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IRA

Converting an Inherited 401(k) to Roth

Nov 30th, 2011
by jblankenship.
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Lillian Roth
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One of the provisions that is available to the individual who inherits a 401(k) or other Qualified Retirement Plan (QRP) is the ability to convert the fund to a Roth IRA.

This gives the beneficiary of the original QRP the option of having all of the tax paid up front on the account, and then all growth in the account in the future is tax free, as with all Roth IRA accounts.

What’s a bit different about this kind of conversion is that, since it came from an inherited account, the beneficiary must take distribution of the account over his or her lifetime, according to the single life table.  This means that, in order for this maneuver to be beneficial, the heir should be relatively young, such that there will be time for a lengthy growth period for the account – making the tax-free nature of the Roth account worthwhile.

A downside to this move is that the heir should be in a position to pay the tax on the account from other funds, otherwise the tax pulled from the account will drastically reduce the funds that can grow over time.

If the heir has an IRA of his or her own that could be converted, and there are only enough other funds for paying tax to enable the conversion of one account or the other, the IRA should be converted rather than the QRP.  This is because the IRA has a much better chance for long-term growth than the inherited QRP due to the requirement for distribution of the account (as discussed above).

This is yet another reason that an individual might want to leave funds in a 401(k) plan rather than rolling it over to an IRA – since the heir does not have this Roth conversion option available if the money is in a traditional IRA.  This option is only available for an inherited 401(k) or QRP.

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Which Account to Take your RMDs From

Nov 23rd, 2011
by jblankenship.
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Scrambling may be required
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When you’re subject to the Required Minimum Distributions (RMDs) and you have more than one IRA account to take the distributions from, you have a choice to make.  Even though you have to calculate the RMD amount from all of your IRA accounts combined, the IRS provides that you could take the total of all your RMDs from a single account if you wish.

With this provision in mind, you could take all of your RMDs from the smallest account, which would provide you the opportunity to eliminate one of the accounts in your list, thereby simplifying things.  By reducing the number of accounts that you have, you could simplify the calculation of RMDs, estate planning, and just general paperwork.

However, it might not always work to your best interests to reduce the number of accounts that you have.  You may have multiple accounts in order to simplify your estate planning process, so that you can direct each account to a specific beneficiary or class of beneficiaries, for example.

In addition, if you’re hoping to eliminate some of your IRA accounts, you could always combine several IRAs together by rollovers – the end result is essentially the same.

This combination of accounts for RMDs can also be used with 403(b) accounts – if you happen to have several 403(b) accounts from previous employers, you can combine the RMDs and take them all from one account.  This doesn’t work with 401(k) plans, though, and you also cannot combine unlike accounts (IRAs with 403(b)s or 401(k)s) to take the RMDs for the dissimilar accounts.

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Arguments in Favor of a Rollover

Nov 16th, 2011
by jblankenship.
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Mutual fund
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If you have a 401(k), 403(b), a (gasp!) tax-sheltered annuity or other qualified retirement plan from a former employer, you may have considered if it would be beneficial to leave it where it is, or perhaps enact a rollover to an IRA.

While it might be easiest to leave the account where it is, it’s possible that you are sacrificing flexibility and/or paying higher fees in exchange for the easier path.

Quite often, 401(k) plans (and other qualified retirement plans, QRPs) are restricted to managed mutual fund investment options.  Managed funds often carry high expense ratios, often greater than 1% and more.  As you know, if you’ve read much about index funds, it is possible to reduce most of your investing expense ratios to far below .5%, in some cases as low as .1% or less.  Over the course of many years, reducing these expenses can have a profound impact on your investment returns.

For example, if you were to save even 1/2 of a percent in expenses, over 20 years this could compound to a 11.05% improvement in your overall investment returns.  This also assumes that the new funds you’ve chosen will perform at the same rate that the funds you’re leaving behind would have.

It’s not a pure “no brainer” to enact the rollover.  There could be compelling reasons to leave the money where it sits, such as if you believe the funds in your plan are superior to options that you could choose outside the plan (such as restricted-access or closed funds), or maybe you have access to investment advice from the custodian.  In addition, if you left the employer during or after the year when you reached age 55, you might want to leave the money where it is until you’re at least age 59½ – see this article on post-55 withdrawals for more information.  There is also the chance that you could benefit by leaving the funds in the former plan if there is Net Unrealized Appreciation of your former employer’s stock that you intend to have treated by the NUA rules.

In general though, the flexibility to reduce your expenses by choosing any investment available is a pretty compelling argument in favor of the rollover.

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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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Prohibited
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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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Uranium conversion 1
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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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Family Portrait - Montreal 1963
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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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