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Retirement Income Planning

Nonretirement Investments – The Key to a Successful Retirement Income Plan

When was the last time someone asked you, “Hey, did you make your nonretirement investment plan contribution this year?” When we think of a retirement income plan, the first thing that typically comes to mind is retirement investments. This includes 401(k), 403(b), SEP-IRA, traditional IRA, Roth IRA, SIMPLE IRA, defined contribution, defined benefit, and other retirement plans. While the maximum allowable contribution varies by plan, the inherent goal of each of them is to provide a source of retirement funds.

With the exception of the Roth and nondeductible traditional IRA’s, both of which receive nondeductible contributions that grow tax-free provided certain rules are followed, all of the other plans enjoy tax-deferred growth. The reason that the growth isn’t nontaxable, and is instead tax-deferred, is because the source of funds for each of these plans is tax-deductible contributions. Whenever this is the case, although plan income, including interest and dividend income and capital gains aren’t taxed, plan distributions are taxable as ordinary income.

While it’s great that Congress has authorized the use of these various types of retirement plans and there are indisputable tax and other advantages associated with each of them, they generally aren’t sufficient for meeting most people’s retirement needs by themselves. Aside from the defined benefit plan, the contribution ceilings, especially those associated with traditional and Roth IRA plans, are inadequate in most cases for building a sizeable nest egg.

Recognizing this fact of life, it’s important to include nonretirement investments in most retirement income plans. What are nonretirement investments? These are simply the same types of investments that you find in retirement plans, i.e., stocks, bonds, mutual funds, exchange traded funds, annuities, CD’s, etc., however, ownership is different. Instead of these assets being owned by a 401(k) , SEP-IRA, Roth IRA, etc., they are owned by you, you and your spouse if married, or perhaps your living trust.

Nonretirement investments enjoy several advantages over retirement investments that make them attractive for funding retirement income plans. For one thing, although contributions to nonretirement investments aren’t tax-deductible, there also aren’t any annual limitations on the amount of contributions that can be made to them. Secondly, investments can be selected that have the potential to match the tax-deferred growth enjoyed by most retirement plans.

Nonretirement investments also offer tax advantages over their retirement plan counterparts when it comes to sales of assets. While gains from sales of assets in retirement plans are nontaxable, they are ultimately taxed as ordinary income at federal tax rates as high as 35% when distributions are taken from a plan. The same gains from sales of nonretirement assets, while they are immediately taxable, have the potential to enjoy favorable long-term capital gains rates of 15% in most cases assuming that the assets that have been sold have been held for more than one year. In addition, unlike losses resulting from sales of investments held within retirement plans that are non-deductible, the same losses in nonretirement plans are considered deductible capital losses.

One of the biggest advantages of nonretirement investments is the ability to control the timing of distributions and the associated exposure to income tax liability. This includes avoidance of required minimum distribution (“RMD”) rules. Beginning at age 70-1/2, with the exception of Roth IRA’s, you’re required to take minimum distributions from your retirement plans each year based on the value of each plan on December 31st of the previous year using an IRS table life expectancy factor, resulting in forced taxation. No such rules exist when it comes to nonretirement investments. In addition, unlike pre-age 59-1/2 distributions from retirement plans that are subject to a federal premature distribution penalty of 10% of the amount of the distribution, there are no such restrictions when it comes to nonretirement investments.

So what is the right mix of retirement vs. nonretirement investments? Read next week’s post to find out.

Categories
Roth IRA

Got Dormant 401(k)? Consider Converting to a Roth IRA

Last week’s blog post, Don’t Forget About Your SEP-IRA for Roth IRA Conversions, made the point that most people who are considering doing a Roth IRA conversion think about using a traditional IRA account into which deductible and/or nondeductible contributions have been made. Many people don’t realize that other types of retirement plans are also eligible for a Roth IRA conversion. One such plan is the popular 401(k).

Many employers allow former employees to keep their 401(k) plans intact, however, there’s an often-overlooked catch which I’ll get to shortly. As a result, 401(k) plans often lie dormant for years after an individual parts ways with his/her employer. In addition to limitation of investment choices, this can also result in an unpleasant surprise for a plan participant’s beneficiaries upon the plan participant’s death. This is due to the fact that employers that permit former employees to retain their 401(k) plans generally don’t allow them to do so indefinitely. Most plans require immediate distribution of plan assets at death, resulting in immediate taxation and the abrupt end of tax-deferred growth of the plan.

The lack of investment choices and the exposure to immediate taxation upon death are two great reasons, in my opinion, to move 401(k) plan assets into another tax-deferred vehicle as soon as possible following employment termination. Before 2008, besides a new employer’s 401(k) plan, the only choice available for rollover of 401(k) plan assets was a traditional IRA account. If you wanted to move your 401(k) plan assets into a Roth IRA, a two-step process was required whereby you first needed to roll 401(k) funds over to a traditional IRA account and then do a Roth IRA conversion of your traditional IRA.

As a result of a change made by the Pension Protection Act of 2006, beginning in 2008, funds from 401(k) plans can now be rolled directly to a Roth IRA via a Roth IRA conversion. Unlike 401(k) plans, with both Roth and traditional IRA’s, there are generally a myriad of investments from which you can choose, depending upon the financial institution you use as your custodian. Unlike traditional IRA’s where assets continue to grow tax-deferred until distributed, all pre-tax contributions and earnings are taxable upon conversion to a Roth IRA, with future earnings and growth accumulating tax-free inside the Roth IRA.

At a minimum, with limited exceptions which are beyond the scope of this blog post, most 401(k) plans should be rolled over to a traditional IRA upon separation from employment. Before doing this, however, a 401(k) plan participant should evaluate whether it makes more sense instead to do a Roth IRA conversion. As with all Roth IRA conversion decisions, there are many factors to consider. These include, but are not limited to, the size of the 401(k) plan, amount of pre-tax contributions and earnings, availability of losses and deductions to offset income from the conversion, current and projected income tax brackets, the plan participant’s age and general health, potential beneficiaries, and affect on taxation of Social Security benefits, Medicare premiums, and qualification for college financial aid.

Do you have a dormant 401(k)? If so, consider converting to a Roth IRA.

Categories
Roth IRA

The 45 to 60 5-Step Roth IRA Conversion Strategy – Part 4

Part 1 of this blog post introduced a 5-step Roth IRA conversion strategy for individuals 45 to 60 years old who either own a sizeable traditional IRA or have the opportunity to roll over a sizeable 401(k) plan or other retirement plan to an IRA. Steps 1 and 2 of this strategy was presented two weeks ago in Part 2 and steps 3 and 4 were discussed last week in Part 3.

This week’s post presents the fifth and final step together with a hypothetical case to illustrate the use of this strategy. If you haven’t done so already, I would recommend reading Parts 2 and 3 to learn about steps 1, 2, 3, and 4.

Step 5 – Complete Your Conversion Plan No Later Than the Year Before You Turn 70-1/2

As discussed in the January 11, 2010 blog post, Year of the Conversion, there are two main benefits of a Roth IRA that aren’t available to traditional IRA owners:

  1. Nontaxable distributions
  2. No required minimum distributions (“RMD’s”)

No one I know likes to be forced to do anything. In order to realize benefit #2, it’s important to target your conversion plan completion date for no later than the year before you turn 70-1/2. Once you reach this milestone, you will be required to take minimum distributions from your traditional IRA accounts each year based on your traditional IRA account value on December 31st of the preceding year and an IRS table life expectancy factor. Assuming that you complete your Roth IRA conversion plan by the year before you turn 70-1/2, you won’t be subject to the “RMD” rules.

Hypothetical Case

Now that we have completed our discussion of the 5-step Roth IRA conversion strategy, let’s take a look at a hypothetical case. Keeping in mind that you want to (a) have your 2010 conversion amount be larger than in subsequent years, (b) skip 2011 and 2012 if you deferred the taxation of your 2010 Roth IRA conversion income, (c) convert equal amounts thereafter, and (d) complete your conversion plan no later than the year before you turn 70-1/2, let’s make the following ten assumptions:

  1. Individual age 50 in 2010
  2. Sufficient liquid nonretirement assets to pay income taxes attributable to annual conversions
  3. SEP-IRA with beginning of 2010 value of $400,000 and cost basis of $0
  4. Earnings of 5%
  5. Annual SEP-IRA contributions of $20,000 through age 65
  6. 2010 Roth IRA conversion of $160,000
  7. Taxation of 2010 Roth IRA conversion deferred to 2011 and 2012
  8. No 2011 and 2012 Roth IRA conversions
  9. 2013 and subsequent year conversions of $45,000
  10. Final conversion at age 69 after which SEP-IRA account value = $0

Per the Hypothetical Roth IRA Conversion Strategy spreadsheet, the 2010 value of $400,000, total earnings of approximately $196,000, and total SEP-IRA contributions of $320,000 results in Roth IRA conversions totaling approximately $916,000 by age 69. Not only will the Roth IRA conversions of $916,000 not be subject to additional taxation, 100% of the growth of the Roth IRA funds will escape income taxation provided that the funds remain in the Roth IRA for at least five years from the beginning of the year of each conversion and until age 59-1/2.

It’s important to keep in mind that this is a hypothetical case and actual conversion amounts in a particular situation, assuming a Roth IRA conversion makes sense, will depend on many factors that need to be carefully analyzed for each conversion year.

Categories
IRA Roth IRA

The 45 to 60 5-Step Roth IRA Conversion Strategy – Part 3

Part 1 of this blog post introduced a 5-step Roth IRA conversion strategy for individuals 45 to 60 years old who either own a sizeable traditional IRA or have the opportunity to roll over a sizeable 401(k) plan or other retirement plan to an IRA. Last week’s post presented steps 1 and 2 of this strategy. This week’s post discusses steps 3 and 4. Step 5 will be presented in Part 4 together with a hypothetical case to illustrate the use of this strategy. If you haven’t done so already, I would recommend reading Part 2 to learn about steps 1 and 2.

Step 3 – Convert An Equal Amount Each Year Beginning in the Year After the Year(s) in Which You Recognize Your 2010 Conversion Income

If you deferred the taxation of your 2010 Roth IRA conversion income, you should plan on converting an equal amount of your traditional IRA to a Roth IRA each year from 2013 until you complete your Roth IRA conversion strategy in order to keep things simple and increase the likelihood of sticking with your plan. Alternatively, if you recognized your 2010 Roth IRA conversion income on your 2010 income tax returns, you should begin your “equalization” phase in 2011.

Depending upon income tax rates and your particular situation, there may be years when you will want to increase or decrease your conversion amount in order to minimize your income tax liability. To the extent that you do this, you will need to adjust your annual equalization amount going forward. You will also need to adjust your future annual equalization amounts for any additional contributions or rollovers to your traditional IRA as well as for any recharacterizations (See Recharacterization – Your Roth IRA Conversion Insurance Policy).

Step 4 – Complete Your Conversion Plan by Your Social Security Benefit Commencement Date If It Makes Sense

As a general rule, if possible, you should plan on completing your Roth IRA conversions by the date when you will begin receiving Social Security benefits. This will be much easier to accomplish if you begin your conversion plan between age 45 and 50 assuming that your traditional IRA is not increased by any sizeable contributions and/or rollovers after age 50.

Given the overriding goal of reducing the taxation of Social Security benefits and the fact that Social Security benefit taxation is directly influenced by the amount of your other taxable income, the absence of Roth IRA conversion income could reduce, or potentially eliminate, otherwise taxable Social Security benefits under current income tax laws.

Assuming your other income is projected to be sufficient to cover your expenses, it may even be advisable to defer your Social Security benefit commencement date so that you may extend your conversion period and, in turn, minimize your Roth IRA conversion income tax liability.

In addition, since the Medicare Part B, or medical insurance, premium amount is determined by one’s income, the absence of Roth IRA conversion income beginning at age 65 could help keep Medicare Part B premiums in check.

Depending upon your current age, it may not be prudent to complete your Roth IRA conversions by your Social Security benefit commencement date since doing so may require you to incur a substantial amount of income tax liability in connection with your Roth IRA conversion amounts. This is especially true if you’re 60 or older when you begin your conversion plan, you have a sizeable traditional IRA, and you aren’t planning on doing any conversions in 2011 and 2012 (see Step 2 in Part 2). In addition, if it is projected that you will have a substantial amount of income from other sources that is projected to result in taxation of your Social Security benefits, it probably won’t make sense in most cases to accelerate your Roth IRA conversion plan so that it is completed by your Social Security benefit commencement date.

For the fifth and final step of the 45 to 60 Roth IRA conversion strategy, watch for Part 4 next week.

Categories
Roth IRA

The 45 to 60 5-Step Roth IRA Conversion Strategy – Part 2

Part 1 of this blog post introduced a 5-step Roth IRA conversion strategy for individuals 45 to 60 years old who either own a sizeable traditional IRA or have the opportunity to roll over a sizeable 401(k) plan or other retirement plan to an IRA. This post presents steps 1 and 2 of this strategy, with steps 3 and 4 to be discussed in Part 3, and step 5 to be presented in Part 4 together with a hypothetical case to illustrate the use of this strategy.

Step 1 – Begin Your Plan in 2010 Using a Larger Conversion Amount Than in Subsequent Years

I’m recommending that you begin your Roth IRA conversion strategy in 2010 to take advantage of the one-time opportunity to defer 50% of the income from your 2010 conversion to 2011 and 50% to 2012 or, alternatively, take advantage of lower income tax rates in 2010 if you elect to include the income from your 2010 conversion on your 2010 federal income tax return if this makes more sense for you (see In Which Tax Year(s) Should You include Your 2010 Roth IRA Conversion Income – Parts 1, 2, and 3).

Given this unique tax planning opportunity, it will make sense in most cases to convert a larger portion of your traditional IRA to a Roth IRA in 2010 than in future years. I generally recommend to my clients a 2010 conversion amount of approximately 2-1/2 to 4 times the size of the annual subsequent year conversion amounts per Step 3 (See Part 3 next week), depending upon their current IRA value, the cost basis of their IRA, future planned IRA contribution amounts, and the total number of years over which conversions will be made.

Furthermore, if you will be doing a larger Roth IRA conversion in 2010, per my blog post two weeks ago (Be on the Lookout for Roth IRA Conversion Opportunities), it’s prudent to execute your conversion(s) following market declines whenever possible in order to convert the largest amount of your traditional IRA with the least amount of income tax liability.

Step 2 – Skip 2011 and 2012 If You Deferred the Taxation of Your 2010 Roth IRA Conversion Income

Assuming that you converted, or will convert, a sizeable portion of your traditional IRA to a Roth IRA in 2010 and will defer the taxation of your 2010 conversion to 2011 and 2012, with some exceptions, it probably won’t make sense in most situations to do any additional Roth IRA conversions in 2011 and 2012. Unless you have some significant tax sheltering opportunity, e.g., sale of rental property resulting in a large passive activity loss with minimal capital gains, net operating loss, large charitable contribution deduction from establishment and funding of a charitable remainder trust, etc., you should plan on skipping 2011 and 2012 Roth IRA conversions in order to avoid adding yet another layer of income onto your already bloated 2011 and 2012 taxable income.

So you know what to do for the next three years. What’s the plan after 2012? Stay tuned for Steps 3 and 4 in Part 3 next week.

Categories
Roth IRA

The 45 to 60 5-Step Roth IRA Conversion Strategy – Part 1

Are you 45 to 60 years old and either have a sizeable traditional IRA or have the opportunity to roll over a sizeable 401(k) plan or other retirement plan to an IRA? If so and you would like to enhance the likelihood of maximizing your retirement benefits, you should consider implementing a multi-year systematic plan to convert the vast majority, if not all, of your traditional IRA to a Roth IRA.

Ideally, you want to begin converting your traditional IRA to a Roth IRA beginning in 2010 and complete your conversion plan by the year that you will begin receiving Social Security benefits or no later than the year before you will turn 70-1/2. Your age, the value of your IRA, future contributions to your IRA, recharacterizations (See Recharacterization – Your Roth IRA Conversion Insurance Policy), income tax rates, income tax planning opportunities, and source of funds to pay the income tax liability attributable to your conversions will directly affect your actual annual conversion amounts as well as when you will complete your plan.

The last factor – source of funds to pay the income tax liability attributable to your conversions – needs to be carefully analyzed before you do a one-time conversion, let alone design a multi-year Roth IRA conversion plan. Per the January 25, 2010 post, Three Roth IRA Conversion “Show Stoppers,” if you don’t have sufficient funds in checking, savings, money market, and other nonretirement accounts outside of your IRA to pay the tax attributable to a Roth IRA conversion, you aren’t a good candidate for a Roth IRA conversion. The importance of this liquidity analysis is magnified in a multi-year plan.

Assuming that liquidity isn’t projected to be an issue and assuming there aren’t any other factors present that would negate the potential benefits to be derived from one or more Roth IRA conversions, there are five steps that should be included in a Roth IRA conversion plan for individuals who are 45 to 60 years old as follows:

  1. Begin your plan in 2010 using a larger planned conversion amount than in subsequent years.
  2. Skip 2011 and 2012 if you deferred the taxation of your 2010 Roth IRA conversion income.
  3. Convert an equal amount each year beginning in the year after the year(s) in which you recognize your 2010 conversion income.
  4. Complete your conversion plan by your Social Security benefit commencement date if it makes sense.
  5. Complete your conversion plan no later than the year before you turn 70-1/2.

Steps 1 and 2 will be addressed in Part 2 of this blog post, steps 3 and 4 will be discussed in Part 3, and step 5 will be presented in Part 4 together with a hypothetical case to illustrate the use of this strategy.