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October, 2009:

Linksharing: Illinois Edition

Oct 11th, 2009
by jblankenship.
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lincoln statue by Tony the MisfitRevisiting an old theme again after a few months off, I wanted to highlight some blogs I’ve read recently that I think are worthy of your review.  This particular edition is dedicated strictly to blogs based in the Land of Lincoln.

The first is a blog I’ve mentioned here before, The Oblivious Investor.  In this blog, Mike Piper, a Chicago native, consistently comes up with excellent topics of great interest.  In Mike’s own words, the goal of his blog:  “To help people (myself included) focus on those investment principles that are actually important rather than on whatever sensationalized news the media has decided to sell us this week.”  We’re on the same page, Mike, and I’m grateful for your efforts – as I’m sure are your regular readers.

Next up is a good friend and colleague’s blog, simply named Chicago Financial Planner, by Roger Wohlner, CFP®.  Roger, of Arlington Heights, offers excellent, fact-driven posts on his blog that assess various topics of importance to the consumer of financial services.  An example is the recent post Why Should I Care if My Financial Advisor is a Fiduciary? – which helps to explain the ins and outs of this question that all savers and investors should ask themselves.

Last (for now!) in my list of Prairie State bloggers is Jeff Rose’s excellent Good Financial Cents blog.  Rose, who is from Carbondale, blends life experience with financial acumen and makes it all work together to bring sound financial wisdom to a his readers.  This young man has seen the financial industry from several angles and has developed wonderful insights into what works for parents, working families, and small businesses.

That’s the three that I know of right offhand – each one deserves a look.  If you know of other great Illinois-based financial blogs, please let me know, I’d love to round out my list!

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Improved Child Care Credit Expiring After 2010

Oct 9th, 2009
by jblankenship.
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16332570 You may not remember this, but way back in the days before the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA 2001) parents had much lower credits for child care (this article also applies to other dependent care credit as well).

Now Through 2010

Until the end of 2010, the credit allows for a range of between 20% (for an AGI over $43,000) to 35% (for an AGI of $15,000 or less) of the smallest of:

  • $3,000 ($6,000 for two or more qualifying children or dependents),
  • The total of the qualified dependent or child care expenses incurred and paid,
  • The taxpayer’s earned income, or
  • The spouse’s earned income

For example, a family of four with both parents working full-time might pay $100 a week for childcare.  Since most daycare outfits require payment even when the child isn’t in attendance, this works out to 52 weeks at $100 per week, or $5,200 in qualified child care expenses.  For the sake of example, the household AGI is assumed at $55,000.

Under the current formula, this family can expect a tax credit for child care expenses of 20% of the total of their qualified expenses ($5,200) – a credit in the amount of $1,040.

Beginning in 2011

With the expiration (at the end of 2010) of the provision changing the credit, the credit amounts and income levels will revert back to the pre-2001 levels.  Under the old (and soon to be new) levels, the credit ranges from 20% (for AGI over $28,000) to 30% (for AGI of $10,000 or less) of the smallest of:

  • $2,400 ($4,800 for two or more qualifying children or dependents),
  • The total of the qualified dependent or child care expenses incurred and paid,
  • The taxpayer’s earned income, or
  • The spouse’s earned income

Using our family from the example above, under the new formula the family can expect a tax credit for child care expenses of 20% of $4,800 (their $5,200 exceeds the upper limit) – a credit of $960.  This is $80 less in tax credit versus the old method.

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Roth Conversions for Inherited Retirement Plans

Oct 7th, 2009
by jblankenship.
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monkey typing by pdimages-com If you have an IRA or a 401(k) that you’ve inherited, you may wonder if it is possible to convert that account over into a Roth IRA.  After all, you’ve got to take RMD (Required Minimum Distributions) from the account since it’s inherited, why couldn’t you just pay all the tax upfront and roll it over?

Well, there are two answers to this question, one for inherited IRAs, and one for inherited qualified retirement plans (QRPs, such as 401(k) or 403(b) plans).  And like many other things in this wonderful tax code of ours – the two kinds of plans are treated differently today, but may be subject to change in the near future.

It should be noted that we’re talking about non-spouse beneficiaries here.  A spouse has pretty much the same rights as the decedent had, so if the decedent was eligible for a Roth conversion, the spouse most likely is as well.

Inherited IRA

For an inherited IRA, current law does not allow you to convert the funds to a Roth IRA.  This is pretty much cut-and-dried, with no interpretation necessary.

There is a great deal of conjecture about whether or not Congress will specifically change this ruling to match the QRP rule – since the QRP rule has only been available for a year or so.  Until it’s actually undertaken, this rule will continue to apply.

Inherited QRP

If you’ve inherited a qualified retirement plan (QRP), this account IS eligible for conversion to a Roth IRA.  The new Roth IRA (and it must be a new account) must be titled as inherited, just the same as if you were rolling over the QRP funds into a traditional IRA.  The new Roth IRA would continue to be subject to RMD, however tax would have been paid up front so future RMD would be tax-free.

In the year of the conversion, you would still have to take your regular taxable RMD from the QRP, but the remainder of the account would be eligible for the Roth conversion.  Keep in mind that this conversion has to be a direct (trustee-to-trustee) conversion, and also must be a direct conversion into the Roth IRA (without rolling over to a traditional IRA first, as was the former method for QRP to Roth conversion).

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Roth Conversion Planning for a Small Business Owner or Farmer

Oct 5th, 2009
by jblankenship.
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bens chili bowl by dbking Continuing with the discussion about Roth IRA conversions – and especially given that the income restriction will be lifted in 2010 – there is an opportunity for the small business owner or farmer that may be quite useful. Many small business owners and farmers have large Net Operating Loss (NOL) carryovers from previous years, due to the fact that NOL can only be deducted to the extent of the individuals’ Adjusted Gross Income. Excess NOL can be carried over for up to 20 years.

For the small business owner or farmer who has retired and closed his business, a large NOL can be difficult to utilize – especially if his income requirement is small in relation to the NOL. If the small business owner or farmer has an IRA, there is a unique opportunity to convert a portion of that IRA to a Roth IRA equal to the carried over NOL, thereby converting the funds to a tax-free account with no tax owed.

The reason that this is important is because carried over NOL disappears when the taxpayer dies. If the NOL is large enough that normal income (or Required Minimum Distributions) doesn’t utilize the NOL completely, then this opportunity can help to create tax-free income for the taxpayer in the future.

Note: estates and trusts can also have NOL, but this provision is not pertinent to estates and trusts.

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Sales Tax Deduction Expires After 2011

Oct 3rd, 2009
by jblankenship.
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cash register by mindluge For the past several years, it has been an option for taxpayers that itemize their deductions to choose between deducting state income tax or a formulaic estimate of their state and local sales tax, plus the specific sales taxes on any “big ticket” items, such as automobiles.

During 2009, there was a new wrinkle added, part of ARRA 2009: for this year only, if you purchase a vehicle between February 17, 2009 and December 31, 2009, you can deduct the sales tax (within a liberal limit) “above the line”, in addition to, your standard or itemized deductions. (see this link for more specifics)

These two provisions are currently set to expire at the end of the 2011 calendar year.  It is unclear how much impact the new, 2009 auto sales tax deduction has had on the automobile industry (which was the primary reason behind this deduction) – so it is possible that Congress may see fit to extend this provision into next year.  We’ll just have to wait and see.

At any rate, it is not likely, in my humble opinion, that the itemized deduction of sales tax will be extended, as this deduction doesn’t appear to have had a stimulating economic impact – most folks don’t even know it’s an option.

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Integrating Roth IRA With Social Security Benefits

Oct 2nd, 2009
by jblankenship.
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social security by Fabricator of Useless ArticlesFrom all the information that I’ve been reading recently, it appears that the coming opportunity to convert IRA or qualified retirement plan funds to Roth IRA isn’t really very popular with most folks.  I suppose it’s not really a surprise – the Roth IRA has long been a confusing topic for a lot of folks, and the conversion itself doesn’t make things much clearer.

There are some great benefits to be had from converting funds to a Roth IRA – but that doesn’t mean that everyone within earshot should just willy-nilly go off and convert their IRAs to Roth IRAs.  One factor that many folks likely haven’t thought about is the integration of Social Security benefits with the possibility of a Roth IRA conversion.

Taxation of Social Security

As you may be aware, depending upon your “provisional income”, various amounts of your Social Security benefits may be taxable.  At this time, for example, if your provisional income is more than $25,000 (or $32,000 for a married couple), then 50% of your benefits would be taxed.  Above $34,000 ($44,000 for a married couple), 85% of your Social Security benefit is taxable.

Provisional income is made up of – your adjusted gross income (AGI, the amount in the last line on the first page of form 1040) plus tax-exempt interest earned for the year, plus ½ of the amount of your Social Security benefit.  So the trick is to limit your income that makes up AGI, while not overdoing it with tax-exempt interest income.  One way to do this is to generate income from a Roth IRA.

A Tale of Two Taxpayers

Two taxpayers, Stevie and Christine, both age 62 and retired, have vastly different outcomes for their tax costs.  For simplicity’s sake, we’ll say that both women are single, and are collecting identical Social Security benefits of $20,000, and that each has an income requirement of $45,000 each year.  In addition, each of the women has a pension available, which will either pay out a $25,000 payment each year, or is available as a lump sum for rollover at the amount of $500,000.

Stevie

Stevie decides to take the pension payments of $25,000 per year.  Come tax time, she learns that she will have to pay tax on 85% of her Social Security benefit ($17,000) because her provisional income adds up to $35,000, which is above the $34,000 limit.  So the tax on this amount ($25,000 pension plus 85% of SS, or $17,000) is $6,688, or roughly 15% of her total income.  Assuming that nothing changes about the situation, Stevie can count on paying around 15% of her income in tax for the rest of her life.

Christine – Option 1

Christine, on the other hand, takes a look at the numbers and decides that it might make more sense to attack the situation differently… she takes the lump-sum payout from her pension plan and rolls the money over into an IRA.  If Christine were to simply leave things this way and start taking a distribution of $25,000 each year, she would have exactly the same tax treatment that Stevie is getting.  However, if Christine should decide to do a conversion of the IRA to a Roth IRA in 2010, paying tax in 2011 and 2012, she would be paying tax of approximately $70,000 each of those years, leaving her with a net balance in the Roth account of roughly $360,000.

Now Christine pays no tax (under current laws) for the rest of her life!  Given that her provisional income can not be more than the limits, her Social Security benefit will never be taxed, and since all of her funds are in the Roth IRA, there is no tax owed at all.  But this is a very high price to pay up front – roughly 1/3 of her IRA account – to make up the difference, Christine would need to take this tax-free income for around 20 years, as long as income tax rates stay the same.  If the income tax rates rise, the break-even time would be less, of course.

Christine – Option 2

But what if Christine instead took her income requirement each year (the same as Stevie), paying the roughly 15% tax, but then took an additional amount from the IRA and converted it to a Roth?  If she converts $50,000 in the first year and pays the tax that year, the additional tax would amount to roughly $12,500.  But here’s the magic:  having done this, Christine can now reduce the amount that she takes from the IRA to just below the $34,000 limit, thereby reducing the amount of her Social Security benefit that is taxed each year to 50%.  The difference, $1,000 each year, could be taken from the Roth IRA at no tax impact.  Now Christine’s annual tax would be reduced to $4,668, a savings of over $2,000 per year in taxes.  This reduces the break-even period to approximately 6 years over Stevie’s situation.

Christine – Option 3

How about another step – what if Christine did the conversion of $50,000 for five years in a row, paying a total of $62,500 in tax.  Now she can reduce the amount that she takes from her IRA each year to an amount that allows for NO tax on her Social Security benefit – and a minimal amount on her IRA distributions, as well – total tax is now $1,668 – a full $5,000 less than the tax that Stevie pays, assuming tax rates remain the same.  As before, rising rates will make this strategy look even better.  The break-even is now approximately 12½ years – but would be less with higher tax rates.

Summary

There’s a lot of math going on in this article… the point was to show how this Roth IRA conversion activity isn’t just a question for the rich.  It can have an impact on folks at all levels of income – and there are many ways to slice the choices.  It can be very costly to do nothing, as well as quite lucrative to do some planning and strategizing on this point.  As always, talk to your financial professional before making any dramatic moves, just to make sure you’ve got it right.  The IRS rarely grants a mulligan.

Note – for the purpose of illustration, I used current tax rates throughout the examples.  I know that rates are going up in 2011 and are likely to increase in years ahead – this will only make the illustrations I’ve done here look better for the Roth conversion (in most cases).

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