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IRA

To IRA or Not to IRA?

Retirement Income Center

Without going into the details, IRA contributions may be deductible, non-deductible, or partially deductible. Assuming that you’re eligible to make a deductible contribution, should you do it? As with all financial decisions, it depends upon the facts.

Let’s assume that you’re married, you’re both 50 years old, neither one of you is an active participant in an employer-sponsored retirement plan, and your marginal federal income tax rate is 25%. Given this scenario, you would be eligible to make deductible IRA contributions of up to $6,000 each, for a total of $12,000. Forgetting about a potential state income tax deduction, assuming you make maximum contributions, you will reduce your income tax liability by $3,000 ($12,000 x 25%). Looking at it another way, the cost of your IRA contributions is $9,000 ($12,000 less income tax savings of $3,000).

Since your spouse and you are both 50 years old, you’re both eligible to make IRA contributions for another 20 years until age 70-1/2. Assuming that you both continue not to be active participants in an employer-sponsored retirement plan, you will be able to make deductible IRA contributions totaling at least $240,000 ($12,000 x 20), excluding potential additional contributions permitted by legislated contribution limit increases. Per Exhibit 1, after making contributions totaling $240,000, 25%, or $60,000 of which was financed by federal income tax savings, resulting in net out-of-pocket total contributions of $180,000 ($240,000 less income tax savings of $60,000), and assuming earnings of 5%, the total value of both of your IRA’s in 20 years is projected to be approximately $417,000.

That’s pretty awesome. Why wouldn’t you implement this plan? Keeping in mind that a deductible IRA plan is a tax-deferral plan, even though you may receive income tax deductions of $12,000 a year, or a total of $240,000 over 20 years, you, and potentially your heirs, will eventually pay income tax on 100% of your contributions. This must occur beginning at age 70-1/2 when you will be required to take minimum withdrawals from your plan that are calculated each year using the value of your IRA on December 31st of the previous year and your current age. Furthermore, the tax rate on your IRA withdrawals may be greater than the rates at the time when you made your contributions, resulting in greater tax liability than the tax savings you received from your contributions.

As an alternative, especially if you have other qualified retirement plans, you may want to consider taking the same $12,000 and instead make nondeductible contributions to a nonretirement investment account. Administratively, this will be easier since, unlike the IRA situation where you must deposit $6,000 into two separate accounts each year assuming you’re married, you can deposit 100% of your contributions into a single account. Furthermore, unlike an IRA which has an annual contribution limit of $5,000 or $6,000 if you are at least 50 years old, there is no cap on the amount of contributions that may be made to a nonretirement investment account.

To the extent that the investments in your nonretirement account don’t produce current taxable income, they will enjoy tax-deferred growth similar to an IRA. Unlike an IRA where withdrawals are taxable as ordinary income, withdrawals from nonretirement investment accounts are nontaxable. Instead, the sales of securities needed to produce the withdrawals are subject to capital gains. Assuming the securities that are sold have been held for at least a year, under current tax law, any gains, i.e., the excess of sale prices over purchase prices, will be taxed at favorable long-term capital gains rates which in most cases is 15%. To the extent that there is a loss on any sale, it can be offset against capital gains from other sales. Total capital losses in any year are deductible to the extent of capital gains plus an additional $3,000, with any net excess losses carried forward to future years. The availability of existing capital loss carryovers makes this alternative plan even more attractive (See last week’s post, Sizeable Capital Loss Carryover? Rethink Your Retirement Plan Contributions).

Even though a nondeductible nonretirement investment account plan may be preferable to a deductible IRA plan in certain situations, there is greater discipline associated with implementing and maintaining the former plan. Unlike a deductible IRA plan, the absence of the incentive of an annual tax deduction associated with a nonretirement plan generally requires an automatic contribution plan to be in place to ensure that regular contributions are made to the plan each year.

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Roth IRA

Roth IRA Conversion Insights – Part 2 of 2

Retirement Income Center

Last week’s post discussed the first three insights to be gained from analyzing two scenarios – one with no Roth IRA conversion and a second with a Roth IRA conversion – that were presented in the April 25, 2011 post, Roth IRA Conversions – Don’t Let the Tax Tail Wag the Dog – Part 6 of 6. This week’s post addresses three additional insights that can be used when confronted with a Roth IRA conversion decision.

Availability of Nonretirement Investment Assets is Essential

As we saw in the two scenarios in Part 6, the availability of nonretirement investment assets is essential (1) in meeting financial needs prior to distributions from a traditional IRA account where there will be no Roth IRA conversion and (2) in fulfilling income tax obligations related to (a) Roth IRA conversions or (b) distributions from traditional IRA accounts in the case of non-conversion.

In the case of nonconversion, insufficient retirement assets to (a) pay the income tax liability attributable to required minimum distributions (“RMD’s”) from traditional IRA accounts and/or (b) meet ongoing financial needs will result in larger distributions from traditional IRA accounts that will in turn result in a larger income tax liability. Per Exhibit 1 of Part 6 of Roth IRA Conversions – Don’t Let the Tax Tail Wag the Dog, the traditional IRA account distribution increased by 30% in the year that this occurred vs. the approximate 5% annual increases attributable to increasing RMD’s up until that point.

Whenever you do a sizeable Roth IRA conversion or series of conversions and the Roth IRA conversion income isn’t sheltered by offsetting losses and/or deductions, a sizeable income tax liability will arise. Per Exhibit 2 of Part 6, there was total Roth IRA conversion income of approximately $236,000 resulting in associated income tax liability totaling approximately $71,000, or 30% of the amount of the conversions over five years. As a result of this immediate and substantial drain of cash, when it came time for taking distributions to meet retirement needs beginning at age 65, the remaining assets in the nonretirement account could only sustain six years of withdrawals before the account was depleted.

Calculation of Projected Capital Gains and Losses is Important

While it was assumed in both scenarios that there would be no capital gains or losses in connection with withdrawals from the nonretirement investment account, the calculation of projected capital gains and losses is important to simulate real life. Unless cash is readily available, there will be a taxable transaction any time that a withdrawal is taken from a nonretirement investment account. As we saw in Exhibits 1 and 2, this will occur in the following three situations:

  1. Income tax liability attributable to a Roth IRA conversion or series of conversions
  2. Ongoing distributions to meet retirement needs
  3. Income tax liability attributable to distributions from traditional IRA accounts

Depending upon the value vs. cost basis of the assets that are liquidated to generate the cash for the withdrawal, there will either be a capital gain or a capital loss. Furthermore, capital gains will either be short- or long-term depending upon how long the assets were held before they were sold, with the latter resulting in favorable tax treatment. To the extent that net capital gains are generated, additional withdrawals from nonretirement accounts will be required to pay the income tax liability attributable to the gains. On the other hand, annual net capital losses in excess of $3,000 can be carried forward to offset future years’ capital gains.

Worst Case Assumptions Should Always be Used

Given the fact that, per insight #1 of Part 1 that actual results are likely to be different than projected results, worst case assumptions should always be used in the preparation of any Roth vs. non-Roth IRA conversion analysis. While there’s a natural tendency to use current interest, inflation, and income tax rates in all projection years since we’re familiar with these rates and it’s easy to do, there’s a strong likelihood that the projected results will be flawed, especially given today’s historic low rates for all three of these items. While many of my readers may not be old enough, I remember 15% interest and 13% inflation rates when I reentered the working world after receiving my MBA in 1980.

In addition to using worst case assumptions, multiple Roth vs. non Roth IRA projections should be prepared to simulate a wide range of possibilities. Having said this, you don’t want to prepare so many projections that you suffer from analysis paralysis.

I hope that the six-part Roth IRA Conversions – Don’t Let the Tax Tail Wag the Dog plus this two-part Roth IRA Conversion Insights series enables you to look at Roth IRA conversions from a new perspective.

Categories
Roth IRA

Roth IRA Conversions – Don’t Let the Tax Tail Wag the Dog – Part 6 of 6

Retirement Income Center

Parts 3, 4, and 5 of this six-part series discussed the three primary benefits to be derived from a Roth IRA conversion: (1) elimination of taxation on 100% of the growth of Roth IRA conversion assets, (2) elimination of exposure to required minimum distributions on traditional IRA funds converted to a Roth IRA, and (3) potential reduction in taxation of Social Security benefits.

This week’s post compares a scenario with no Roth IRA conversion to a second scenario with a Roth IRA conversion to determine which one is projected to result in more total investment assets throughout the life of the scenario. Benefit #3, i.e., potential reduction in taxation of Social Security benefits, isn’t included in the Roth IRA conversion scenario since, as stated in Part 5, this benefit is less certain than the other two and there are enough moving parts in both scenarios without including this possibility.

The decision whether or not to do a Roth IRA conversion is extremely complicated with many variables that need to be considered, a change in any one of which could significantly affect the results. Given this fact, it’s critical to understand that the results of the two scenarios presented in this blog post cannot be generalized and used as the basis for determining whether a Roth IRA conversion is appropriate for a particular situation. A detailed analysis needs to be prepared by a qualified retirement income planner for every potential Roth IRA conversion situation.

The following is a list of seven assumptions common to both scenarios:

  1. There are initially two investment accounts – a nonretirement investment account and a contributory IRA account.
  2. The scenario begins at age 50, at which time the value of each of the investment accounts is $200,000, and ends at age 85.
  3. The annual rate of return of the nonretirement and IRA accounts (contributory and Roth) is 2% and 6%, respectively.
  4. Retirement age is 65 at which time annual withdrawals of $30,000 increasing by 3% to pay for living expenses begins.
  5. There will be additional withdrawals required to pay for income tax liability attributable to the IRA withdrawals and Roth IRA conversions at an assumed combined federal and state rate of 30%.
  6. There will be annual required minimum distributions (“RMD’s”) from the contributory IRA account beginning at age 70-1/2 based on the value of the account on December 31st of the previous year using divisors obtained from the Uniform Lifetime Table.
  7. There are no capital gains in connection with withdrawals from the nonretirement investment account.

In addition to the foregoing seven assumptions, the Roth IRA conversion scenario assumes annual Roth IRA conversions of $50,000 beginning at age 50 through age 53 with a final conversion of the balance of the contributory IRA account at age 54.

Exhibit 1 assumes no Roth IRA conversion. It’s fairly straightforward from age 50 through age 64, with both investment accounts simply growing by their assumed rates of return of 2% and 6%, respectively. The annual withdrawals of $30,000 increasing by 3% begin at age 65 with the initial source of 100% of the withdrawals coming from the nonretirement investment account. The nonretirement investment account withdrawals are reduced by the contributory IRA account RMD’s beginning at age 70-1/2, the initial amount of which is projected to be approximately $24,000, however, they are increased by the income tax attributable to the IRA account withdrawals at an assumed rate of 30%. As a result, the total withdrawals from both accounts is projected to increase from approximately $34,000 at age 69 to approximately $42,000 ($18,000 + $24,000) at age 70.

When the value of the nonretirement investment account is no longer sufficient to fund the difference between the annual inflated living expenses of $30,000 and the IRA account RMD’s plus the income tax attributable to the RMD’s, which occurs beginning at age 77, additional withdrawals from the IRA account above and beyond the RMD’s are required. Per Exhibit 1, the IRA account withdrawals are projected to increase from approximately $33,000 at age 76 to $43,000 at age 77. When the nonretirement investment account is depleted at age 78, the IRA account withdrawals are projected to jump from approximately $43,000 at age 78 to approximately $57,000 at age 78. The IRA account withdrawals increase by 3% each year plus income tax at a rate of 30% until they are projected to be approximately $70,000 at age 85.

Exhibit 2 assumes a staged Roth IRA conversion, with annual conversions of $50,000 from age 50 through age 53 and a final conversion of the balance of the contributory IRA account at age 54. Unlike Exhibit 1 in which there are no withdrawals from the nonretirement investment account before age 65, annual withdrawals of $15,000 for four years plus a final projected withdrawal of approximately $11,000, for a total of $71,000, are required to pay the income tax attributable to the annual Roth IRA conversions. After age 54, there are no further withdrawals required from any of the investment accounts to pay for income taxes since (1) the contributory IRA account is depleted at age 54 as a result of the Roth IRA conversions resulting in no RMD’s or other taxable withdrawals from this account, and (2) there is no income tax attributable to withdrawals from the Roth IRA account.

Per Exhibit 2, as a result of the age 50 – 54 withdrawals from the nonretirement investment account required to pay the income tax liability attributable to the annual Roth IRA conversions and the annual living expense distributions of $30,000 increasing by 3% beginning at age 65, this account is projected to be depleted at age 70 at which time the Roth IRA account will begin to be used to fund the difference. At age 71, a projected withdrawal of approximately $36,000 is taken from the Roth IRA account. This increases by 3% per year until the projected withdrawal amount is approximately $54,000 at age 85 which is approximately $16,000 less than the contributory IRA account projected withdrawal amount at age 85 per Exhibit 1.

Exhibit 3 is a comparison of the projected investment account values at each age for the “No Roth IRA Conversion” (Exhibit 1) vs. “Roth IRA Conversion” (Exhibit 2) scenario. Given all of the assumptions used in both scenarios, the total investment value of the “No Roth IRA Conversion” scenario is projected to be greater than the “Roth IRA Conversion” scenario from age 50 through age 80, with the projected difference increasing from approximately $74,000 at age 54 following the completion of the staged Roth IRA conversion to approximately $99,000 at age 69. The projected difference decreases each year until age 81 when the total value of the “Roth IRA Conversion” assets is projected to begin to be greater than the “No Roth IRA Conversion” assets.

Once again, as stated earlier in this post, it needs to be emphasized that the results of the two scenarios presented in this blog post cannot be generalized and used as the basis for determining whether a Roth IRA conversion is appropriate for a particular situation. Furthermore, a detailed analysis needs to be prepared by a qualified retirement income planner for every potential Roth IRA conversion. Some lessons, however, can be derived from this exercise that can be applied to individual planning scenarios that will be the subject of next week’s post.