exposure to 10-year vs. lifetime distribution requirement and associated potential increased income tax liability for non-minor children, grandchildren, and other nonspouses who inherit Traditional IRAs and other retirement plans resulting from the SECURE Act that went into effect on January 1st
  • Elimination of taxation on appreciation of funds used for the Roth IRA conversion
  • Opportunity to do a market-sensitive Roth IRA conversion to optimize lifetime after-tax distributions to the extent that the conversion is done before the stock market recovers from its recent 38.4% downturn

The primary disadvantage of rolling over a distribution from a traditional IRA to a Roth IRA vs. returning it to the traditional IRA is that it will be subject to taxation in 2020. The other potential disadvantage is increased Medicare Part B monthly premiums in 2022 if the conversion is done when you’re 63 or older depending upon the conversion amount and your adjusted gross income in 2020.

Given the prospects for higher income tax rates in the future, the potential long-term benefits of doing a Roth IRA conversion are likely to exceed additional 2020 income tax liability and potential increased 2022 Medicare Part B premiums attributable to the conversion.

The Three Options Aren’t Mutually Exclusive

As is often the case with income tax planning strategies, the three options discussed in this post aren’t mutually exclusive. It may be in your best interest to use a combination of two or three of them to optimize your and your heirs’ lifetime after-tax retirement income depending upon your situation.

Categories
Income Tax Planning IRA Retirement Income Planning

2020 Required Minimum Distributions Waived

Business and finance concept

We didn’t have to wait long for the answer to the question posed in the title of my March 16th blog, Will Congress Suspend 2020 Required Minimum Distributions?

On March 27th, President Trump signed the $2.2 trillion, 880-page Coronavirus Aid, Relief, and Economic Security (CARES) Act. Buried in the act is a four-page provision that waives required minimum distributions, or RMDs, for 2020.

The waiver applies to traditional IRAs and workplace retirement plans including 401(k), 403(b), and 457(b) plans. 2020 RMDs are also waived for inherited traditional and Roth IRAs.

What If You Have Already Taken Your 2020 RMD?

As pointed out in my March 16th blog, there’s precedent for waiving RMDs. This was last done in response to the economic downturn in 2008 with the enactment of the Worker, Retiree, and Employer Recovery Act. The Act was signed on December 23, 2008 and was effective for 2009.

One of the issues discussed in my blog post was that any 2020 RMD suspension would need to be retroactive. Retroactive suspension of RMDs would give individuals who have already taken their 2020 RMD the opportunity to return the full amount to the retirement plan account from which it was withdrawn.

The CARES Act waives 2020 RMDs retroactively, however, there’s a catch. You must apply the “60-day rollover rule” to determine if you can return your RMD to your Traditional IRA or other retirement plan account. Under this rule, you have 60 days from the date you received your distribution to return it back to the account from which it came. You can do this provided you haven’t done any other rollovers within the previous 365 days.

As an example, assuming that you withdrew your 2020 RMD of $20,000 from your IRA on February 10th and you did no other IRA rollovers in the previous 365 days, you have until April 10th to return the funds to your IRA.

Let’s assume that you had federal and state income tax of $4,000 and $1,000, respectively, withheld from your RMD. What happens if you return $15,000 to your IRA account by the deadline? You will be taxed on your original distribution of $20,000 less the amount returned of $15,000, or $5,000. You can also claim your RMD income tax withholding totaling $5,000 on your 2020 income tax returns.

Not all RMDs are eligible for the 60-day rollover rule. Non-spouse beneficiary owners of inherited IRAs cannot do a 60-day rollover. Once the money is withdrawn from an inherited IRA, it cannot be returned.

Planning Opportunity

Any time that legislation is enacted that affects retirement plans, you should use this as an opportunity to revisit your retirement income plan to determine how you can use it to optimize your plan. The CARES Act waiver of RMDs for 2020 is no exception.

You should begin with the question that you should be asking yourself every year regardless of your RMD:  How much should you withdraw from your retirement plan accounts? The answer to this question, as always, depends on a number of factors that need to be considered and analyzed holistically for the current and future years. These include current and projected expenses, income sources, investment assets, taxation, and extended care plan.

As pointed out in my March 30th blog post, The Roth IRA Conversion Trifecta, there’s an unprecedented opportunity to do a sizable Roth IRA conversion this year. Assuming that you haven’t taken your 2020 RMD yet or have done so and aren’t beyond the 60-day deadline for returning it to your traditional IRA or other retirement plan account, you may want to use this amount as the starting point for doing a Roth IRA conversion this year.

Using the previous example, assuming that your 2020 RMD is $20,000, you haven’t taken it yet or are within the 60-day window for returning it, and you have other sources of income to meet your needs, why not consider a Roth IRA conversion of $20,000? Furthermore, given the three events discussed in my March 30th post, it could make sense to do a much larger conversion this year subject to availability of cash to pay the income tax liability attributable to the conversion.

Benefits of 2020 RMD Waiver

Looking back to 2009 which was the last time that RMDs were waived, the long-term benefit of one-year relief from RMDs is questionable. This is due to the fact that many retirees still needed to take distributions from their retirement plans since they didn’t have alternative income sources to meet their financial needs. This is certainly the case for many, if not the majority, of retirees today.

There’s no doubt that the 2009 RMD waiver provided psychological relief for many retirees, especially those who had recently retired and were forced to return to the workplace. Unlike 2009 when many retirees were able to find work, this won’t be the case this time around as evidenced by the 10 million unemployment claims filed in the last two weeks with coronavirus job losses projected to total 47 million.

On the positive side, individuals who don’t rely on RMDs to meet their financial needs can retain tax-deferred funds and avoid 2020 taxation on distributions they would otherwise take. Many can use the 2020 RMD waiver as a planning opportunity to optimize their retirement income plan.

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Income Tax Planning IRA Retirement Income Planning Roth IRA

The Roth IRA Conversion Trifecta

Race for the prize of the Summer in Pyatigorsk,Caucasus.

Those of you who have read my Retirement Income Visions™ posts and MarketWatch Retirementors articles over the years know that I’m a big fan of Roth IRA conversions. A Roth IRA conversion, when implemented timely, can be one of the most effective strategies for optimizing retirement income.

As a result of a series of three events, the most recent of which is unfortunately in response to the coronavirus pandemic, there’s an unprecedented opportunity to do a sizable Roth IRA conversion this year. Taking advantage of this opportunity is predicated on availability of cash to pay the income tax liability attributable to the conversion.

Event #1:  Stock Market Downturn

In less than six weeks, The Dow Jones Industrial Average (DJIA) plummeted 11,355 points, or 38.4%, from its high of 29,569 on February 12th to its recent low of 18,214 on March 23rd. While it recaptured 3,423 points this past week to close at 21,637 on Friday, the DJIA is down 26.8% from its high.

Keeping in mind that any appreciation in a Roth IRA account following a Roth IRA conversion will permanently escape taxation, this is one of those market-sensitive conversion opportunities, the likes of which we haven’t experienced in 11 years. Assuming that you’re healthy and you have a reasonably long planning timeframe, you or your financial advisors should be examining how you can take advantage of this.

Event #2:  Low Income Tax Rates Expire After 2025

The current historically low income tax rates and widening tax brackets to which they’re applied that went into effect in 2018 will end after 2025. Prior to the economic meltdown triggered by the coronavirus pandemic, there was widespread agreement that tax rates will increase in 2026, if not sooner. The signing of the $2 trillion coronavirus relief bill, or CARES Act, by President Trump on Friday piled on top of our national debt of $24 trillion makes this inevitable.

Knowing that you only have six years, including 2020, to pay income tax at a lower rate than you’re likely to pay in the future, Roth IRA conversions should be a high priority for most employees who have Traditional 401(k) plans with a Roth 401(k) option as well as Traditional IRA account owners.

Event #3:  Inherited Retirement Plan Lifetime Distributions Eliminated for Non-Minor Children

In addition to the likelihood of being subject to higher income tax rates, adult children and grandchildren will no longer be able to take distributions from inherited retirement plans over their lifetime. The “stretch IRA” has been replaced with a 10-year rule for most beneficiaries with the enactment of the SECURE Act that went into effect this year.

Most nonspouse beneficiaries, including non-minor children and grandchildren are now required to withdraw 100% of the funds from their inherited retirement plans by the end of the tenth year following the year of death for deaths occurring after 2019. This will accelerate distribution of assets and taxation at higher rates for beneficiaries of 401(k) plans and Traditional IRA accounts. Although distributions won’t be taxed, this change also applies to inherited Roth IRA accounts.

With the elimination of the “stretch IRA,” it no longer makes sense in many cases to leave sizable taxable retirement plan accounts to children and grandchildren. An aggressive Roth IRA conversion plan is one way to reduce, or potentially eliminate, this problem.

Transfer Securities When Doing a Roth IRA Conversion

I have had a number of clients and other individuals tell me that they thought that they need to sell securities in their Traditional IRA account in order to do a Roth IRA conversion. This is generally not a good idea given the fact that appreciation in a Roth IRA account following a Roth IRA conversion will permanently escape taxation.

Instead, you want to specify on your Roth IRA conversion form a number of shares of one or more securities that you would like to transfer from your Traditional IRA account to your Roth IRA account. These should ideally include equity securities, e.g., large or small cap value exchange traded funds or mutual funds, which are likely to appreciate. The total value of the securities being transferred should approximate the desired amount of your conversion, keeping in mind that the value and associated tax liability is likely to change between the time that your form is submitted and your conversion is processed, especially in the current volatile environment.

Unprecedented Opportunity

As a seasoned financial advisor, I’ve experienced, and have presented to clients, several windows of opportunity to create and optimize retirement income. The three events discussed in this post, two of which didn’t exist three months ago, are a Roth IRA conversion trifecta, or perfect storm.

The three events can be leveraged to do a sizable Roth IRA conversion this year as part of a staged, or multi-year, Roth IRA conversion plan subject to availability of cash to pay the income tax liability attributable to the conversion. This is an unprecedented opportunity that many of us probably won’t experience again in our lifetime.

Categories
Income Tax Planning IRA

Will Congress Suspend 2020 Required Minimum Distributions?

Senior gentleman reading the news and celebrating with his fist in the air isolated on white background

With the Dow Jones Industrial Average (DJIA) spiraling downwards the last month in response to the spreading Coronavirus, decreasing 28.5% from its record high of 29,568.57 on February 12th to its recent low of 21,154.46 on March 12th, President Trump declared a national emergency on March 13th. Trump’s move invoked the Stafford Act, making available up to $50 billion in federal aid to the states.

The stock market decline has conjured up memories for many investors of the last major bear market when the DJIA declined 54.4% from its high of 14,198.10 on October 11, 2007 to its low of 6,469.95 on March 6, 2009. While the circumstances, duration (29 days vs. 512 days), and the economic impact of the current stock market decline are quite different from the previous one, investors’ portfolios have taken a hit.

Unlike the 2007 – 2009 event, we’re still in the early stages since the Coronavirus was declared a pandemic by the World Health Organization on March 11th.  Although the DJIA increased 1,985 points, or 9.4%, on March 13th from its previous close, 1,176 points, or 72%, of the increase occurred in the last half-hour of trading after President Trump announced his financial response to the Coronavirus. The global economic impact, which is already widespread, is just beginning to unfold.

Precedent for Required Minimum Distribution Relief

Flashback to 2008. 439 days and 41% into the stock market decline from its October 11, 2007 high, Congress unanimously enacted, and President Bush signed, the Worker, Retiree, and Employer Recovery Act of 2008 on December 23, 2008. The Act contained various provisions designed to help pension plans and plan participants weather the economic downturn that existed at that time.

One of the key provisions of the Act was the waiver of the rule for individuals to take required minimum distributions, or RMDs, from their qualified retirement plans and IRAs in 2009 only. This was in response to many individuals, especially older ones, being upset that they would be forced to sell deflated assets to satisfy their RMD and avoid a 50% penalty.

While the long-term benefit of one-year relief from RMDs is questionable, especially since many retirees still needed to take distributions from their retirement plans in 2009 due to lack of alternative income sources to meet their financial needs, it did serve a purpose. Most important, it provided psychological relief for many retirees, especially those who had recently retired and were forced to return to the workforce.

Potential for 2020 RMD and Other Retirement Plan Relief

Will Congress suspend 2020 RMDs as part of an ongoing economic response to the Coronavirus situation? Will they enact other legislation to provide other types of retirement plan relief? I believe that both are possibilities, especially if the stock market continues its downward trend. Unlike the 2009 RMD suspension, there are five key differences that need to be considered before this becomes reality:

1.  We’re still early in the game.

As previously stated, the 2008 legislation to provide RMD relief was enacted after the stock market dropped 41% in fourteen months. The current stock market decline, while significant, has lasted only about a month. As such, it doesn’t qualify as a bear market, which is generally a decline of 20% or more over a sustained period of time, typically at least two months.

Given the possibility that the stock market could reverse its course in the next three to six months, if not sooner, many would argue that it’s premature to enact any legislation to provide RMD and other retirement plan relief in 2020.

2.  We were overdue for a sizable stock market correction.

Many financial advisors, including myself, have been warning clients about the likelihood of a major stock market correction for the last several years. The DJIA experienced unsustainable growth of 225% from 2009 through 2019. The average annual return of 20.5% over that 11-year period dwarfed the DJIA’s 99-year average return of 7.75% from 1921 to 2019, unadjusted for dividends and inflation.

Seasoned investors as well as younger ones who are familiar with the 54% drop between October, 2007 and March, 2009, are psychologically better prepared for the current market correction. Having said this, we’re living in different economic times and once again, we’re early in the game with the Coronavirus.

To the extent that the stock market continues to experience sharp daily declines and individual investors’ portfolios underperform for an extended period of time, many will experience buyer’s remorse. This will be more prevalent among those approaching, and who are already in, retirement that don’t have adequate sustainable income and extended care protection plans.

3.  There’s more awareness of the importance of sustainable income when planning for retirement.

An interesting development that makes it less likely for Congress to implement an RMD suspension plan and other types of retirement plan relief is that more individuals have assumed personal responsibility for their retirement planning. This began with the replacement of the vast majority of private industry defined benefit pension plans that our parents and grandparents depended on for a significant portion of their retirement income with 401(k) plans.

Following the 2007 – 2009 stock market decline, people became more aware of the importance of sustainable income when planning for retirement. I personally expanded my business model in 2009 from one that focused on traditional investment management, or accumulation, to a retirement income planning, or distribution, model.

The inclusion of appropriate sources and adequate amounts of sustainable income, taking into consideration timing of income distributions to meet projected changing expense needs throughout retirement, is essential to preparing for a financially successful retirement. Individuals who recognize this and have developed a retirement income plan are less vulnerable to stock market downturns and less dependent on the government for financial relief.

4. The SECURE Act recently provided retirement relief.

Congress, when considering any retirement relief in 2020, including suspension of RMDs, may be reluctant to pass new legislation at this time because of favorable changes in the SECURE Act which became law on December 20, 2019 and went into effect this year. One of the key provisions was the increase in the RMD age from 70-1/2 to 72. Another favorable change was the elimination of the 70-1/2 age limit for making traditional IRA contributions.

The foregoing changes were enacted in exchange for elimination of the “stretch IRA” which was replaced with a 10-year rule for most beneficiaries. This change will result in most non-spouse retirement plan beneficiaries no longer being allowed to take retirement plan distributions over their lifetime. These individuals are now required to withdraw 100% of the funds from their inherited plans by the end of the tenth year following the year of death for deaths occurring after 2019.

Given the Coronavirus pandemic and associated negative economic impact that has occurred since the SECURE Act went in effect, Congress may be willing to consider a delay of the commencement of the 10-year rule until 2021 or 2022 or changing to a 12-year rule.

5. 2020 RMD suspension would need to be retroactive.

The fifth and final consideration relates to timing. When the Worker, Retiree, and Employer Recovery Act of 2008 was enacted, it occurred at the end of 2008 effective for 2009. Given the fact that we’re already two and a half months into 2020 and many individuals have already taken their 2020 RMDs, any legislation providing RMD relief for 2020 would need to be retroactive to January 1st.

The legislation would need to give individuals who have already taken their 2020 RMDs the option to return the full amount to the retirement plan accounts from which they were withdrawn. Retirement plan sponsors and IRA custodians would have additional responsibilities, including tracking the returns, not issuing 2020 Form 1099-R’s to report the withdrawals, and confirming that the returned amounts don’t exceed the distributions that were taken.

Retirement Plan Relief More Likely in 2021

Suspension of 2020 RMDs and other types of financial relief for retirement plan participants, while possible, aren’t likely to be enacted and made effective this year. Although such legislation would increase the longevity of retirees’ assets and provide psychological relief, there are various considerations discussed in this blog post that need to be addressed.

If the economy and stock market continue its downward trend for the next six months or so, it’s more likely that legislation suspending RMDs and delaying the commencement of the nonspouse beneficiary10-year rule, or potentially changing to a 12-year rule, would be enacted at the end of 2020 effective in 2021.

 

Categories
Income Tax Planning IRA Retirement Income Planning Roth IRA

7 Reasons to Start a Staged Roth IRA Conversion Plan Today

- ‘A goal without a plan is just a wish’ written on a blackboard. Blurred styled background.

If you want to succeed at chess, you need a plan for evaluating positions and setting short- and long-term goals. This includes being willing to strategically sacrifice pawns, knights, bishops, and even rooks in order to achieve the object of the game, i.e., checkmating your opponent’s king.

Just like chess, when planning for retirement you need to keep the ultimate goal in mind if you want to win — optimizing the longevity of your assets. With retirement, your opponent is the IRS as well as your state tax agency if you’re subject to state income tax. Similar to chess, you need to be willing to sacrifice pieces to achieve success. The pieces in the game of retirement planning come in the form of strategic income tax prepayments.

If you’re in your 50’s or 60’s and you have traditional 401(k) plans, SEP-IRAs, and traditional IRAs to which you’re contributing, why wait until 70-1/2 when the value of your plans have potentially doubled and tax rates are potentially higher to pay income tax on your distributions? Wouldn’t you rather use prudent retirement income planning strategies today to pay less tax for the rest of your life and have more funds available when you need them the most – during your retirement years?

One underutilized strategy for accomplishing this is with a staged, or multi-year, Roth IRA conversion plan. The length of the plan needs to be flexible with the number of years dependent upon many variables, a discussion of which is beyond the scope of this post. The following are seven reasons to start this type of plan today.

1. Eliminate taxation on the future growth of converted assets.

Assuming that you will be subject to taxation during your retirement years, eliminating taxation on the future growth of converted assets is the most important reason for implementing a staged Roth IRA conversion plan before you retire. 100% of the value of Roth IRA assets, including appreciation, will be permanently exempt from taxation.

Appreciation is typically responsible for the majority of the value of retirement plan assets over time. Suppose that you did a $60,000 partial Roth IRA conversion using a moderately aggressive equity portfolio in the beginning of March, 2009 when the Dow Jones Industrial Average was 7,000. Let’s further assume that you paid income tax at a rate of 25%, or $15,000, attributable to your conversion. Assuming that you retained your portfolio, it could potentially be worth $240,000 today.

To keep the example simple, let’s further assume no additional growth and a current tax rate of 25%. If you didn’t do the Roth IRA conversion in 2009, you would have net assets of $240,000 less income tax of $60,000, or $180,000. As a result of doing the Roth IRA conversion, you have $225,000 ($240,000 less income tax liability of $15,000 paid in 2009) or an additional $45,000 available for your retirement needs.

2. Take advantage of low federal tax rates scheduled to expire after 2025.

While there have been numerous changes in the federal tax law over the last 35 years making for a difficult comparison, the income tax rates that took effect in 2018 are historically on the low side. This is especially true when you also consider the widening of the various tax brackets. A bonus for business owners was the reduction of the Subchapter “C” corporate tax rate to 21% and addition of  a qualified business income (QBI) deduction of up to 20% for other business entities. The latter change reduced the effective tax rate for affected individuals.

With federal tax rates scheduled to expire after 2025 and higher rates likely thereafter, there’s a window of opportunity for Roth IRA conversions. You can potentially benefit from paying taxes on conversions at a low rate for up to seven years if you implement a multi-year staged Roth IRA conversion plan in 2019.

3. Reduce required minimum distributions beginning at age 70-1/2.

Minimum distributions, or RMDs, are required to be taken from non-Roth retirement plans beginning at age 70-1/2 based on the value of your accounts using an IRS table life expectancy factor. The income tax liability attributable to RMDs can be significant, reducing spendable income in retirement.

Why let your opponent, i.e., IRS, control your retirement income plan? A staged Roth IRA conversion plan can go a long way toward minimizing the value of taxable retirement plan accounts subject to RMDs while growing your nontaxable Roth IRA accounts.

4. Potentially reduce Medicare Part B premiums.

Reducing RMDs has a domino effect. One example is Medicare Part B premiums which are determined using modified adjusted gross income (MAGI) from two years prior to the current year. Medicare Part B annual premiums currently range from $1,626 to $5,526 depending upon income. Couples pay double this amount, or $3,252 to $11,052.

To the extent that you successfully execute a staged Roth IRA conversion plan and reduce your taxable retirement plans and RMDs, you can also reduce your MAGI. This can result in significant Medicare Part B premium savings over the course of one’s retirement.

Income tax planning, which is always recommended when considering Roth IRA conversions, is especially important beginning at age 63 since the amount of your conversions in a particular year can potentially increase your Medicare Part B premiums that you would otherwise pay beginning at age 65.

5. Reduce widow or widower’s income tax liability.

A second example of the domino effect of reducing RMDs is the ability to reduce the negative effects of the widow or widower’s income tax penalties. Surviving spouses who don’t remarry are subject to higher income taxes. An example of this was illustrated in Is Your Widow(er) Included in Your Income Tax Plan?.

A staged Roth IRA conversion plan executed while both spouses are alive can reduce the survivor’s ongoing income tax liability. If you’re married, own non-Roth retirement accounts, and you recognize that there’s a realistic possibility that one of you may outlive the other for several years, a staged Roth IRA conversion plan makes sense.

6. Reduce dependency on taxable assets in retirement.

In addition to reducing or potentially eliminating RMDs, a Roth IRA conversion plan reduces your dependency on taxable assets in retirement. The easiest way to illustrate this is with an example.

Let’s suppose that you’re retired and you want to do some major home improvements that you’ve been putting off, the cost is $100,000, you have $600,000 in traditional IRA accounts, and you’re in a combined 35% federal and state income tax bracket. You would need to withdraw $154,000 from your traditional IRA accounts in order to net $100,000 after tax.

If you instead had Roth IRA accounts, you could withdraw $100,000, or $54,000 less, since income tax liability wouldn’t be an issue. To the extent that you can reduce your dependency on taxable assets in retirement, you will optimize the longevity of all of your retirement assets.

7. Stay focused on retirement income planning.

The seventh reason for starting a staged Roth IRA conversion plan today, while not obvious, is very important. Given the multi-year nature of this type of plan, you’re forced to get in the habit of focusing on retirement income tax planning as long as you continue to own non-Roth retirement assets.

Whenever you visit your staged Roth IRA conversion plan, it’s an opportunity to examine and implement other retirement income planning and protection strategies that can also optimize the longevity of your assets. Given the fact that it’s difficult at best to do this yourself and a single mistake can be costly, an investment in a qualified team of income tax, investment, insurance, and legal professionals who specialize in retirement income planning is prudent.

Retirement income planning, much like chess, requires a great deal of patience and focus to be successful. If executed well, you can optimize the longevity of your assets while accomplishing another goal — stalemate IRS!