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

Not Converting 100% of Your Traditional IRA’s? – Don’t Use All of Your Basis – Part 1

In the August 2, 2010 post, Remember Your IRA Basis Scorecard When Planning Roth IRA Conversions, the concept of basis, including the importance of tracking it and using it to offset otherwise taxable gains in connection with Roth IRA conversions, was discussed. This post and next week’s post are follow-ups to that post since they expand upon the discussion of how taxable gains are calculated in connection with a partial Roth IRA conversion when basis is available.

We learned in Remember Your IRA Basis Scorecard When Planning Roth IRA Conversions that you’re taxed on the difference between the value of your distribution and your basis in the distribution. This is a relatively simple calculation when you convert 100% of all of your traditional IRA accounts, however, it’s a different story when you do a partial Roth IRA conversion.

A partial Roth IRA conversion occurs when you convert less than the total value of all of your traditional IRA accounts to a Roth IRA. Partial Roth IRA conversions come in three flavors. They include conversions of:

  1. A portion of a single traditional IRA account,
  2. A portion of a traditional IRA account where there are multiple traditional IRA accounts, or
  3. 100% of one of two or more traditional IRA accounts

Scenario #1 is pretty straightforward when calculating taxable gains, however, scenario’s #2 and #3 can be problematic when basis is present if you’re not careful. The best way to illustrate is by using examples. Before doing so, however, it’s important to point out an often-overlooked issue when dealing with scenarios #2 and #3 which can contribute directly to the taxable gain calculation problem.

When considering one’s traditional IRA’s, always keep in mind that there are several types of accounts that fall under the traditional IRA umbrella. Basically, any IRA account that isn’t a Roth IRA, beneficiary IRA, or SIMPLE IRA account is generally a traditional IRA account. This includes regular, or contributory IRA accounts which can include both deductible and nondeductible IRA contributions, rollover IRA’s, SEP-IRA’s (see the June 21st post, Don’t Forget About Your SEP-IRA for Roth IRA Conversions), and 72(t) IRA’s (see the July 26th post, Considering a Partial 72(t) Roth IRA Conversion? – Tread Lightly).

Whenever you calculate the taxable gain in connection with a partial Roth IRA conversion, the first thing you should always do is take an inventory of your various IRA accounts to make sure that you include all of your traditional IRA accounts as well as the basis from each of your accounts in your calculation.

Next week’s post will illustrate each of the three partial Roth IRA conversion scenarios, including the calculation of taxable gain. Stay tuned.