Annuities Deferred Income Annuities

You Don’t Have to Wait Until 85 to Receive Your Annuity Payments

Longevity insurance was recently blessed again by the IRS with its finalization of a regulation allowing the inclusion of an advanced-age lifetime-income option in retirement plans such as 401(k) plans and IRAs.

As discussed in my July 25 MarketWatch article, 6 Ways a New Tax Law Benefits a Sustainable Retirement, “longevity insurance” isn’t an actual product that you can purchase from a life insurance carrier. It’s instead a term that refers to a deferred lifetime fixed income annuity with an advanced age start date, typically 80 to 85.

In a nutshell, IRS’ final regulation allows you to invest up to the lesser of $125,000 or 25% of your retirement plan balance in “qualifying longevity annuity contracts” (QLACs) provided that lifetime distributions begin at a specified date no later than age 85. Although the regulation leaves the door open for other types of fixed-income annuities in the future, QLAC investment vehicles are currently limited to lifetime deferred income annuities, or DIAs.

Suppose you’re concerned about the possibility of outliving your assets and you’re considering investing a portion of your retirement plan in a QLAC. Do you have to wait until age 85 to begin receiving your lifetime annuity payments? Absolutely not. So long as distributions begin no later than the first day of the month following the attainment of age 85, you will be in compliance with the regulation.

Although the regulation doesn’t define the earliest starting date of QLAC payments, based on previous legislation, it would seem to be April 2 of the year following the year that you turn 70-1/2. Why April 2? Per my MarketWatch article, regulations in effect before the new rule allow for inclusion of fixed income annuities without limit provided that the periodic annuity payments (a) begin by April 1 of the year following the year that the owner turns 70-1/2 and (b) are structured so that they will be completely distributed over the life expectancies of the owner and the owner’s beneficiary in compliance with IRS’ required minimum distribution, or RMD, rules.

Let’s suppose that you’re doing retirement income planning when you’re 60 and you’re planning on retiring at 67. In addition to your IRA which has a value of $600,000, you have a sizeable nonretirement portfolio that will not only enable you to defer your Social Security start date to age 70, there’s a high likelihood that you won’t need to withdraw from your IRA until 75.

Despite the fact that you don’t foresee needing income from your IRA until 75, IRS requires you to begin taking minimum annual distributions from your IRA beginning by April 1 of the year following the year that you turn 70-1/2. This is true, however, IRS now also allows you to circumvent the RMD rules by investing a portion of your retirement plan assets in a QLAC. Relying on these rules, you decide to invest $125,000 of your IRA in a QLAC with an income start date of 75. This enables you to longevitize, or extend the financial life of, your retirement using the six ways described in my MarketWatch article.

As you can see, there’s a lot of flexibility when it comes to selecting the start date of your lifetime income distributions from a QLAC. There’s approximately a 13- to 14-year window depending upon your birth date which falls between April 2 of the year following the year that you turn 70-1/2 and age 85. The key is that you must define your income start date at the time of applying for your QLAC. This is a requirement of all deferred income annuities, not just QLAC’s.

Finally, a QLAC may, but is not required to, offer an option to begin payments before the contract’s annuity starting date. While the amount of your periodic distributions will be greater the longer you defer your start date, you don’t have to wait until age 85 to begin receiving lifetime income.

Roth IRA

Don’t Forget About Your SEP-IRA for Roth IRA Conversions

On a recent occasion, I was discussing the Roth IRA conversion strategy with a long-time friend who told me that he converted his IRA to a Roth IRA years ago, and furthermore, he spread the income from the conversion over four years to reduce his tax bite. My friend was referring to the one-time opportunity to do a Roth IRA conversion in 1998 and spread the income from the conversion over four years starting with 1998 provided that your modified adjusted gross income was less than $100,000.

I knew that, in addition to his Roth IRA, my friend, who is an employee of his closely-held corporation, had another type of retirement plan. When I questioned him about this, he told me that he also has a SEP-IRA account into which he makes contributions every year. I asked him if he was aware that he could convert a portion, or all, of his SEP-IRA to a Roth IRA and he told me he didn’t know he could do this.

My friend is not alone. Some of you may have noticed in last week’s blog post, The 45 to 60 5-Year Roth IRA Conversion Strategy – Part 4 that a SEP-IRA was used in the hypothetical Roth IRA conversion strategy spreadsheet and may have wondered about the ability to use a SEP-IRA to do a Roth IRA conversion.

When you hear about doing a Roth IRA conversion, most people immediately think about using a traditional IRA account into which you made, or are still making, deductible and/or nondeductible contributions, the maximum contribution limits of which began at $1,500 in 1974, increased to $2,000 in 1981, $4,000 in 2005, and $5,000 in 2008, with an additional $1,000 for individuals 50 and over beginning in 2002. Traditional IRA’s can also include rollovers, or tax-free distributions, from another retirement plan, such as a 401(k) or 403(b) plan.

What isn’t so common, and is often lost in the Roth IRA conversion conversation, is the ability to use a SEP-IRA for the conversion. For those of you not familiar with SEP-IRA’s, this is a retirement plan used by self-employed individuals and small business owners. Sole proprietorships, Subchapter “S” and “C” corporations, partnerships, and LLC’s are all eligible to establish a SEP-IRA. Unlike traditional IRA’s which have relatively small contribution limits, currently $5,000 if under age 50 and $6,000 for individuals 50 and older, the maximum allowable contribution limit for SEP-IRA’s is much greater. Contributions of up to 25% of salary, or 20% of net adjusted self-employment income, up to $49,000, may be made to a SEP-IRA.

With this higher contribution limit, it isn’t unusual for SEP-IRA accounts to quickly grow to several hundred thousand dollars. Assuming similar starting dates, other than traditional IRA’s that contain sizeable rollovers from other retirement plans, the value of most SEP-IRA accounts typically dwarf those of traditional IRA’s. Given this situation, partial, rather than full, conversions of SEP-IRA’s generally will achieve the goal of minimizing income tax liability attributable to the conversion. Furthermore, assuming that ongoing contributions are still being made to the plan, a multi-year conversion strategy such as the hypothetical Roth IRA conversion strategy illustrated in last week’s blog post, The 45 to 60 5-Step Roth IRA Conversion Strategy – Part 4 can make a lot of sense.

If you have a SEP-IRA account, I would strongly urge you to explore the possibility of converting a portion, or all, of the current balance, as well as future contributions, to a Roth IRA, using a multi-year strategy such as the one illustrated in the four-part series, The 45 to 60 5-Setp Roth IRA Conversion Strategy.


Clearing the Roth IRA Conversion Hurdles

Should you convert your traditional IRA’s to Roth IRA’s? This question is a hot topic this year with the repeal of the $100,000 modified adjusted gross income barrier for converting traditional IRA’s to Roth IRA’s. Last week’s blog post, Three Roth IRA Conversion “Show Stoppers” discussed three scenarios where the answer is a definitive “no.”

Assuming that none of the three “show stoppers” are applicable to your situation, you’re ready to lace up your running shoes and step onto the track. I liken the Roth IRA conversion decision-making process to the 100 meter (women) and 110 meter (men) high hurdles events in track and field.

Before discussing the various hurdles, once again it should be noted that a Roth IRA conversion doesn’t have to be an all-or-nothing event – you can do partial conversions over one or more years. The other important thing to keep in mind is that just because 2010 is the first year that you can convert your traditional IRA to a Roth IRA doesn’t mean that this is “the” year to do it. The hurdles discussed in this blog may be applicable to you this year, however, next year may be a totally different story.

Although the 100 meter, in the case of women, or the 110 meter, for men, high hurdles is a relatively short race, clearing ten hurdles 3.5 feet in height while running an all-out sprint is no easy feat. Likewise, there are three “high hurdle” situations when it comes to converting a traditional IRA to a Roth IRA as follows:

  1. Payment of Roth IRA conversion tax liability requiring liquidation of assets resulting in additional tax liability
  2. Withdrawals anticipated within five years of Roth IRA conversion
  3. Individuals with life expectancy of five years or less with no beneficiaries

Payment of Roth IRA Conversion Tax Liability Requiring Liquidation of Assets Resulting in Additional Tax Liability

One of the three “show stoppers” discussed in last week’s blog post was no source of funds for payment of Roth IRA conversion tax liability outside of retirement plans. If your nonretirement liquid assets, i.e., checking, savings, credit union, and money market funds are limited and you will need to sell securities to generate funds to pay the income tax liability attributable to a Roth IRA conversion, will you be creating additional income tax liability as a result of those sales?

If the result of your sale(s) will either be a capital loss or a capital gain that can be offset by either a capital loss carryover from the previous year or a capital loss generated earlier in the current year, then this isn’t problematic. If, on the other hand, your securities sales will result in a capital gain that cannot be offset by a capital loss, you will incur income tax liability in addition to the liability from doing a Roth IRA conversion. At a minimum, even if the securities that you sell were held for one or more years resulting in favorable long-term capital gains treatment, your tax liability from the capital gain will be at least 15% of the amount of your gain plus state tax liability. If significant, this additional tax liability on top of the tax liability attributable to the Roth IRA conversion could be a deal killer.

Withdrawals Anticipated Within Five Years of Roth IRA Conversion

Any distributions from Roth IRA conversions that aren’t attributable to non-deductible IRA contributions will be taxable as ordinary income if they’re taken within five years of January 1st of the year of the Roth IRA conversion.

If your situation is such that there’s a good chance that (a) you will need to take a withdrawal from your Roth IRA conversion within five years of January 1st of your Roth IRA conversion, (b) most of the distribution won’t be attributable to non-deductible IRA contributions, and (c) the income from your projected withdrawal isn’t projected to be sheltered by losses and/or itemized deductions or you aren’t otherwise projected to be in a lower tax bracket than in the year of conversion, a Roth IRA conversion probably doesn’t make sense. This is especially true if you will be less than 59-1/2 when you are projected to take your withdrawal since a 10% premature distribution penalty will be assessed in addition to the tax attributable to the income from your withdrawal.

Individuals With Life Expectancy of Five Years or Less With No Living Beneficiaries

Whenever analyzing the potential viability of a Roth IRA conversion, it’s important to keep in mind that, while the numbers may not favor a conversion if the analysis is based solely on the IRA owner’s life, this may not be the case when beneficiaries are considered, especially younger non-spousal beneficiaries, assuming that the Roth IRA isn’t projected to be depleted during the Roth IRA owner’s lifetime.

On the other hand, If you’re in a situation where either you’re very advanced in age or otherwise have a life expectancy of five years or less and you have no living beneficiaries who will inherit your IRA, the potential benefits to be achieved from a Roth IRA conversion probably won’t exceed the income tax liability attributable to the conversion in most cases.

So, you weren’t eliminated from the Roth IRA conversion game by any of the three “show stoppers” discussed in last week’s blog and you cleared all three “high hurdles” in this one. Are you a candidate for a Roth IRA conversion? Read next week’s blog post to learn the answer to this question.


Year of the Conversion

If you grew up in my generation, you probably remember Al Stewart’s 1976 hit, “Year of the Cat” from his platinum album with the same name. Well, 34 years later (boy, am I getting old!), 2010 is being dubbed by the financial community as the “Year of the Conversion” in reference to the removal of the income threshold in connection with Roth IRA conversions.

Although the Roth IRA and the Roth IRA conversion technique were both established by the Taxpayer Relief Act of 1997 for taxable years beginning in 1998, like a lot of tax legislation that provides for potentially favorable benefits, the ability to  take advantage of the latter until now has been dependent on one’s income level. From 1998 through 2009, only taxpayers with modified adjusted gross income of less than $100,000 were eligible to convert a traditional IRA to a Roth IRA.

It wasn’t until January 1st of this year that the $100,000 income threshold was eliminated as a result of the Tax Increase Prevention and Reconciliation Act (TIPRA) of 2005. Now anyone who has a traditional IRA can convert part or all of his/her accounts to one or more Roth IRA accounts.

What’s So Special About a Roth IRA?

Like a traditional IRA, Roth IRA’s enjoy tax-exempt growth. So long as you don’t take any withdrawals from either a regular or Roth IRA, you won’t pay income taxes on the income earned. This includes interest, dividends, and realized gains from securities sales. Unlike a traditional IRA to which you may make potentially deductible contributions depending on your income, contributions to a Roth IRA aren’t deductible.

So if contributions aren’t deductible and you receive the same tax-exempt growth as a traditional IRA, why do a Roth IRA? There are two main attractions of a Roth IRA that aren’t available to traditional IRA owners:

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

Nontaxable Distributions

Whenever a deduction is allowed for contributions to a retirement plan, whether it be an IRA, 401(k), or some other type of pension plan, withdrawals from the plan are taxable as ordinary income just like salary. Since contributions to a Roth IRA aren’t deductible, withdrawals generally aren’t taxable.

There is, however, an important exception to this rule. Any distributions, with limited exceptions that are beyond the scope of this blog post, that aren’t attributable to non-deductible IRA contributions will be taxable as ordinary income if they are taken before the later of (a) five years after the Roth IRA owner established and funded his or her first Roth IRA account or, in the case of a Roth IRA conversion, five years from the date of the conversion, or (b) age 59-1/2. In addition, if the distribution is from a Roth IRA conversion and you are less than 59-1/2 when you take your distribution, it is also subject to a 10% premature distribution penalty.

No Required Minimum Distributions (“RMD’s”)

Whereas contributions to traditional IRA’s are potentially deductible and the accounts also enjoy tax-exempt growth until you begin taxing withdrawals from them, IRS doesn’t allow this nirvana to continue indefinitely. Once you turn 70-1/2, you must begin taking annual required minimum distributions, or “RMD’s,” from your traditional IRA based on the value of your IRA accounts at the end of the previous year using a life expectancy factor from an IRS table. A 50% penalty is assessed on the amount of any RMD’s not distributed.

Roth IRA’s are not subject to the RMD rules during the owner’s lifetime. You can convert 100% of a traditional IRA to a Roth IRA at age 25 and not take any distributions from it for the duration of your life without being exposed to any penalties. Once again, IRS doesn’t allow this benefit to continue indefinitely. Roth IRA’s are subject to RMD’s after the death of the owner. Therefore, if you inherit a Roth IRA, you will be required to take minimum distributions from it.

As you can see, even though we’re in the midst of the “Year of the Conversion,” the two main attractions of a Roth IRA are not bullet-proof. With this in mind, should you convert your traditional IRA to a Roth IRA? Hmm, sounds like an idea for another blog post!

Retirement Income Planning

The Retirement Planning Paradigm Shift – Part 1

It’s a fact of life that, unlike our parents’ generation who could depend on a monthly pension supplemented by Social Security, most individuals retiring today from the private sector don’t receive a pension. Many of us have 401(k) plans that are typically rolled over into an IRA as a lump sum when we retire. However, generally speaking, the various organizations that employed us during our working years won’t be making monthly electronic deposits into our checking accounts when we retire.

Unless your lifestyle allows you to survive solely on Social Security or a comparable monthly benefit if you don’t qualify for Social Security, it’s necessary for you to create your own monthly pension. Similar to private sector pension plans that were popular years ago, your monthly pension needs to last for an uncertain period of time – your lifetime as well as your spouse’s lifetime if you’re married.

Many of you are probably asking yourself, “Why do I need to create a monthly pension when I’ve been accumulating all of these assets for all of these years that I plan on using to fund my retirement?” That’s the million dollar question and is precisely the reason why I created this blog. The answer to this question requires a paradigm shift, or a sudden and radical change in one’s accepted thought pattern or behavior. You know when this occurs when you have an “Aha!” experience whereby you suddenly see things in a totally new and different way.

The term paradigm shift was introduced by Thomas Kuhn in his 1962 landmark book, The Structure of Scientific Revolutions. Kuhn demonstrated how almost every significant scientific breakthrough is initially a break with accepted, and typically, long-standing, ways of thinking. While Kuhn provided many historical scientific examples to explain this phenomenon, Stephen Covey provided us with one of the best and most powerful non-scientific examples of a paradigm shift in his #1 national bestseller, The 7 Habits of Highly Effective People.

Covey was traveling on a New York subway one Sunday morning where people were sitting quietly. Suddenly, a man and his children entered the subway. The man sat next to Covey, closing his eyes. His children began running wild, yelling back and forth, throwing things, and even grabbing people’s papers. While everyone on the subway, including Covey, felt irritated, the children’s father was oblivious to the situation. Finally, Covey asked the father if he could control his children since they were disturbing a lot of people. The father replied, “We just came from the hospital where their mother died about an hour ago. I don’t know what to think, and I guess they don’t know how to handle it either.”

Needless to say, Stephen Covey suddenly saw everything differently. This caused him to think differently, feel differently, and behave differently. His heart was filled with the man’s pain. Everything changed in an instant.

So how exactly does the paradigm shift phenomenon apply to retirement planning? Be sure to mark your calendar for Monday, August 31st at the crack of dawn when “The Retirement Planning Paradigm Shift – Part 2” AKA “Return of the Blog” descends from the blogosphere to a local blog site near you. If you haven’t yet subscribed to Retirement Income VisionsTM, please do so now since you won’t want to miss it! And remember, don’t be afraid to click on “Subscribe” at the top of this page.