Category: Retirement Income Planning

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Annuities Fixed Index Annuities Retirement Income Planning

Indexing Strategies to Eliminate Stock Market Risk

Chain Reaction In Business Concept, Businessman Intervening Dominos Continuous Toppling and Protecting Assets

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

It’s no secret that I’m a huge fan of fixed annuities as part of a retirement income plan. The purpose of including fixed annuities in a retirement income plan is to reduce the risk of your investment portfolio. Two features of fixed annuities that have traditionally made them a preferred investment choice when compared to similar-duration CDs are higher interest rates and tax-deferred growth.

There are two types of fixed annuities that can be used to reduce investment portfolio risk:  fixed income annuities and fixed index annuities. This article will discuss how fixed index annuities can be used to reduce stock market risk.

What is a Fixed Index Annuity?

A fixed index annuity, or FIA, is a fixed annuity that offers a minimum guaranteed interest rate and potential for higher earnings than traditional fixed annuities based on the performance of one or more stock market indexes. FIAs can include lifetime income either with a minimum guaranteed withdrawal benefit (“MGWB”) or an optional income rider. Issue ages for most FIAs are 0 to 80 or 85.

There are two types of FIAs – single premium and flexible premium. A single premium FIA is a one-time investment whereas a flexible premium FIA allows for ongoing additions. Some insurance carriers place annual limits on the amount of premiums that can be added to their flexible premium FIAs.

When you purchase a FIA, you’re given the opportunity to allocate your initial premium between a fixed account and one or more indexing strategies. You can typically change your allocation during a 30-day window prior to each contract anniversary. The fixed account pays a fixed rate of return that currently ranges between 1% and 2%, depending upon the FIA.

Indexing strategies earn interest based on the performance of a defined stock market index, with the Standard & Poor’s 500 Index being the most popular offering. The measuring period for most indexing strategies is one year, however, two-year strategies are also available.

Fixed index annuities are subject to a declining surrender charge schedule that’s standard in all deferred annuities and is generally five to ten years. FIAs are meant to be held for the long term. Surrender charges help insurance carriers invest in longer-term bonds with higher yields and to recover initial fixed costs for setting up the contract. They also help actuaries price their deferred annuity products efficiently.

The majority of FIAs allow free withdrawals of up to 10% of the contract value or the initial premium beginning in the first or second year. Surrender charges apply only to excess withdrawals.

Losses are Eliminated and Positive Returns are Limited with a Fixed Index Annuity

Unlike a direct investment in an index where you participate in gains as well as losses, there are two basic differences when you allocate funds to an indexing strategy within a FIA:

  • If the index’s return is negative, no loss is posted to your account.
  • If the index’s return is positive, interest is credited to your account subject to a cap.

With a FIA, you don’t participate in losses. This is sometimes referred to as the “power of zero.” You also don’t participate in gains to the extent that the performance of a particular indexing strategy exceeds that of a defined cap.

FIA Indexing Strategy Examples

I will illustrate how FIA interest crediting works with some examples. Let’s assume that you invest $100,000 in a FIA and one of the indexing strategies that you choose is the S&P 500 one-year point-to-point strategy with a cap of 4%. Here are three different scenarios that occur during the first three contract years:

Year #1 – Return = 3%
Since the return is positive and it’s less than the cap of 4%, you’re credited with 3%, or $3,000, increasing your FIA account value to $103,000.

Year #2 – Return = 9%
Once again the return is positive, however, it exceeds the cap of 4%, therefore, you’re credited with 4%, or $4,120, increasing your FIA account value to $107,120. Although this is $5,150 less than the value of $112,270 through a direct investment in the S&P 500 Index, this needs to be balanced against the potential for loss.

Year #3 – Return = -12%
Since the return is negative, no interest is credited and you maintained your FIA account value at $107,120. Had you invested directly in the S&P 500 index instead of using a FIA indexing strategy, you would have realized a loss of $13,472, reducing your investment value to $98,798.

Gains are Retained with a Fixed Index Annuity

Unlike other types of investments, FIAs are unaffected by stock market declines. Although gains from increases in indexing strategies are limited by cap rates, they’re locked in.

The ability to shelter gains from subsequent losses isn’t available with most other types of equity investments. This benefit can be especially important for retired individuals who don’t have a long-time horizon to recover from sizable stock market losses.

The best way to illustrate this is with a multi-year example comparing an investment in the S&P 500 Index with a fixed index annuity S&P 500 indexing strategy for the duration of retirement using the following five assumptions:

  • Investment of $1 million at age 65
  • Annual withdrawals of $50,000 from age 65 to 90
  • Annual rates of return per the “Return” column
  • S&P 500 one-year point-to-point strategy with a cap of 4% and 7-year declining surrender charge schedule
  • Free annual withdrawals of 10% of the contract value in the first 7 years

There’s “good news, bad news” for the S&P 500 Index investment. The good news is that it participates in 100% of the positive year returns. This includes nine years when returns are 10% or greater and 20 out of 21 years when the returns exceed the FIA S&P 500 indexing strategy annual cap of 4%.

The bad news for the S&P 500 Index investment is that it participates in 100% of the negative year returns. While there are only five negative return years, three of which are single-digit, the first three years are all negative returns:  18%, 12%, and 3%, respectively. This results in a decrease in value from $1 million at age 65 to $574,000 at age 67. After a one-year uptick to $608,000, the value of the S&P 500 Index declines until it reaches $0 at age 88 after a final withdrawal of $14,000.

The fixed index annuity S&P 500 indexing strategy is the winner. Although annual returns are limited to 4%, which is less than the S&P 500 index returns in 20 out of 21 positive return years, interest crediting of 0% in the five negative S&P 500 years preserves the FIA S&P 500 indexing strategy value for the duration of retirement without reduction for losses.

There’s a total net increase in value of $385,000 with the FIA S&P 500 indexing strategy, or $221,000 greater than the S&P 500 Index total of $164,000. This results in total withdrawals of $1.3 million or $136,000 more than the S&P 500 Index. Furthermore, values of the FIA S&P 500 indexing strategy exceed those of the S&P 500 index each and every year by $85,000 to as much as $276,000.

Conclusion

Defensive investment and protection strategies are the key to the success of a retirement income plan. Just like a HECM mortgage strategy can be used to protect against sequence of returns risk, fixed index annuities can provide a buffer against stock market risk. Both strategies are timely given the current 12+-year bull market.

If you don’t want exposure to losses with a potential decrease in available investments to draw upon throughout retirement, are unsatisfied with taxable CD rates, and are seeking tax-deferred growth with an opportunity to participate in the upside potential of the stock market, then you may want to consider diversifying into one or more fixed index annuities.

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HECM Reverse Mortgage Retirement Income Planning Reverse Mortgage

Insure Sequence of Returns Risk with a HECM Mortgage

Business Finance Document with Calculator

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

So here you are, crossing the threshold from earning a living to entering retirement. You worked hard for many years. You accumulated a sizeable, diversified investment portfolio. You purchased deferred income annuities to provide you with sustainable lifetime income. You hedged your bet with life insurance and long-term care insurance. Your will and other estate planning documents have been updated to reflect your current financial situation and goals. Everything’s in place for a financially successful retirement – or so you think.

Sequence of Returns Risk

What could possibly go wrong? Flashback to October, 2007 to March, 2009. After doubling in value from 7,200 to 14,200 in the five-year period beginning October 10, 2002 through October 11, 2007, the Dow Jones Industrial Average (DJIA) plummeted 7,700 points, or 54%, in just 17 months to a low of 6,500 on March 6, 2009.

Welcome to sequence of returns risk. They say there’s no greater teacher than first-hand experience. If you retired during those tumultuous 17 months and weren’t familiar with this dreaded investment risk, you were quickly immersed.

Sequence of returns risk is unique to the decumulation, or distribution, stage of retirement. The order of investment returns during this stage has an impact on how long a portfolio will last, especially if a fixed amount is being withdrawn. Negative returns in the first few years of retirement, if not protected, can significantly increase the possibility of portfolio depletion.

This article is particularly timely given the fact that the DJIA, which was at 35,600 when it was written, or about 1,000 points less than its November 8th record high of 36,565, is up over 29,000 points, or 448%, from its low of 6,500 on March 6, 2009. This translates to an average annualized return of 35%. Furthermore, there have been only two small down years since 2008: 2.2% in 2015 and 5.6% in 2018.

Three Sequence of Returns Risk Hypothetical Scenarios

Let’s illustrate sequence of returns risk with an example using three hypothetical scenarios, each of which includes the following five assumptions:

  1. Retirement age: 65
  2. Life expectancy: age 90
  3. Initial portfolio value: $1 million
  4. Annual withdrawals: 5% of the initial portfolio value, or $50,000, increasing by 3% each year
  5. Average rate of return: 7%

Please keep in mind that none of the scenarios considers the investment account type, i.e., non-retirement, Roth, or taxable retirement, nor potential federal and state income tax liability associated with taxable investment income, realized gains, and distributions from the account.

Scenario #1 – 7% Return Each Year

Although a scenario with the same rate of return each year throughout retirement never occurs in real life, it’s often used for illustration purposes. After taking withdrawals of $50,000 in the first year of retirement that more than double to $105,000 in the final year, the portfolio in Scenario #1 remains intact, decreasing from a value of $1 million at age 65 to $924,000 at age 90.

Scenario #2 – Good Early Years

The positive returns during the first 12 years, most of which are double-digit, enable the portfolio in Scenario #2 to increase in value from $1 million to almost $3 million at age 87 before three consecutive negative years reduce it to $1.8 million at age 90. This is double the value of $924,000 in Scenario #1 despite the fact that the average rate of return during the same period is identical, i.e., 7%.

Scenario #3 – Bad Early Years

Scenario #3 reverses the order of investment returns in Scenario #2, with negative returns of 18%, 12%, and 3% in the first three years, respectively. This reduces the portfolio value by $430,000, or 43%, going from $1 million to $570,000 in just three years at age 67. Despite the fact that the investment return in 12 of the next 14 years is positive and the average return from age 65 to 81 is a respectable 5%, the portfolio is depleted at age 81. Once again, the average rate of return is 7%.

Potential Solution – Maintain Withdrawals of $50,000 in All Years

In hindsight, the longevity of the investment portfolio in Scenario #3 could have been extended, and depletion avoided, had withdrawals not increased by 3% each year and simply remained at $50,000 for the duration of retirement. This is illustrated in Scenario #4 – Bad Early Years with Withdrawals of $50,000 Each Year.

The downside of Scenario #4 is the loss of purchasing power due to inflation. Assuming average annual inflation of 3%, purchasing power of the age 65 withdrawal of $50,000 is reduced by $27,000, or 54%, to $23,000 at age 90.

Scenario #4 is far from a perfect solution in real life. Assuming that it’s necessary to increase annual withdrawals by 3% each year to maintain the individual’s lifestyle, other sources of income would be required to support her financial needs. This might necessitate the sale of her house, assuming she is a homeowner, and associated downsizing.

Not to mention the fact that portfolio depletion could still occur if the individual lives past age 90. This is more likely if investment returns are unfavorable in one or more of those years or if she experiences an uninsured or underinsured long term care event.

HECM Reverse Mortgage – Insurance for Sequence of Returns Risk

A proactive planning solution that can be used strategically by homeowners beginning at age 62 to insure against sequence of returns risk is a home equity conversion mortgage, otherwise known as a HECM reverse mortgage. I recommend that you read Not Your Father’s Reverse Mortgage to familiarize yourself with HECMs and 5 Key Financial Metrics When Evaluating a HECM Reverse Mortgage to learn about an objective process for analyzing a HECM in any situation.

While there are several potential strategic uses of a HECM, one of the most, if not the most, important is to insure against sequence of returns risk. This is due to the fact that sequence of returns risk, by definition, is applicable to the first few years of retirement. The risk of portfolio depletion, if not protected, can increase significantly in the event that negative returns are experienced during this critical period.

How a HECM Reverse Mortgage Can Insure Against Sequence of Returns Risk

The best way to illustrate how a HECM reverse mortgage can insure against sequence of returns risk is with an example. In addition to the five assumptions used in Scenarios #1, #2, and #3, Scenario #5 – Bad Early Years with HECM Mortgage includes the following 13 assumptions:

  1. Apply for HECM at age 62.
  2. No mortgage when applying for HECM mortgage.
  3. Appraised home value of $1 million with assumed annual appreciation of 4%.
  4. HECM mortgage of 48.64% of the maximum 2021 FHA claim, or insurable, amount of $822,375, or $400,000, is approved.
  5. Initial mortgage insurance premium of 2% of $822,375, or $16,448.
  6. Initial loan amount is $25,000, which is equal to the total closing costs, including mortgage insurance premium of $16,448, origination fee of $6,000, and other closing costs totaling $2,552.
  7. HECM mortgage variable interest rate of 3.5% with a ceiling of 8.5%.
  8. Interest rate of 3.5% remains unchanged for the life of the loan.
  9. Annual mortgage insurance premium of 0.5% of the outstanding balance.
  10. No payments made on the HECM mortgage.
  11. Initial credit line of $375,000 (approved mortgage of $400,000 less initial loan amount of $25,000).
  12. Credit line variable interest rate of 3.5% with a ceiling of 8.5%.
  13. 100% of all withdrawals are taken from the credit line in years in which the investment account return is negative.

Per Scenario #5, withdrawals totaling $154,545 are taken from the HECM credit line instead of from the investment account from age 65 through age 67 when returns are -18%, -12%, and -3%, respectively. Withdrawals of $61,494 and $73,427 are also taken from the HECM credit line at age 72 and 78, respectively, when returns are -2% and -6%. Withdrawals from the HECM credit line total $289,465.

The strategy of taking tax-free withdrawals from the HECM credit line instead of the investment account in negative years results in the preservation of the investment account for the life of the plan. The effectiveness of this strategy in this scenario is supported by the following additional facts:

  • The strategic withdrawals from the HECM credit line totaling $289,000 during the five negative return years, including $155,000 in the first three years, enabled the investment account to sustain itself for the duration of the plan.
  • Whereas 100% of the HECM credit line withdrawals totaling $289,000 were tax-free, the investment account withdrawals during the same period in the non-HECM plan were fully taxable as ordinary income assuming a non-Roth retirement investment account and were potentially taxable as capital gains in a non-retirement account.
  • The HECM credit line resulted in withdrawals from the investment account and credit line totaling $1.927 million ($1.638 million from the investment account plus $289,000 from the HECM credit line), or $845,000 more than the total withdrawals of $1.082 million in the non-HECM plan in Scenario #3.
  • The investment account value in the HECM plan was $586,000 when the non-HECM investment account was depleted at age 81.
  • The investment account value in the HECM plan was $110,000 at age 90.
  • Despite the fact that withdrawals from the HECM credit line totaled $289,000, the credit line, which had a balance of $375,000 at age 62, increased to $419,000 at age 90.
  • The combined balance of the investment account of $110,000 and HECM credit line of $419,000 resulted in total liquidity of $529,000 at age 90.

Cost of HECM Mortgage

The foregoing benefits associated with the HECM plan did not occur without cost. Obtaining insurance against sequence of returns risk and associated depletion of the investment portfolio came at a cost of $742,000, which was the amount of the HECM mortgage balance at age 90.

The HECM plan cost of $742,000 was well worth it when you consider the fact that the investment portfolio was intact at age 90 vs. depleted at age 81 in Scenario #3. Four other factors supporting the HECM strategy are as follows:

  • Additional withdrawals of $845,000, $289,000 of which was tax-free.
  • Liquidity of $529,000 at age 90.
  • $419,000 of liquidity was in the HECM credit line which could have been used strategically for other purposes, including paying for long term care needs.
  • Appreciation of the house of $2.119 million (value of $3.119 million at age 90 less $1 million at age 65) exceeds the mortgage balance of $742,000 by $1.377 million.

Two essential keys to this successful outcome include the fact that the HECM mortgage was obtained at age 62, the first year of eligibility, and there was no existing mortgage balance. This accomplished two things: (a) maximization of the HECM credit line and (b) minimization of the HECM mortgage balance.

Conclusion

Negative returns in the first few years of retirement, if not protected from sequence of returns risk, can significantly increase the possibility of premature portfolio depletion. A HECM mortgage, with its accompanying credit line, provides tax-free liquidity during this critical period to insure against this risk in lieu of taking potentially taxable distributions from an investment account that’s declining in value.

The proposed strategy enables you to ride out the storm whenever there are downturns in the market. It protects you from the temptation to sell when the market is on its way down and attempting to time the market when buying back in, both of which are generally losing propositions. All of this translates to peace of mind during the most critical stage of retirement, i.e., the first few years, that can last for the duration of retirement with proper 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!

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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 Retirement Income Planning

How to Enjoy a Guilt-Free Retirement

Blaming you. Anxious man judged by different people pointing fingers at him. Negative human emotions feeling

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

Tilney, a highly-regarded financial planning firm in England where workers are automatically enrolled in employer pension plans unless they opt out, surveyed 1,300 employees in 2018 regarding what they planned to do with their pension when they retire. The results were as follows:

  • 40% said they didn’t know what they would do.
  • 22% said they expected to keep most of it invested, taking some withdrawals.
  • 10% would potentially cash it all in.
  • 10% would use the pension to buy an annuity.

When the word “annuity” was removed as an option and replaced with a “pension that provided a guaranteed income for life,” 79% of respondents said that this was more appealing than a plan where the value and income varied each year. This was the result despite the disclosure that a traditional investment plan offered the prospect for higher returns.

Annuitized Income Enables Guilt-Free Spending in Retirement

David Blanchett and Michael Finke’s recent research paper, Guaranteed Income:  A License to Spend, confirms Tilney’s survey results. Their ThinkAdvisor article, Why Annuities Work Like a “License to Spend” in Retirement, which summarizes their research, discusses the behavioral costs that may be experienced by retirees who fail to annuitize. Two of their key findings are as follows:

  • Retirees who are behaviorally resistant to spending down savings may better achieve their lifestyle goals by increasing the share of wealth allocated to annuitized income.
  • An annuity can not only reduce the risk of an unknown lifespan, it can also allow retirees to spend their savings without the discomfort generated by seeing one’s nest egg get smaller.

Annuitized income, whether the source is pensions, fixed income annuities, or Social Security, enables guilt-free spending in retirement. To the extent that the start date for Social Security benefits is delayed resulting in a higher lifetime benefit, this increases the enjoyment.

Income Annuities May Give Retirees a Psychological License to Spend

Perhaps Blanchett and Finke’s most interesting finding, which also confirms Tilney’s survey results, is that annuities may give retirees a psychological “license to spend” their savings in retirement. Blanchett and Finke cited the fact that “Surveys reveal a clear preference among retirees to live off income, and many don’t feel comfortable spending down assets to fund a lifestyle.”

Blanchett and Finke found that retirees who hold more of their wealth in guaranteed, or sustainable, income spend significantly more each year than those who depend on traditional investments. Specifically, retirees with similar wealth who have sustainable income will spend twice as much each year in retirement. Per Blanchett and Finke’s article, “every $1 of assets converted to guaranteed income will result in twice the equivalent spending compared to money left invested in a portfolio.”

Timing of Converting Assets to Sustainable Income

Assuming that you don’t want to depend exclusively on an investment portfolio for your retirement needs and you would like to include a “psychological license to spend” strategy with sustainable income as part of your retirement income plan, when should you purchase fixed income annuities?

The timing of fixed income annuity purchases, as well as purchase amounts, types of annuities, and location, i.e., nonqualified vs. qualified account, is best determined as part of a holistic retirement income plan. The objective of a retirement income plan is to optimize projected after-tax lifetime income to pay for projected inflation-adjusted expenses during different stages of retirement.

Income optimization, rather than investment return, 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.

Enjoy a Guilt-Free Retirement

My personal experience as a financial advisor specializing in analyzing, recommending, and implementing retirement income planning strategies for clients for the last 12 years confirms David Blanchett and Michael Finke’s research. Clients who have retirement income plans that include a sustainable income component are more confident about their prospects for a successful retirement, less fearful of running out of money, and more likely to enjoy a guilt-free retirement.

In the unsolicited words of one of my long-time clients, “At 70 years old it’s good to reflect back on how a great financial advisor has set my wife and I up for a steady income stream so we can enjoy these senior birthdays very comfortably regardless of the stock market or politics that can affect a person’s retirement years.”

Furthermore, the earlier a “psychological license to spend” strategy with sustainable income is implemented as part of a holistic retirement income plan, the sooner pre-retirees and retirees are able to sleep better at night. The title of a recent Kiplinger article, Retirees with a Guaranteed Income are Happier, Live Longer, says it all.

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
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.

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Retirement Income Planning Roth IRA

Should You Do a Roth IRA Conversion After Age 62?

Traditional IRA and Roth IRA text on a book isolated on office desk.

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

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. Roth IRA conversions are under-utilized even though they can provide greater after-tax retirement income than would otherwise be possible.

The primary reason for this is a reluctance to plan for and prepay income tax liability attributable to conversions. This is the case even though current historic low-income tax rates and wide income brackets favoring Roth IRA conversions are slated to be replaced by higher pre-2018 tax rates and narrower income brackets beginning in 2026.

Potential Medicare Part B Premium Reduction

One of the benefits of converting taxable retirement income to nontaxable Roth IRA income through Roth IRA conversions is the potential reduction of Medicare Part B premiums beginning at age 65. After-tax retirement income will be increased to the extent that this can be accomplished.

Medicare Part B premiums are income sensitive. They’re determined using modified adjusted gross income (MAGI) from your federal income tax return two years prior to the current year. You can potentially reduce your spouse and your Medicare Part B premiums to the extent that you’re able to reduce your income beginning at age 63 through prior year Roth IRA conversions.

There are six income brackets that are used to determine monthly Medicare Part B premium amounts. In 2020, the premium amounts range from $144.60 to $491.60 per person. An Income Related Monthly Adjustment Amount (IRMAA), or surcharge, is assessed beginning when your MAGI exceeds $87,000 for an individual return or $174,000 for a joint return.

2020 Medicare Part B Premiums

Per the table, the IRMAA surcharge can increase monthly Medicare Part B premiums by as much as $347.00 ($491.60 – $144.60), or $4,164 per year for those in the highest tax bracket. This can result in additional annual premiums of double this amount, or $8,328 for a couple.

Medicare Part D drug plan monthly premiums are also subject to an IRMAA surcharge that ranges from $12.20 to $76.40 per person with the same income brackets as Medicare Part B.

Roth IRA Conversion Surcharge After Age 62

Although timely Roth IRA conversions can be used to decrease Medicare Part B and D premiums and increase after-tax income throughout retirement, there’s a potential price to pay if the conversions occur after age 62. You and your spouse, if married, will pay higher Medicare Part B and D monthly premiums two years after the year of the conversions if the taxable amount of your conversions causes you to jump into a higher Medicare income bracket.

As an example, suppose John and Mary, age 64 and 63, respectively, are married, and their 2018 modified adjusted gross income, or MAGI, is $228,000 prior to doing any Roth IRA conversions. Let’s assume that John and Mary do conversions of $23,000 and $22,000, respectively, for a total of $45,000.

Fast forward two years to 2020 when John and Mary are 66 and 65, respectively, and are both on Medicare Part B. Using John and Mary’s 2018 MAGI of $228,000 prior to their Roth IRA conversions of $45,000, their monthly Medicare Part B premiums would be $289.20 each. They would pay a total of $3,470.40 each for the year, or $6,940.80 for both.

John and Mary’s actual 2018 MAGI is $228,000 increased by their taxable Roth IRA conversions of $45,000, or $273,000. This causes John and Mary to jump into the $272,001 to $326,000 Medicare income bracket, increasing their monthly Part B premiums from $289.20 to $376.00 each.

John and Mary’s total 2020 Medicare Part B premiums are $4,512.00 each, or $9,024.00 for both. In summary, John and Mary’s 2018 taxable Roth IRA conversions of $45,000 resulted in an increase in their 2020 Medicare Part B premiums of $2,083.20 ($9,024.00 – $6,940.80).

Should You Do Roth IRA Conversions After Age 62?

John and Mary’s situation begs the question, should you do Roth IRA conversions after age 62 given the fact that they can potentially increase Medicare Part B and D premiums that you would otherwise pay without the conversions?

Assuming your goal is to minimize potential increases in Medicare premiums resulting from Roth IRA conversions, a staged Roth IRA conversion plan should be established 15 to 20 years before age 62. By starting your plan when you’re in your 40’s, you take the pressure off since you can convert smaller amounts and pay less tax each year on your conversions than would otherwise be possible if you begin your plan later.

Conversion amounts don’t have to, and generally shouldn’t, be the same each year. Current historic low federal income tax rates and wide tax brackets favor higher conversion amounts through 2025. In addition, strategic Roth IRA conversion opportunities, which can be discovered and analyzed through tax planning, as well as market-sensitive conversions, should always be on your radar.

Although the timely establishment and implementation of an ongoing staged Roth IRA conversion plan won’t necessarily result in the conversion of 100% of taxable retirement plan assets to Roth IRA accounts by age 63, it can provide the following nine benefits:

Given the fact that the foregoing nine benefits of a staged Roth IRA conversion plan work together to optimize lifetime after-tax retirement distributions, it makes sense to continue doing income tax-sensitive strategic Roth IRA conversions after age 62. Paying increased Medicare Part B and D premiums in one or more years, the amount of which can be minimized through Medicare income bracket planning, is usually a small price to pay to accomplish this goal.

Finally, remember to include your Part B, Part D, and supplemental Medicare premiums in the above-the-line deduction for health insurance premiums on your income tax returns if you’re self-employed. This will soften the blow in years when Roth IRA conversions increase your premiums and throw you into a higher Medicare income bracket.

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Income Tax Planning IRA Retirement Income Planning Roth IRA

Contribute Your 2020 RMD to a Roth IRA

Childlike seniors wearing superhero costumes

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.

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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.

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Annuities Deferred Income Annuities Long-Term Care Retirement Income Planning Roth IRA Social Security

5 Lifetime Valentine’s Day Gifts for Your Spouse

Valentine day background with red hearts, top view - Image

The mad scramble is on. With Valentine’s Day just around the corner, what should you buy your spouse to show him/her your everlasting love and appreciation? Forget about traditional gifts such as roses and chocolate that are short-lived and just as quickly forgotten.

Here are five unique ideas you won’t find on Amazon that are designed to fulfill you and your spouse throughout your life. A word of caution:  Brush up on your presentation skills since each one will likely be met with dead silence or outrage depending upon the mood of your spouse.

VD Gift Idea #1:  Eliminate Your Mortgage by Retirement

One of the biggest cash flow challenges for many retirees is their mortgage. When you apply for a mortgage while you’re working, the mortgage amount and associated monthly payment is determined using your employment income.

Although your employment income generally increases, so do your expenses. When you retire, your guaranteed sources of income that are available to cover your mortgage payments are often a small percentage of your former employment income.

Given this common scenario, you should design a plan to eliminate your mortgage by retirement whenever possible. This can include an increase in your monthly payment amount, making bi-weekly payments, or using a portion of bonuses to reduce your outstanding balance. Your plan should be part of an overall strategy that includes various savings vehicles.

VD Gift Idea #2:  Defer Your Social Security Start Date

When your spouse dies, you can generally receive 100 percent of his/her Social Security retirement benefit if (a) the amount exceeds your benefit and (b) you have reached your full retirement age, which is between 66 years and two months and 67 depending upon when you were born. This is the good news.

The bad news is that the monthly amount that you receive for your lifetime could be significantly less than what you would otherwise qualify for depending upon when your spouse began collecting his/her benefits. The difference could be as much as 77% if he/she began collecting benefits at age 62 vs. waiting until 70.

Assuming that your Social Security benefit will be greater than your spouse’s, you’re in good health, you have other financial resources, and your goal is to maximize your spouse’s benefit in the event that you predecease him/her, it behooves you to defer your Social Security starting date as long as possible, up to age 70.

VD Gift #3:  Start a Staged Roth IRA Conversion Plan

While there are several benefits of a staged, or multi-year, Roth IRA conversion plan, one of the least publicized is the ability to reduce a widow or widower’s income tax liability. This is due to the fact that surviving spouses who don’t remarry are subject to higher income taxes.

Distributions from Roth IRA accounts, unlike traditional 401(k) plans and IRAs, generally aren’t taxable. A staged Roth IRA conversion plan can be used when both spouses are alive to convert otherwise taxable assets to nontaxable assets. Although income tax will probably need to be paid on the conversion amounts, the amount will be less in many cases than what will be payable by the surviving spouse, especially if income tax rates increase which is likely after 2025.

VD Gift #4:  Include Sustainable Lifetime Income in Your Retirement Plan

When you retire, you want to minimize sleepless nights by knowing that you have, and will continue to have, sufficient income to cover your expenses. Designing a plan that will provide you and your spouse with sustainable after-tax income streams to cover your non-discretionary expenses throughout different stages of retirement is an effective way to accomplish this goal.

There are five reasons for including sustainable lifetime income in your retirement plan that will benefit you and your spouse:

  • Hedge against longevity
  • Match income to projected expenses
  • Protect against the sequence of returns
  • Increase cash flow from potential income tax savings
  • Simplify your financial life

VD Gift #5:  Create an Extended Care Plan

I saved this idea for last since, although it’s potentially the most beneficial one, it’s also likely to be met with the most resistance. Previously suggested as a birthday gift for parents, it’s also suitable for one’s spouse on Valentine’s Day.

Extended care is the least understood and most under-planned for life event. When it’s needed, extended care takes its biggest toll on family and friends in the absence of a plan. Studies have shown that providing extended care for an individual who is chronically ill can have a devastating effect, both emotionally and financially, on caregivers.

An extended care plan may or may not include long term care insurance. When included, long term care insurance provides a predictable, readily available, tax-free source of funds that can be used to pay for a portion, or potentially all, of one’s extended care expenses without disrupting one’s retirement income plan.

The Gifts That Keep on Giving

While the foregoing Valentine’s Day gift suggestions aren’t traditional and won’t provide immediate gratification, each one is designed to fulfill you and your spouse throughout your life. Furthermore, all of them will eventually be appreciated by both of you, even after the other is gone.

If you’re looking for the ultimate gift, include each one as part of a comprehensive retirement income plan. Financial advisor sold separately. Finally, don’t forget the card. Happy Valentine’s Day!

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!

Categories
Income Tax Planning Retirement Income Planning Roth IRA

Is Your Widow(er) Included in Your Income Tax Plan?

Widow looking at the photo of her dead husband

Most of the time when we do income tax planning it’s motivated by one or more transactions that have occurred or may occur in the current year. A common example would be the proposed sale of a rental property. Depending upon the particular facts, the sale could trigger income tax liability or savings, the latter occurring when there are passive loss carryovers. Either way, preparation of an income tax projection to determine the appropriate course of action given one’s financial situation and financial goals would be prudent.

Rarely do we look ahead and do income tax planning for multiple years. In addition, married couples, especially those who are young and in good health, don’t like to think about, let alone plan for, the possibility of losing their spouse.

Married vs. Surviving Spouse Example

Unfortunately, the income tax law isn’t 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. The best way to illustrate this is with an example.

Let’s assume that John and Susan, who live in California, have the following income that they will report on their 2019 income tax returns:

  • Qualified dividends – $5,000
  • Rental property net income – $40,000
  • John’s Social Security – $20,000
  • Susan’s Social Security – $40,000
  • Traditional IRA required minimum distributions – $56,000
  • Fixed income annuity income distribution – $24,000

Let’s also assume that John and Susan’s standard deduction, the amount of which is $27,000, exceeds their total itemized deductions. After excluding 15%, or $9,000, of their Social Security benefits from taxation, John and Susan’s taxable income is $149,000. Their federal and California income tax liability is $24,200 and $4,300, respectively, for a total of $28,500.

Suppose instead that John died in 2018 and Susan hadn’t remarried as of the end of 2019. No matter which day John’s death occurred, Susan would have been allowed to use married filing joint status for 2018.

Assume that all income items are unchanged in 2019 with the exception of John’s Social Security of $20,000 which is eliminated. This would result in a reduction in total income of $17,000 after the 15% Social Security exclusion. As an aside, the exclusion can be as much as 100% depending upon one’s other income.

Widow(er) Penalties

As a surviving spouse, Susan will be subject to several widow penalties that will result in greater 2019 federal and California income tax liability than would have been the case had John not died in 2018. The first penalty that Susan encounters is a 49% reduction in the standard deduction she can claim, going from $27,000 if John was still alive to $13,850. This results in taxable income of $145,150 for Susan.

Even though Susan’s taxable income is $3,850 less than John and Susan’s taxable income of $149,000, Susan is hit with widow penalty #2, i.e., increased marginal federal tax rate. This is now 24% vs. 22% when Susan was married. This increases her federal income tax liability by $4,400, or 18%, going from $24,200 to $28,600.

The state of California is also unsympathetic toward widows and widowers. Although Susan’s California adjusted gross income of $125,000 is identical to when she was married due to the fact that California doesn’t tax Social Security benefits, she is subject to three penalties as a single taxpayer:

  • 50% reduction in allowable standard deduction, decreasing from $8,802 to $4,401
  • Higher effective tax rate of 7% vs. 4.6%
  • 50% reduction in personal exemption credit

The foregoing penalties increase Susan’s California income tax liability by $3,700, or 86%, going from $4,300 when she was married to $8,000. Susan’s total 2019 income tax liability is $36,600 which is $8,100, or 28.4%, greater than John and Susan’s 2019 income tax liability of $28,500.

Income Tax Planning Opportunity

Surviving spouses, especially older ones, often don’t remarry. This needs to be considered in income tax plans knowing that widow(er) penalties often result in increased income tax liability. This approach also dovetails with the retirement income planning goal of optimizing after-tax retirement income to cover projected expenses and prolong the life of investment assets.

The use of income acceleration strategies increases in importance when you combine widow(er) penalties with the window of opportunity offered by the Tax Cuts and Jobs Act of 2017. The wider income tax brackets and lower income tax rates that went into effect in 2018 end in 2025. Many income tax professionals, including myself, are of the opinion that income tax rates will increase in 2026 given the multiple financial and associated budget challenges we face as a country.

Timely Roth IRA conversions are at the top of my list of income acceleration strategies for clients who understand that it can make sense to prepay income tax in order to increase longevity of investment assets. There are two types of timely Roth IRA conversions:  strategic and market-sensitive.

Strategic conversions take advantage of opportunities to minimize income tax liability associated with the conversion, e.g., a rental property suspended loss.  Market-sensitive conversions take advantage of sizable stock market declines without attempting to time the market.

The goal of Roth IRA conversions is to optimize lifetime after-tax distributions. Strategic and market-sensitive Roth IRA conversions can accomplish this in four ways:

  • Elimination of income tax on appreciation of Roth IRA accounts
  • Reduction of required minimum distributions (RMDs) and associated income tax liability to the extent that funds have been transferred from tax-deferred non-Roth qualified retirement plans and traditional IRA accounts to nontaxable Roth IRA accounts
  • Potential reduction of taxable Social Security benefits as a result of reduced RMDs subject to amount of other income
  • Potential reduction of Medicare Part B premiums as a result of reduced RMDs and modified adjusted gross income

Elimination of income tax on appreciation of Roth IRA accounts and reduction of RMDs and associated income tax liability can potentially reduce widow(er) penalties. If you’re married and are hesitant about prepaying income tax in connection with a proposed Roth IRA conversion, think about the increased income tax liability your widow(er) may incur.