IRA

Avoid Awkwardness in the Afterlife–Confirm Your Beneficiary Designations

May 24th, 2013

This is a topic that I cover with all clients, and one that I recommend you for everyone with retirement plans and other accounts with beneficiary designations. Too often we think we have the beneficiary designation form filled out just the way we want it, and then (once it’s too late) it is discovered that the form hadn’t been updated recently – and the designation is not what we hoped for.

I made this recommendation to a client not long ago. He assured me that he had all of his designations set up just the way he wanted. His wife, sitting next to him in our meeting, asked him to make sure – talk to the IRA custodian and get a copy of the designation as it stands today. A bit miffed about it all, he agreed to do so, and did the next day. Guess what he found – as it stood on that day, his IRA beneficiary designation form indicated 100% of his IRA would pass to his ex-wife from 15 years ago! Plus, he had no secondary beneficiaries named, which meant that if the ex predeceased him, HER heirs would be the primaries. Thankfully he had checked on this to avoid this awkward and possibly devastating situation.

Know what was fixed pretty much immediately?

Take the time

You owe it to yourself and your heirs to take the time to review your beneficiary designations and keep copies of them in your “dead file”. This includes IRAs, Roth IRAs, 401(k)/403(b)/457 plans, and other pensions or retirement plans. You also may have POD or TOD (Pay on Death or Transfer on Death) designations on non-retirement accounts – confirm these and keep copies as well.

For your standard retirement accounts, such as IRAs, 401(k)s and the like, you typically have the option of naming a primary beneficiary (or beneficiaries) and a secondary or contingent beneficiary or beneficiaries. It makes a huge difference on these accounts that you name a specific person (or persons) as the primary beneficiary, and a specific person (or persons) as the contingent beneficiary. With IRAs, if you leave the designation blank, you may be taking away important options for your heirs.

If you leave the primary beneficiary designation blank you are leaving the transfer of your IRA up to the custodian’s default designation. Quick! What’s your IRA custodian’s default beneficiary designation?? I didn’t think you’d know.

Often this default is your spouse first, and then your “issue” – meaning your children and other descendants. Other times, the default beneficiary is your estate. In the event that the estate is the default beneficiary, any beneficiaries of the estate will receive the IRA, but they will not be able to utilize the “stretch” option of receiving payout of the account over their remaining lifetimes. This is because the IRS rules state that a “named beneficiary” must be in place in order to use the stretch provision. If no “named beneficiary” exists, the stretch option is not allowed. If the default is your spouse and your issue, these can be treated as “named beneficiary” if they are alive.

Discuss with your heirs

At face value, even though you think your intent for your beneficiary designations is clear, it might not be clear to your heirs. For example, you may have chosen to pass along half of your IRA to your youngest child and only a quarter to the older two children because you believe the youngest child can use the money more than the other two. Or maybe you decided to leave the entire IRA to your oldest daughter, and you want to designate your three sons to split up the farmland – which you believe is an equitable division.

Whatever you’ve decided, especially if there are perceived inequities in your division plan, you should take the time to review your plan with your heirs. If that makes you uncomfortable, there are a couple of things to consider: First, if you’re uncomfortable discussing it with them, imagine how uncomfortable your heirs may be when the time comes to distribute your estate. Maybe it’s not such a good idea after all if it could cause contention among your heirs. Second, if you still believe your split is the right way to go, you should explain your plan to someone – your designated executor would be a good choice. And the designated executor should be a disinterested separate party, someone who isn’t receiving benefit from your estate plan, in order to keep the process “clean”. Otherwise, if one of the heirs is your executor and the executor is perceived to receive preferential treatment, again you’ll have some contention among your heirs.

If there are complex instructions involved, consider making an addendum to your will. Instructions in your will would have no impact on the beneficiary designations on your IRAs and other plans (these pass outside of your estate as long as you’ve made specific designations) but other asset divisions aside from retirement accounts may require explanation for your heirs to understand your intent. Don’t expect that everyone will understand or agree with your thought process when you’re gone. Explaining your thought process in advance will likely help to ensure that your division plan doesn’t result in a family rift.

Take the time to review your beneficiary designations. Make sure that you have the primary beneficiary or beneficiaries that you want, and the percentages that you’d like each to have. Also make sure that you have named contingent beneficiary or beneficiaries in the event that your primaries have predeceased you. Lastly, make sure that you note how division is done after the death of the beneficiaries: per stirpes or per capita.

State Income Tax and Retirement Income

May 8th, 2013

by sraskie.

3 comments

On only a few rare occasions does it make sense to defer money to your 401(k) or other employer sponsored plan instead of a Roth IRA. Those occasions include when your gross income excludes you from contributing directly to a Roth IRA (you can still convert), you are currently at a very high tax rate or the case of when you live in a state where retirement income is excluded from state taxation.

Here in Illinois, the current law exempts retirement income from being taxed at the state level. What this means, is that any contributions to a 401(k), 403(b), SEP, SIMPLE and 457 avoid state income taxation. Qualified distributions at retirement are only taxed at the federal level, and then only as income.

If you contribute directly to a Roth IRA that money is after-tax money going in. After-tax in this case meaning it’s been already taxed at the federal and state level. So in this case the money going into the Roth IRA has been “hit twice” with federal and state taxes.

One possible way to avoid this double whammy (going by current Illinois law) is to contribute to your employer’s plan and then at retirement or whenever you leave your job, convert that money to a Roth IRA. In this case the money from your paycheck is already deferred from state taxation and then when it’s converted to a Roth IRA, avoids state income taxation again – since it’s income from a retirement plan and considered retirement income – which Illinois does not tax. This is evidenced by the 1099-R you’ll receive at the time of conversion.

Another way to avoid this is if your employer’s plan allows, convert your 401(k) to a Roth 401(k) while you’re still employed. Again, you’ll pay federal income tax but avoid the state taxation if your state excludes retirement income for tax purposes. If you’re in a higher tax bracket, you may consider staging your conversions up to the point where you maintain low tax costs (converting small amounts over many years). Or you may just want to wait to convert the whole amount when you know you’ll be in a lower tax bracket.

Fixing an IRA With the “Wrong” Beneficiary

May 1st, 2013

by jblankenship.

3 comments

Quite often, for many different reasons (often known only to the deceased original owner), the original owner of an IRA designates a beneficiary that the survivors don’t necessarily agree with. It might be that only one of several children is designated, or perhaps additional beneficiaries are designated along with a spouse. In cases like these, there are ways to make changes to the outcome of the inheritance. In this article we specifically deal with the case where only one of four children was designated as the primary beneficiary of the IRA.

To resolve the situation, let’s consider the following IRA: John, the decedent, designated April (his daughter) as the primary beneficiary of his IRA. It isn’t known why John only designated April as the beneficiary, as he has three other children – Bill, Chuck, and Dale – and John had only his IRA as an asset to pass along to the children. April could choose to take the entire IRA as her own and receive payments over her lifetime using the stretch rules, but she sees the inherent lack of fairness in the situation, so she wants to make the IRA available to her brothers as well.

One way to accomplish this would be for April to withdraw 75% of the IRA and split that amount with her brothers. She would then be able to stretch out the payments on the remaining 25% over her lifetime. Mission accomplished, right?

The problem with this option is that April would have to pay tax on the 75% distribution – and since the IRA is sizeable, this is a significant cost. Naturally she could just pass along this tax cost to her brothers in the form of a reduced payment, but this isn’t a very efficient way to distribute the money.

On the other hand, April could maintain the account in her name and stretch out payments over her lifetime, splitting each payment (after tax) among herself and her brothers. Again, this accomplishes what she had set out to do, but she’s still paying tax on the entire amount and since our tax system works on a graduated scale, the tax on 100% received by one person is likely to be much higher than the tax would be for four persons each receiving 25% from the account. In addition, the three brothers would be required to wait until April decides to take a distribution before they would have access to the account. Bill for example, would prefer to withdraw a large sum right away as he’s building a home and could use the funds for the construction. This would be very inefficient (tax-wise) if April had to make the withdrawal for him and pay the tax at her higher rate.

So – what else could be done? It would be great if there was a way for April to re-write the beneficiary designation so that all four children were considered to be the beneficiaries, but that’s not possible. What is possible is to re-direct a portion of the inheritance, by way of a method called disclaiming.

It’s important to know how to properly disclaim the inheritance of an IRA. The person disclaiming all or a portion of an IRA must not be an eventual beneficiary as a result of the disclaimer. Plus, the person disclaiming must not be in a position to direct who are the new beneficiaries; the natural course of the law must be followed. If either of these rules is broken, the disclaimer is considered to be nonqualified, and any distribution would be considered to have been done by April. Any amount transferred to her brothers would be considered a gift, subject to gift taxes.

So, if April disclaims the entire IRA, the new beneficiary would be John’s estate. Since John’s will dictates that the four children will split all of his assets equally, this would accomplish the desired result, right? No, not really.

The problem is that, when April disclaims the entire IRA, she is still an eventual beneficiary of the IRA since the estate becomes the de facto beneficiary, breaking the first rule above. In addition, since the estate isn’t a “person”, the stretch rules can’t be used for this IRA at all. When there is no real person as a beneficiary of an IRA, the entire account must be paid out within five years, rather than stretched out over a beneficiary’s lifetime.

What April should do is to disclaim 75% of the IRA, and also disclaim rights to the IRA portion of the estate that results from her first disclaimer. This gives her 25% of the original IRA with the stretch benefits still intact. In addition, since she’s disclaimed her right to the estate portion of the IRA asset, her brothers each have right to 25% of the IRA – 1/3 each of the 75% that April disclaimed. This portion passes through the estate to the brothers.

The brothers will not be allowed to stretch out their payments from the account for more than five years – this is one unfortunate circumstance that can’t be avoided. But otherwise, the eventual distribution is much more “fair” – even if it’s not what John had planned. And each brother has control over his portion of the funds, at least for distribution purposes. Bill can take the large distribution right away, and Chuck and Dale can delay up to five years before taking a distribution. And each of the four siblings will only pay tax on the distribution that he or she takes.

Last-Minute Tax Tips

Apr 15th, 2013

by jblankenship.

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Since today is D-Day for income tax filing, I’ve pulled together a few recent tips that the IRS published. These tips cover a few of the areas that you may find interesting, including how to get a six-month extension for your filing (but not for payment of tax), errors to avoid as you complete your tax return, how to make IRA contributions, and tips for the self-employed at tax time. This is a much longer post than I normally write, but I think it has a lot of very good and very timely information that will be useful today.

The actual text of these tips are listed below, with the reference number of each tip.

IRS Newswire IR-2013-38

Can’t File by April 15? Use Free File to Get a Six-Month Extension; E-Pay and Payment Agreement Options Available to People Who Owe Tax

WASHINGTON – The Internal Revenue Service today reminded taxpayers that quick and easy solutions are available if they can’t file their returns on time, and they can even request relief online.

The IRS says don’t panic. Tax-filing extensions are available to taxpayers who need more time to finish their returns. Remember, this is an extension of time to file; not an extension of time to pay. However, taxpayers who are having trouble paying what they owe may qualify for payment plans and other relief.

Either way, taxpayers will avoid stiff penalties if they file either a regular income tax return or a request for a tax-filing extension by this year’s April 15 deadline. Taxpayers should file, even if they can’t pay the full amount due. Here are further details on the options available.

More Time to File

People who haven’t finished filling out their return can get an automatic six-month extension. The fastest and easiest way to get the extra time is through the Free File link on IRS.gov. In a matter of minutes, anyone, regardless of income, can use this free service to electronically request an automatic tax-filing extension on form 4868.

Filing this form gives taxpayers until Oct. 15 to file a return. To get the extension, taxpayers must estimate their tax liability on this form and should also pay any amount due.

By properly filing this form, a taxpayer will avoid the late-filing penalty, normally five percent per month based on the unpaid balance, that applies to returns filed after the deadline. In addition, any payment made with an extension request will reduce or eliminate interest and late-payment penalties that apply to payments made after April 15. The current interest rate is three percent per year, compounded daily, and the late-payment penalty is normally 0.5 percent per month.

Besides Free File, taxpayers can choose to request an extension through a paid tax preparer, using tax-preparation software or by filing a paper Form 4868, available on IRS.gov. Of the nearly 10.7 million extension forms received by the IRS last year, almost 5.8 million were filed electronically.

Some taxpayers get more time to file without having to ask for it. These include:

Taxpayers abroad. US citizens and resident aliens who live and work abroad, as well as members of the military on duty outside the US, have until June 17 to file. Tax payments are still due April 15.
Members of the military and others serving in Afghanistan or combat zone localities. Typically, taxpayers can wait until at least 180 days after they leave the combat zone to file returns and pay any taxes due. For details, see Extensions of Deadlines in Publication 3, Armed Forces Tax Guide.
People affected by certain tornadoes, severe storms, floods and other recent natural disasters. Currently, parts of Mississippi are covered by a federal disaster declaration, and affected individuals and businesses in these areas have until April 30 to file and pay.

Easy Ways to E-Pay

Taxpayers with a balance due now have several quick and easy ways to electronically pay what they owe. They include:

Electronic Federal Tax Payment System (EFTPS). This free service gives taxpayers a safe and convenient way to pay individual and business taxes by phone or online. To enroll or for more information, call 800-316-6541 or visit www.eftps.gov.
Electronic funds withdrawal. E-file and e-pay in a single step.
Credit or debit card. Both paper and electronic filers can pay their taxes by phone or online through any of several authorized credit and debit card processors. Though the IRS does not charge a fee for this service, the card processors do. For taxpayers who itemize their deductions, these convenience fees can be claimed on Schedule A Line 23.

Taxpayers who choose to pay by check or money order should make the payment out to the “United States Treasury”. Write “2012 Form 1040”, name, address, daytime phone number and Social Security number on the front of the check or money order. To help insure that the payment is credited promptly, also enclose a Form 1040-V payment voucher.

More Time to Pay

Taxpayers who have finished their returns should file by the regular April 15 deadline, even if they can’t pay the full amount due. In many cases, those struggling with unpaid taxes qualify for one of several relief programs, including the following:

Most people can set up a payment agreement with the IRS on line in a matter of minutes. Those who owe $50,000 or less in combined tax, penalties and interest can use the Online Payment Agreement to set up a monthly payment agreement for up to 72 months. Taxpayers can choose this option even if they have not yet received a bill or notice from the IRS. With the Online Payment Agreement, no paperwork is required, there is no need to call, write or visit the IRS and qualified taxpayers can avoid the filing of a Notice of Federal Tax Lien if one was not previously filed. Alternatively, taxpayers can request a payment agreement by filing Form 9465. This form can be downloaded from IRS.gov and mailed along with a tax return, bill or notice.
Some struggling taxpayers may qualify for an offer-in-compromise. This is an agreement between a taxpayer and the IRS that settles the taxpayer’s tax liabilities for less than the full amount owed. The IRS looks at the taxpayer’s income and assets to make a determination regarding the taxpayer’s ability to pay. To help determine eligibility, use the Offer In Compromise Pre-Qualifier, a free online tool available on IRS.gov.

IRS Tax Tip 2013-52

Five Things to Know if You Need More Time to File

The April 15 tax-filing deadline is fast approaching. Some taxpayers may find that they need more time to file their tax returns. If you need extra time, you can get an automatic six-month extension from the IRS.

Here are five important things you need to know about filing an extension:

Extra time fo file is not extra time to pay. You may request an extension of time to file your federal tax return to get an extra six months to file, until Oct. 15. Although an extension will give you an extra six months to get your tax return to the IRS, it does not extend the time you have to pay any tax you owe. You will owe interest on any amount not paid by the April 15 deadline. You may also owe a penalty for failing to pay on time.
File on time even if you can’t pay. If you complete your return but you can’t pay the full amount due, do not request an extension. File your return on time and pay as much as you can. You should pay the balance as soon as possible to minimize penalty and interest charges. If you need more time to pay, you can apply for a payment plan using the Online Payment Agreement tool on IRS.gov. You can also send Form 9465,Installment Agreement Request, with your return. If you are unable to make payments because of a financial hardship, the IRS will work with you. Call the IRS at 800-829-1040 to discuss your options.
Use Free File to request an extension. Everyone can use IRS Free File to e-file their extension request. Free File is available exclusively through the IRS.gov website. You must e-file the request by midnight on April 15. If you e-file your extension request, the IRS will acknowledge receipt of your request.
Use Form 4868 if you file a paper form. You can request an extension of time to file by submitting Form 4868, Application for Automatic Extension of Time to File US Individual Income Tax Return. You must submit this form to the IRS by April 15. Form 4868 is available on IRS.gov.
Electronic funds withdrawal. If you e-file an extension request, you can also pay any balance due by authorizing an electronic funds withdrawal from a checking or savings account. To do this you will need your bank routing and account numbers.

IRS Tax Tip 2013-51

Eight Tax-Time Errors to Avoid

If you make a mistake on your tax return, it usually takes the IRS longer to process it. The IRS may have to contact you about that mistake before your return is processed. This will delay the receipt of your tax refund.

The IRS reminds filers that e-filing their tax return greatly lowers the chance of errors. In fact, taxpayers are about twenty times more likely to make a mistake on their return if they file a paper return instead of e-filing their return.

Here are eight common errors to avoid.

Wrong or missing Social Security numbers. Be sure you enter SSNs for yourself and others on your tax return exactly as they are on the Social Security cards.
Names wrong or misspelled. Be sure you enter names of all individuals on your tax return exactly as they are on their Social Security cards.
Filing status errors. Choose the right filing status. There are five filing statuses: Single, Married Filing Jointly, Married Filing Separately, Head of Household and Qualifying Widow(er) With Dependent Child. See Publication 501, Exemptions, Standard Deduction and Filing Information, to help you choose the right one. E-filing your tax return will also help you choose the right filing status.
Math mistakes. If you file a paper tax return, double check the math. If you e-file, the software does the math for you. For example, if your Social Security benefits are taxable, check to ensure you figured the taxable portion correctly.
Errors in figuring credits, deductions. Take your time and read the instructions in your tax booklet carefully. Many filers make mistakes figuring their Earned Income Tax Credit, Child and Dependent Care Credit and the standard deduction. For example, if you are age 65 or older or blind check to make sure you claim the correct, larger standard deduction amount.
Wrong bank account numbers. Direct deposit is the fast, easy and safe way to receive your tax refund. Make sure you enter your bank routing and account numbers correctly.
Forms not signed, dated. An unsigned tax return is like an unsigned check – it’s invalid. Remember both spouses must sign a joint return.
Electronic signature errors. If you e-file your tax return, you will sign the return electronically using a Personal Identification Number. For Security purposes, the software will ask you to enter the Adjusted Gross Income from your originally-filed 2011 federal tax return. Do not use the AGI amount from an amended 2011 return or an AGI provided to you if the IRS corrected your return. You may also use last year’s PIN if you e-filed last year and remember your PIN.

IRS Tax Tip 2013-50

Top Ten Tips on Making IRA Contributions

The IRS has 10 important tips for you about setting aside money for your retirement in an Individual Retirement Arrangement.

You must be under age 70½ at the end of the tax year in order to contribute to a traditional IRA.
You must have taxable compensation to contribute to an IRA. This includes income from wages, salaries, tips, commissions and bonuses. It also includes net income from self-employment. If you file a joint return, generally only one spouse needs to have taxable compensation.
You can contribute to your traditional IRA at any time during the year. You must make all contributions by the de date for filing your tax return. This due date does not include extensions. For most people this means you must contribute for 2012 by April 15, 2013. If you contribute between Jan. 1 and April 15, you should contact your IRA plan sponsor to make sure they apply it to the right year.
For 2012, the most you can contribute to your IRA is the smaller of either your taxable compensation for the year or $5,000. If you were 50 or older at the end of 2012 the maximum amount increases to $6,000.
Generally, you will not pay income tax on the funds in your traditional IRA until you begin taking distributions from it.
You may be able to deduct some or all of your contributions to your traditional IRA.
Use the worksheets in the instructions for either Form 1040A or Form 1040 to figure the amount of your contributions that you can deduct.
You may also qualify for the Savers Credit, formally known as the Retirement Savings Contributions Credit. The credit can reduce your taxes up to $1,000 (up to $2,000 if filing jointly). Use Form 8880, Credit for Qualified Retirement Savings Contributions, to claim the Saver’s Credit.
You must file either Form 1040A or Form 1040 to deduct your IRA contribution or to claim the Saver’s Credit.
See Publication 590, Individual Retirement Arrangements, for more about IRA contributions.

IRS Tax Tip 2013-46

Top Six Tax Tips for the Self-Employed

When your are self-employed, it typically means you work for yourself, as an independent contractor, or own your own business. Here are six key points the IRS would like you to know about self-employment and self-employment taxes:

Self-employment income can include pay that you receive for part-time work you do out of your home. This could include income you earn in addition to your regular job.
Self-employed individuals file a Schedule C, Profit or Loss from Business, or Schedule C-EZ, Net Profit from Business, with their Form 1040.
If you are self-employed, you generally have to pay self-employment tax as well as income tax. Self-employment ax includes Social Security and Medicare taxes. You figure this tax using Schedule SE, Self-Employment tax.
If you are self-employed you may have to make estimated tax payments. People typically make estimated tax payments to pay taxes on income that is not subject to withholding. If you do not make estimated tax payments, you may have to pay a penalty when you file your income tax return. The underpayment of estimated tax penalty applies if you do not pay enough taxes during the year.
When you file your tax return, you can deduct some business expenses for the costs you paid to run your trade or business. You can deduct most business expenses in full, but some costs must be ‘capitalized’. This means you can deduct a portion of the expense each year over a period of years.
You may deduct only the costs that are both ordinary and necessary. An ordinary expense is one that is common and accepted in your industry. A necessary expense is one that is helpful and appropriate for your trade or business.

For more information, visit the Small Business and Self-Employed Tax Center on the IRS website. There are three IRS publications that will also help you. See Publications 334, Tax Guide for Small Business; 535, Business Expenses and 505, Tax Withholding and Estimated Tax. All tax forms and publications are available on IRS.gov or by calling 800-TAX-FORM (800-829-3676).

A Few Facts to Know About Retirement Plan Contributions

Apr 5th, 2013

by jblankenship.

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As we near the tax filing deadline, there are a few things you need to be aware of as you consider your retirement plan contributions for tax year 2012 (or whatever the prior tax year is, if you’re reading this sometime later).

Regular IRA contributions are due by the filing deadline, with no extensions. That means April 15, 2013 for the 2012 tax year. Your contribution for 2012 is considered made “on time” if your payment is postmarked by midnight on April 15, 2013.

Perhaps you wish to make a more substantial contribution to a retirement plan – in 2012, you can contribute up to $50,000 to a Keogh plan. That amount is limited to 20% of the net self-employment income, or 25% of wage income if the individual is an employee of the business. Keogh plan contributions can be made by the extended due date of your return – in most cases this is October 15, 2013 (for tax year 2012). The downside is that you must have established the Keogh plan by December 31, 2012 in order to make contributions for the 2012 tax year. If you have not established your Keogh plan yet, it’s too late for tax year 2012.

However, you still have another option if you want to make significant retirement plan contributions (above and beyond the $5,000/$6,000 limit on traditional IRAs) – and this is to establish and fund a SEP-IRA. The funding limit for SEP-IRAs is the same as for Keogh plans, but you can establish the SEP-IRA as late as the extended filing date (October 15) and fund it for the prior tax year.

Happy saving!

How an IRA is Treated When a Beneficiary Dies

Mar 27th, 2013

by jblankenship.

2 comments

When an IRA owner dies while the IRA still has funds in it, the primary beneficiary(ies) have the opportunity to transfer the account to an inherited IRA and begin taking the Required Minimum Distributions (RMDs) over his or her lifetime. When this primary beneficiary dies, it can be difficult to figure out who the money goes to. This is known as the successor beneficiary.

It’s important to know the difference between a successor beneficiary and a contingent beneficiary. A contingent beneficiary takes the place of the primary beneficiary in the event that the primary beneficiary dies before the original owner does. A successor, on the other hand, takes the place of the primary beneficiary when the primary beneficiary outlives the original owner. So it’s a matter of timing. What we’re interested in is the successor beneficiary.

There are four main ways that a successor beneficiary is determined:

Successor is named by the primary beneficiary. When the inherited IRA is established, the primary beneficiary has the opportunity to name one or more beneficiaries of the inherited IRA, along with contingent beneficiaries if desired.
Successor is the primary beneficiary’s estate. If the primary beneficiary hasn’t designated a beneficiary of the inherited IRA, the primary beneficiary’s estate becomes the successor beneficiary of the IRA.
Custodial documents name a successor beneficiary. Some IRA custodians provide for the designation of a successor beneficiary in the original plan documents. This is relatively rare, and even more rare that a successor is actually named.
Original owner names a successor beneficiary. Sometimes the original owner has had the foresight to utilize a trust document of some variety to control succession among beneficiaries. In a case like this, the trust is the primary beneficiary, and the trust has a primary beneficiary and successor beneficiary(ies).

Below is a flowchart which describes how the ownership of an IRA flows to different beneficiaries. (click on the chart to see a larger view)

Distribution for the Successor Beneficiary

So, having sorted out that we are working with the appropriate successor beneficiary, we need to determine what is the proper distribution period for the successor beneficiary. As we know, if the IRA is an inherited IRA, it is subject to Required Minimum Distributions, over a period determined by the beneficiary’s age at the time of the death of the original owner. This figure is determined from Table I in the first year of distribution (the year after the death of the original owner), and is a set period of time. The factor from Table I is used in the first year, and each subsequent year one is subtracted from the first factor and the IRA is distributed based on that amount.

So, for example, if the beneficiary is 71 years of age in the first year of distribution, according to Table I the factor is 16.3. The IRA value is divided by 16.3 to come up with the RMD for the first year. Each subsequent year 1 is subtracted from the Table I factor, so that the IRA is distributed over 16.3 years. This is known as the Applicable Distribution Period, or ADP.

When a successor beneficiary takes over to receive distributions from the inherited IRA, the original ADP is still in effect, and the IRA must be distributed over that remaining period to the successor beneficiary(ies).

Complications

Several factors can add a considerable degree of complication to the process – such as if there are multiple primary beneficiaries and/or multiple successor beneficiaries.

Each primary beneficiary is treated separately, and the successors for each (unless determined by the original plan as mentioned above) are determined by the individual beneficiary. When there are multiple successors, each one is treated separately and the original ADP for the applicable primary beneficiary applies to all successors pro rata for the successor’s share.

Another complication is when one or more beneficiaries disclaims the inheritance. In a case like that, first it is determined whether the original beneficiary designation had pre-determined the successor for each primary beneficiary (such as “per stirpes”, meaning that the heirs of the original beneficiary are bequeathed the disclaimed share). In the absence of this sort of designation, the other beneficiaries in the primary class take over the disclaimed share.

Of course in the real world there are many, many more complications, but this should give you a place to start. Use the comments section below to bring in your more complex situations and we’ll work them out.

The Roth IRA

Mar 20th, 2013

by sraskie.

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Once you’ve established your emergency fund, it’s time to continue to pay yourself first but for a sunny day in the future – your retirement. For most people (this includes you) the Roth IRA is going to be a great option to save money for retirement and have a tax-free source of income once they hit their golden years. The Roth IRA was named after its namesake, Senator William Roth of Delaware. The IRA part simply means Individual Retirement Arrangement.

Roth IRAs work like this: You save money into your Roth IRA on an after-tax basis. What this means is that when you get paid from your job and you’ve already paid Uncle Sam his share in taxes – you get what’s left over. Of those leftovers (couldn’t help the food reference) you can take some of that money and put it into a Roth IRA. This money then goes into an account of your choosing. This could be into mutual funds, stocks, bonds, ETFs, or even a simple savings account at your bank. There are a few things that are not allowed in IRAs such as life insurance and collectibles like art and antiques.

Over time your contributions, depending on how they’re invested, will grow tax-deferred into a nice little nest egg ready for you to hatch at retirement. The magic of the Roth IRA really begins here. Remember when I said that after-tax money was going into the account? Well, since you’ve gone through the pain of having been taxed on that money already, any qualified withdrawals from your Roth IRA are now…wait for it…TAX FREE! Imagine an income source in retirement that cannot be taxed.

There are some great calculators online that can be used to show you how much you can have saved in 10, 20 or 30 years. I’ve included some websites you can visit at the end of the book.

As of this writing in 2013 you are allowed to contribute $5,500 annually to your Roth IRA and if you’re age 50 or older, another $1,000 as a “catch-up” contribution. These numbers will generally increase periodically as inflation increases and as time goes on.

To see if a Roth IRA is an option for you to consider, talk with your financial professional and explore your options. Some good rules of thumb when looking at your options for funding a Roth IRA are to avoid mutual funds with high fees and expenses, insurance products (annuities) with high fees and surrender charges and complex products that are difficult for you (and your advisor) to understand and explain.

Social Security Benefits and Taxes

Mar 8th, 2013

by jblankenship.

2 comments

When you’re receiving Social Security benefits, you may be subject to income tax on those benefits. At the end of the year, you’ll receive a form SSA-1099 from the government that details the benefits that you’ve been paid, as well as the amount that has been deducted for Medicare premiums, and any federal income tax that you’ve had withheld from the benefit checks.

When you prepare your tax return for the year, if you’re using a software program (does anyone prepare them by hand any more?), the program will give you a place to enter the figures from your SSA-1099 form. Then after you’ve entered all of your other income information into the system, it will calculate how much of your Social Security benefit is subject to income tax.

But that’s no fun, is it? How do you know how much of your benefit is going to be taxable?

Here’s how it works: there is a figure known as provisional income, which is calculated using all of your other income (including tax-exempt interest) plus half of your Social Security income. Your provisional income is then compared to a base amount, depending upon your filing status.

For filing status of Single, Head of Household, Qualifying Widow(er) with a Dependent Child, or Married Filing Separately (if you did not live with your spouse at any time in the year), the base amount is $25,000
Married Filing Jointly, the base amount is $32,000
Married Filing Separately (if the spouses lived together at any time during the year), the base amount is $0

If your provisional income is above the base amount for your filing status, your Social Security benefit at least a portion of your benefit is going to be taxable. Up to 50% of your benefit may be taxable as ordinary income, until you reach the next base level. If your provisional income is greater than the first base level but less than the next base level, at most 50% of the Social Security benefit will be taxable. The next base levels are:

$34,000 (Single, Head of Household, etc.)
$44,000 (Married Filing Jointly)
$0 (Married Filing Separately)

When your provisional income is greater than the second base level, a portion of your Social Security benefit will become 85% taxable. Upon reaching the second level, a portion of the benefit is 50% taxable and the amounts above the second level are 85% taxable. As your income increases, eventually all of your Social Security benefits become 85% taxable.

If you want more detail on the calculations, you can look at this earlier article which works through the calculations for Social Security benefit taxation. It gets pretty complicated, but it’s useful to know how it all works, in case you can change your income to make a difference in how the benefits are taxed. This is also useful as you plan which types of income to recognize – if you can take Roth-type income versus regular IRA income,it can have a profound effect on the taxation of your Social Security benefits. For more on how this works, see this article on Roth Conversions and Social Security benefits.

Why You Need an Emergency Fund

Mar 6th, 2013

by sraskie.

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You may or may not have heard that it’s wise to have an emergency fund. Even if you’ve heard it, you may not be aware of what it means and why you should have one – and more importantly why you need one. An emergency fund is just that. It’s money set aside for a rainy day, an unexpected bump in the road, or for a real emergency or an expense that you haven’t specifically planned for. Examples of those unexpected expenses (borderline redundant – I know) include a car accident, disability, storm damage to your home, losing a job, being a victim of theft, etc.

So what makes up an emergency fund? Generally, a good place to start is to have a goal of at least 3 to 6 months of non-discretionary living expenses put away in a relatively liquid account such as a savings, checking or money market account. Non-discretionary living expenses are those that do not go away, should you lose your job or the ability to generate income. These expenses would include your mortgage payment, rent, utilities, food, car payment and taxes.

Now comes the easy part.

Simply add up all of your non-discretionary living expenses that you have in a month and multiply by 3 and then multiply by 6. This is the amount you’d need to have set aside. For example, if I have a $1,200 mortgage, $400 in groceries per month, and utilities of $300, I would have a total of $1,900 monthly in expenses. Multiply that number by 3 ($5,700) and again by 6 ($11,400) and it looks like I’d need between $5,700 and $11,400 set aside for my emergency fund.

These amounts are not set in stone. The amount you’ll need will also depend on your job, your income, and how you’re paid. If I’m a tenured college professor making $6,000 monthly, I may only need 3 to 6 months put away. If I’m an executive or CEO of a large company and I make $20,000 monthly, or I’m a commissioned sales person making $10,000 monthly, I may consider having a fund of 9 to 12 months. This would be because there’s a good chance of me not being able to find another job at that income level if I were fired or laid off. And generally, as peoples’ incomes increase, so do their expenses.

Now comes that hard part – actually saving the money.

It’s really not that hard, it just takes a bit of planning and discipline you’ll be well on your way. You can start by putting away a small sum every week or month – depending on what works for you. This could be $50, $100, or even $500 per month until you’ve funded account. If you’re looking for places to find money consider cutting unnecessary expenses until you’ve got your emergency fund at 100%. Reduce your phone bill, cut your cable TV costs, and pack your lunch instead of dining out. Notice a pattern? These are all discretionary expenses – those that can go away if you want them to.

Your emergency fund can also be used in tandem with your insurance deductibles. Let’s say you have low deductibles on your auto insurance and want to save some money. You can simply increase your deductibles and should you need to use your deductible for a claim, you can take from your emergency fund. This is wise especially if you rarely file claims. If you have a disability policy with a 60 day elimination period (time deductible) before benefits start, you can use your emergency fund to help cover the expenses for those 60 days until your benefits begin.

Now that you know what an emergency fund is, it’s important to know what it’s not. It is not a slush fund to buy toys like a new car, boat, TV, etc. It’s not money to play with, gamble with or dip into because “It’s only a couple bucks, it can’t hurt anything.” Those couple of bucks can add up to thousands in no time. Don’t steal from yourself. Resist the temptation to spend it. If you feel you may be the type of person to be tempted, consider putting the money in an account that’s not easy to get to – such as a money market account outside of your city or state. You may also consider having check writing privileges but only on amounts above a certain amount like $250. This can help resist the urge to spend on little things help put a time buffer on when you think you want the money, and when you can actually get it.

One final note is to make sure your emergency fund is not your 401(k), 403(b), traditional or Roth IRA. These are retirement accounts and should stay as such. A properly funded emergency fund will reduce if not eliminate any reliance on premature retirement account distributions.

Now, sit back, relax, and pray you don’t need to use it!

Don’t Forget to Pay Tax on Your 2010 Roth Conversion

Feb 27th, 2013

by jblankenship.

2 comments

Remember back in those heady days in 2010, when you finally had carte blanche eligibility to convert your IRA funds to a Roth IRA regardless of your income? And then there was a special provision that the IRS made available: you could convert money to your Roth IRA in 2010, and delay recognizing the income and paying the tax over the next two years… remember that? That was so cool.

However.

(Ever notice how there’s always a “however” in life?)

Here we are, two years later, and NOW you have to pay tax on the Roth conversion that happened way back then. You might have forgotten it altogether, but you can bet the IRS hasn’t forgotten.

Hopefully you didn’t forget this on your 2011 tax return that you filed in 2012 as well. At that time, you should have recognized half of the deferred Roth IRA conversion from 2010 on your 2011 return, and paid tax on that half. Now, in 2012, you’re up to the point where you can finish this off. On your 2012 return you will recognize the remaining half of the 2010 conversion, and pay the tax on it.

The good news is that the tax rates haven’t gone wild like a lot of folks projected – as long as your income didn’t dramatically increase your rates should be roughly the same as they were in 2010. In addition, if you decided to do your Roth Conversion as soon as possible in 2010 and you invested in the S&P 500 (for example), you would have experienced an increase of more than 33.3% to this writing (February, 2013). That should help take the sting out of the tax cost.

Just don’t forget to finish paying the taxes on your conversion this year. The penalties and interest on the unpaid tax could take all of the benefit out of your conversion/delay strategy.

IRA