Roth IRA

Roth IRA Conversion Insights – Part 1 of 2

Last week’s post completed a six-part series discussing 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.

Part 6, the finale of the series worked through two comprehensive scenarios – one with no Roth IRA conversion and a second with a Roth IRA conversion – to determine which one was projected to result in more total investment assets throughout the life of the scenario. As emphasized in the post, the results of the two scenarios cannot be generalized and used as the basis for determining whether a Roth IRA conversion is appropriate in a particular situation. Furthermore, a detailed analysis needs to be prepared by a retirement income planner for every potential Roth IRA conversion situation.

Having said this, there are several insights to be gained from analyzing the two scenarios that can be applied to any potential Roth IRA conversion analysis. This post will discuss the first three with next week’s post addressing three others.

Actual Results are Likely to be Different Than Projected Results

By far, the most important insight to keep in mind going into any Roth IRA conversion analysis is that actual results are likely to be different than projected results. Without listing them individually, the multitude of assumptions that must be considered and the interaction between them is the reason for this. Contributing to the complexity and uncertainty is the lengthy timeframe that needs to be considered in most situations with the associated potential for multiple changes in the realization of each assumption. In addition, the timeframe needs to include spouses’ and other potential beneficiaries’ lifetimes when applicable.

Multi-Year Income Tax Planning is Critical

When I read, or attend presentations, about Roth IRA conversions, the importance of marginal income tax rates in the year(s) of conversion(s) and the years of distribution from traditional IRA accounts is often emphasized as one of the key factors in a Roth IRA conversion analysis. When I entered the tax profession in 1980 and the top marginal federal income tax rate was 70%, did I know that by 1987, the top rate would be slashed to 38.5% and would stay within three percentage points of this rate for at least the next 25 years with today’s top rate of 35% scheduled to remain in effect through 2012? While a strong argument can be made that a tax increase is inevitable given our huge federal budget deficit, no one knows for certain when this will occur or what future tax rates will be.

It’s not just about tax rates. Comprehensive multi-year income tax planning on both the “front-end” and “back-end” is critical to the success of any Roth IRA conversion analysis. Keeping in mind that a Roth IRA conversion generally shouldn’t be a one-year event, “front-end” planning should include preparation of multi-year income tax projections to determine how much of one’s contributory IRA should be converted and in which years. On the “back-end,” multi-year ongoing projections need to analyze the impact of projected required and discretionary distributions from contributory and Roth IRA accounts as well as nonqualified investment accounts in meeting one’s projected financial needs. Each “back-end” projection should include an analysis of taxable Social Security benefits. Finally, both “front-end” and “back-end” income tax projections need to consider all projected sources of income, losses, and deductions in each year.

Growth of Roth IRA Conversion Assets is Dependent on Roth IRA Conversion Timing

The number one benefit to be derived from a Roth IRA conversion, i.e., elimination of taxation on 100% of the growth of Roth IRA conversion assets, is dependent upon the timing of a Roth IRA conversion relative to stock market valuation assuming that a sizeable portion of one’s Roth IRA conversion portfolio is equity-based. In order to realize this benefit, by definition, there needs to be an increase in the value of one’s Roth IRA from the date(s) of conversion(s) to the future comparison date.

With the Dow Jones Industrial Average increasing by approximately 1,000 points, or 8%, in the past month to finish at 12,811 on Friday combined with a 100% increase, or doubling, from its close of 6,440 on March 9, 1999 a little over two years ago, the determination of the timing of a Roth IRA conversion is more difficult than it was last year at this time. Recharacterization, (see the April 19, 2010 post, Recharacterization – Your Roth IRA Conversion Insurance Policy) is a strategy that’s available for retroactively undoing a Roth IRA conversion that was done prior to a market decline if it’s implemented during a specified limited time period following a conversion.

Income Tax Planning Social Security

Increase Your After-Tax Social Security Benefits – Part 4 of 4

If you read Part 3 of this series last week, you should be familiar with my football analogy. Specifically, when it comes to winning the Social Security retirement benefit game once you start receiving benefits, you need to win two halves of the game: (1) reduce taxable benefits, and (2) reduce the tax attributable to your benefits. Parts 2 and 3 of this series discussed how to win the first half. Now that the halftime entertainment is over, we’re ready to start the second half.

In order to reduce the tax attributable to your Social Security retirement benefits, once you’ve employed appropriate strategies for reducing your taxable benefits, the focus should be on maximizing your itemized deductions – without increasing your exposure to alternative minimum tax (“AMT”). If the total amount of your itemized deductions is less than the standard deduction – game over. If you’re able to itemize your deductions, read on.

There are basically five categories of itemized deductions to pay attention to:

  1. Medical and dental expenses
  2. Taxes paid
  3. Interest paid
  4. Gifts to charity
  5. Job expenses and certain miscellaneous deductions

Here’s a brief overview of each category, two of which are only deductible if the total amount exceeds a specified percentage of adjusted gross income (“AGI”):

Medical and Dental Expenses

A deduction is allowed only for expenses paid primarily for the prevention or alleviation of a physical or mental defect or illness. You may only take a deduction for the amount of your total medical and dental expenses that exceeds 7.5% of your AGI.

Taxes Paid

Deductible taxes primarily include (1) the greater of state income taxes or general sales taxes, (2) real estate taxes, and (3) motor vehicle registration fees. You need to be careful about prepaying state income and real estate taxes at the end of the year to maximize these deductions since they can also increase your alternative minimum taxable income and your AMT liability.

Interest Paid

The most notable deduction in this area is home mortgage interest on first and second homes up to specified limits. Investment interest is also deductible to the extent of investment income.

Gifts to Charity

Charitable contributions made to qualified charitable organizations are deductible and include gifts made by cash or check as well as noncash contributions.

Job Expenses and Certain Miscellaneous Deductions

The most notable deduction in this area is unreimbursed employee expenses, including job travel, union dues, and job education. Other potential deductions include tax preparation and planning fees, investment management fees, and safe deposit box fees. You may only deduct the amount of your total job expenses and specified miscellaneous deductions that exceeds 2% of your AGI.

Based on my 25+ years of experience as a tax professional, including defending deductibility of itemized deductions on behalf of clients in IRS examinations, I can tell you unequivocally that consultation with a tax professional is crucial to maximizing, and defending, your itemized deductions – without increasing your exposure to AMT.

Assuming you’ve implemented strategies to reduce your taxable benefits and maximize your itemized deductions without increasing your exposure to AMT, you’ve won both halves of the game since you will have (1) reduced your marginal income tax rate, (2) reduced the income tax attributable to your taxable Social Security benefits, and (3) increased your after-tax Social Security benefits. Congratulations – let the celebration begin!

Social Security

Plan for the Frays in Your Social Security Blanket – Part 1 of 2

Until recent years, most of us thought of Social Security as our retirement income security blanket. Even if they had other sources of retirement income that were greater in amount, retirees knew that, come hell or high water, they would receive a monthly check or electronic deposit from the Social Security Administration. This feeling of comfort was based on a long-standing history of benefits being paid to workers when they retired at age 65 beginning with the enactment of the Social Security Act of 1935 by President Franklin D. Roosevelt and the first payment of monthly benefits in 1940.

Although there were periodic cost of living adjustment, or COLA, increases as early as 1950, beginning in 1975 and until 2009, retirees also knew that they could depend on them with the enactment of statutory annual increases based on annual Consumer Price Index, or CPI, changes. The annual COLA, was never less than 1.3% (1986 and 1998) and was as much as 14.3% (1980), averaging 4.4% over 34 years and 2.8% over the last 20 years. 2009 was the first year since 1975 that there was no COLA with the possibility of a repeat looming for 2010.

Nine years after the beginning of statutory COLA’s in 1975, an indirect reduction of benefits for many Social Security recipients was enacted beginning in 1984. The basic rule put into place in that year was that up to 50% of Social Security benefits is taxable if one’s income exceeded certain thresholds. With the highest marginal income tax rate at 50%, this equated to a maximum 25% (50% x 50%) tax on Social Security.

Nine years later in 1993, legislation was passed that increased the percentage of taxable Social Security benefits from 50% to up to 85% for “higher income” beneficiaries. With a top marginal income tax rate of 39.6%, this equated to a 33.7% (85% x 39.6%) maximum tax rate on Social Security benefits. Although the current highest marginal income tax rate is 35%, resulting in a 29.8% (85% x 35%) maximum tax rate on Social Security benefits, the top marginal income tax rate is currently expected to increase from 35% to 39.6% in 2011.

Part 2 will discuss additional changes that have reduced or delayed the commencement of receipt of one’s Social Security benefits.