Tag: traditional IRA

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Annuities Deferred Income Annuities Fixed Index Annuities Retirement Income Planning

Looking for a Deferred Fixed Income Annuity on Steroids?

Deferred income annuities (DIAs) have been getting a lot of attention since the Treasury and IRS finalized a regulation in July, 2014 blessing the use of qualified longevity annuity contracts, or “QLACs.” A QLAC is a DIA that’s held in a qualified retirement plan such as a traditional IRA with a lifetime income start date that can begin up to age 85. It’s subject to an investment limitation of the lesser of $125,000 or 25% of one’s retirement plan balance.

Fixed Income Annuity Hierarchy

For individuals concerned about longevity who are looking for a sustainable source of income they can’t outlive, fixed income annuities are an appropriate solution for a portion of a retirement income plan. There are three types to choose from:

  1. Immediate annuities
  2. Deferred income annuities (DIAs)
  3. Fixed index annuities (FIAs) with income riders

The overriding goal when choosing fixed income annuities is to match after-tax income payouts to periodic amounts needed to pay for specified projected expenses using the least amount of funds. Immediate annuities, with a payout that begins one month after purchase date, are appropriate for individuals on the cusp of retirement or who are already retired. DIAs and FIAs with income riders, with their built-in deferred income start dates, are suitable whenever income can be deferred for at least five years, preferably longer.

Assuming there isn’t an immediate need for income, a deferred income strategy is generally the way to go when it comes to fixed income annuities. This includes one or more DIAs or FIAs with income riders. Which should you choose?

DIA Considerations

As a general rule, DIAs and FIAs are both qualified to fulfill the overriding income/expense matching goal. Both offer lifetime income payouts. If your objective is deferred lifetime sustainable income, DIA and FIA with income rider illustrations should be prepared to provide you with an opportunity to compare income payouts.

DIAs can also be purchased for a specified term of months or years. This can be important when there are projected spikes in expenses for a limited period of time.

DIAs may also be favored when used in a nonretirement account since a portion of their income is treated as a nontaxable return of principal. Finally, if you’re looking to defer the income start date beyond the mandatory age of 70-1/2 for a limited portion of a traditional IRA, a QLAC, which is a specialized DIA, may be an appropriate solution.

Let’s suppose that you’re a number of years away from retirement and you’re not sure when you want to retire or how much income you will need each year. A DIA may not be your best choice since you lock in a specified income start date and income payout at the time of investment with most DIAs.

FIA with Income Rider Features

FIAs with income riders hold a distinct advantage over DIAs when it comes to income start date flexibility. Unlike a DIA, there’s no requirement to specify the date that you will begin receiving income when you purchase a FIA.

The longer you hold off on taking income, the larger the periodic payment you will receive. Furthermore, there’s no stipulation that you ever need to take income withdrawals. This is ideal when planning for retirement income needs ten or more years down the road.

For individuals not comfortable with exchanging a lump sum for the promise of a future income stream beginning at a specified date, i.e., a DIA, a FIA with its defined accumulation value and death benefit, offers an attractive alternative assuming similar income payouts. While an optional death benefit feature can be purchased with a DIA to provide a return of premium to one or more beneficiaries prior to the income start date, this will reduce the ongoing income payout amount.

A FIA also has a defined investment, or accumulation, value that equates to a death benefit. Unlike with most DIAs, flexible-premium FIAs offer the ability to make additional investments that will increase income withdrawal amounts in addition to the investment value.

Some FIAs offer a premium bonus that matches a limited percentage, e.g., 5%, of your initial, as well as subsequent, investments for a specified period of time. The accumulation value is also increased by contractually-defined periodic interest credits tied to the performance of selected stock indices.

Finally, a FIA’s accumulation value is reduced by withdrawals and surrender and income rider charges. Any remaining accumulation value is paid to beneficiaries upon the death of the owner(s).

Summary

A comprehensive retirement income plan is a prerequisite for determining the type(s), investment and income payout timing, and investment amounts of fixed income annuities to match after-tax income payouts with projected expense needs assuming that longevity is a concern. If you don’t have an immediate need for income and your objective is lifetime sustainable income, DIA and FIA with income rider illustrations should be prepared to provide you with an opportunity to compare potential income payouts.

With their ability to match a spike in expenses for a limited period of time, term DIAs offer a unique solution. When it comes to lifetime income payouts, FIAs with income riders, with their flexible income start date and accumulation value and associated built-in death benefit, are, in effect, a DIA on steroids.

Given the foregoing advantages and assuming similar income payouts, FIAs with income riders generally offer a more comprehensive solution for fulfilling sustainable lifetime income needs, with the possibility of a larger death benefit. A potential exception would be when investing in a nonretirement account for higher tax bracket individuals subject to one’s preference for a flexible income start date and accumulation value/death benefit in a particular situation.

Last, but not least, all proposed annuity solutions should be subjected to a thorough due diligence review and analysis of individual life insurance companies and products before purchasing any annuity contracts.

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Annuities Deferred Income Annuities Income Tax Planning Qualified Longevity Annuity Contract (QLAC)

Is a QLAC Right for You?

2014 marked the introduction of qualified longevity annuity contracts, or QLACs. For those of you not familiar with them, a QLAC is a deferred fixed income annuity designed for use in retirement plans such as 401(k) plans and traditional IRAs (a) that’s limited to an investment of the lesser of $125,000 or 25% of the value of a retirement plan and (b) requires that lifetime distributions begin at a specified date no later than age 85. QLAC investment options are currently limited to deferred income annuities, or DIAs.

The purchase of deferred fixed income annuities in retirement plans for longevity protection isn’t a new concept. What’s unique about QLACs is the ability to extend the start date of required minimum distributions (RMDs) from April 1st of the year following the year that you turn 70-1/2 to up to age 85. This provides potential income tax planning opportunities for QLAC holders subject to the purchase cap.

Potential Income Tax Savings

A lot of individuals are selling QLACs short due to the purchase cap. While on the surface, $125,000 may not represent a sizable portion of a retirement plan with assets of $750,000 or more, the potential lifetime income tax savings can be significant.

The amount of savings is dependent on six factors: (a) amount of QLAC investment (b) age at which QLAC investment is made, (c) deferral period from date of QLAC purchase until income start date, (d) rate of return, (e) income tax bracket, and (f) longevity.

Illustration

I have prepared the attached exhibit to illustrate potential income tax savings achievable by investing $125,000 at three different ages in a QLAC by comparing it to a non-QLAC investment that’s subject to the RMD rules. Assumptions used in the preparation of the exhibit are as follows:

  1. $125,000 is invested in a non-QLAC vehicle at one of three different ages: 55, 60, or 65.
  2. Rate of return is 5%.
  3. RMD’s are taken from age 71 through 85, the range of ages between which RMD’s and QLAC distributions, respectively, are required to begin.
  4. Income tax brackets are 2015 federal income tax brackets plus 5% for assumed state income tax.

In addition to assumed rates of return and income tax brackets, a key assumption is the age at which the QLAC investment is made. All else being equal, purchases at earlier ages avoid greater amounts of RMDs and associated income tax liability. Per the exhibit, the amount of projected income tax savings over 15 years ranges from approximately $20,000 to $97,000 depending upon assumed QLAC investment date and income tax bracket.

Considerations

Reduction of RMDs and associated income tax liability is an important goal, however, it may not be the best strategy for achieving the overriding goal of retirement income planning, i.e., making sure that you have sufficient income to meet your projected expenses for the duration of your retirement.

There are several questions you need to answer to determine the amount, if any, that you should invest in a QLAC:

  • What are your projected federal and state income tax brackets between age 71 and 85?
  • What are the projected rates of return on your retirement funds between 71 and 85 taking into consideration the likelihood of at least one bear market during this time?
  • What is your, and your spouse, if married, projected life expectancy?
  • Which years between age 71 and 85 can you afford to forego receipt of projected net RMD income, i.e., RMD less associated income tax liability?
  • Will you need to take retirement plan distributions in excess of your RMDs, and, if so, in which years and in what amounts?
  • What other sources of income do you have to replace the projected RMD income you won’t be receiving?
  • What is the projected income tax liability you will incur from withdrawing funds from other sources of income?
  • What is the amount of annual lifetime income that you will receive from a QLAC beginning at various ages between 71 and 85 assuming various investment amounts, with and without a death benefit with various payout options?
  • Does it make more sense to invest in a non-QLAC longevity annuity such as a fixed index annuity with an income rider?
  • Should you do a Roth IRA conversion instead?

Given the fact that opportunities to reduce RMDs and associated income tax liability are limited, QLACs are an attractive alternative. Projected income tax savings are just one factor to consider and can vary significantly from situation to situation, depending upon assumptions used. There are a number of other considerations that need to be analyzed before purchasing a QLAC to determine the best strategies for optimizing your retirement income.

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Roth IRA

5 Ways to Reduce Your Tax Liability Using Roth IRA Conversions

One of the most important financial goals for retirees is maximization of after-tax income. There are two ways to accomplish this: (a) maximize pre-tax income and (b) minimize income tax liability. A Roth IRA can go a long way toward helping you achieve the latter.

There are two ways to fund a Roth IRA: (a) annual contributions and (b) conversions. Annual contributions, in and of themselves, generally won’t result in a significant source of retirement income due to the relatively low limitation – currently $5,500 or $6,500 if you’re age 50 or older. In addition, eligibility to make Roth IRA contributions is limited to the extent that your income exceeds defined limits.

Roth IRA conversions, on the other hand, have the ability to generate substantial after-tax income while also reducing income tax liability for up to 20 to 30 years or more of retirement. Since income tax liability on the value of Roth IRA conversions will need to be paid, timing of conversions is key. See the May 10, 2010 post, Be on the Lookout for Roth IRA Conversion Opportunities, for a discussion of this topic.

There are five ways that you can potentially reduce your income tax liability and increase your after-tax income during your retirement years by doing Roth IRA conversions.

1. Never pay income tax on the growth of your Roth IRA

While you’re required to include the value of your IRA, 401(k) or other qualified plan assets that you convert to a Roth IRA in your taxable income in the year of conversion, 100% of the growth of your Roth IRA is excluded from taxation. This is true whether or not you ever take any distributions from your Roth IRA.

Individuals who did Roth IRA conversions in March, 2009 when the Dow dipped below 7,000 didn’t mind paying income tax on those conversions in retrospect given the fact that the Dow is currently hovering over 17,000 less than six years later. The income tax savings on the growth of the equity portion of their converted accounts over this period of time plus future potential growth is significant for those in this situation.

2. Roth IRA accounts aren’t subject to required minimum distribution rules

If you don’t do a Roth IRA conversion, 100% of the value of your traditional IRA, 401(k), and other qualified plan assets, including appreciation, will be subject to IRS’ required minimum distribution, or RMD, rules. These rules require you to take annual minimum distributions from your retirement plan accounts beginning by April 1st of the year following the year that you turn 70-1/2. 100% of distributions reduced by any allowable portion of nondeductible contributions are taxable.

As an example, suppose you were born on January 7, 1940 and you own a traditional IRA account with a value of $500,000 on December 31, 2013, you would be required to take a minimum distribution of $21,008.40 from your account by December 31, 2014 and include it in your 2014 taxable income. If instead you owned a Roth IRA account with the same value, you wouldn’t be required to take any distributions from your account.

3. Potentially reduce net investment income tax

The RMD rules sometimes force people to take distributions from their taxable IRA accounts that they don’t need. Often times, they transfer RMDs from their taxable IRA account to a nonretirement investment account and leave them there. For individuals with high levels of income, this can result in additional taxation as a result of subjecting the earnings on their nonretirement account to the net investment income tax of 3.8%. This isn’t an issue for Roth IRA account holders since the RMD rules don’t apply to them.

4. Roth IRA distributions aren’t included when calculating taxable Social Security benefits

The taxation of Social Security benefits is dependent upon your combined income and tax filing status. Combined income includes adjusted gross income, nontaxable interest, and 50% of Social Security benefits.

Single filers are subject to tax on 50% of their Social Security benefits for combined income between $25,000 and $34,000 and up to 85% of benefits when combined income exceeds $34,000. Married filing joint taxpayers are subject to tax on 50% of their Social Security benefits for combined income between $32,000 and $44,000 and up to 85% of benefits when combined income exceeds $44,000.

Roth IRA distributions aren’t included in adjusted gross income, therefore, they don’t affect taxation of Social Security benefits.

5. More opportunities for income tax bracket planning

For all taxpayers, taxable income is subject to seven different rates of tax ranging from 10% to 39.6% depending upon the amount of taxable income. Given the foregoing four potential ways of reducing taxable income and associated income tax liability, Roth IRA conversions can also reduce the income tax rates that are used to calculate income tax liability on other sources of income. This allows for more opportunities for income tax bracket planning to potentially further reduce income tax liability in one or more years.

Although it’s not income-tax related, one other potential benefit of Roth IRA conversions that shouldn’t be overlooked is their impact on the calculation of Medicare Part B premiums. Monthly Medicare Part B premiums currently range from $104.90 to $335.70 depending upon tax filing status and the amount of modified adjusted gross income from two years ago. Roth IRA distributions aren’t included in the calculation of adjusted gross income. As such, they don’t affect the amount of Medicare Part B premiums paid.

As you can see, assuming (a) you can get over the hurdle of prepaying a portion of your income tax liability when you do Roth IRA conversions and (b) you have sufficient nonretirement funds to pay the tax, this can create several tax reduction opportunities as well as a potential reduction of Medicare Part B premiums throughout your retirement years. These benefits, combined with the ability to eliminate taxation on the growth of Roth IRA accounts, can result in greater and longer-lasting after-tax retirement income compared to not doing any Roth IRA conversions.

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Deferred Income Annuities Longevity Insurance Qualified Longevity Annuity Contract (QLAC) Retirement Income Planning

Don’t Expect to See QLAC’s Soon

One of the most exciting retirement income planning opportunities since the elimination of the Roth IRA conversion income threshold in 2010 has been approved, however, it isn’t available yet for purchase.

For those of you who may not be familiar with the change in Roth IRA conversion eligibility rules, prior to 2010, only taxpayers with modified adjusted gross income of less than $100,000 were eligible to convert a traditional IRA to a Roth IRA. With the elimination of the income threshold, Roth IRA conversions have soared in popularity since anyone may convert part, or all, of his/her traditional IRA to a Roth IRA. See Year of the Conversion to learn more.

The most recent potential retirement income planning game-changer, qualified longevity annuity contracts, or “QLAC’s,” have received a fair amount of press since the Treasury and IRS finalized a regulation in the beginning of July blessing their use. I have personally written two other articles about them, beginning with 6 Ways a New Tax Law Benefits a Sustainable Retirement published July 25th in the RetireMentors section of MarketWatch and my August 4th Retirement Income Visions™ blog post, You Don’t Have to Wait Until 85 to Receive Your Annuity Payments.

What are QLAC’s?

QLAC’s came about in response to increasing life expectancies and the associated fear of outliving one’s assets. With the passage of IRS’ final regulation, retirement plan participants can now invest up to the lesser of $125,000 or 25% of their retirement plan balance in specially-designated deferred income annuities, or “DIA’s,” that provide that lifetime distributions begin at a specified date no later than age 85. Unlike single premium immediate annuities, or “SPIA’s,” that begin distributing their income immediately after investment, the start date for DIA income payments is deferred for at least 12 months after the date of purchase.

As discussed in my July 25th MarketWatch article, QLAC’s offer a new planning opportunity to longevitize your retirement in six different ways. While longevity is the driving force for QLAC’s, the income tax planning angle, which is the first possibility, has been attracting the lion’s share of media attention. Specifically, QLAC’s provide retirement plan participants with the ability to circumvent the required minimum distribution, or “RMD,” rules for a portion of their retirement plan assets. These rules require individuals to take annual minimum distributions from their retirement plans beginning by April 1st of the year following the year that they turn 70-1/2.

Where Do I Buy a QLAC?

I’ve had several people ask me recently, “Where do I buy a QLAC?” Unlike the Roth IRA conversion opportunity that expanded the availability of an existing planning strategy from a limited audience to anyone who owns a traditional IRA with the elimination of the $100,000 income barrier beginning on a specified date, i.e., January 1, 2010, the implementation of IRS’ QLAC regulation is much more complicated. This is resulting in an unknown introduction date for QLAC offerings.

There are several reasons for this, not the least of which is the nature of the product itself. First and foremost, although an existing product, i.e., a deferred income annuity, or “DIA,” will initially be used as the funding mechanism for QLAC’s, the contracts for DIA’s that are currently available don’t necessarily comply with all of the various provisions of IRS’ new QLAC regulation. While the three mentioned are the most important, i.e., (1) Only available for use in retirement plans, (2) limitation of lesser of $125,000 or 25% of retirement plan balance, and (3) distributions must begin at a specified date no later than age 85, there are other technical requirements that must be met in order for a DIA to be marketed and sold as a QLAC.

In addition to understanding and complying with the nuances of the IRS regulation, life insurance carriers that want to offer QLAC’s are scrambling to restructure existing DIA products and develop new products that will (a) match consumers’ needs, (b) be competitive, and (c) meet profit objectives. This requires a host of system and other internal changes, state insurance department approvals, and coordination with distribution channels, all of which must occur before life insurance companies will receive their first premiums from sales of this product.

Another important obstacle to the introduction of QLAC’s is the fact that fixed income annuities with deferred income start dates, including DIA’s and fixed index annuities, or “FIA’s,” with income riders, are a relatively new product to which many consumers haven’t been exposed. While both products are designed, and are suitable, for use in retirement income plans, most investment advisors don’t currently have the specialized education, licensing, and experience to understand, let alone offer, these solutions to their clients. See What Tools Does Your Financial Advisor Have in His or Her Toolbox?

So when will you be able to purchase QLAC’s? Although current speculation is that product launch may begin in the fourth quarter of this year, it’s my personal opinion that widespread availability will not occur until well into 2015. This will give investment advisers and consumers, alike, additional time to get more educated about fixed income annuities, including their place in retirement income plans. Once the word spreads, I believe that the demand for fixed income annuities will increase significantly, especially if the timing is preceded by a stock market decline.

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Annuities Deferred Income Annuities Retirement Income Planning

Consider a Death Benefit When Buying Deferred Income Annuities

If you’re in the market for sustainable lifetime income, you’ve come to the right place if you’re looking at fixed income annuities. A fixed income annuity is a fixed (vs. variable) annuity that provides income payments for your lifetime or for a contractually-defined term.

There are three types of fixed income annuities, each one serving a different purpose in a retirement income plan. The three types are as follows:

The main distinction between the three types of fixed income annuities is the timing of the commencement of income payments. As its name implies, the income from a SPIA begins immediately. The actual start date is one month after the date of purchase assuming a monthly payout.

The income start date of DIA’s and FIA’s with income riders, on the other hand, is deferred. With both DIA’s and FIA’s with income riders, it’s contractually defined and is generally at least one year from the purchase date. Although you choose it when you submit your application, most DIA’s have a defined start date; with some wiggle room available on some products. The income commencement date for FIA’s with income riders is flexible other than a potential one-year waiting period and/or minimum age requirement.

Assuming that a DIA meets your retirement income planning needs, you should always consider including a death benefit feature which is optional with most DIA’s. Keeping in mind that the income start date is deferred, and it’s not unusual for the deferral period to be 10 to 25 years, especially when purchasing a DIA as longevity insurance, you probably don’t want to lose your premium, or investment, if you die prematurely.

If you purchase a DIA without a death benefit or return of premium (“ROP”) feature, and you die during the deferral period, not only will the income never begin, your beneficiaries won’t receive anything either. The death benefit or ROP feature serves the purpose of insuring your investment in the event that you die before your income distributions begin.

So how much does it cost to insure your DIA investment by adding an optional death benefit? To illustrate, I recently evaluated the transfer of $100,000 from one of my client’s IRA brokerage accounts to a DIA. My client is approaching her 65th birthday and, like all individuals with traditional IRA accounts, must begin taking annual required minimum distributions, or “RMD’s,” from her account by April 1st of the year following the year that she turns 70-1/2.

Assuming that $100,000 of my client’s IRA is transferred from her brokerage account to a DIA, and assuming that the income from her DIA begins when she turns 70-1/2, she can expect to receive lifetime monthly income of approximately $600 to $700, depending upon the DIA chosen. In one case, the monthly benefit would be reduced by $2.27, from $691.68 to $689.41 with a death benefit feature. In another case, the monthly benefit would be $1.09 less, at $664.41 without any death benefit vs. $663.32 with a death benefit.

In other words, the cost to insure the return of my client’s investment of $100,000 in the event of her death prior to turning 70-1/2 translates to an annual reduction in lifetime benefits of $13.08 or $27.24, depending on the DIA chosen. Not only is there no question about the value of the death benefit in this situation, it would be negligent in my opinion for any life insurance agent not to illustrate the addition of this feature.

Assuming that a fixed income annuity makes sense for you, and further assuming that a DIA is an appropriate solution as a piece of your retirement income plan, always evaluate your potential lifetime income payout with and without a death benefit.

Categories
Annuities Deferred Income Annuities Fixed Index Annuities

Invest in DIA to Fund LTCI Premiums When Retired – Part 4 of 4

The first three posts in this series discussed five differences between fixed index annuities (“FIA’s”) with income riders and deferred income annuities (“DIA’s”) that will influence which retirement income planning strategy is preferable for funding long-term care insurance (“LTCI”) premiums in a given situation. If you haven’t done so already, I would recommend that you read each of these posts.

This week’s post presents a sample case to illustrate the use of a FIA with an income rider vs. a DIA to fund LTCI premiums during retirement.

Assumptions

As with all financial illustrations, assumptions are key. A change in any single assumption will affect the results. The following is a list of assumptions used in the sample case:

  1. 55-year old, single individual
  2. Planned retirement start age of 68
  3. Life expectancy to age 90
  4. Current annual LTCI premium of $4,000 payable for life
  5. Need to plan for infrequent, although potentially double-digit percentage increases in LTCI premium at unknown points in time
  6. Given assumptions #4 and #5, plan for annual pre-tax income withdrawals of approximately $6,000 beginning at retirement age
  7. Solve for single lump sum investment at age 55 that will provide needed income
  8. Investment will come from a nonqualified, i.e., nonretirement, investment account
  9. One investment option is a fixed index annuity (“FIA”) with an income rider with lifetime income withdrawals beginning at age 68.
  10. Second investment option is a deferred income annuity (“DIA”) with no death benefit and lifetime income payout beginning at age 68.
  11. FIA premium bonus of 10%
  12. FIA annual return of 3%
  13. FIA income rider charge of 0.95% of income rider value otherwise known as the guaranteed minimum withdrawal benefit (“GMWB”)
  14. No withdrawals are taken from the FIA other than the income withdrawals.
  15. All investments are purchased from highly-rated life insurance companies known for providing innovative and competitive retirement income planning solutions.

Investment Amount

The first thing that needs to be solved for is the amount of investment that must be made at the individual’s age 55 in order to produce lifetime annual income of approximately $6,000 beginning at age 68. The goal is to minimize the amount of funds needed for the investment while choosing a strategy from a highly-rated insurance company that’s known for providing innovative and competitive retirement income planning solutions.

It turns out that an investment of $50,000 to $65,000 is needed to produce lifetime annual income of approximately $6,000 beginning at age 68. Given the fact that my goal as a retirement income planner is to use the smallest amount of investment for a fixed income annuity to produce a targeted income stream in order to preserve the remainder of a client’s investment portfolio for my client’s other financial goals, the amount of the investment needed is $50,000.

Results

There are three items we will examine to compare the results between investing $50,000 in a FIA with an income rider vs. a DIA to fund LTCI premiums during retirement. They are as follows:

  • Annual gross income
  • Annual taxable income
  • Value/death benefit

Annual Gross Income

Per the Exhibit, the annual payout, or gross income, from the FIA is $5,764, or $236 less than the annual gross income of $6,000 from the DIA. This equates to a total of $5,428 for the 23 years of payouts from age 68 through age 90.

Annual Taxable Income

If the investment was made in a retirement account like a traditional IRA and assuming there have been no nondeductible contributions made to the IRA, 100% of the income would be taxable. This would be the case for both the FIA or DIA.

As stated in assumption #8, the investment will come from a nonqualified, i.e., nonretirement, investment account. Per Part 2 of this series, this makes a difference when it comes to taxation of the withdrawals. Per the Exhibit, 100% of the annual FIA income of $5,764 is fully taxable vs. $3,066 of the DIA income. This is because the DIA, unlike the FIA, is being annuitized and approximately 50% of each income payment is nontaxable as a return of principal. Over the course of 23 years of payouts, this results in $62,054 of additional taxable income for the FIA vs. the DIA.

The amount of income tax liability resulting from the additional taxable income from the FIA will be dependent upon several factors that will vary each year, including (a) types, and amounts, of other income, (b) amount of Social Security income, (c) potential losses, (d) adjusted gross income, (e) itemized deductions, (f) marginal tax bracket, and (g) applicable state income tax law.

Value/Death Benefit

While the present value of the future income stream of a DIA represents an asset, you generally won’t receive an annual statement from the life insurance company showing you the value of your investment. In addition, while some DIA’s will pay a death benefit in the event that the annuitant dies prior to receiving income, per assumption #10, this isn’t the case in this situation. Consequently, the DIA column of the “Value/Death Benefit” section of the Exhibit is $0 for each year of the analysis.

On the other hand, there’s a projected value for the FIA from age 55 through age 79. This value is also the amount that would be paid to the FIA’s beneficiaries in the event of death. There’s a projected increase in value each year during the accumulation stage between age 55 and 67 equal to the net difference between the assumed annual return of 3% and the income rider charge of 0.95% of the income rider value.

Per the Exhibit, the projected value/death benefit increases from $56,278 at age 55 to $68,510 at age 67. Although the assumed premium bonus of 10% is on the high side these days, this is reasonable given the fact that FIA values never decrease as a result of negative performance of underlying indexes, the assumed rate of return of 3% is reasonable in today’s low index cap rate environment, and the assumed income rider charge of 0.95% of the income rider value is on the upper end of what’s prevalent in the industry. The projected value/death benefit decreases each year from age 68 to age 79 until it reaches $0 beginning at age 80 as a result of the annual income withdrawals of $5,764.

Conclusion

As discussed in Parts 1 – 3 of this series, there are five important differences between FIA’s with income riders and DIA’s that will influence which retirement income planning strategy is preferable for funding LTCI premiums during retirement in a given situation. Two of the differences, income start date flexibility and income increase provision, haven’t been addressed in this post.

In addition to the five differences, the amount of the investment required to produce a targeted lifetime annual income amount to pay LTCI premiums, including potential increases, will differ depending upon the particular FIA or DIA strategy used. In the illustrated case, which isn’t uncommon today, an investment of $50,000 resulted in an almost identical lifetime income payout whether a FIA with an income rider or a DIA is used.

As illustrated, the taxable income associated with a DIA in a nonqualified environment is much less compared to a FIA. As previously discussed, the amount of tax savings resulting from the reduced taxable income will depend upon an analysis of several factors and will vary each year. Ignoring the potential income tax savings resulting from the tax-favored DIA payouts, the FIA with income rider would be the preferred investment choice for many individuals in this case given the presence, duration, and projected amount of, the investment value/death benefit.

The FIA edge is reinforced by the fact that, unlike most traditional DIA’s, the income start date and associated annual lifetime income payout amount for FIA’s is flexible. This would be an important consideration in the event that the year of retirement changes. Furthermore, this is quite possible given the fact that the individual is 13 years away from her projected retirement year.

As emphasized throughout this series, the purchase of LTCI needs to be a lifetime commitment. Planning for the potential purchase of a LTCI policy should be included as part of the retirement income planning process to determine the sources of income that will be used to pay for LTCI throughout retirement. Whether it’s a FIA with an income rider, a DIA, or some other planning strategy that’s used for this purpose will depend on the particular situation.

Categories
Annuities Fixed Index Annuities Income Tax Planning

Annuitization Tax Treatment of Nonretirement Distributions

Retirement Income Center

Per last week’s post, there are four things that you don’t receive when you purchase an income rider with a fixed index annuity that are associated with fixed income annuities. The first three, i.e., annuitization, immediate payments, and ability to receive payments over a fixed period, were discussed in last week’s post. The fourth thing – annuitization tax treatment of nonretirement distributions – is the subject of this week’s post.

Before we discuss tax treatment of distributions, I want to talk briefly about taxation of annuities during the accumulation stage before any distributions are made. Similar to IRA’s and other qualified retirement plans, unless they’re immediately annuitized, all annuities, including fixed income annuities, enjoy tax-deferred growth. That is, until distributions are taken, there’s no taxation. This is true whether the annuity is held within a nonretirement account, a traditional IRA or other qualified plan, or a Roth IRA.

Once payments begin, they’re subject to taxation. Income tax treatment is dependent upon the type of account or plan in which the annuity is held. The remainder of this post will discuss income tax treatment of payments as it pertains specifically to fixed index annuity income riders.

At the two extremes when it comes to taxation are traditional IRA’s and Roth IRA’s. If held within a traditional IRA or other qualified plan, all distributions, other than those deemed to come from nondeductible contributions, are taxable as ordinary income. For fixed index annuities held within a Roth IRA, and assuming that the investment has been held for at least until the greater of five years or age 59-1/2, none of the distributions are taxable.

Taxation of distributions from annuities held within nonretirement accounts, on the other hand, uses a hybrid approach. Furthermore, the tax treatment is different depending upon whether you’re annuitizing an annuity vs. receiving payments from a fixed index annuity income rider.

When you annuitize a nonretirement fixed income annuity, part of each payment is considered to be a return of principal and part is deemed to be earnings. The principal portion is nontaxable and the earnings are taxable as ordinary income. Once the total amount of the investment in the contract is recovered, all future payments are fully taxable.

Per the “Annuitization” section of last week’s post, income rider payments are deemed to be withdrawals vs. annuitization of a fixed index annuity contract. This is an important distinction when it comes to income tax treatment of nonretirement distributions. As withdrawals, last-in first-out, or “LIFO,” tax treatment applies for investments made after August 13, 1982. This means that the first money that comes out is taxable as ordinary income similar to distributions from contributory IRA’s. Once all of the earnings have been received, all future payments are considered to be a return of investment, and, as such, are nontaxable.

In summary, the fourth and final thing that you don’t receive when you purchase an income rider with a fixed index annuity is annuitization tax treatment of nonretirement distributions. This is initially less favorable compared to annuitization since distributions are fully taxable until all earnings have been received. After this occurs, future distributions are nontaxable vs. taxable as ordinary income once the investment in the contract has been recovered when you annuitize an annuity.

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Retirement Income Planning

Where Have All the Pensions Gone?

Retirement Income Center - Pensions

If you aren’t receiving a pension from a former private sector employer, there’s a pretty good chance that your employee benefit package doesn’t include this once-cherished perk. According to a study by Towers Watson & Co., as of May 31, 2011, only 30% of Fortune 100 companies offered a defined benefit plan to new salaried employees. That’s down from 37% at the end of 2010, 43% in 2009, 47% in 2008, and 83% as recently as 2002. This is a far cry from 1985 when 90% of Fortune 100 companies offered a traditional pension plan to new employees.

While defined contribution plans, predominantly 401(k) plans, have replaced defined benefit plans in the private sector, the pension aspect is lacking in the majority of such plans today. Specifically, with limited exceptions, these plans generally don’t provide for a predetermined monthly payment that an employee can expect to receive beginning at a specified age for the rest of his/her life and his/her spouse’s life if married.

Furthermore, to the extent that a 401(k) plan is available, the future accumulation value of a participant’s account is unknown. It’s dependent upon several variables, including number of years of participation, IRS-imposed employee and employer contribution limits, employee contribution amounts, potential employer matching contributions, investment offerings, performance of chosen investments, participant loans, and potential plan distributions.

The inability to provide for a known monthly lifetime income upon retirement is not unique to employer-sponsored plans. It’s also common to employee and self-employed retirement plans, including, but not limited to, traditional IRA’s, Roth IRA’s, and SEP-IRA’s.

In addition, the nature of many investment vehicles, whether held inside or outside a retirement plan, don’t lend themselves to plan for a predictable known future lifetime or joint lifetime stream of income. Whether you’re talking about a savings account, CD, bond, stock, mutual fund, or exchange traded fund, this feature is generally unavailable.

Finally, a discussion about retirement income wouldn’t be complete without mentioning Social Security. Social Security is a wonderful provider of monthly retirement income for those individuals who qualify to receive it. Of all non self-funded plans, it comes closest to duplicating the pension aspect of a defined benefit plan. Unlike most defined benefit plans, the monthly benefit can increase as a result of cost of living adjustments. Unfortunately, the uncertainty that surrounds the Social Security system makes it difficult to plan for this benefit, especially for younger individuals.

Given (a) the scarcity of traditional defined benefit pension plans, (b) the inability of 401(k) plans, employee and self-employed retirement plans, and many nonretirement investment vehicles to provide for a predetermined monthly lifetime income beginning at a specified age, and (c) the inadequacy and uncertainty of the Social Security system, it behooves each and every one of us to create our own pension plan.

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Retirement Income Planning

Nonretirement Investments – The Key to a Successful Retirement Income Plan

Retirement Income Center

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.

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Roth IRA

Roth IRA Conversion Insights – Part 1 of 2

Retirement Income Center

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.

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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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Roth IRA Social Security

Roth IRA Conversions – Don’t Let the Tax Tail Wag the Dog – Part 5 of 6

Retirement Income Center

Parts 3 and 4 of this series addressed the first two of three primary economic benefits associated with a Roth IRA conversion: (1) elimination of taxation on 100% of the growth of Roth IRA conversion assets and (2) elimination of exposure to required minimum distributions, with the first one being the most important and overriding reason in most cases for doing a conversion. This post discusses the third and final benefit – potential reduction in taxation of Social Security benefits.

Economic benefit #3 has intentionally been saved for last. Unlike the first two benefits which will occur provided there is an increase in the value of the Roth IRA after the conversion (benefit #1) and you live until at least age 70-1/2 and you haven’t depleted your traditional IRA (benefit #2), reduction in taxation of Social Security benefits is less certain. This is why this benefit is prefaced by the word, “potential.”

As we know from reading the two-part series, Say Goodbye to Up to 30% of Your Social Security Benefits that was published on January 10, 2011 and January 17, 2011, you can lose up to 30% of your Social Security benefits to federal income tax. Per the series, the amount of benefits subject to tax in a particular year is dependent upon four factors: (1) tax filing status, (2) total amount of Social Security benefits received, (3) adjusted gross income, and (4) tax-exempt income. Generally speaking, factor #3 is the most important one in determining the percentage of benefits that will be lost to federal income tax. The greater your adjusted gross income, or “AGI,” the more likely a larger portion of your Social Security will be eaten up by federal income tax.

Traditional IRA distributions are included in AGI. This includes both voluntary as well as required minimum distributions, or “RMD’s.” Roth IRA distributions, on the other hand, typically aren’t included in AGI since they generally aren’t taxable provided that certain rules are followed regarding the timing of distributions. Assuming that you’ve obeyed the rules, you will reduce your AGI in future years when you would have otherwise taken taxable traditional IRA distributions had you not done your Roth IRA conversion.

While a reduction in AGI doesn’t necessarily translate to a reduction in taxation of Social Security benefits, as illustrated in Exhibit 1 of Part 2 of Say Goodbye to Up to 30% of Your Social Security Benefits, there’s a very good chance that this will happen unless the total of your AGI, tax-exempt income, and 50% of your Social Security benefits exceeds several hundred thousand dollars. Per Part 1 of that series, the loss of 30% of Social Security benefits to taxation won’t occur unless you’re in the top 35% tax bracket. In 2011, the 35% bracket isn’t an issue until taxable income, i.e., AGI less itemized deductions and personal exemptions, exceeds $379,150.

Although reduction in taxation of Social Security benefits won’t occur in every situation, it should nonetheless be included as part of most Roth IRA conversion analyses.

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Roth IRA

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

Retirement Income Center

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!

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Roth IRA

Roth IRA Conversions – Don’t Let the Tax Tail Wag the Dog – Part 3 of 6

Retirement Income Center

As stated last week in Part 2 of this series, there are three primary potential economic benefits to be derived from a Roth IRA conversion, with the first one being the most important and overriding reason in most cases for doing a 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. Benefit #1 is the subject of this post with the other two benefits to be discussed in Parts 4 and 5 of this series, respectively.

There are many situations in life that require a leap of faith in order to realize the potential benefits from our decision that result in actually implementing a particular course of action. Like many people, buying my first house comes to mind as one of those such moments. It’s natural for us to simply think of the immediate impact of a particular decision on our daily lives. In the case of my first house purchase, the monthly mortgage payment and all of the other expenses and responsibility associated with home ownership loomed before me as formidable obstacles. It wasn’t until I was able to visualize the long-term potential benefits of my decision that I was able to feel comfortable with signing the dotted line.

Implementing a Roth IRA conversion that requires payment of income taxes today that otherwise wouldn’t be payable for several years in many cases can be a similar experience for many people. Until one visualizes and understands the number one potential benefit and power of a Roth IRA conversion, i.e., elimination of taxation on 100% of the growth of the Roth IRA conversion assets, the traditional IRA that was being considered for conversion will remain untouched.

One of the best examples that I can share with you regarding visualization of potential benefits in connection with a Roth IRA conversion is that of one of my clients, who I will call Mary. Mary had a sizeable IRA account that was formerly her deceased husband’s IRA. She was taking annual required minimum distributions (“RMD’s”) from her IRA, the amount of which was approximately $35,000 in 2008. In 2009, which was the year when RMD’s were waived and Mary wasn’t required to take any distributions from her IRA, Mary, who was 80 years old at the time, did a partial Roth IRA conversion of approximately $100,000, or 20%, of the remaining value of her IRA of approximately $500,000.

Why would an 80-year old who had sufficient nonretirement investments to live on take any distributions from her IRA in a year when she wasn’t required to do so, i.e., 2009, incur income tax liability of approximately $37,000 in connection with her Roth IRA conversion, and, furthermore, not wait until 2010 to do her conversion when she would have the ability to defer 50% of the income from her conversion to 2011 and the other 50% to 2012? Not only didn’t she “let the tax tail wag the dog,” Mary, at her advanced age, was able to visualize the elimination of taxation on growth of her Roth IRA account during not only her remaining lifetime, but also that of her daughter as well.

To put things in historical perspective, the stock market had been spiraling downward, with the Dow Jones Industrial Average decreasing from a high of about 14,000 in October, 2007 to a low of around 6,500 in the beginning of March, 2009. At the time when Mary did her Roth IRA conversion in March, 2009, a sizeable portion of which was invested in equities, the Dow was right at about 7,000. With the Dow closing at 12,321 on Friday, subject to a potential future decline in value, Mary has experienced a 75% increase in just two years in the value of the equity portion of her Roth IRA that will never be taxed. With approximately half of her Roth IRA invested in equities, the appreciation of Mary’s Roth IRA account since she did her conversion in March, 2009 has already exceeded the income tax that she paid in connection with her conversion. The growth in Mary’s Roth IRA will never be taxed during Mary’s lifetime nor that of her daughter.

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Roth IRA

Roth IRA Conversions – Don’t Let the Tax Tail Wag the Dog – Part 2 of 6

Retirement Income Center

Per last week’s post, the 2010 “tax tail wag the dog” provision that enabled 2010 Roth IRA converters to avoid inclusion of the income from their conversion on their 2010 income tax returns and instead defer 50% of it to 2011 and the other 50% to 2012 was the driving force behind many Roth IRA conversions in 2010. As stated in the post, this was despite the fact that, until the 2010 Tax Relief Act was enacted in the last two weeks of the year which left tax rates unchanged for 2011 and 2012, converters were facing potential higher tax rates in those two years on their deferred income.

When the dust settles, was it really such a big deal that you could defer 50% of the income from a 2010 conversion to 2011 and the other 50% to 2012? In certain cases, this did enable some people to have their conversion income taxed at a lower tax rate due to the splitting of their income over two years, however, in many situations, this wasn’t the result. These individuals simply received the benefit of postponing payment of 50% of their tax liability for one year and the other 50% for two years. Yes, you can earn interest on 50% of those funds for an additional year and another 50% for an additional two years, however, with our current abysmal interest rate environment, how much additional after-tax earnings will you actually receive?

Now that Roth IRA conversions are no longer “on sale,” i.e., if you do a conversion in 2011 and future years, you must report 100% of the income from your conversion in the year that you convert your traditional IRA to a Roth IRA, why should you do a Roth IRA conversion? As pointed out in the February 8 and 15, 2010 posts, The Ideal Roth IRA Conversion Candidate – Parts 1 and 2, there are several specific scenarios whereby the income from a Roth IRA conversion will result in little or minimal income tax liability. These specific fact patterns, once they are recognized, analyzed, and determined to be applicable to one’s situation, translate into slam-dunk Roth IRA conversion opportunities.

Assuming that you aren’t an “ideal Roth IRA conversion candidate,” why should you derail the investment growth of your nonretirement assets and instead use these valuable funds to pay income tax today on the income from a voluntary IRA distribution that you wouldn’t otherwise be required to pay for many years down the road in a lot of cases? After all, isn’t one of the basic guiding income tax principles that has been engrained in all of us from our earliest tax planning days is to defer income and associated taxation as long as possible? The answer to this question is yes – in most cases. The exception is when the projected long-term economic benefits from an alternative course of action exceed the projected benefits to be derived from not pursuing that course of action.

In the case of a Roth IRA conversion, what are the potential long-term economic benefits? There are three primary benefits to be derived, with the first one being the most important and overriding reason in most cases for doing a 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.

Benefit #1 will be discussed in Part 3 of this post, with the other two benefits being the subject of Parts 4 and 5, respectively. Part 6 will work through an example to demonstrate how the potential economic benefits to be derived from a Roth IRA conversion compare to the upfront cost, or tax liability, associated with a conversion.