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February, 2010:

The Downside of Prepaid Tuition

Feb 28th, 2010
by jblankenship.
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drop fees by Medmoiselle TWhen planning to save for future college expenses, you may run across several options – including insurance policies, savings bonds, retirement accounts and specific education accounts, such as Coverdell Education Savings and Section 529 plans.

Among the options for Section 529 plans are two types of account:  savings and prepaid tuition.  Following is a brief explanation of the two types of account.

Savings-Type 529 Plan

The savings type of 529 plan works much like an IRA or 401(k): contributions are made and the amounts contributed to the plan are allocated among various sorts of investment options, mostly mutual funds or derivatives of mutual funds.  Over time, assuming that you’ve made appropriate allocation choices and the investments grow, the balance of the account will in turn grow, increasing the amount of funds available to pay for college expenses.  Growth in the account is tax-free when used for qualified higher education expenses (QHEE).

As with any investing activity there are risks to investing in these plans – similar to the risks you face in your IRA or 401(k) plan.  It’s possible that your account could lose value at any given point in time (like late 2008, for example) but prudent investment choices, appropriate time-orientation, and risk management can help to assure that your account will grow over time – but there are no guarantees.

Prepaid Tuition 529 Plan

On the other hand, the prepaid tuition type of plan is set up quite differently from any other type of account.  Instead of a savings account, in this case you’re purchasing discounted “units” or semesters of education – which, backed by the sponsoring state, are guaranteed to be traded for equivalent semesters of public college education (in the sponsoring state) when the student reaches college age.

If the student chooses to attend a non-public school or a school in another state, the programs guarantee that the equivalent of the then-current tuition cost will be available to pay the college of choice, even though the cost at that school will be different from the state universities in the sponsoring state.

Just as with the savings-type of plan, growth in the account is tax-free if used for QHEE – and in either type of plan if you choose not to use the account proceeds for education, you can withdraw the value and pay tax and a penalty on the growth.

The Downside to Prepaid Tuition

So, with all the market volatility, you’d think that the prepaid plan is the way to go – after all, this type is guaranteed!  Unfortunately, that guarantee by the sponsoring state is only as good as the state’s finances; these days, for many states, finances are currently listed under the heading of “Deplorable”.  When you couple the finances of the state with the dramatic increases in tuition costs we’ve seen in recent years, someone is bound to take a hit.  Guess who “someone” is?

Many prepaid tuition plans were forced to bar adding new participants to their plans after the dot-com bubble burst several years ago, since poor market returns and higher tuition rates were causing the plans to lose money far too quickly to make up reserve balances.  Now, similar situations abound, and the states backing the plans may or may not have the funds to help shore things up.  As a result, new fees have sprouted for many plans – along with large increases in the discounted costs for new credits being purchased, which chokes off the new money coming into the plans.

According to a recent article in the Wall Street Journal, all across the nation prepaid tuition plans are operating in the red – seems that the market volatility does have an impact on these plans after all, just a little more subtle and after the fact.  And it’s up to the state to determine if their promises are worth keeping… and here in Illinois we don’t have that much faith in our state government. Your mileage may vary.

For my money, it just makes far more sense to use the savings-type of 529 plan: a plan that you can understand, can follow the balance, and perceive how and why fluctuations occur.  With those plans, you know what you have in the account, day in and day out.  With the prepaid plans, especially given the poor fiscal conditions of the states guaranteeing things, it’s all in question, in my opinion.

Photo by Medmoiselle T

Choosing a Beneficiary for Your IRA

Feb 26th, 2010
by jblankenship.
4 comments

peoples choice award logo by ponchosquealOne of the very important tenets of estate planning is to ensure that you’ve made an appropriate choice, or set of choices, for beneficiary(s) of your IRA account(s).  The title of this article could be a bit misleading – the point of this article is to list some of the consequences of various choices for a beneficiary of your IRA.

Don’t get me wrong – this article doesn’t suggest that the tax consequences should drive your choice of beneficiary(s).  Rather, the assumption here is that you have several beneficiaries to choose from, and other classes of assets that you can direct toward heirs that aren’t as able as others to take advantage of the tax-favorable provisions.

Following are the benefits and consequences of some of the major groupings of choices that you might make for beneficiary(s) of your IRA.

Age

Younger Individual

If you choose a young individual as the beneficiary of your IRA, your heir will be able to take advantage of long-term tax deferral using the method that provides for payout over the life expectancy of the beneficiary.  By doing so, the tax-deferred status of the account can remain in force for a considerably long time (consider a 2-year-old heir, providing for 80+ years of potential tax deferral).

Older Individual

If you choose an older individual as the beneficiary of your IRA, this heir can also take advantage of the life expectancy payout method – but the payout period will be much less (due to the age of the beneficiary).  Therefore the tax-deferral benefit will be considerably less for the older individual versus the younger individual.

Spouse (any age)

Directly

If you leave your IRA directly to your spouse by name, he or she can elect to treat the inherited IRA as his or her own IRA.  This means that your spouse will be able to defer distributions from the account until he or she reaches age 70½, and then use the Uniform Life Table for distributions.  As you know, the ULT is much more favorable than the Single Lifetime Table, which is the one required to be used by owners of inherited IRAs.  Your spouse can also name his or her own beneficiary for any amounts remaining in the IRA at his or her death – which provides for additional deferral in the account.

In Trust

If instead, you decide to leave your IRA to your spouse via a trust (even a look-through trust), you remove the possibility for your spouse to assume ownership of the trust (as described above).  By doing so, the account must be treated as an inherited IRA, subject to the immediate Required Minimum Distributions from the account, regardless of the age of your spouse.  Further deferral of taxes is limited in many cases, since if the spouse is younger than 70½ he or she has to take distributions now rather than delaying until age 70½.  In addition, your spouse will be required to use the less-favorable Single Lifetime Table for the distributions; your spouse also cannot name his or her own beneficiary for the account for further deferral after his or her death.

Now, if the spouse is the sole beneficiary of the trust, the account can be treated as if it were directly inherited by your spouse, as in effect the look-through trust becomes a conduit trust.  With a conduit trust, the effect is the same as naming your spouse the sole beneficiary of the account – so the same rules apply as when you leave the account directly to your spouse.  The only difference is that you’ve spent extra money drafting the trust agreement.

Other Beneficiary Options

Group (versus Individual)

Leaving your IRA to a group of people instead of one person, this can introduce quite a bit of complexity to the situation.  Where possible you could split your IRA into separate accounts and direct each account to an individual beneficiary, saving your beneficiaries a lot of extra headaches at your passing.  If this is not possible or you would prefer not to split your account your heirs can do it later – it’s just a lot of extra paperwork for them that you could have handled for them in advance.  See this article for additional information on splitting inherited IRAs.

Charity

As tax-exempt entities, charities do not have to pay tax on any donations.  So if you choose to name a charity as beneficiary of your IRA, there are no tax consequences on an asset that would otherwise be fully subject to ordinary income tax.  This can be a very tax efficient way to provide charitable bequests – leaving your more tax-favorable assets to non-charity recipients.

Your Estate

If you choose to leave your IRA assets to your estate – either intentionally by naming your estate as beneficiary, or unintentionally by not naming a beneficiary or by naming a non-look-through trust as your beneficiary – tax deferral benefits are lost. Estates and non-look-through trusts have no life expectancy, therefore there is no life expectancy payout option.  This is not to say that there are no good reasons to choose your estate as beneficiary of your IRA – but that’s a topic for another post…

Bottom Line

As I mentioned before, you should not cause the tax code to be the determining factor when choosing a beneficiary.  You should leave your assets to whomever you wish.  You can, however, use the information on this page to help guide your process of choosing a beneficiary, making tax-efficient choices.  Making thoughtful decisions about this process can ease the tax burden for your heirs.

Photo by ponchosquealº

Social Security Eligibility

Feb 24th, 2010
by jblankenship.
2 comments

social security administration by Ken_MayerIn order to be eligible to receive Social Security benefits – retirement, disability, or survivor benefits – a worker must earn eligibility to receive the benefits.  The general rule of thumb is that for full benefits, the worker must earn at least 40 quarters of credit within the system.

Social Security Credit

Generally speaking, a quarter of Social Security credit is earned for each $1,120 earned (in 2010 or 2011).  This amount is generally indexed each year – for example, the amount of earnings for a credit in 2009 was $1,090.  So if a worker earns at least $4,480 in 2011, four quarters of credit are earned with the Social Security system.

Minimum Credits

If you become disabled before age 62, disability benefits may be available to you if you have at least six quarters of credits earned.  Of course, these benefits will be reduced from the maximum, based upon how many credits you happen to have earned.

Photo by Ken_Mayer

Missing a W2? Here’s What to Do…

Feb 22nd, 2010
by jblankenship.
1 comment

theres a hole where something was by whatmegsaidSo – you’re all set to do your taxes.  And then… you realize you’re missing something.  One of your W2’s hasn’t shown up in the mail.  Maybe it was a short-term or a part-time gig, or maybe the business changed hands – or maybe it just got lost in the mail.

Whatever the reason, you’re short the documents that you need in order to prepare your tax return.  So what do you do?

What Do You Do?

Your employer is required to send your W2 earnings statement to you by February 1 for the prior year’s earnings. But sometimes things go awry, and you don’t receive the form. There are four steps to follow to retrieve the required information…

  1. Contact your employer – inquire if and when the W2 forms were mailed out.  It’s possible that the postal service returned it to your employer due to an incorrect or incomplete address.  Even if it hasn’t been returned, your employer should be able to produce a new copy of the form and send it out to you.
  2. Contact the IRS – the IRS receives a copy of all W2 forms filed.  Wait until after February 16, and then you can call the taxpayer assistance line at 800-829-1040.  Make sure you have as much information about the earnings as possible – including your employer’s name and address, your dates of employment, and an estimate of your earnings (you can get this from your end-of-year pay stub).  The IRS should be able to produce the appropriate information for you or direct you to the steps you need to take.
  3. File your return – on time if you can, or with a timely filed extension request, even if you have not received the W2.  If you have taken the first two steps and still have not received the form by April 15, use Form 4852, “Substitute for Form W2, Wage and Tax Statement”.  Attach Form 4852 to your return, using your last pay stub to estimate your earnings and withholding taxes.  Keep in mind that using Form 4852 may delay any refund due to additional processing required.
  4. File an amended return – if you happen to receive your W2 after you’ve filed using Form 4852 and the W2 includes different information than you used to prepare your return.  Use Form 1040X to file this amended return, within 3 years of the original return deadline.

You can find the forms mentioned above on the IRS website, along with the original text of this IRS Tax Tip, #2010-28.

Photo by whatmegsaid

Eligible Rollover Distributions (ERDs)

Feb 20th, 2010
by jblankenship.
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beethoven by HitchsterSo what funds can be rolled over from your retirement plan into another retirement plan or IRA?  Interestingly, the IRS doesn’t specifically tell you what can be rolled over – but rather, what can not be rolled over.

Let’s look at the definition from the IRS…

Definition

Only Eligible Rollover Distributions, or ERDs, can be rolled over, according to the IRS.  The definition that is given is really an anti-definition, explaining that any normally taxable distribution is eligible for rollover unless it fits the exceptions listed.

An ERD is defined as – a distribution that is eligible to be rolled over to an eligible retirement plan. Eligible rollover distributions include a participant’s balance in a qualified plan, 401(k), 403(b) or 457 plan, except for certain amounts that include the following:

  • Any of a series of substantially equal periodic payments (SOSEPP) paid at least once a year over:
    • The participant’s  lifetime or life expectancy,
    • The joint lives or life expectancies of the participant and his/her beneficiary, or
    • A period of 10 years or more,
  • A required minimum distribution,
  • Hardship distributions,
  • Corrective distributions of excess contributions or excess deferrals, and any income allocable to the excess, or of excess annual additions and any allocable gains,
  • A loan treated as a distribution because it does not satisfy certain requirements either when made or later (such as upon default), unless the participant’s accrued benefits are reduced (offset) to repay the loan
  • Dividends on employer securities, and
  • The cost of life insurance coverage.

So, as long as the distribution plan that you set up doesn’t fit any of the requirements above and has a payout period of 10 years or less, your distributions can be considered ERDs, and therefore rolled over into an IRA or other retirement plan.

Understand that these distributions will be subject to mandatory 20% withholding if paid out to you.  Plus, you must complete the rollover within 60 days when it’s not done by trustee-to-trustee (or direct) rollover.

Whenever possible, you would want to set up these payments as direct rollovers into your IRA (or other QRP) to avoid this withholding requirement and 60-day limit.  If this can’t be done, you should make up the 20% withheld difference from other savings as you rollover the distributions in order to avoid tax and penalties.

Photo by Hitchster

A Little-Known Social Security Spousal Benefit Option

Feb 18th, 2010
by jblankenship.
6 comments

Most everyone is familiar with the concept of Social Security Spousal Benefits – if not, click this link for a complete explanation.

vintage photoIn this article, we’ll be discussing an option that is available to all married recipients of Social Security retirement benefits – but you might not have thought of it.  For most all married couples, it makes the most sense for the spouse with the higher wage base – that is, the spouse that has earned the most money throughout his or her working career – to delay receiving Social Security retirement benefits as long as possible.

As described in the article about credits for delaying Social Security benefits, each year that you delay receiving your Social Security retirement benefit past your full retirement age (FRA) can result in up to an 8% increase in your benefit amount.  When delaying like this, it often also makes sense for the spouse with the lower wage base to begin receiving benefits at the lower rate, either at the early retirement age of 62, or upon reaching FRA.  Then later, when the spouse with the higher wage base begins taking the increased, delayed, benefits, the spouse with the lower wage base will begin receiving the spousal benefit, based upon one-half of the higher wage base spouse’s benefit.

But Wait, There’s More!

What most folks don’t realize is that, while the spouse with the lower wage base is receiving the reduced benefit, the spouse with the higher wage base can apply for a spousal benefit based upon one-half of the lower wage base spouse’s benefit, beginning at the higher wage base spouse’s reaching FRA.

While this doesn’t necessarily amount to a very large payment, it is money that you are entitled to and should receive.  The spouse with the higher wage base can receive this spousal benefit from FRA up to the time when election is made to begin receiving the delayed benefit based on his or her own record, at age 70.  At that time, the spouse with the lower wage base will begin receiving the spousal benefit based upon the higher wage based spouse’s benefit, as well.

Quick Example

Let’s say Jane and Bob are a stereotypical couple – Jane didn’t work outside the home while their children were in school, while Bob has worked and earned Social Security credits since age 21.  As a result Jane’s PIA is considerably lower than Bob’s.  (Keep in mind, the roles could easily be reversed, depending upon circumstances.)

So at age 62, Jane begins drawing her Social Security retirement benefit, in the amount of $666 per month (PIA of $888).  They have decided to delay Bob’s benefit as long as possible, to his age 70.  Once Jane reaches FRA, when both of them are age 66, Bob can now begin drawing a spousal benefit based upon Jane’s PIA (now $1,000).  So Bob can draw a spousal benefit equal to 50% of Jane’s benefit, or $500 per month.

When the couple reaches age 70, Bob applies for and begins receiving his full, delayed benefit – which is approximately $3,600 per month (PIA of ~$2,650).  Jane’s benefit has grown to $800 (PIA of $1,000).   Her Spousal Benefit will be based upon the difference between her PIA and 50% of Bob’s PIA – $1,325 minus $1,000 equals $325.  This is added to her own benefit for a total of $1,125.

That’s all there is to it.  It may not seem like a lot of money, why would you not go for it?

Photo by HA! Designs - Artbyheather

Coming Soon: No Change For the Financial Services Consumer If FatCats Get Their Way

Feb 16th, 2010
by jblankenship.
1 comment

fatcat by ChikaWe talked about this issue of the accountability standards for financial professionals some time ago (click here to get the background).  Unfortunately, it seems that the big money and best interests of the large brokerages, banks, and insurance companies is turning the tide against the proposed fiduciary standard for all financial professionals.

The fiduciary standard has long been sought after by consumer advocates, as the great majority of financial professionals are held to a much lower standard of care – one that often leaves the consumer of financial services exposed to higher costs and a low likelihood of advice being in his or her best interests.  Last year, proposals were offered in Congress to require the fiduciary standard of all regulated financial professionals – which is a step in the right direction.

However, intense lobbying efforts by the fatcats, the heavyweights of the financial services industry (think banks, brokerages, and insurance companies) has just about killed the concept of an industry-wide single standard altogether.  The original proposal by Senator Dodd (head of the Senate Banking Committee) that was to require a fiduciary standard across the board has been withdrawn due to intense opposition from lobbied members of the committee.  Now the committee is working on a compromise, which is not likely to carry the same requirement.

WHY?

You’ve got to ask yourself – Why?  Why is it so important to these companies that their sales forces are not held to a standard of fiduciary care?  After all – the fiduciary standard requires that advice given is in the best interest of the consumer.  Who could be against something like that?

If you look at the industry makeup, you’ll get a clue:  90% of the members of the financial professional industry are not held to a fiduciary standard, and much of the remaining 10% are small, independent firms, not backed by large marketing budgets.  The reason becomes clear when you think about where the money is – it takes a lot of hard work to provide a fiduciary level of care, and as a result it can be costly to provide, and therefore difficult to justify.  It is much more lucrative (and cost-effective) for these companies to provide one-size fits all solutions to masses of clients, especially if you don’t have to care if the solution is in the best interest of the client.

When there are billions of dollars annually at stake, it’s not hard at all to understand why the lobbying effort against the fiduciary standard is so intense.  If this standard were to come into being, current sales techniques would have to be totally re-tooled, and likely the vast majority of the existing sales force would have to be replaced, due to increased training required to adequately provide the level of care that the fiduciary standard will necessitate.

So what can you do?

As consumers of financial services, we all owe it to ourselves to remain diligent – to understand the requirements and standards that our financial professionals are held to.  Just because Congress isn’t up to the challenge of requiring a fiduciary standard of all financial professionals doesn’t mean that you have to swim with the sharks.

Know that your insurance guy, the broker down the street, and those bank employees are only required to provide you with “suitable” solutions, not solutions that are in your best interests.  That’s not to say that you will never get a good solution from these folks – most often the non-fiduciary guy or gal truly wants to direct you to the right solution.  But if a choice comes down to selling you a product that’s suitable versus pointing you to a solution that’s in your best interests but doesn’t pay off for him or her… it’s not hard to imagine that the product sale would win out most of the time.

Instead, seek out a true fiduciary, Fee-Only, CFP® professional to get your advice from.  (You can start your search at www.NAPFA.org, the National Association of Personal Financial Advisors.)  Those other guys are salesmen – go to them specifically to buy your insurance products, investments, and the like – but get the advice of a fiduciary advisor first.

Photo by Chika

Understanding the 2010 Estate Tax Repeal

Feb 15th, 2010
by jblankenship.
3 comments

The start of a new year often signals a time for change–especially when it comes to taxes, and 2010 has brought some major changes. As of January 1, the federal estate and generation-skipping transfer (GST) taxes are repealed, and the step-up in basis rule is modified for 2010. While it’s possible (and some believe very likely) that Congress will reinstate these taxes, until that time, it’s important to understand these significant federal tax law changes and how they might affect you.

Federal estate tax repeal

In 2009, the top estate tax rate was 45%, and estates received an exclusion of $3.5 million, (meaning that up to $3.5 million of assets were exempt from estate tax). However, as part of the tax cuts initiated in 2001, the estate tax is repealed for 2010 but is scheduled to return in 2011, albeit with a reduced $1 million exclusion and an increased top tax rate of 55%.

It’s possible Congress may reinstate the estate tax retroactively, that is, back to January 1, 2010, in which case heirs who already received their inheritance may have to reimburse the estate to enable it to pay the reinstituted estate tax. On the other hand, heirs who haven’t received their inheritance may have to wait for their gifts until the likely challenges to the constitutionality of instituting the estate tax retroactively have been resolved in the courts. In any case, until these issues have been cleared up, it may be wise for executors and trustees of estates in 2010 to retain sufficient assets in the estate to pay a potential estate tax.

What should you be doing about the estate tax? Review and, if necessary, revise your estate planning documents, like wills and trusts. For example, many wills and trusts drafted with an estate tax in mind leave an amount of assets up to the applicable exclusion amount to children, with the balance going to the surviving spouse. However, in 2010, since there is no estate tax, there also is no exclusion. Depending on how documents are worded, this could create a situation where all of the assets pass to the children with nothing going to the surviving spouse, or vice versa. Thus, it’s important that your estate planning documents be reviewed to ensure that your intentions are actually carried out.

Generation-skipping transfer tax repeal

The generation-skipping transfer tax is a federal tax on transfers of property made, either during life or at death, to an individual who is more than one generation below you, such as your grandchild. The tax, also repealed for 2010, had a $3.5 million exemption in 2009 and a top tax rate of 45%. However, like the estate tax, the GST tax is also scheduled to be reintroduced in 2011, with a $1 million exemption and top tax rate of 55%.

What should you do about the GST tax in 2010? The repeal of the generation-skipping transfer tax in 2010 means the elimination (albeit temporarily) of one of the taxes on gifts made during life. The other applicable tax is the gift tax, which provides a $1 million lifetime exemption and a top tax rate of 35% in 2010. The gift tax rate is scheduled to increase in 2011 to 45%. Thus, assets can be gifted in 2010, either directly or through a trust, to grandchildren and younger generations while accounting only for the gift tax, unless, of course, the GST tax is reinstated, retroactively or otherwise.

Step-up in basis repeal

Along with the 2010 repeal of the estate tax and GST tax is the partial elimination of the step-up in basis rule. In 2009, the tax basis of property in a decedent’s estate was generally increased, or stepped up, to the asset’s fair market value as of the decedent’s date of death. However, in 2010, the cost basis of estate assets is equal to the lesser of the decedent’s adjusted cost basis or the fair market value of the assets on the date of the decedent’s death. This means that estate assets likely will retain the decedent’s cost basis. Absent Congressional action to the contrary, the modification of the step-up in basis rule is temporary, with the full step-up in basis rule scheduled to return in 2011.

The law does allow estates to exempt up to $1.3 million of gain (generally, the difference between the decedent’s cost basis in property and its date-of-death fair market value), which executors and trustees may allocate among estate assets. Also, an additional $3 million of gain may be exempted for assets passing to a surviving spouse. This means that estates in 2010 may be able to increase the cost basis of assets up to $4.3 million.

The modification of step-up in basis can lead to some issues for estate administrators. For example, executors or trustees of estates larger than $1.3 million will have to figure out which assets should receive the step-up in basis. This is especially important for heirs and beneficiaries other than a surviving spouse.

In addition, heirs who want to sell inherited assets not covered by the step-up in basis will have to try to figure out the decedent’s cost basis in order to calculate potential capital gain. For example, assume you inherit shares of XYZ Company stock in 2010. You sell them and now have to determine whether you owe a capital gains tax. First, you need to know if any of the $1.3 million step-up in basis applies to these shares. If your XYZ stock didn’t receive a basis step-up, you’ll have to figure out the cost basis of your inherited stock. Arriving at the cost basis of inherited property may prove difficult, if not impossible, especially if the decedent didn’t keep accurate purchase records, or if the stock split over the years, or if the decedent received some of the stock by gift or inheritance.

What’s next?

Most observers believe Congress will restore these taxes retroactively sometime in 2010. There are a number of proposals under consideration and exactly what plan will be adopted and when are important questions that remain unanswered.

Another potential issue surrounds the constitutionality of Congress reinstating the estate tax and/or GST tax retroactive to January 1, 2010. Congress has imposed taxes retroactively in the past and when challenged, taxpayers have lost the majority of the time. Whether Congressional reinstatement retroactive to January 1 will withstand a challenge is conjecture at this point since Congress has yet to act, but the possibility of reinstatement of either or both taxes further adds to the estate planning conundrum in 2010.

One case that is likely to receive a lot of attention deals with the estate of author J. D. Salinger, who recently passed away.  Salinger, author of the classic book The Catcher in the Rye, died in 2010 with the film rights to his book unspoken for – as Salinger repeatedly denied offers from a multitude of Hollywood luminaries to turn the book into a blockbuster.  Those rights, plus the purportedly written and unpublished works Salinger left behind, could be worth a huge fortune to his heirs.  And with the current limbo of estate tax laws, this situation is likely to become a defining test case for the ages.  As Salinger’s character Holden Caulfield stated “… money.  It always ends up making you as blue as hell.”

And don’t forget to consider possible state taxes. Currently, 16 states plus the District of Columbia impose their own estate and/or inheritance tax, separate from any federal estate tax.

Despite all of this uncertainty, do not put off making or reviewing your estate plan. Not having an estate plan, or having an outdated plan, could mean your intentions aren’t carried out and could cost your surviving spouse and heirs.

The table below summarizes the evolution of the estate, generation-skipping transfer, and gift taxes over the three years affected, barring any changes by Congress:

Year Estate tax Generation-skipping transfer tax Step-up in basis Gift tax
2009 $3.5 million exemption

45% top tax
rate

 $3.5 million exemption

45% top tax
rate

 Full step-up
in basis		 $1 million
lifetime
exemption

45% top tax
rate
2010 Repealed Repealed First $1.3
million gets
step-up

Assets to
spouse get
added $3
million
step-up

 $1 million
lifetime
exemption

35% top tax
rate
2011 $1 million exemption

55% top tax
rate

 $1 million exemption

55% top tax rate

 Full step-up in basis $1 million
lifetime exemption

45% top tax
rate

 
Copyright 2010 Forefield Inc.

What Hath Congress Roth?

Feb 14th, 2010
by jblankenship.
1 comment

… or better yet, what will they Roth in the future? You’re right, terrible attempt at a pun.

wrought iron steps by Rennett StoweIn case you aren’t a retirement and financial planning geek like myself, there has been a proposal put forth by the current administration to require all employers to automatically enroll employees in a retirement plan.  I find it interesting that the choice for a “default” retirement plan for the proposed system is a Roth IRA.

The reason this is so interesting is because a Roth IRA doesn’t provide the participant with an immediate benefit – there is no tax deductibility, no employer match, etc..  Granted, any sort of retirement savings is a good idea, but this type of plan will be a hard sell for those folks who haven’t already bought into the concept of saving strictly for the benefit of saving on their own.

In addition, there’s the current push (in 2010) for lots and lots of Roth conversions.  This one is even better – there’s not only no adverse tax revenue consequence, there’s a great tax revenue advantage if lots of IRA money is converted and taxed. This push has been referred to as a “mortgaging of the future” – since we’ll get lots of tax revenues from the conversions today at the expense of future revenues on the growth in the accounts. It wouldn’t be hard to imagine a future administration pointing to 2010 as the first domino that caused the soon-to-be current circumstances.

Is there more to it?

Perhaps there is more to it – obviously, a dramatic increase in participation in deductible IRAs could have a significant negative impact on tax revenues, hence the Roth being recommended as the default.  But what if Congress decides at some point down the line that this Roth deal looks too good for the taxpayer??  What if the idea of completely tax-free distributions starts to cause extreme anxiety among our legislators (as un-taxed benefits often do)?

It’s quite possible that the reason the Roth IRA account has been deemed the plan of choice is primarily because of the non-existent tax impact in the short run.  And the longer-run consequence (the mortgage of the future) of potentially locked up funds that will bring no tax revenues can be dealt with by future administrations – when such tough decisions can be confronted far distant from the decision-makers who helped us to get into the position in the first place.

Another thing that’s pretty interesting is the fact that many of the online Roth Conversion calculators are reportedly over-stating the benefits of Roth Conversion – putting far more emphasis on the potential for future higher tax rates and the benefits of no RMDs than is warranted.  It’s not hard to guess why asset-gathering companies might suggest that it would be in your best interest to convert assets to Roth IRAs; conveniently under the management of the company who recommends conversion.

Imagine the case in 20+ years when a great amount of the wealth in this country is locked up in Roth IRA accounts – with no tax ever to be paid on it (under current law), and no Required Minimum Distributions (RMDs) of the funds.  I can imagine that there might be an “emergency needs-based” change to the law – perhaps something simple like a requiring RMDs, with maybe a value-added tax, along with possibly inclusion of Roth IRAs as taxable assets in your estate.  That would pretty much knock all these conversion schemes on their collective ears, don’t you think?

Your Defense

It is for these reasons that I believe most folks are best served by not putting too many eggs in one tax treatment basket – you should not only have traditional IRA or 401(k) assets along with Roth IRA or 401(k) assets – you should also have taxable savings, such as a standard brokerage account and/or savings account.  By diversifying your savings across multiple tax treatments you can hedge your bets against whatever adverse changes there may be for the future.

In addition, cast a wary eye toward any recommendation for conversion to a Roth IRA – make sure that this makes complete sense to you, both from a tax payout standpoint today, and from the point of view of what you know and expect about future tax rates and laws.  Most importantly, don’t take advice strictly from someone who stands to benefit from the very advice he’s giving.  Don’t take this to mean that Roth IRA conversion isn’t ever beneficial: for many people there are compelling reasons to convert at least some assets to Roth.  It just makes good sense to proceed with caution and make no swift, dramatic changes.

And pay attention, because these things have a tendency to happen so subtly that you might even think it’s a good idea…

Photo by Rennett Stowe

Ah, Sweet Procrastination!

Feb 12th, 2010
by jblankenship.
8 comments

tapping a pencil by Rennett StoweIt’s usually best, for most things in the financial world, to act now rather than waiting around.  The notable exception is with regard to applying for Social Security benefits.  We’ve discussed it before (in fact part of this article is a re-hash of an earlier post) but it is an important point that needs more emphasis, in my opinion.

As you’ll see from the table below, if you’re in the group that was born after 1943 (that’s you, Boomers!) you can increase the amount of your Social Security benefit by 8% for every year that you delay receiving benefits after your Full Retirement Age (FRA – see this article for an explanation).

Delaying Receipt of Benefits to Increase the Amount

If you are delaying your retirement beyond FRA, you’ll increase the amount of benefit that you are eligible to receive.  Depending upon your year of birth, this amount will be between 7% and 8% per year that you delay receiving benefits – which can be an increase of as much as 32½% if you delay until age 70 and you were born in 1941 – when your FRA is 65 years and 8 months, and the increase amount is 7½% per year at that age.  See the table below for the increase amounts per year based upon birth year:

Birth Year FRA Delay Credit Minimum
(age 62)		 Maximum
(age 70)
1940 65 & 6 mos 7% 77½% 131½%
1941 65 & 8 mos 7½% 76?% 132½%
1942 65 & 10 mos 7½% 75 5/6% 131¼%
1943-1954 66 8% 75% 132%
1955 66 & 2 mos 8% 74 1/6% 130?%
1956 66 & 4 mos 8% 73?% 129?%
1957 66 & 6 mos 8% 72½% 128%
1958 66 & 8 mos 8% 71?% 126?%
1959 66 & 10 mos 8% 70 5/6% 125?%
1960 & later 67 8% 70% 124%

So you can see the impact of delaying receipt of retirement benefits – it can amount to more than 50% of the PIA (Primary Insurance Amount), when you consider early benefits versus late benefits.  Of course, by taking benefits later, you’re foregoing receipt of some monthly benefit payments; given this, early in the game you’d be ahead in terms of total benefit received.  This tends to go away as the break-even point is reached in your mid-70′s to early-80′s in most cases, which we’ll review in a later article.

An Example

Here’s an example of the benefit of delay in action:

You were born in 1954, and as such your FRA is age 66.  According to the benefit statement you’ve received from Social Security, you are eligible for a monthly benefit payment of $2,000 when you reach your FRA (which would be in 2020).  If you delayed applying for your benefit until the next year, your monthly benefit payment would be $2,160 per month – an increase of $1,920 per year.  If you delayed until age 68 (two years after FRA), the monthly payment would be increased to $2,320, for an annual increase of $3,840.  At age 69, delaying would increase your annual benefit by $5,760, and at age 70, your monthly payment would be $2,640, for an annual benefit of $31,680 – $7,680 more than at FRA.  This amounts to a 32% increase in your benefit by delaying receipt of the benefit by 4 years!

Notes

It’s important to note that this is not a compounding increase – that is, your potentially-increased benefit from one year is not multiplied by the increase for the following year.  The factor for each year (or portion of a year) is simply added to the factor(s) from prior years.  You also don’t have to wait a full year to achieve the benefit – this delay is calculated on a monthly basis, so if you delayed by 6 months your increase would be 4% over the FRA amount.

The biggest benefit of this is that you can not only increase the amount you will receive over your lifetime, but also the survivor benefit that your spouse will receive upon your passing.  For some folks this can make a huge difference as they plan for the inevitable.

Photo by Rennett Stowe
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