Tag: required minimum distributions

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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.

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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.

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Annuities Income Tax Planning Retirement Income Planning Roth IRA Social Security

Increase Your After-Tax Social Security Benefits – Part 1 of 4

Retirement Income Center

The last two posts, Say Goodbye to Up to 30% of Your Social Security Benefits – Parts 1 and 2 discussed taxation of Social Security benefits. As explained in both posts, up to 50% or 85% of Social Security benefits can be taxable depending upon the amount of one’s “combined income” (50% of Social Security benefits plus adjusted gross income increased by tax-exempt income) compared to specified thresholds that are dependent upon one’s tax filing status (i.e., single, head of household, married filing separate, or married filing joint) and one’s tax rates.

Although, as pointed out in last week’s post, taxation of Social Security benefits has been a thorn in Congress’ side ever since it came into being in 1984, it appears that it’s here to stay. Income taxation of Social Security benefits can be reduced or, in some cases, eliminated, in one or more years with proper planning. While much of the planning is ongoing throughout the years that one is collecting benefits, there are several opportunities that should be analyzed and potentially implemented beginning in one’s 40’s, many years before the receipt of one’s first Social Security check. This post focuses on pre-benefit receipt planning and Parts 2, 3, and 4 address planning strategies during the Social Security benefit receipt years.

Before discussing strategies that can be implemented to reduce taxation of Social Security benefits, let me make clear one strategy that generally isn’t effective. Although it hasn’t been given as much attention the last several years in our low-interest rate environment, income tax and investment planning strategies often include an analysis of after-tax return returns from taxable vs. tax-exempt investments. As mentioned in the previous two posts as well as the beginning of this one, “combined income,” which is the starting point for calculating taxable Social Security benefits, is increased by tax-exempt income. As a result, assuming that your goal is to reduce taxable Social Security benefits, other than the fact that the amount of income from a tax-exempt investment is generally less than the income from a similar taxable investment, inclusion of tax-exempt investments as part of your investment portfolio won’t be of much benefit to you.

Perhaps one of the greatest opportunities for reducing taxable Social Security benefits and ongoing associated taxation of same that can be implemented beginning 20 or more years before the receipt of one’s first Social Security check is a Roth IRA conversion or series of conversions over several years. This strategy was featured in the March 15, 2010 post, Want to Reduce Taxable Social Security Benefits? Consider a Roth IRA Conversion as part of Retirement Income Visions™ extensive Roth IRA conversion series.

As discussed in that post, to the extent that a Roth IRA conversion reduces the amount remaining in your traditional IRA, your required minimum distributions (“RMD’s”) that you must take from your traditional IRA’s beginning when you turn 70-1/2 will be reduced. Reduced RMD’s result in less “combined income” which can reduce the amount of taxable Social Security benefits and can also reduce the marginal tax rate that is applied to the taxable portion of your benefits, resulting in less taxes. It’s important to keep in mind that this strategy, in order to be effective, needs to be implemented before receipt of Social Security benefits. To the extent that it is executed while one is receiving benefits, it will generally increase taxable income and taxation of benefits.

Another strategy than can be implemented well before receipt of Social Security is investment in one or more non-qualified (i.e., not within an IRA or other retirement plan) deferred income annuities, or “DIAs”. For an introduction to this powerful retirement income planning investment strategy, please refer to the November 23, 2009 post, Deferred Income Annuities: The Sizzle in a Retirement Income Plan. When structured as a nonqualified annuity, there are two potential ways that DIAs can be used to reduce taxation of Social Security benefits. First, the payout start and end dates from one or more DIAs can be selected to plan for the amount of income that will be paid out to reduce taxation of Social Security benefits. Secondly, a portion, sometimes very sizeable, of DIA payouts from nonqualified investments are tax-favored since they aren’t subject to income taxation by virtue of an “exclusion ratio.” Furthermore, unlike tax-exempt investment income, the portion that is excluded isn’t added back to “combined income” when calculating taxable Social Security benefits.

Permanent life insurance is another strategy that can be implemented many years before receipt of Social Security retirement benefits to reduce taxation of those benefits. To the extent that there is build-up of cash value within whole life, universal life, or variable universal life insurance policies, this cash value, when not subject to modified endowment contract, or “MEC,” taxation rules, can be distributed either through loans and/or withdrawals during one’s retirement years, often with little or no associated income taxation. To the extent that this is achieved, this will favorably affect taxation of Social Security benefits.

When you get into your later 50’s and get closer to the earliest potential start date for receipt of your Social Security benefits, i.e., age 62, a key Social Security tax-reduction strategy that has been discussed extensively in several of the Social Security posts beginning with the October 4, 2010 post, Plan for the Frays in Your Social Security Blanket – Part 2 of 2, is the choice of benefit start date for you and your spouse if married. While a delay in start date can result in increased total benefits received during one’s lifetime, it will also result in delay of taxation of benefits as well as potential increased after-tax benefits once commencement of benefits occurs.

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Social Security

Breadwinner Approaching Social Security Retirement Age? – File and Suspend – Part 1 of 2

Retirement Income Center

If you’ve been reading the Social Security retirement income strategy series that began on September 27th, you know that there are several options regarding commencement of receipt of Social Security benefits. You can begin receiving a reduced benefit as early as age 62, a standard benefit at full retirement age (“FRA”) which can vary from 65 to 67 depending upon your year of birth, or wait until 70 at which time your benefit will be 32% greater than the amount you would receive at FRA.

As a spouse, you can either claim a benefit based on your earnings record, or, alternatively, you can collect a spousal benefit equal to 50% of your spouse’s Social Security benefit. Although you can start receiving Social Security survivors benefits at age 60, you must be age 62 to qualify to receive a spousal benefit.

There’s another unpublicized Social Security strategy for potential maximization of Social Security Benefits called “file and suspend.” Candidates for implementing this strategy are typically in the following situation:

  • Married.
  • Older spouse is the breadwinner.
  • Spousal benefit will be greater than what would be received under the spouse’s work record.
  • Older spouse is in good health.
  • Couple has other sources of income, e.g., older spouse is still working, IRA account(s) is (are) available, etc.
  • There is no immediate need for additional income.
  • Older spouse is at least 62, preferably FRA.
  • Younger spouse is at least 62.

By employing this strategy, a couple can start the spousal benefit while enabling the breadwinner to increase his/her FRA benefit by 32%. Here’s how it works. Beginning as early as age 62, and preferably at FRA, i.e., age 65 to 67 depending upon year of birth, the breadwinner files for his/her benefits and his/her spouse files for spousal benefits. The breadwinner immediately requests a suspension of his/her benefits and his/her spouse continues collecting a spousal benefit.

Assuming that the breadwinner is at FRA, his/her benefit will increase 5.5% – 8% each year, depending upon year of birth, until age 70. If the breadwinner dies, his/her spouse will collect a larger benefit equal to what the breadwinner would have collected based on his/her age at his/her time of death.

To the extent that a couple is employing the “file and suspend” strategy and is also taking distributions from an IRA account that wouldn’t otherwise be taken until age 70-1/2, the distributions will reduce the required minimum distributions (“RMD’s”) that would otherwise need to be taken beginning at age 70-1/2. Even though his/her Social Security benefits will be greater when he/she finally begins receiving them at age 70, this strategy can potentially reduce the amount of the breadwinner’s taxable Social Security benefits.

The “file and suspend” strategy is a viable solution for maximizing a married couple’s Social Security benefits, however, it’s not without risk. Stay tuned for Part 2 next week to learn about why this strategy may fall short of accomplishing its goal of maximizing a married couple’s Social Security benefits.

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Roth IRA

Roth IRA Conversion – Analysis Paralysis? – Part 2 of 2

Retirement Income Center

Per Part 1 of this blog post last week, there are dozens of questions that need to be answered when deciding whether a Roth IRA conversion makes sense in your situation. Just looking at, let alone trying to answer, all of the questions is overwhelming and discourages many people from proceeding with one or more Roth IRA conversions.

This is without doubt an area that requires professional analysis and guidance. Even professional financial advisors, however, are often guilty of “analysis paralysis” when dealing with Roth IRA conversions. This term is defined by Wikipedia as:

“…over-analyzing (or over-thinking) a situation, so that a decision or action is never taken, in effect paralyzing the outcome. A decision can be treated as over-complicated, with too many detailed options, so that a choice is never made, rather than try something and change if a major problem arises. A person might be seeking the optimal or ‘perfect’ solution upfront, and fear making any decision which could lead to erroneous results, when on the way to a better solution.”

Roth IRA conversion analysis is a classic situation whereby one can spend an inordinate amount of time preparing dozens of multi-year “what if” projections, changing a single assumption in each scenario with each one being a potentially valid result. Is it necessary, forget about practical and cost-efficient, however, to go through such an arduous process in order to make a Roth IRA conversion recommendation and decision? I personally don’t think this is the best way to approach Roth IRA conversions.

While certain assumptions are important in Roth IRA conversion analysis, we need to recognize the fact that many of them are simply beyond our control. These include, but are not limited to, life expectancy, inflation rates, marginal income tax rates, and investment rates of return. While these assumptions need to be considered, they shouldn’t be over-analyzed since the possibilities are endless, inevitably resulting in analysis paralysis.

It’s also important to recognize that a Roth IRA conversion of any meaningful size is generally not a single event. It should instead be structured as a plan, or series of conversions, over several years in most situations. Besides reducing tax liability attributable to Roth IRA conversions, this approach also minimizes the possibility of unfavorable outcomes, in turn reducing the likelihood of analysis paralysis.

Perhaps the most important consideration in any Roth IRA conversion analysis is to not lose sight of the 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”)

Analysis paralysis, combined with a natural and understandable reluctance to prepay income tax liability attributable to a Roth IRA conversion, can be a strong deterrent to implementing a prudent Roth IRA conversion plan, especially if one doesn’t understand, or loses sight of, the long-term potential benefits of the plan.

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Roth IRA

Roth IRA Conversion – Analysis Paralysis? – Part 1 of 2

Retirement Income Center

As is evident by the sheer number of blog posts to date about Roth IRA conversions – 33 – there’s a lot of things to consider when deciding whether a Roth IRA conversion makes sense for you. These include, but are not limited to, the following questions:

  • Should you do a Roth IRA conversion?
  • How much traditional IRA should be converted?
  • In which year(s) should a conversion be made?
  • Should you employ a multi-year conversion strategy, and, if so, what’s the best plan for you?
  • At which point during a particular year should a conversion be done?
  • Does it make sense to do multiple conversions in a single year?
  • Even though the income from a conversion in 2010 can be deferred to 2011 and 2012, should you do a conversion in 2010?
  • If you do a Roth IRA conversion in 2010, should you go with the default of reporting 50% of the conversion income on your 2011 tax returns and 50% on your 2012 returns or should you instead make an election to report 100% of your conversion income on your 2010 income tax returns?
  • Will your income tax rate be higher or lower than what it is now when you take distributions from your IRA accounts?
  • Which assets should be converted?
  • Should you set up multiple Roth IRA conversion investment accounts?
  • Is the current primary beneficiary of your traditional IRA a charity?
  • Are there retirement plans available for conversion other than active 401(k) plans?
  • What is the amount of projected income tax liability attributable to a potential conversion?
  • When will the tax liability attributable to the conversion need to be paid?
  • What sources of funds are available for payment of the tax liability?
  • Will withdrawals need to be made from the converted Roth IRA within five years of the conversion?
  • Do you have a life expectancy of five years or less with no living beneficiaries?
  • Do your itemized deductions and personal exemptions exceed your gross income such that you can convert a portion, or perhaps all, of your traditional IRA to a Roth IRA without incurring any income tax liability?
  • Do you own a rental property with a large passive activity loss carry forward that you can sell and do a Roth IRA conversion while incurring minimal or no income tax liability?
  • Is there a net operating loss that you can use to offset Roth IRA conversion income?
  • Is there a large charitable contribution available from the establishment of a charitable remainder trust that can be used to offset income from a Roth IRA conversion?
  • What is the basis of your traditional IRA, i.e., how much of your IRA has come from nondeductible IRA contributions or qualified retirement plan after-tax contributions?
  • Are you a surviving spouse in a low tax bracket who isn’t dependent on your IRA and one or more of your children are in a high income tax bracket?
  • What are the years and amounts of your projected required minimum distributions with and without a Roth IRA conversion?
  • What is the amount of projected taxable Social Security benefits that can be reduced by doing a Roth IRA conversion?
  • Do you have a SEP-IRA that can be converted to a Roth IRA?
  • Do you have a dormant 401(k) plan that can be converted?
  • How will a Roth IRA conversion affect financial aid qualification?
  • Will your Medicare Part B premium increase if you do a Roth IRA conversion?
  • If you do a Roth IRA conversion in 2010, will your Medicare Part B premium increase in more than one year?
  • What are the income tax consequences of a partial 72(t) Roth IRA conversion?
  • Should you not do a full Roth IRA conversion and instead leave funds in your traditional IRA for future nondeductible IRA contributions?

Feeling overwhelmed? Read Part 2 next week.

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Roth IRA

The 45 to 60 5-Step Roth IRA Conversion Strategy – Part 4

Retirement Income Center

Part 1 of this blog post introduced a 5-step Roth IRA conversion strategy for individuals 45 to 60 years old who either own a sizeable traditional IRA or have the opportunity to roll over a sizeable 401(k) plan or other retirement plan to an IRA. Steps 1 and 2 of this strategy was presented two weeks ago in Part 2 and steps 3 and 4 were discussed last week in Part 3.

This week’s post presents the fifth and final step together with a hypothetical case to illustrate the use of this strategy. If you haven’t done so already, I would recommend reading Parts 2 and 3 to learn about steps 1, 2, 3, and 4.

Step 5 – Complete Your Conversion Plan No Later Than the Year Before You Turn 70-1/2

As discussed in the January 11, 2010 blog post, Year of the Conversion, there are two main benefits of a Roth IRA that aren’t available to traditional IRA owners:

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

No one I know likes to be forced to do anything. In order to realize benefit #2, it’s important to target your conversion plan completion date for no later than the year before you turn 70-1/2. Once you reach this milestone, you will be required to take minimum distributions from your traditional IRA accounts each year based on your traditional IRA account value on December 31st of the preceding year and an IRS table life expectancy factor. Assuming that you complete your Roth IRA conversion plan by the year before you turn 70-1/2, you won’t be subject to the “RMD” rules.

Hypothetical Case

Now that we have completed our discussion of the 5-step Roth IRA conversion strategy, let’s take a look at a hypothetical case. Keeping in mind that you want to (a) have your 2010 conversion amount be larger than in subsequent years, (b) skip 2011 and 2012 if you deferred the taxation of your 2010 Roth IRA conversion income, (c) convert equal amounts thereafter, and (d) complete your conversion plan no later than the year before you turn 70-1/2, let’s make the following ten assumptions:

  1. Individual age 50 in 2010
  2. Sufficient liquid nonretirement assets to pay income taxes attributable to annual conversions
  3. SEP-IRA with beginning of 2010 value of $400,000 and cost basis of $0
  4. Earnings of 5%
  5. Annual SEP-IRA contributions of $20,000 through age 65
  6. 2010 Roth IRA conversion of $160,000
  7. Taxation of 2010 Roth IRA conversion deferred to 2011 and 2012
  8. No 2011 and 2012 Roth IRA conversions
  9. 2013 and subsequent year conversions of $45,000
  10. Final conversion at age 69 after which SEP-IRA account value = $0

Per the Hypothetical Roth IRA Conversion Strategy spreadsheet, the 2010 value of $400,000, total earnings of approximately $196,000, and total SEP-IRA contributions of $320,000 results in Roth IRA conversions totaling approximately $916,000 by age 69. Not only will the Roth IRA conversions of $916,000 not be subject to additional taxation, 100% of the growth of the Roth IRA funds will escape income taxation provided that the funds remain in the Roth IRA for at least five years from the beginning of the year of each conversion and until age 59-1/2.

It’s important to keep in mind that this is a hypothetical case and actual conversion amounts in a particular situation, assuming a Roth IRA conversion makes sense, will depend on many factors that need to be carefully analyzed for each conversion year.

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Roth IRA

Roth IRA – Retirement Plan Holey Grail?

Retirement Income Center

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.

Categories
Annuities Deferred Income Annuities Retirement Income Planning

Designing Your Income Annuity Plan

While one of the benefits of income annuities as stated in Immediate Income Annuities: The Cornerstone of a Successful Retirement Income Plan is reduced dependence on ongoing investment management, anyone considering the purchase of an annuity should first engage the services of a professional retirement income planner.

A professional retirement income planner, after discussing your retirement income needs with you and analyzing your financial situation, will prepare an income annuity plan that includes a comprehensive analysis and recommendations. The analysis should include multi-year cash flow, income tax, and portfolio projections that illustrate the following:

  • Use of income annuities vs. other types of annuities
  • Use of income annuities vs. other types of investments
  • Amount of taxable vs. nontaxable annuity payments in the case of nonqualified annuities
  • Taxation of projected Social Security benefits with and without single premium immediate annuities (“SPIAs”) and deferred income annuities (“DIAs”)
  • Affect of the use of income annuities on projected required minimum distributions (“RMDs”)
  • How income annuities are being used to close one’s income gap
  • Advantages and disadvantages of implementing an income annuity plan now vs. later
  • Projected portfolio assets in the event of a long-term care situation
  • Projected portfolio assets upon death
  • Projected ongoing cash flow following death to surviving spouse and other beneficiaries
  • Implementation of other planning techniques that can be used in conjunction with income annuities

If it is determined that fixed income annuities should be part of the recommended solution, the recommendations should discuss specific design parameters, including the following:

  1. Contract type: nonqualified or qualified
  2. Whether SPIAs and/or DIAs should be used
  3. Number of SPIA and DIA contracts to be purchased
  4. Initial purchase amounts
  5. Ongoing purchase amounts and timing of same
  6. Source of funds to be used for initial and ongoing purchases of each contract
  7. Whether the annuity contract is replacing another annuity contract or life insurance policy
  8. Plan type: period certain, life, joint life
  9. Payment commencement dates for DIAs
  10. Payment amount
  11. Payment frequency: monthly, quarterly, semi-annual, or annual
  12. Inflation percentage increase
  13. Number of payments in the case of a period certain
  14. Owners
  15. Annuitants
  16. Beneficiaries
  17. Life insurance companies

As you can see, the analysis and parameters associated with the design of an income annuity plan is complex, to say the least. Annuities should never be purchased as stand-alone products when used as part of a retirement income planning solution. A professional retirement income planner should always be engaged to perform the requisite analysis and make recommendations that will result in the best solution for determining, and closing, your projected income gap before purchasing any annuities.