Annuities Celebration Income Tax Planning IRA Retirement Income Planning Roth IRA Social Security

Retirement Income Visions™ Celebrates 2-Year Anniversary!

Thanks to all of my subscribers and other readers, Retirement Income Visions™ is celebrating its two-year anniversary. Since its debut on August 16, 2009, Retirement Income Visions™ has published a weekly post each Monday morning, the theme of which is Innovative Strategies for Creating and Optimizing Retirement Income™.

As stated in the initial post two years ago, Retirement Income Visions™ Makes Its Debut, the importance of retirement income planning as a separate and distinct discipline from traditional retirement planning was magnified during the October, 2007 – March, 2009 stock market decline. Although the stock market experienced three positive and encouraging days this past week, the market volatility the last three weeks has only served to emphasize the need for a comprehensive retirement income plan.

Add to the mix the increasing instability of the Social Security and Medicare programs and the rapid decline of traditional pensions as a source of retirement income. Not to mention increasing life expectancies, soaring health care costs, and an economic situation ripe for inflation. Retirement income planning is no longer an option – it has quickly become a downright necessity.

Since inception, Retirement Income Visions™ has used a themed approach, with several weeks of posts focusing on a relevant retirement income planning strategy. This past year was no exception. The weekly posts, together with the customized Glossary of Terms, which currently includes definitions of 99 terms to assist in the understanding of technical subject matter, has contributed to a growing body of knowledge in the relatively new retirement income planning profession.

Going back a year, the six August 16 through September 20, 2010 posts completed a 36-part series on Roth IRA conversions. This was a very timely topic with the January 1, 2010 availability of this strategy to all taxpayers regardless of income level, combined with the ability to defer 50% of the reporting of income from a 2010 Roth IRA conversion to 2011 and the other 50% to 2012.

The September 27, 2010 post, Plan for the Frays in Your Social Security Blanket, began a 25-part educational series about Social Security. The first two parts discussed some of the historical events in connection with changes to the Social Security system affecting benefit amounts and delay in the commencement of receipt of benefits. The October 11, 2010 post, Do Your Homework Before Flipping the Social Security Switch, began a five-part series regarding various considerations in connection with electing to begin receiving Social Security benefits before full retirement age (“FRA”).

The November 15, 2010 post, Wait Until 70 to Collect Social Security? examined the opposite end of the spectrum, i.e., delaying the start date of receipt of Social Security benefits. The follow-up three-part series, Pay-to-Play Social Security, presented the “do-over” strategy, a little-publicized strategy for increasing monthly benefits in exchange for repayment of cumulative retirement benefits received.

The “file and suspend” and “double dipping” strategies for potential maximization of Social Security benefits were addressed in the next two two-part posts from December 13, 2010 through January 3, 2011, Breadwinner Approaching Social Security Retirement Age? – File and Suspend and Working? Remember Your Social Security Spousal Benefit When Your Spouse Retires.

Income taxation and associated planning strategies was the subject of the subsequent respective two- and four-part January 10 through February 14, 2011 series, Say Goodbye to Up to 30% of Your Social Security Benefits and Increase Your After-Tax Social Security Benefits. The February 21, 2011 post, Remember Your Future Widow(er) in Your Social Security Plan made the point that the decision regarding the start date of Social Security Benefits, in addition to fixing the amount of your retirement benefit, may also establish the amount of your spouse’s monthly benefit.

Retirement Income Visions™ Social Security series culminated with the three-part February 28 through March 24, 2011 series, Your Social Security Retirement Asset. These three posts discussed the importance of Social Security as an asset, perhaps one’s most important asset, in addition to its inherent role as a monthly retirement income stream.

With the media’s emphasis in 2010 on the two-year deferral of inclusion of income from a 2010 Roth IRA conversion as the motivating factor for pursuing this planning technique, I felt that there wasn’t enough attention given to the potential long-term economic benefits available through use of this investment strategy. Roth IRA Conversions – Don’t Let the Tax Tail Wag the Dog began a six-part series on this important topic on March 21, 2011 that ran through April 25, 2011. The May 2 and May 9, 2011 Roth IRA Conversion Insights two-part series followed up the Roth IRA conversion economic benefit discussion.

The importance of nonretirement assets in connection with retirement income planning was discussed in the May 9, 2011 Roth IRA Conversions Insights post as well as the May 23 and May 30, 2011 respective posts, Nonretirement Investments – The Key to a Successful Retirement Income Plan and Nonretirement vs. Retirement Plan Investments – What is the Right Mix? This was followed up with two posts on June 6 and 13, 2011 regarding traditional retirement funding strategies, Sizeable Capital Loss Carryover? Rethink Your Retirement Plan Contributions and To IRA or Not to IRA?

The June 20 and June 27, 2011 posts, Do You Have a Retirement Income Portfolio? and Is Your Retirement Income Portfolio Tax-Efficient? addressed the need for every retirement income plan to include a plan for transitioning a portion, or in some cases, all, of one’s traditional investment portfolio into a tax-efficient retirement income portfolio. This was followed by the July 5, 2011 timely Yet Another “Don’t Try to Time the Market” Lesson post.

The July 11, 2011 Shelter a Portion of Your Portfolio From the Next Stock Market Freefall began a new timely and relevant ongoing series about indexed annuities. This post was published just ten days before the July 21st Dow Jones Industrial Average peak of 12,724.41 that was followed by the beginning of a steady stock market decline coinciding with the final days of U.S. debt limit negotiations and Standard & Poor’s unprecedented U.S. credit rating downgrade, culminating with a closing low of 10,719.94 this past Wednesday. As implied in the titles of the July 18 and July 25, 2011 posts, Looking for Upside Potential With Downside Protection – Take a Look at Indexed Annuities and Limit Your Losses to Zero, this relatively new investment strategy has the potential to be a key defensive component of a successful retirement income plan.

As I did a year ago, I would like to conclude this post by thanking all of my readers for taking the time to read Retirement Income Visions™. Once again, a special thanks to my clients and non-clients, alike, who continue to give me tremendous and much-appreciated feedback regarding various blog posts. Last, but not least, thank you to my incredible wife, Nira. In addition to continuing to support my weekly blog-writing activities, she also endured my year-long family tree project that I recently completed. Well, sort of. Is a family tree ever completed?

Income Tax Planning Retirement Income Planning

Sizeable Capital Loss Carryover? Rethink Your Retirement Plan Contributions

Last week’s post answered the question, “What is the right mix of retirement vs. nonretirement investments in a retirement income plan?” with a simple, but correct, answer: “It depends.” It pointed out that each scenario is different, requiring a professional analysis by a qualified retirement income planner of the interaction between a host of many variables unique to that situation.

One of the variables mentioned last week was income tax carryover losses. There are limitations on the amount of losses arising from various types of transactions that may be deducted on the tax return for the year in which the loss incurred. The portion of the loss that isn’t deductible in the year of origin of the loss must instead be carried forward to the following year, and potentially to additional future years, until the requisite type and amount of income becomes available to absorb the loss.

An example of a common income tax carryover loss is a capital loss. After netting capital losses against capital gains, to the extent that there is an excess of capital losses over capital gains, you end up with a net capital loss. Under income tax laws that have been in existence since at least 1980 when I started practicing as an accountant, only net capital losses up to $3,000 ($1,500 if married and filing a separate return) are allowed to be deducted in the current tax year. Any net losses in excess of the specified amounts are required be carried forward to the following year.

If you have a sizeable capital loss carryover, as many people do as a result of 2009 securities sales when the stock market plummeted, nondeductible contributions to a nonretirement investment account may be preferable to making deductible retirement plan contributions, including 401(k) plans, SEP-IRA plans, deductible IRA’s, and other retirement plans. This assumes that you’re not planning on selling an asset, such as a piece of real estate or a business that will generate a sizeable capital gain that can be used to absorb your capital loss carryover.

Why is this? Doesn’t it make sense to contribute to a retirement plan where you know that you’re going to receive a current income tax deduction, often sizeable, that will save you a bunch of income taxes today? Keeping in mind that the tradeoff for a current income tax deduction when it comes to retirement plan contributions is deferred income inclusion and associated taxation when the assets are distributed, perhaps at a higher tax rate, the answer to this question isn’t necessarily “yes.”

This is especially true when large capital loss carryovers are present. If you’re in this situation and you don’t realize any capital gains, you will be taking a $3,000 tax deduction on your tax return for many, many years with the possibility, depending upon your age and the amount of your loss, that your carryover loss won’t be used in its entirety during your lifetime. Given this situation, the goal should be to create opportunities for capital gains that can be used to absorb chunks of your capital loss carryover each year without incurring any income tax liability until such time as there is no further available capital loss.

How do you do this assuming limited financial resources? One option that can make sense in many situations is to divert funds that would otherwise be used for making deductible retirement plan contributions into nonretirement equity investment accounts that have the potential to generate capital gains. To the extent that the equities appreciate in value, they can be sold, with the gains generated by the sales used to offset a portion of your capital loss carryover without incurring any income tax liability. Furthermore, unlike other situations where capital losses aren’t present and your goal may be to hold onto investments for longer than a year in order to obtain the benefit of favorable long-term capital gains tax treatment, this isn’t necessary. Capital loss carry forwards can be offset again any capital gains, whether short- (i.e., one year or less) or long- (i.e., greater than one year) term.

Using this strategy, you won’t receive an income tax deduction for investing in your nonretirement investment account. You will, however, create an opportunity to potentially increase the value of your nonretirement account up to the amount of your capital loss carryover plus $3,000 without incurring any income tax liability that you might not otherwise do. In addition, once your capital loss carryover has been used in its entirety, subsequent sales of assets can create additional losses or capital gains that can be taxed at favorable long-term capital gains rates. All of this can occur without exposing yourself to guaranteed ordinary income taxation at potentially higher tax rates down the road when you take distributions from your retirement plans had you instead invested the same funds in retirement plans.

Roth IRA

Considering a Partial 72(t) Roth IRA Conversion? – Tread Lightly

The topic of this week’s blog post is one which, quite frankly, doesn’t pertain to very many people. You may be wondering why I’m writing about it if this is the case. Besides bringing the topic to the attention of those who may be affected by it, the main reason I’m writing this post is to provide interested readers with an example of a tax planning strategy that, while it doesn’t run afoul of any IRS rules, hasn’t been officially blessed by IRS.

As with many of my blog posts, this one was inspired by one of my clients. Mr. and Mrs. R., who are retired, aren’t yet receiving Social Security benefits, and derive the majority of their income from Mrs. R.’s 72(t) IRA and two nonqualified term certain annuities, a sizeable portion of which is nontaxable.

For those of you unfamiliar with a 72(t) IRA, some brief background. Generally you must wait until age 59-1/2 to begin taking distributions from an IRA, otherwise you’re subject to a 10% premature distribution penalty in addition to any income tax liability on your distributions. IRS has carved out an exception to this rule whereby you won’t be subject to the 10% penalty if you receive a series of substantially equal periodic payments, or “SOSEPP,” from your IRA for the greater of five years or until you reach 59-1/2. A 72(t) IRA account is a traditional or a Roth IRA account from which a SOSEPP is being made.

While Mrs. R has been taking her SOSEPP for five years, she’s still about a year and a half from turning 59-1/2. If Mrs. R. discontinues her SOSEPP before she turns 59-1/2, IRS would consider this to be a modification of her SOSEPP. As such, Mrs. R. would be subject to a 10% premature distribution penalty on future distributions from her IRA. Furthermore, the 10% penalty would also be applied retroactively to all of the distributions she has already taken from her 72(t) IRA.

In addition to their 72(t) IRA and nonqualified annuity distributions, my clients recently sold a rental property at a loss of $26,000. After reducing their adjusted gross income by various itemized deductions, they were projected to have a 2010 taxable loss of approximately $25,000. While this would result in no income tax liability, without further income tax planning, this would be a potentially wasted opportunity to recognize additional income and still pay no income taxes.

How could my clients recognize additional income? While they could potentially sell securities at a gain in their nonretirement account, this would be offset by a sizeable capital loss carryover. The other option was to do a Roth IRA conversion of Mrs. R.’s 72(t) IRA. IRS regulations permit a full Roth IRA conversion of a 72(t) IRA provided that the IRA owner continues his/her 72(t) distributions from the Roth IRA account following conversion.

Since the value of Mrs. R’s. 72(t) IRA was approximately $280,000, the potential income tax liability attributable to a full 2010 conversion of Mrs. R.’s 72(t) IRA to a Roth IRA couldn’t be justified based on my client’s current and projected multi-year income tax planning even with splitting the reporting of Mrs. R.’s conversion income between 2011 and 2012. I calculated that Mrs. R. could do a partial conversion of $50,000 without incurring any income tax liability due to my client’s ability to use a net operating loss carryover that they couldn’t otherwise use in 2010. Furthermore, Mrs. R.’s conversion amount could be as much as $70,000 before my client’s marginal income tax rate would exceed 15%.

Since IRS has endorsed the full conversion of a 72(t) IRA to a Roth IRA, it would seem that there should be no issue with a partial conversion so long as the 72(t) payments continue following the conversion. Logically, the post-conversion 72(t) payment amount should be paid from both the original 72(t) IRA and the new Roth IRA accounts based on the allocation of the relative values of the two accounts. The problem is that IRS has provided no guidance on partial Roth IRA conversions of 72(t) IRA accounts, including the allocation of post-conversion 72(t) payment amounts.

Given this situation, while it isn’t logical, IRS could potentially challenge a partial Roth IRA conversion of a 72(t) IRA. If IRS were to prevail on this issue, as previously stated, future, as well as retroactive, 72(t) distributions would be assessed a 10% premature distribution penalty. IRS would also assess interest on any assessed penalties.

After consulting with Natalie Choate, a well-known attorney who specializes in estate planning for retirement benefits, I recommended to my clients that they consider doing a partial Roth IRA conversion of Mrs. R.’s 72(t) IRA in 2010, file a 2010 income tax extension application, and plan on recharacterizing, or undoing, Mrs. R.’s partial Roth IRA conversion by October 15, 2011, the extended due date of Mr. and Mrs. R.’s 2010 income tax returns, in the event that IRS doesn’t provide definitive guidance on partial Roth IRA conversions of 72(t) IRA’s by this date. (For an explanation of the recharacterization process, please see Recharacterization – Your Roth IRA Conversion Insurance Policy.)