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December, 2009:

Health Savings Accounts – The Basics, Part 1

Dec 12th, 2009
by jblankenship.
3 comments

physican by a.drianA Health Savings Account (HSA) is a tax-exempt trust or custodial account that you set up with a bank or other US financial institution which allows you to pay or be reimbursed for qualified medical expenses.  The HSA must be used in conjunction with a High Deductible Health Plan (HDHP).  The HSA can be established using a qualified trustee or custodian that is separate from the HDHP provider.  Contributions to an HSA must be made in cash or through a cafeteria plan.  Contributions of stock or property are not allowed.

Benefits of an HSA

There are quite a few benefits to an HSA:

  1. Contributions to an HSA are deductible from income – even if you don’t itemize deductions;
  2. If your employer makes contributions to an HSA on your behalf (such as via a cafeteria plan) the contributions can be excluded from your gross income;
  3. Your account contributions can remain in the account year-after-year until you use them – there is no annual “use it or lose it” clause;
  4. Growth in the account (via interest, dividends, or capital gains) is tax-free;
  5. Distributions from the account are tax-free if used for qualified medical expenses; and
  6. Your HSA is portable – not tied in any way to your employment with a particular employer.  You take the account with you if you change employers or leave the workforce.

Qualifications for an HSA

In order for you to qualify for an HSA, the following conditions must be met:

  1. You have an HDHP;
  2. You (and your spouse, if married) cannot have any other health plan beyond the HDHP, with the exception of another plan that is limited to the following coverages:
    1. accidents,
    2. disability,
    3. dental care,
    4. vision care,
    5. long-term care,
    6. benefits related to worker’s compensation laws, tort liabilities, or ownership or use of property,
    7. specific disease or illness, or
    8. a fixed amount per day (or other period) of hospitalization.
  3. You are not entitled to Medicare benefits (i.e., beginning with the first month that you are eligible for benefits under Medicare, you can no longer contribute to an HSA.  You are still allowed to take distributions from your existing plan, however.); and
  4. You cannot be claimed as a dependent on someone else’s tax return.

Qualified Medical Expenses

Qualified medical expenses are those that qualify for the medical and dental expenses deduction under §213. Examples include amounts paid for doctors’  fees, prescription and non-prescription medicines, and necessary hospital services not paid for by insurance. Qualified medical expenses must be incurred after the HSA has been established.

You cannot deduct qualified medical expenses as an itemized deduction on Schedule A (Form 1040) that are equal to the tax-free amount of the distribution from your HSA.

In Part 2 we’ll cover the contribution limits as well as some of the other special considerations for the HSA.

Photo by a.drian

Three Reasons You May Not Want to Convert to a Roth IRA

Dec 10th, 2009
by jblankenship.
2 comments

There’s been a lot (I mean a LOT!) of press surrounding the coming “opening of the floodgates” for Roth IRA conversions. You only have to glance through the headlines lately to see wild cries about the coming tsunami of Roth conversions beginning with 2010.  Personally I think that, while there will likely be more conversions after the start of 2010, there are a lot of reasons why this might not be the best idea for a lot of folks.  Here are three really good reasons why you probably should reconsider…

Three Reasons You May Not Want to Convert to a Roth IRA

david byrne by alterna2

  1. “Same as it ever was…” Several factors must be considered when determining if a Roth conversion makes sense for you:
    1. the amount of the conversion
    2. your conversion tax rate
    3. your earnings on the converted account
    4. the amount that you withdraw from the Roth account
    5. the date that you begin withdrawing that amount from the Roth account

    If you would have begun taking the withdrawals on the same date (E) regardless of the account (traditional or Roth), in the same net (after tax) amount (D), at the same rate (B) – assuming your earnings would be the same either way – there is no advantage to the Roth conversion.

    In order for there to be a benefit to the conversion, one or more of the following must happen:

    • the date you begin taking distributions must be later;
    • the amount you would take as a distribution must be less; and/or
    • the tax you pay on the distribution would have been higher than the conversion rate.
  2. A downward spiral. If the value of the investments in the account actually reduce in value, or if the tax rates decline, you’ll be in a worse position if you convert to a Roth IRA.For example, if your IRA was worth $100,000 when you converted it, if your tax rate was 25% the tax cost of the conversion is $25,000. If the value of the account subsequently fell to $50,000 (of course, some time after the time limit has expired for recharacterization) – now the overall rate that the conversion cost you has inflated to 33%.By the same token, if (heaven forbid) the tax rates are lower in the future, it doesn’t make any sense for you to do a Roth conversion. The more likely event is that your personal tax rate might be a lot less – especially possible if in retirement you have a pretty low-cost lifestyle.
  3. The game changes. What happens to you if Congress decides that this Roth deal is just too good?  Maybe they’ll start requiring distributions of the original account owner – or restrict the amount of time that your heirs can stretch payments?It’s really impossible to guess what Congress might do – but given the potential cost of lost tax revenues from Roth accounts, it’s not hard to believe that the rules could be changed to have a negative impact on your converted account.

Of course, this is not an exhaustive list – just a few good reasons why you really need to think this over before you do a Roth conversion. Don’t let the hype over the coming tsunami let you get caught in a wave.

Photo by alterna2

Why Most People Are So Bad At Stock Picking (and what does Howie Mandel have to do with it?)

Dec 8th, 2009
by jblankenship.
4 comments

deal or no deal by MuffetYou know the TV show “Deal or No Deal”, right?  If you aren’t familiar with it, here’s a basic rundown of the premise: the contestant is faced with 26 briefcases, each with a dollar amount inside, ranging from one penny up to one million dollars.  At the beginning of the show, the contestant chooses one of the cases as her prize.

The amount in the case she has chosen remains secret until the end of the show.  Then the contestant begins eliminating the remaining 25 cases – first in groups of descending amounts, then later one at at time.  As the cases are chosen, the amount in each case is revealed.  At the end of each round of “reveals”, a character called “the banker” offers the contestant a sum of money to drop out of the game.

The amount that the banker offers is statistically relative to the amounts that have yet to be revealed – if more high-dollar amounts are remaining to be revealed (which means a high-dollar amount could be in the contestant’s prize case), a relatively higher amount is offered.  If the amount offered is attractive enough to the contestant, she can choose to take that amount and quit the game.  If not, the contestant will have to choose another case and reveal the amount.

As the match progresses, often we see the contestant choosing cases that reveal high dollar amounts in them – which prompts the banker’s offer to reduce.  Even when faced with seemingly impossible odds against her, when this situation occurs, the contestant often becomes a risk-taker – more so than you would normally expect.

This is because the contestant feels as if she has already lost something (the earlier offer from the banker) and somehow she must “make it up” by continuing the game in spite of the odds becoming less and less that they’ll “make it up”.  Statistics will rule, and on average the contestant walks away with a much smaller prize than expected.

So what does this have to do with investing?

Quite often we see the same sort of behavior in the stock market: always trying to do better than the average, folks will use all kinds of methods, including paying extra to get the top dog stock picker’s advice – because they’re sure they can beat the market.  And then, if the chosen stock shoots up in value, the investor hangs on, “knowing” that if it went up 10% it is bound to go up another 10%.  But what happens when the stock goes on up to 20%?  Yep, hang in there, cuz it’s bound to keep up.

Then suddenly the stock pulls back, and now is down 5% from the original investment – what happens now?  This is just like when the banker on the show reduces his offer:  the investor feels like she’s lost something that she already had in hand, so she begins to take more risks.  Perhaps she’ll buy some more of the stock – again, “knowing” she’ll “make it up”.  But it rarely works out for the hapless investor.

The problem is that the investor didn’t go into the investment with a plan – and the same would hold true for a contestant on the game show.  If you decided that you were shooting for a 10% return from this particular stock, you’d have sold out at that level and could have gone looking for the next great option.  Without a plan, you never know when to get out of the position.

A Plan!

If a contestant were to go into the show with the plan that she’d like to do better than average – the first time the banker offered more than $131,477.50, she should take it.  ($131,477.50 is the average of all the amounts in suitcases) That would be an excellent strategy to take, especially when you consider the fact that 20 of the 26 cases have less than the average…

As an investor, the odds are much better for you, using history as a guide. If our investor chose to take a shortcut and get a return that is at least the average of the stock market – since in the last 40 or 50 years the stock market has only returned a negative roughly 20% of the time, using the average would assure you of a positive return 80% of the time.  That’s much better than the results of the average Joe or Jane who plays the active stock picking game.

To get the average of the overall marketplace, the investor can choose to invest in broadly-diversified indexes, covering domestic and global markets.  This is a very cost-effective way to achieve the average – and then you don’t have to worry about when to get in or get out, or even shout “NO DEAL”.  Go for it.  And if you want a fist-bump, fine, come by my office.  But I won’t be afraid to actually shake your hand.

Photo by Muffet

Options For a Spousal Inherited IRA

Dec 6th, 2009
by jblankenship.
2 comments

wedding 1946 by dlisbonaIn these articles we’ve discussed inherited IRAs and how to handle them – but we have not covered all of the options for a Spousal Inherited IRA separately.  There are some differences, specifically more options available, so this is an important topic.  It should be noted that the majority of this article applies to inheriting IRAs or Qualified Retirement Plans (QRPs, such as a 401(k) or 403(b)), although the term IRA is used throughout.  The receiving account must always be an IRA, though.

As a person who has inherited an IRA from your spouse, you have the following options if you are the sole beneficiary of the IRA:

  • Leave the IRA where it is, and begin taking distributions based upon your own life (see Table I for the factors).  This is the default position.
  • Rollover the IRA to an inherited IRA (see this post for more information).  In this case, you’re treating the situation as if you’re a non-spouse beneficiary.
  • Rollover the IRA into an existing or new IRA in your own name.  This is the special provision that spouses can use that a non-spouse beneficiary can not.  (Note:  you could also leave the IRA where it is and just begin treating the account as if it was your own – more on this below.)

Rollover Into Your Own IRA

There’s nothing terribly complex about the mechanics of a spousal rollover of an inherited IRA – you simply put in motion the paperwork for a rollover, making sure that both the original custodian and the new custodian are aware of the fact that you’re taking advantage of this special provision for spouses.  It is also possible to leave the IRA in place where it is and treat the IRA as your own – this will become the default if you 1) make a contribution into the account; or 2) fail to take the RMDs as if the account were inherited.

Now you have the IRA funds in your own account – which you can contribute to, convert to a Roth IRA, or whatever you’d like.  Plus, if you’re under age 70½, you don’t have to start Required Minimum Distributions (RMDs) from the account. This brings up the one possible downside that you should be aware of as well, prompting a word of caution…

A word of caution

IF you go ahead and rollover the IRA from your deceased spouse’s account into an account in your own name, if you’re less than age 59½, you do not have free access to the funds in the account – one of the 72(t) exceptions must apply, or you’d be charged the extra 10% penalty in addition to taxes on the withdrawal.  It is for this reason that many inheriting spouses do not take the IRA on as their own account – especially when there is a need to access the funds for income.

One more provision

As mentioned earlier, the provision for the spousal beneficiary to treat the IRA as her own is generally for a spouse that is the sole beneficiary.  There are two ways to resolve this situation if the spouse would like to rollover the account to her own IRA and there are more than one beneficiary.

  1. Other beneficiaries could disclaim the inheritance, leaving only the spouse (see this article for more information).  Many times, a well-intentioned IRA owner will designate her spouse and a child or grandchild (or a trust for the whole mob of children and/or grandchildren) as split beneficiaries of an IRA account.  This can bring about unintended results, such as very young children having to take RMDs that they do not need.  By disclaiming the inheritance and leaving only the spouse, the spouse can set up a new IRA in her own name, with the same original, now disclaimed, beneficiary or class of beneficiaries as the beneficiary(s) of the new account. This will fulfill the original owner’s intent, while opening up the account to the extra privileges available to an owner of an IRA versus an inheritant.
  2. A somewhat less messy method is available – as a spousal beneficiary, but not the sole beneficiary, you can take a distribution of your entire share from the account, and then roll it over to an IRA in your own name, as long as it’s within the 60-day period following the distribution.  You may need to make up the difference of the withholding – in general a distribution from an IRA will be subject to 20% withholding.  If you don’t roll over the full amount into your own IRA, you will be taxed and perhaps assessed a 10% penalty on the amount that you did not roll into the new account.  Using this method eliminates the disclaimer requirement which might be necessary if there are many other beneficiaries or if the other beneficiaries do not wish to disclaim.  (Note:  This method is STRICTLY for a spousal beneficiary.  A non-spouse beneficiary will bust the stretch IRA by taking a distribution of this type, even if they rollover the amount into a properly-titled account within the time allotted.  Those rollovers should ONLY be done via trustee-to-trustee transfer.)
Photo by dlisbona

Trust Me, You’re Gonna Like This – The See-Through Trust as a Beneficiary

Dec 2nd, 2009
by jblankenship.
2 comments

sniff alert by obensonOne area that often gets short shrift in discussions of IRAs and beneficiary designation is the use of a trust as the beneficiary.  Part of the reason behind this may be the perceived complexity of trusts in general; at any rate, it’s not as hard as it sounds, and it can be beneficial, depending upon your circumstances.  We’re specifically discussing the “see-through” trust here, as this type of trust is most appropriate for IRA and Qualified Retirement Plan beneficiary designations.

The See-Through Trust as a Beneficiary

If you designate a trust as the beneficiary of your IRA or Qualified Retirement Plan (QRP), the trust should be set up with certain properties associated with it:

  • the trust must be valid under the plan owner’s state’s law;
  • the trust must be irrevocable upon the plan owner’s death;
  • the trust beneficiaries must be identifiable;
  • ALL of the trust beneficiaries must be individuals (cannot be another trust); and
  • the trust documentation must be delivered to the plan administrator or custodian by October 31 of the year following the year of death of the plan owner.

Taken together, these properties describe a “see-through” or “look-through” trust.  Other types of trusts could be eligible as beneficiaries, but the see-through trust provides the ability to enact a rollover (a trustee-to-trustee transfer) to an inherited IRA for the benefit of the beneficiaries.  With this ability, your beneficiaries can split out the IRA into separate inherited IRAs and stretch out the payments over their individual lifetimes, rather than all beneficiaries having to use the oldest beneficiary’s lifetime for Required Minimum Distribution (RMD) calculations.

Why?

You might want to use a trust as your beneficiary because it is much simpler to make changes to the trust documents than to file additional beneficiary designation forms with your plan administrator.  The trust also provides for additional flexibility. For example, if you wanted your IRA to be distributed to your three children, and in the event of one or more of your children’s pre-deceasing you then you’d like that child’s share to be apportioned equally among the heirs of that child – and so on, and so on.  This sort of language doesn’t fit in very well with the standard IRA beneficiary designation form, but a trust could quite easily describe this situation ad infinitum.

Photo by obenson
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