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November, 2009:

Help Mr. Wizard – I didn’t wanna do a Roth Conversion!

Nov 12th, 2009
by jblankenship.
1 comment

tooter-t“Drizzle, Drazzle, Drozzle, Drome – time for zis one to come home…”

So you’ve done a Roth Conversion and now you’re ready to do your taxes and (horrors!) you see the bill for the conversion!  Yikes!  Somehow a simple decimal point miscalculation has caused your nice little conversion to run up a HUGE tax bill… What to do?

Well, just the same as with Tooter the Turtle in the old cartoon, you can follow Mr. Wizard’s advice and “be just what youse is, not what youse is not” – in other words, you can undo the conversion, so that you are back where you started.  This is called a Recharacterization of the IRA.

The Great Undo

When you get yourself into such a situation, a complete “undo” is the cleanest way to go about this.  So what you do is simply move the holdings back into the IRA account from the Roth, and file a form 8606 with your tax return.  The recharacterization must be complete by the deadline for filing your return, plus extensions, which means by October 15 of the following year for most folks.

On the form 8606, you’ll indicate the amount that was converted to the Roth IRA, then indicate how much was recharacterized, and show the gain or loss on the funds, as well.  This is one reason why it makes very good sense to open a new Roth account for each year’s conversion.  Once the deadline for recharacterization has passed, you can roll over the converted funds into your regular Roth account to reduce paperwork (but of course, you don’t have to do this).

One additional reason besides the tax bill that many folks decide to recharacterize their Roth conversion is because the value of their holdings in the account has decreased, and they don’t want to pay tax on the higher value.  For example, if you converted $10,000 to a Roth account and the market took a 40% dive (like that’s never happened, right?) – when it comes time to pay taxes, you’d owe (for example) 25% on the originally-converted $10,000, while your account is only worth $6,000 now.  For lots of folks, that’s just too much to stomach, so they recharacterize.  After 30 days, they can then convert the funds again at the new, lower value, and forestall the tax until the following tax year (since presumably this is the following year from the original conversion by now).

Stay tuned for more – it can get pretty complicated… see here for more.

Image by toonopedia.com

5 Tactics for Required Minimum Distributions

Nov 10th, 2009
by jblankenship.
No comments yet

old faithful by sergeant killjoySo – you’ve reached that magic age, 70½, and now you’ve got to begin taking the dreaded Required Minimum Distributions (RMDs) from your various retirement accounts.  Listed below are a few tactics that you might want to employ as you go through this process.  Perhaps one or another will make the process a little less onerous on you.

5 Tactics for Required Minimum Distributions

1.  Take all of your RMDs from your smallest IRA account. If you have several IRA accounts, you can aggregate the amount of your RMD for the year and take it all out of one (presumably the smallest) account.  This way you’ll eventually eliminate that extra account, and reduce paperwork, time and error in calculating RMD amounts, and complication in estate planning.

The same can be done for your 403(b) accounts, but you can’t use IRA distributions to make up your 403(b) RMDs or vice versa.  Each type of account must have its own distributions.  This does not apply to 401(k) accounts, though:  each 401(k) has its own separate RMD.

Keep in mind though, that distributions from an inherited IRA or inherited 403(b) can not be used to satisfy the RMD for your other, regular IRAs or 403(b)s.

2.  Take distributions in kind, rather than in cash. There is no requirement that your RMD must be in cash – so if the situation is advantageous to you, you might consider taking the distribution in stocks, bonds, or any other investments to fulfill the RMD requirement.  When the distribution occurs, the value of the investment is considered taxable income to you – and therefore becomes the new basis of that investment.

There are three situations when this type of distribution is particularly useful:

a) If you wish to remain “fully invested”, you will save on commissions since you don’t have to sell the investment inside the IRA, remove the cash, and the re-purchase the same investment in your taxable account.

b) If you hold a stock that you believe is undervalued and expect to appreciate in value, transferring it outside the IRA gives you the ability to receive capital gains treatment on the appreciation.  Even better, once outside the IRA, if you hold the stock until your death, your heirs will receive the stepped up basis of the stock as of the date of your death, bypassing tax altogether (depending upon the size of your estate, of course).

c) If you hold an investment that is particularly difficult to value, such as a thinly-traded stock or a limited partnership, you can take a portion of the distribution from this holding (e.g., if you’re required to take 5% of the account, take 5% from the LP and the rest in cash or whatever else the account holds).  This way you don’t have to come up with a value of the difficult to value holding each year when taking distributions.

3.  Take your distribution early in the year.  No wait, take it late in the year. There are arguments on either side of the issue, but in general I agree more with the benefit of the latter statement, which I’ll explain in a moment.

Taking the distribution early in the year is most helpful for your heirs.  If you happen to pass away during the year and have not yet taken the RMD, your heirs will need to make certain that the RMD is taken before the end of the year – at a time when they aren’t necessarily thinking about this sort of thing.

On the other hand, taking the distribution later in the year provides you with the opportunity to take advantage of any rule changes that Congress tosses your way through the year.  For example, in 2009 you didn’t have to take an RMD at all, and if you did you got to roll exactly one distribution back into your IRA by 11/30/09.  Similarly, in 2006 and again in 2008 there were the late-in-the-game rule changes that allowed the IRA holder to make distributions directly to a Qualified Charity, so that the income was never factored into the tax return at all (an advantageous thing, especially with regard to Social Security taxation calculations, for example).

So, all in all, I think it’s better to wait – at least until the first half of the year is over – before taking the RMD.  Besides, your heirs will get over it.

4.  Take extra distributions (more than the RMD) when your income is lower. This is similar to the “Fill Out The Bracket” strategy that I’ve written about before.  Essentially you look at your available tax bracket (especially if you are in the lower brackets) and take out extra distributions up to the maximum in your applicable bracket.  This will reduce your RMDs in future years, allowing you to either convert those funds over to Roth IRA accounts or a taxable account subject to the much lower capital gains rates.

5.  Take extra distributions when subject to AMT. This is mostly useful if you are normally subject to the highest tax brackets (35% these days), but for other reasons you find yourself subject to AMT.  You can take additional distributions from your IRA up to the limit that keeps you in the AMT tax, and these funds will only be taxed at a 26-28% rate.  These distributions could either be taken as income or converted to a Roth IRA.  (Note:  bear in mind that if the final calculation shows that you’ve taken too much from the IRA and kicked yourself back into the 35% bracket, you’ll have to work quickly to get the excess rolled back into the IRA account.  The Service doesn’t have any sense of humor about allowing extensions of the 60-day rollover period in cases like this. For this reason it would be prudent to not try to maximize this benefit.)

Photo by sergeant killjoy

Flash! Extension for First-Time Homebuyer’s Credit

Nov 8th, 2009
by jblankenship.
1 comment

flash I wrote about this credit’s expiration some time ago, (you can see this post for the original article) – and as anticipated, this past week Congress has opted to stretch out the expiration date for 7 months, through June 30, 2010. Note: it was extended again, through September 30, 2010. Briefly, this credit provides up to $8,000 in credit for first-time homebuyers who have MAGI less than $150,000 (for married couples – $75,000 for single filers).

I haven’t seen any numbers to show what impact this particular credit has had on the housing market – but any impact it has had must have been minimal, albeit positive.  The housing market continues to be pretty dismal throughout much of the country, even in the face of continued reductions in mortgage rates, which have now dipped below the 5% level for 30-year typical mortgages.

So, if you weren’t quite ready to take the plunge and buy before December 1, you now have 7 more months to get ready (if you want to take advantage of this credit).

Image by Epix

Change Coming for Earned Income Tax Credit Calculation in 2011

Nov 7th, 2009
by jblankenship.
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EITC by bostontaxhelp12/17/2010 – with the passage of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010, the rate changes formerly discussed in this article have been superseded.

Photo by bostontaxhelp

A Roth Conversion Strategy – Spread the Tax Over 3 Years

Nov 6th, 2009
by jblankenship.
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split blood orange by ccharmonAs you consider your options for a 2010 Roth Conversion strategy, you’ll probably agonize over the decision of when to pay the tax:  you can choose to pay all of the tax in 2010, or half in 2011 and half in 2012.  All of it upfront is a lot of money!  But then again, half in 2011 and half in 2012 – didn’t someone mention that tax rates are going to increase?  It sure would be nice to be able to split this up over all three years!

The problem with this strategy is that each taxpayer is required to treat all Roth conversion taxation with the same method, either all tax paid in 2010 or half in 2011 and half in 2012.  So even if you make two or more different Roth conversions in 2010 and elect the deferred treatment for the tax (or elect to pay the tax in 2010), then you have to use that election for all of your conversions for 2010.  This rule is per taxpayer… which opens up a possible workaround!

There’s a Workaround

There is one way to work around the tax law on this one – but you have to be married.  I know some folks (both guys and gals) who would say that no amount of tax savings would be enough to get married, and it’s probably not the best idea to rely on tax code provisions as a reason to enter into wedlock.  Rare indeed is the situation where the IRS is responsible for a flourishing union…

But for the purpose of the example, let’s just say you had other reasons, and now you find yourself eligible to file taxes with the status of Married Filing Jointly. Let’s further say that you and your spouse jointly have $300,000 in IRA accounts, split as follows: $200,000 in your name and $100,000 in your spouse’s name.  In order to convert the total amount of $300,000 in 2010 and reduce taxes to the lowest possible amount, your spouse could convert $100,000 and elect to have the conversion taxed in 2010… and then you could convert $200,000 and elect to defer the tax to 2011 and 2012.

Now you’ve effectively spread out the tax over 3 years, with even amounts being taxed each year.  Given the graduated nature of our tax system, this is likely the most tax efficient method for affecting a conversion.  Unfortunately for filers in other statuses (stati?) this option is not available – it’s either all in 2010 or half & half in 2011 and 2012.

Photo by ccharmon

Don’t Forget Social Security in Your Roth IRA Conversion Strategy

Nov 4th, 2009
by jblankenship.
6 comments

With the coming change to the Roth IRA conversion rules, there is lots of focus on the decisions you face when considering a conversion.  One area that often gets short shrift is the future impact on Social Security benefits taxation.

fatcat by ChikaUnderstandably, this hasn’t really hit the radar for next years’ conversion topics, because this is primarily important to folks with a much lower income.  So if you’re one of those fatcats with an annual retirement income projected above $100,000, then you might not want to bother reading any further – this likely doesn’t apply to you. (But look at the note at the bottom before you leave!)

However, (and there’s always a however in life), this will be important to consider if you are in a position to reduce your net non-Social Security plus ½ of your Social Security Benefit to a level below $44,000 (even moreso if you can reduce it to below $32,000).  Those are the numbers for Married Filing Jointly – the figures for Single, Qualifying Widow(er), Head of Household, or Married Filing Separately are  $34,000 and $25,000, respectively.

Now, it may seem like this is a pretty insurmountable position to be in… after all, you need an income of (for example) $60,000 in order to just get by!  Imagine, though, what would happen if you were able to take a large portion of that $60,000 from a tax-free source, such as a Roth IRA.  In that case, you might be able to get by without having to pay tax on any or a large portion of your Social Security benefits.

social security lips by Aric Riley

The Facts

I guess I got a little ahead of myself – let’s back up and look at the facts.  If your net AGI (not including line 20b) plus ½ of your Social Security Benefit is less than $32,000 ($25,000 for Singles, et al), then none of your Social Security Benefit is taxed.  If the amount described above is greater than $32,000 but not more than $44,000 (between $25,000 and $34,000 for Singles), then 50% of your Social Security Benefit will be taxed.  If that same figure is above $44,000 ($34,000 for Singles), then 85% of your Social Security Benefit will be taxed.

Example (*uses 2009 tax tables – your mileage may vary)

Let’s say for example that John and Mary’s lifestyle need requires an income of $60,000, and they have a combined Social Security Benefit of $25,000.  So, John and Mary take a total of $35,000 from their IRAs (total balance of $500,000) to make up the difference.  Running the calculation, when we add ½ of the SS benefit to the rest of the income ($12,500 plus $35,000) we get $47,500.  Since this is greater than $44,000, 85% of the SS benefits are taxed.

If John and Mary decided to convert 20% of their IRAs to Roth IRAs ($100,000), now instead of taking $35,000 from the traditional IRA each year, they could take $28,000 from the traditional IRA and $7,000 from the Roth.  Re-running the calculation, now ½ of SS benefit plus AGI ($12,500 plus $28,000) equals $40,500.  Now, only 50% of the SS benefit is taxed!  Granted, in the year of the Roth conversion, John and Mary had to pay considerably more tax on the conversion amount, an additional $21,980, but this pays off in reduced taxable SS benefit after just over 9 years.

Taking this a step further, if John and Mary decided to convert 40% of their IRAs to Roth IRAs ($200,000), we can eliminate taxation of SS benefits altogether.  Now we’re taking only $21,000 in income from the traditional IRA and $14,000 (tax free) from the Roth.  Running the calculation again, we come up with $33,500 ($12,500 plus $21,000) – now we’re less than the $34,000 limit.  At this level, NONE of the Social Security benefit is taxed.  Again, there is a significant tax cost in the year of conversion ($51,415), which is paid off in reduced taxes in just over 11 years at today’s rates.  With both examples, if future tax rates increase when future tax rates increase, the payoff is even faster.

So you can see how this could be a great strategy for folks that are capable of reducing their income component by such a factor.  There’s also the added benefit of reduced amounts against which Required Minimum Distributions are calculated.  As you reach the RMD age limit (70½), you may have determined that you don’t need the amount that is prescribed as income.  If you’ve reduced the traditional IRA balance by converting a good portion to a Roth IRA, the RMD amount will be less by proportion.

Of course, you could also reduce the tax hit by drawing out the time within which you do the conversions – such as splitting up that $200,000 over four years, for example – this way you’d have much more of the conversion being taxed at lower rates.  Obviously, your situation is going to vary from the example, so work closely with your tax advisor as you make plans.

Note:  Keep in mind that this strategy could work for literally anyone at any income level – as long as the income isn’t from a fixed source, such as a traditional pension.  If it’s from investment accounts, IRAs, annuities, or some qualified retirement plan, then you should consider this strategy to see if it makes sense for you.

Photo #1 by Chika

Photo #2 by Aric Riley

Not So Fast! 9 Special Considerations Before Rolling Over Your 401(k)

Nov 2nd, 2009
by jblankenship.
3 comments

going nowhere fast by YtseJam Photography Conventional wisdom has long told us that when we leave employment – either by taking another job, getting laid off, or retiring – it makes good sense to rollover our 401(k) plans to either an IRA or to our new employer’s 401(k) plan if that makes sense.

However – and if you read here much, you know there’s always a however in life – this decision isn’t as cut-and-dried as conventional wisdom leads us to believe.  As with just about every financial decision we make, it’s not wise to go off willy-nilly without considering all of the benefits that we’re giving up. (If you’ve worked with me in the past, you know I don’t cater much to the willy-nilly…)

9 Special Considerations Before Rolling Over Your 401(k)

  1. If you are happy with your former employer’s plan, consider it well-managed, low cost, and possibly with some investment options that are not readily available (such as desirable mutual funds that are closed to new investors), you may want to leave the plan intact.  This would be especially beneficial if you don’t have another employer plan to roll over into, or you are squeamish about establishing your own IRA.
  2. Depending upon your opinion of future legislation being considered, it is possible that maintaining a 401(k) account could garner you some employer-sponsored financial advice.  There have been quite a few options floated in Congress regarding the requirement for employers to provide advice for their retirement plan participants, although none have been passed into law as of this writing.  Removal of your funds via a rollover would eliminate this benefit for you.
  3. If you have commingled deductible and non-deducted IRA contributions in your IRA account, having an active 401(k) plan can help you to “separate” the deductible IRA assets from the non-deducted.  See this article for more information.  Essentially this benefit gives you a way to bypass the “little bit pregnant” rule wherein you must consider all IRA funds pro-rata when making distributions… a common issue when doing a Roth IRA conversion, for example.  If you have no 401(k) plan, this option is lost.
  4. If you have an investment in your former employer’s stock in your 401(k), you need to consider the ramifications of utilizing the Net Unrealized Appreciation (NUA) option – before doing a rollover.  This article explains NUA, in case you need a refresher.  The point is, if you’ve taken even a partial rollover of your 401(k), the NUA treatment is no longer available to you.
  5. capitol building by terren in Virginia If you think you may be returning to this employer, it might make sense to leave your funds where they are.  This is especially true for government employers with section 457 plans – due to the nature of these plans’ ability to provide you with retirement income without penalty much earlier than an IRA can.  With the vagaries of governmental policy changes, if you’ve withdrawn and closed your account and come back to work for the same agency, the old plan may no longer be available to you since you’re a “new” participant.
  6. If you’re at or above age 55 and are not moving to a new employer (or are undertaking self-employment), maintaining the 401(k) plan gives you an option to begin taking distributions prior to age 59½ without penalty.  If you move these funds over to an IRA, this option is lost.
  7. On the off-chance that you might need a loan from your retirement funds, you should know that IRAs do not have this provision.  Retain at least some balance in the plan if you might need this option – but also you should check with your plan administrator to see if this option is available for non-employee plan participants, because it might not be (and actually, it likely is not).  But keeping in mind #5, if you’ve maintained a healthy balance in the plan and you return to work with this same employer, you’d have a much larger account to work with if you needed to borrow.
  8. Funds in a 401(k) account are protected by ERISA – and as such are generally not available to creditors.  Depending upon the state you live in, IRA assets may be available to your creditors in the event of a bankruptcy.  If you’d like to bone up more on this, see this article.  At any rate, ERISA protection is pretty much an absolute, so this is yet another reason you might consider leaving funds in a former employer’s 401(k) plan.
  9. Take your after-tax contributions out first, if your plan happens to include these.  If you’ve made after-tax contributions, as some plans allow, it makes sense to separate these contributions from the pre-taxed amounts.  You can convert these contributions directly over to a Roth IRA in most cases, income allowing (and in 2010, income won’t be a problem, either).  This is because the 401(k) isn’t subject to the “little bit pregnant” rule alluded to earlier.  Once you’ve removed the after-tax contributions and put them into a Roth IRA, you can then rollover the rest of your 401(k) if it makes sense.

I don’t imagine that this is an exhaustive list of all the reasons you need to stop and think about it before rolling over a 401(k) plan, but we’ve hit the high points.  If you have other good reasons to share, please leave a comment!

Photo #1 by YtseJam Photography

Photo #2 by terren in Virginia

Are You Ready For the DB/k?

Nov 1st, 2009
by jblankenship.
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happy retirement by grantlairdjr Buried deep within the bowels of the Pension Protection Act of 2006 (pages 231-238 of the technical explanation) was a special provision that most folks don’t know about… this provision contains the framework of a new type of retirement plan.  This new type of retirement plan is called a combination plan – meaning the combination of a defined benefit plan with a 401(k) plan.  Don’t expect to find much written about it – there’s very little out there, in part because these plans aren’t set to become available until January 1, 2010.

The Combination Plan

A defined benefit plan is the IRS’s description of the old-style pension plan.  And of course, we all know what a 401(k) plan is.  So this new Combination Plan – referred to by many names, such as DB/k, Defined Benefit/401(k), or by the code section it comes from, 414(x) – is a safe-harbor version of both plans combined.  With this type of plan, which is limited to employers of between 2 and 500 employees, the employer can provide the 401(k)-type of savings plan with prescribed matching, along with the old-style pension benefit (you remember, a percentage of your highest annual income, multiplied by your years of service, and all that?).

Being a safe-harbor plan means that there are prescribed percentages that the employer must follow in order to ensure that the plan maintains appropriate balances – such as matching at least 50% of the deferrals of the employee, up to 4%.  In addition, the amounts prescribed for the DB portion of the plans are specific to the age of the employee, ranging from 2% for an employee aged 30 or less, up to 8% for an employee age 50 or better.

Although these amounts have been set forth by the law, it’s really not clear how the plan makes up the difference for employees… since an employee age 60 with 20 years’ time with the company, making $50,000 per year would have $4,000 credited to his account, somehow the account has to come up with a total of $10,000 (the 20 years times 1% times his salary) in annual pension payments when the employee retires.  I suppose in time this will work out.

The Bottom Line

The bottom line for the DB/k in my opinion is that this is a nice plan, but it is likely to be 1) ignored, due to the complexity; or 2) dismissed altogether due to the costs.  Either way, I wouldn’t expect to see a lot of DB/k plans in the industry, but I could be wrong.  (Note:  This likely accounts for the dearth of information available about these plans.  Heck the IRS only asked for technical input on these plans a few months ago.)  This sort of plan may be exactly what small employers have been looking for to make a difference and retain employees.  I think that some sort of defined benefit (or rather, guaranteed income) component is likely to become an important part of retirement plans in the future, but I also believe that it will come as part of existing plans, such as low-cost annuities.

What do you think?  Are you hearing a lot about these plans?  Let me know in the comments section…

Photo by grantlairdjr
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