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.

Roth IRA

Roth IRA Conversions – Don’t Let the Tax Tail Wag the Dog – Part 4 of 6

Part 3 of this series discussed the first of three primary economic benefits to be derived from a Roth IRA conversion, i.e., elimination of taxation on 100% of the growth of Roth IRA conversion assets. As emphasized in the post, this is the most important and overriding reason in most cases for doing a conversion. The other two benefits are: (1) elimination of exposure to required minimum distributions on traditional IRA funds converted to a Roth IRA and (2) potential reduction in taxation of Social Security benefits. The second benefit is this week’s topic with the third benefit being the subject of Part 5 of this series.

Even though most people generally don’t celebrate half birthdays, Congress, in its infinite wisdom, decided for some reason, that two particular half birthdays are crucial as they pertain to income taxation of distributions from retirement plan assets – age 59-1/2 and age 70-1/2. Congress has determined that if you take distributions from a retirement plan, e.g., 401(k) plan, traditional IRA, etc., before age 59-1/2, this is too soon. If you dare to do this, subject to specified limited exceptions, in addition to paying income tax, you will be assessed a premature distribution penalty of 10% of the amount of your distributions. You may also be subject to a state-imposed penalty which is 2-1/2 percent in California where I live.

At the other extreme, Congress has mandated that 70-1/2 is the drop-dead age by which you must begin taking annual required minimum distributions, or “RMD’s,” from your various retirement plans. Up until this age, your employers and you have benefited by income tax deductions for contributions to your retirement plans and your assets have enjoyed the much-cherished benefit of tax-deferred growth. Beginning at age 70-1/2, it’s time for the government to begin receiving its share of your retirement assets.

If you’re not doing so voluntarily, at age 70-1/2, you must begin taking annual minimum distributions from your various retirement plans based on the value of your retirement assets on December 31st of the previous year and a life expectancy factor as specified in an IRS table. To the extent that either (a) you don’t take your “RMD” in a particular year or (b) the amount of your distribution falls short of your “RMD,” you will pay dearly. IRS’ penalty in this situation is onerous – 50% of the amount that you were suppose to take less the amount that you actually withdrew.

Even though I agree with Congress’ “RMD” justification and believe that the “RMD” tables are fair since they use a life expectancy that extends to 115 years, I personally don’t want to be forced to take X dollars from my IRA account in a particular year if I (a) have other more tax-favored retirement income sources to draw from and/or (b) don’t need the amount specified by IRS to meet my financial needs.

With foresight and proper planning, there is a way to reduce, or potentially eliminate, your exposure to “RMD’s” and associated forced taxation of retirement funds. That way, of course, is to convert a portion, or all, of your traditional IRA’s, including SEP-IRA’s, to Roth IRA’s. Roth IRA accounts are not subject to the “RMD” rules during the owner’s lifetime. While it’s a wonderful goal, reduction or elimination of “RMD’s” shouldn’t be the primary reason in most situations for doing a Roth IRA conversion. Generally speaking, it won’t make sense to pay income taxes today solely for the purpose of avoiding forced taxation of the same assets beginning at age 70-1/2.

As emphasized in Part 3, elimination of taxation on 100% of the growth of Roth IRA conversion assets is the most important and overriding reason in most cases for doing a conversion. To the extent that you’re able to achieve this goal while also minimizing your “RMD” exposure, more power to you!

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.)


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.


Three Roth IRA Conversion “Show Stoppers”

Effective January 1st this year, the $100,000 modified adjusted gross income barrier for converting traditional IRA accounts to Roth IRA accounts was eliminated. Now that the floodgates are open and everyone can convert their traditional IRA’s to Roth IRA’s, if you haven’t done so already, should you jump on the bandwagon? While the potential benefits of tax-free withdrawals and not being subject to required minimum distributions (“RMD’s”) (See Year of the Conversion) are extremely attractive, there are several obstacles one must overcome before switching horses.

Before discussing these obstacles, which will be continued in next week’s blog post, it’s important to keep in mind that when contemplating a Roth IRA conversion, it doesn’t have to be an all-or-nothing event. You can, and it’s often preferable, to do partial conversions of traditional to Roth IRA’s over one or more years.

There are three scenarios, in my opinion, that are “show stoppers” when evaluating a potential Roth IRA conversion:

  1. Primary beneficiary of traditional IRA is a charity
  2. 100% of retirement plan funds are invested in an active 401(k) plan
  3. No source of funds for payment of Roth IRA conversion tax liability outside of retirement plans

Primary Beneficiary of Traditional IRA is a Charity

The first thing one should do when considering a Roth IRA conversion is to examine the beneficiary designation of the IRA account(s) to be converted. If the beneficiary is a charitable organization, it generally doesn’t make sense to prepay income taxes if there is a possibility that there will be a tax-free distribution of the IRA to a charity.

100% of Retirement Plan Funds Are Invested In An Active 401(k) Plan

Sometimes people will roll over inactive pension plans, including 401(k) plans, into a traditional IRA and then convert the traditional IRA to a Roth IRA. If you are an active participant in a 401(k) plan, short of borrowing or taking a hardship withdrawal from the plan if permitted by the plan, you are prohibited from taking distributions from the plan prior to attaining age 59-1/2 or separation from service.

No Source of Funds for Payment of Roth IRA Conversion Tax Liability Outside of Retirement Plans

Assuming that you aren’t one of the fortunate individuals who is able to do a tax-free Roth IRA conversion, after calculating the potential income tax liability attributable to your conversion, you need to ask yourself the following question: What will be the source of payment of the income tax liability attributable to your Roth IRA conversion?If you don’t have sufficient funds in checking, savings, money market, and other nonretirement investment 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.

When you incur income tax liability in connection with a Roth IRA conversion, you always want to pay the income tax from funds outside of retirement plans, including the traditional IRA being converted. If you elect to have income tax withheld from your traditional IRA being converted to a Roth IRA, in addition to reducing the amount of the conversion by the amount of income tax withheld, if you are under age 59-1/2, you will be subject to a 10% premature distribution penalty on the amount of withholding since it is considered to be a distribution from your IRA that is not converted to a Roth IRA within 60 days.

Paying the tax from other retirement plans is also self-defeating since the funds will no longer continue to grow tax-deferred, there will be a taxable distribution, and, to the extent that you are under age 59-1/2, you will be subject to a 10% premature distribution penalty on the amount of the distribution.

If the primary beneficiary of your traditional IRA account isn’t a charitable organization, 100% of your retirement plan funds aren’t invested in active 401(k) plans, and you have funds outside of retirement plans to pay the income tax liability attributable to your Roth IRA conversion, put on your running shoes and get ready to run the high hurdles in Clearing the Roth IRA Conversion Hurdles, the topic of next week’s blog post.

Roth IRA

Roth IRA – Retirement Plan Holey Grail?

With all of the buzz in the investment/retirement planning community about Roth IRA’s as a result of the January 1st elimination of the $100,000 modified adjusted gross income threshold for converting a traditional IRA to a Roth IRA, you would think that they’re the only game in town. Although the two main attractions of a Roth IRA that were introduced in last week’s blog post, Year of the Conversion, i.e., nontaxable distributions and no required minimum distributions (“RMD’s”), are two desirable benefits of any retirement plan, there is a price you must pay to obtain them.

The Ideal Retirement Plan

In order to understand the Roth IRA club entry fee, let’s take a step back and examine the eight features of an ideal retirement plan to see which ones are present or lacking in a Roth IRA:

  1. Contribution ability not subject to income test
  2. Fully deductible contributions
  3. Unlimited contribution amounts
  4. Nontaxable income
  5. Nontaxable distributions
  6. Distributions at any age without penalties
  7. No required minimum distributions
  8. No income tax liability upon conversion to the plan

Contribution Ability Not Subject to Income Test

Unlike other types of retirement plans, potential IRA owners must clear an income hurdle in order to be eligible to make contributions. If your adjusted gross income exceeds specified limits, which are different depending upon your filing status, then you won’t be allowed to make a contribution to either a traditional or Roth IRA.

Fully Deductible Contributions

Contributions to plans that are used directly and indirectly for conversion to Roth IRA’s are often, but not always, fully deductible. These include traditional IRA’s, SEP-IRA’s, 401(k) plans, profit sharing plans, and defined benefit plans. This is an extremely important benefit not to be overlooked, particularly if you’re in a high marginal income tax bracket when making contributions to these types of plans. Roth IRA contributions, on the other hand, are never deductible.

Unlimited Contribution Amounts

In addition to being fully deductible, allowable contribution amounts for certain retirement plans, such as defined benefit plans, while they aren’t unlimited, can be quite generous, particularly for highly-compensated older employees. In addition to being nondeductible, Roth IRA contributions are currently limited to $5,000 per year, or $6,000 if 50 and above.

Nontaxable Income

All retirement plan participants enjoy the benefit of nontaxable income while funds remain in the plan. This includes interest, dividends, and realized gains from securities sales that would otherwise be taxable if the same investments were held in a nonretirement plan.

Nontaxable Distributions

As pointed out in Year of the Conversion, 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. As also mentioned in last week’s post, since contributions to a Roth IRA aren’t deductible, withdrawals generally aren’t taxable provided that they remain in the plan for 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 conversion, and the owner is at least 59-1/2.

Distributions At Any Age Without Penalties

To promote the fact that retirement plans are intended to be used for retirement, distributions from retirement plans before age 59-1/2 are generally subject to a 10% federal premature distribution penalty plus potential state penalties. This includes distributions from Roth IRA conversions.

No Required Minimum Distributions

In exchange for tax-deductible contributions and nontaxable income while funds remain in a plan, IRS requires you to begin withdrawing funds, otherwise known as required minimum distributions, or “RMD’s,” from plans at a specified age, generally age 70-1/2, or be subject to a 50% penalty on RMD’s not distributed. While Roth IRA’s escape this requirement during the owner’s lifetime, Roth IRA beneficiaries are required to take minimum distributions from their inherited plans.

No Income Tax Liability Upon Conversion to the Plan

When you convert, or roll over, company pension plans, such as 401(k) plans, profit sharing plans, and defined benefit plans to a traditional IRA, there’s generally no income tax liability assessed upon conversion. Roth IRA conversions, however, are fully taxable as ordinary income with the exception of funds originating from nondeductible IRA contributions.

Depending upon facts and circumstances, assuming you have the funds available outside of your retirement plans to pay it, in many cases, the income tax liability associated with a Roth IRA conversion won’t outweigh the potential benefits one might potentially receive from a Roth. Even though Roth IRA’s share many of the eight desirable features of an ideal retirement plan, as you can see, they aren’t the holy grail of retirement plans, and, depending on your situation, may in fact, end up being the “holey” grail for you.