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Using an IRA Distribution and Withholding to Reduce Estimated Taxes

Nov 9th, 2011
by jblankenship.
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A little-known fact about how withholding works for IRA distributions can work in your favor.  While withholding from a paycheck and estimated tax payments are credited as paid during the quarter actually paid, it’s different for withholding from an IRA distribution.

When you have taxes withheld from a distribution from an IRA, no matter when it occurs during the calendar year, it is treated by the IRS as having been withheld evenly through the tax year.  This means that if you had other income in the first quarter of the year, you could take care of the tax burden with a distribution from an IRA and withholding enough tax even in late December of the same year.

So – many folks find themselves in this position, especially in years when income is is not equal in each quarter, or if the tax burden was not known or misunderstood throughout the year.

This method could be used by anyone at any time, as long as you have access to your IRA funds.  For example, if you are required to take a distribution, that is, if you’re over age 70½ or you have an inherited IRA, you could use that distribution to cover your tax burden for the entire year (if it was enough).

Rather than making quarterly estimated tax payments throughout the year, toward the end of the year you could instruct your IRA custodian to distribute enough funds to cover the tax burden for the year (and don’t forget to include the amount of your IRA distribution in your calculation). Then you would also instruct the custodian to withhold the distribution as taxes, using form W-4P.

The one downside to this method is that if the IRA account owner dies before the distribution with withholding for the tax year (and let’s face it, this will probably happen at some point), then the estate will owe penalties for underpayment of estimated tax for that year.

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Using the Prohibited Transaction Rules to Your Advantage

Oct 19th, 2011
by jblankenship.
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I’ve written in the past about the types of transactions that are prohibited in your IRA, and how these transactions are generally quite onerous if you happen to use one of them.  In fact what happens is that your entire IRA becomes disqualified as of the first of the year in which the transaction occurred.

So – if you’re inquisitive you might wonder: How could I use this to my advantage?

It is possible to work this rule in your favor – but I don’t necessarily recommend it.  I present this option here as an exercise of what could be done according to the rules.  I learned this one from Natalie Choate, by the way, who you may recall I regard as a rock star in the world of IRA law.

Working in your favor

So, given that the rule against prohibited transactions requires that the IRA is considered to have been entirely distributed on the first day of the tax year when the prohibited transaction occurred, this is a factor that could be used to work to your advantage.

If, for example, you owned an investment in your IRA that was worth $10,000 as of the first of the year.  Over the course of the year, the investment has now grown in value to something ridiculous, let’s say $500,000.  If you were particularly nefarious inventive, you’d take advantage of the rules and perform some sort of prohibited transaction with your IRA before the end of the tax year.  By doing so, your IRA would be disqualified as of the first of the year, and the investment you owned would have been considered distributed at that point in time.

This means that you would owe ordinary income tax on the original $10,000 value, and your investment has a basis of $10,000 – if you sold it now at its $500,000 value, the additional $490,000 would be taxed at the capital gains rate.  If your ordinary income tax rate is 25%, the tax on the full $500,000 would work out to $125,000.  But under this plan, only $10,000 is taxed at 25% ($2,500), and $490,000 is taxed at 15% ($73,500), for a total tax on the IRA of $76,000, a savings of $49,000.  You’d have to wait until at least the second day of the following year in order to qualify for long-term capital gains.

If you were caught in just such a situation, this is a way you might use the tax law in your favor for a bit of hindsight tax planning.  It doesn’t happen often, but this is one case where you could work the rules to your advantage.

Note: Bear in mind that I have not used this method myself or with clients, and the example I have given is purely hypothetical.  If you choose to use this method, although the rules appear to be in your favor, but there are no guarantees that the IRS would totally agree with this.  On face value I believe it will work exactly as I have written, but I have not seen any cases where this set of facts was put into play, successfully or not.  Proceed at your own risk.

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A Beneficiary Designation Dilemma

Oct 12th, 2011
by jblankenship.
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Qtips
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Since families today are different and more complicated from the traditional situation, with ex-spouses, children from first and subsequent marriages, and children from unions where a marriage didn’t take place, designating beneficiaries for IRA accounts can be very complex.

For example, it’s not out of the question for an individual to have re-married later in life and have children from an earlier marriage. In addition, the new spouse could have children from his or her previous marriage.  And then possibly children resulting from the current marriage.

So, this individual might wish to leave the proceeds of his IRA to his or her current spouse first and foremost at his or her passing – but then to split the remainder of the account among his or her children from the first marriage and the children from the second marriage equally. If you know anything about how IRA beneficiary designation forms work, this situation likely couldn’t be accomplished using that simple form.  You need something more…

QTIP Trust

The tool you’re looking for here is a QTIP trust.  No, it has nothing to do with a stick with cotton on the end of it or any bathroom product for that matter, QTIP stands for Qualified Terminal Interest Property.  This QTIP trust is a special sort of trust that allows an individual to leave the income from their assets to a spouse and then, at the death of the surviving spouse the remaining principle is passed on to the beneficiaries designated by the original owner of the account(s).  In this fashion the children from the previous marriage have protection of the assets that they would eventually receive.

If a vehicle such as a QTIP trust isn’t used, then the current spouse could take control of the account and either use up all of the assets, or change the beneficiaries to only include his or her own children, excluding the children from the former marriage.

QTIPs are very complicated to put into use, since there are a lot of moving parts, beneficiaries, and a considerable amount of time could elapse from the time it is put into play (the first death) and the death of the surviving spouse.  The distribution process from the IRA is also complicated, since using a trust as a beneficiary takes away the designated beneficiary from the process, meaning that the account would be distributed to the trust within five years, as an example.

It’s best to make sure you’ve got an attorney who specializes in estate planning and IRAs to help with the process. But if you have a situation like the one described (or even more complicated) the QTIP trust may be your best bet to accomplish what you’d like to do with your IRA.  Incidentally, other assets besides an IRA could be put into a QTIP trust as well, for the same purpose.

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Roth Conversion/Recharacterization Strategy

Sep 28th, 2011
by jblankenship.
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If you have an IRA you probably know about the concept of a Roth IRA conversion – where you take distribution of a portion of your IRA and directly transfer that money into your a Roth IRA, paying tax as you go.  Then the Roth IRA can continue to grow tax-free (as Roth IRAs do) and you’ll never owe tax on your qualified distributions from the Roth IRA.

In addition, if the investments you’ve made in the Roth IRA have lost money, before October 15 of the following year you have the opportunity to recharacterize your Roth conversion.  If you didn’t recharacterize, you’d be paying tax on a conversion amount that is much lower now if there was a downturn in the investments, so your average tax rate is much higher than you’d hoped.  By recharacterizing, you can undo the conversion or a part of it.

I had a question raised to me recently about using the recharacterization option to your advantage.  Here’s the gist of the strategy:  If you have an IRA worth, say $100,000, you could convert it into two Roth IRAs, one half invested in a 2x leveraged bull-oriented investment, and the other half invested in a 2x leveraged bear-oriented investment.

If the two investments go flat for the year, your conversion could be recharacterized with no tax consequence.  However, if the market went up by 10%, your bear holding would be down 20% (being leveraged 2x) and the bull holding would be up 20% (vice versa had the market dropped).  This would give you the opportunity to recharacterize only the bear holding, leaving you with a traditional IRA worth $40,000.  Your Roth IRA would be worth $60,000, although you would only have to pay tax on the original $50,000 converted.  At a 25% tax rate that works out to $12,500 in tax, which would only be 20.83% on the Roth IRA.

Perhaps that rate isn’t low enough for you though – maybe you need to ensure that the tax rate is even lower, say 15% or less.  Following the example, you’d need to see an increase of 66% or more in your holdings, which would equate to a 33% move in the market (for your leveraged holdings, one way or the other).  If the market doesn’t move in the amount you hoped, you can just recharacterize the entire conversion, nothing lost.

You probably want to pull your “winnings” off the table and put the remaining Roth IRA into a safe(r) investment than the leveraged investments chosen before, such as a balanced fund or even straight bonds.

Now you now can pull the same maneuver in the following year with whatever is left in the traditional IRA, splitting it just as before.  Over time you should wind up with a significant Roth IRA with a lower tax cost.

This is not a huge payoff strategy – you’ll be losing money in your traditional IRA holdings each year, guaranteed.  Your net position would be the same (minus the tax).

After the first year of the example, assuming a 20% gain you’d have with $60,000 in the Roth and $40,000 in the traditional IRA, having paid $12,500 in tax.  Second year, same result and you’d have $84,000 in Roth, and $16,000 in traditional IRA, paying $5,000 more in tax.  Third year, again the same 20% gain  resulting in a total of $93,600 in Roth, $6,400 in trad, paying $2,000 in tax.  And so on, until the amount gets too small to work with any more.

The end result is that all of this tallies up to the same $100,000 that you started with, having paid tax of just less than $21,000, versus the original $25,000 you would have paid.  Holding out for a higher return from the strategy would yield a lower tax rate overall.

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Leaving Your IRA to Your Family First, Then to Charity

Sep 14th, 2011
by jblankenship.
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Image by Mikey G Ottawa via Flickr

Suppose you have a situation where you’d like to leave your IRA (or at least some of it) to a family member or a group of beneficiaries, and then leave the remainder of the IRA to a charity of your choice.

One way to do this is to split the beneficiary designation between your family members and the charity.  This is a simple way to make this designation, but it might not really achieve the purpose you’re hoping to.  Suppose you’d like to make certain that a non-spouse family member has adequate income from your IRA for the remainder of his or her life, but you don’t want to overdo the bequest with a large appropriation (and taxes on the distribution).  There’s a way to do this that may fit your needs:  the Charitable Remainder Trust, or CRT.

The Charitable Remainder Trust

Using a Charitable Remainder Trust, or CRT, can be a useful way to ultimately pass your IRA or Qualified Retirement Plan (QRP) to a charity, while at the same time providing income to other beneficiaries for life.  The way this works is that the CRT would receive a distribution of the account’s assets, and the beneficiaries can then receive income for the remainder of their lives.  Because the remainder of the trust will ultimately pass to the charity, the estate receives a charitable contribution deduction for a portion of the account, actuarially-defined.

Since the funds are no longer in the IRA or QRP, the beneficiaries are not subjected to Required Minimum Distributions (RMDs) from the account – these can be tailored to the individual beneficiary’s requirements.  On the downside, the amount of income will have to be pre-set, either a set amount or a set percentage of the account, and this amount cannot be changed.  In other words, if the beneficiary wants more than the set amount of distribution, the distribution amount cannot be increased.

If there are multiple beneficiaries of the trust, as members of the beneficiary group die the other remaining beneficiaries will receive the income attributed to those beneficiaries, until all beneficiaries have passed on.  Since there are restrictions on the CRT that require that at least 10% of the total trust value remains to be distributed to the charity, it won’t work well if the beneficiary class includes very young members.  If there is a very long period of time to pay income, the remaining account value may be reduced below that restricted amount.

This method may not be useful to everyone, but it could be useful for certain specific situations.  An example would be if you had multiple IRAs, and had one in particular that you wanted to eventually pass on to a charity.  At the same time you want to ensure that you don’t short-change your family or friends – maybe you have a couple of siblings that you’d like to pass along a life income to, perhaps in addition to leaving other assets these beneficiaries.

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Roth IRA for Youngsters

Sep 7th, 2011
by jblankenship.
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Many times it is among the best of ideas to establish a Roth IRA for your child.  This way, your child can benefit from the long-term growth in the account and have a very good head start on retirement savings for later in life.  There are other benefits, including the fact that retirement funds are not included when financial aid is being calculated for college expenses, as well as providing funds for the child to use when the time comes to buy a house.

One thing can cause a real problem though: if you undertake to make contributions to a Roth IRA for your child that aren’t based in fact.  What’s that?  How can this be?  So there’s a way you can make contributions to Roth IRA that aren’t based in fact?  What fact is that??

The rules for making contributions to Roth IRAs (actually, any IRA) include the fact that the person who owns the account must have earned income.  This means that the individual whose account is being contributed to must have earned at least the amount that is being contributed from some sort of job – which could include self-employment or any sort of employment.  In addition, scholarships or fellowships that are reported in box 1 of Form W2 are considered earnings for IRA contributions.

If your child doesn’t have income of any realistic form, it is not allowed for you to make contributions to a Roth IRA (or any IRA) on behalf of the child.  And it doesn’t work for you to invent income, such as paying the child to clean up his or her room.  The income has to be “real” – making contributions without some sort of real income will result in some nasty penalties.  The penalty for over-contribution to a Roth IRA is 6% per year.  If several years have gone by, you’ll get hit with this penalty for all of those years – which is even worse than just putting the money in a savings account the first place.

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If You Converted to Roth in 2010 – You Have About 50 Days Left to Recharacterize

Aug 24th, 2011
by jblankenship.
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For those of you who took advantage of the one-time opportunity in 2010 to convert IRA funds to Roth IRA accounts, spreading the tax over the following two years (2011 and 2012), you are faced with a decision-point:  if you have reason to recharacterize the conversion, you have to do this by October 18, 2011.

Why might you want to recharacterize?

Here’s a ferinstance: If you converted $10,000 from your IRA account on December 31, 2010 into your Roth IRA and invested it in the S&P 500, that $10,000 converted is now worth approximately $8,997 (using a recent price).

If you are in the 25% bracket, you will owe $2,500 on the conversion, which equates to 27.79% in taxes on the conversion.  If your chosen investments did worse than the S&P 500 (and you know some of them probably did), your effective tax will be even higher.

Now, chances are that your investment may increase in value before you actually pay the tax on your 2011 and 2012 returns, but then again maybe it won’t.  Why pay the extra tax (or rather, the tax on the extra amount) if you don’t have to?

You can recharacterize the amount in your Roth IRA that corresponds to this conversion back into your traditional IRA – but you must do it before October 18.  At that time, you’ll also want to file an amended tax return showing that the conversion “did not happen” for tax year 2010.

On the other hand

If you bought the S&P 500 about a year ago with that same $10,000, it’s likely worth about $10,335 today, so you might want to leave the conversion alone.  Now your effective tax rate on the conversion (if you’re in the 25% bracket) is only about 24.19%.  Granted, it’s not a dramatic increase, but still it probably is better than you originally thought when you started this process.  And you’ve got two more years to pay all of the tax.

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Should I Use IRA Funds or Social Security at Age 62?

Aug 19th, 2011
by jblankenship.
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Folks who have retired or are preparing to retire before the Social Security Full Retirement Age (FRA) face a dilemma if they have IRA assets available.  Specifically, is it better to take an income from the IRA account during the years prior to FRA (or age 70) in order to receive a larger Social Security benefit; or should they preserve IRA assets by taking the reduced Social Security benefits at age 62?

At face value, given the nature of IRA assets, it seems like the best method would be to preserve the IRA’s tax-deferral on those assets, even though it means that your Social Security benefit will be reduced.

If you look at the taxation of Social Security benefits though, you might discover that delaying receipt of your Social Security will provide a much more tax effective income later in life.  In the tables below I’ll work through the numbers to illustrate what I’m talking about.

Example

For our example, we have an individual who has a pre-tax income requirement of $75,000 per year.  The individual has significant IRA assets available.  If he takes Social Security at age 62, he will receive $22,500 per year.  Delaying Social Security benefits to FRA would get him $30,000; waiting until age 70 would provide a benefit of $39,600 per year.  In tables below we show what the tax impact would be for using Social Security at age 62, FRA, and age 70.  In each case the required income is always $75,000.

Table 1 – taking Social Security benefit at age 62:

IRA SS Tax
62 $ 52,500 $ 22,500 $ 9,556
63 $ 52,500 $ 22,500 $ 9,556
64 $ 52,500 $ 22,500 $ 9,556
65 $ 52,500 $ 22,500 $ 9,556
66 $ 52,500 $ 22,500 $ 9,556
…
90 $ 52,500 $ 22,500 $ 9,556
Totals $ 1,522,500 $ 652,500 $ 277,113

Table 2 – taking Social Security benefit at age 66:

IRA SS Tax
62 $ 75,000 $ 0 $ 11,113
63 $ 75,000 $ 0 $ 11,113
64 $ 75,000 $ 0 $ 11,113
65 $ 75,000 $ 0 $ 11,113
66 $ 45,000 $ 30,000 $ 7,953
…
90 $ 45,000 $ 30,000 $ 7,953
Totals $ 1,425,000 $ 750,000 $ 243,263

Table 3 – taking Social Security benefit at age 70:

IRA SS Tax
62 $ 75,000 $ 0 $ 11,113
63 $ 75,000 $ 0 $ 11,113
64 $ 75,000 $ 0 $ 11,113
65 $ 75,000 $ 0 $ 11,113
66 $ 75,000 $ 0 $ 11,113
67 $ 75,000 $ 0 $ 11,113
68 $ 75,000 $ 0 $ 11,113
69 $ 75,000 $ 0 $ 11,113
70 $ 35,400 $ 39,600 $ 5,901
…
90 $ 35,400 $ 39,600 $ 5,901
Totals $ 1,343,400 $ 831,600 $ 212,811

The difference that you see in the tables is due to the fact that Social Security benefits are at most taxed at an 85% rate. With that in mind, the larger the portion of your required income that you can have covered by Social Security, the better.  At this income level, the rate is even less, only 85% of the amount above the $44,000 base (provisional income plus half of the Social Security benefit). This results in almost $34,000 less in taxes paid over the 29-year period illustrated by delaying to age FRA, and nearly $65,000 less in taxes by delaying to age 70.

Note: at higher income levels, this differential will be less significant, but still results in a tax savings by delaying.  It should also be noted that COLAs were not factored in, nor was inflation – these factors were eliminated to reduce complexity of the calculations.  In addition, in calculating the tax, deductions and exemptions were not included.

This is to assume that the individual has the available IRA assets to allow for the early use of the funds, although in the end result, delaying to age 70 required less of a total outlay from the IRA, by nearly $180,000, in addition to the tax savings.

Hands down, this is a very significant reason to delay receiving Social Security benefits at least to FRA, and even more reason to delay to age 70.  The only factor working against this strategy would be an early, untimely death, especially if the individual in question is not married.  In that case the IRA assets would have been used up much more quickly than necessary, and no surviving spouse is available to carry on with the Social Security survivor benefit.

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