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

Aug 24th, 2011
by jblankenship.
3 comments
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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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Calculating RMDs for Various IRA Beneficiaries

Aug 17th, 2011
by jblankenship.
3 comments

There are a few different ways that Required Minimum Distributions are calculated for beneficiaries of IRAs.  The two primary determining factors are:

  1. Is the beneficiary the spouse of the original owner? and
  2. Did the original owner attain age 70½ prior to death?

There are two more factors that also have an impact on the nature of the calculations, although the impact is different:

  1. Is there more than one beneficiary? and
  2. Is the beneficiary a person or an entity, such as a trust, a charity or the estate of the original owner?
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Spouse

If the beneficiary is the spouse of the original owner of the account, and the original owner died before age 70½, then the rule is that no RMDs are required until the owner would have reached age 70½.  At that time the beneficiary will use the Single Life table to calculate the distribution amount based upon his or her own attained age.  In each subsequent year, the spouse beneficiary will recalculate the RMD using the Single Life table and the currently-attained age.  In this manner, the RMDs will stretch out over the lifetime of the beneficiary spouse.  (We’ll refer to this as Method A.)

Now, if the owner died after attaining age 70½, first of all, in the year of the owner’s death, a regular RMD is required using the Uniform Life table and the decedent’s attained age (if the deceased owner hasn’t already taken it).  For the next and subsequent years, RMDs are based on the lesser of 1) the amount calculated by using the beneficiary spouse’s attained age with the Single Life table; or 2) the amount calculated using the deceased owner’s age with the Single Life table.  If the second factor results in the longer distribution period, then each subsequent year the initial factor is reduced by 1, rather than re-calculating based upon a new factor from the table based on that year’s attained age. (Method B)

In addition to the two above scenarios, a spouse beneficiary has the unique ability to rollover the IRA into an account in his or her own name, and to treat the IRA as such.  Only a spouse beneficiary has this option.  If the original owner had already reached age 70½, RMDs must continue but they are based upon the surviving spouse’s attained age using the Uniform Lifetime table.

Non-spouse (sole beneficiary)

If there is a sole, non-spouse beneficiary and the owner has not reached age 70½, the RMDs must begin in the year following the year of the original owner’s death.  The RMD is calculated based upon the beneficiary’s attained age using the Single Life table for the first year, and the factor from the table is reduced by 1 for every subsequent year. (Method C)

The only difference if the owner was at least age 70½ is that in the year of the original owner’s death the RMD must be made for that year (if the deceased owner hasn’t already taken it).  Thereafter, RMDs for the beneficiary are calculated using Method C.

Non-spouse (multiple beneficiaries)

If there is more than one beneficiary of the account, there is one activity that could take place which will change the outcome of the distribution calculations.  If the account is divided into separate accounts for each beneficiary by the end of the calendar year following the year of the death of the original owner, then each non-spouse beneficiary will be able to treat the distributions just the same as was explained above for sole non-spouse beneficiaries (Method C).  The same is true if one of the beneficiaries is a spouse – this beneficiary can use the rules for a spouse beneficiary (outlined above, Method A or Method B).

If the account is not divided into separate accounts as described above, RMDs are calculated based upon the oldest beneficiary’s attained age as if the oldest beneficiary is a sole beneficiary.  Then each subsequent distribution is divided up based upon the nature of the beneficiary designations to each beneficiary. (Method D)

See-through Trust

If the beneficiary of the account is a see-through trust designed to create a single source of funds for multiple beneficiaries, then Method D is used. On the other hand, if the see-through trust has separate sub-trusts for each beneficiary, then each beneficiary’s RMD is calculated using Method C.

Non-Qualified Trust

If the beneficiary of the account is not qualified as a see-through trust, typically because one or more of the beneficiaries is not a person, if the original owner had not reached age 70½ then the entire account must be distributed within five years of the death of the original owner. (Method E)

If the original owner was at least age 70½, then the regular RMD must be made for that year (if the deceased owner hasn’t already taken it).  Then for subsequent years, RMDs are calculated using Method C.

It should be noted that a non-qualified trust could become qualified as a see-through trust if the non-individual (entity-type) beneficiary’s portion is cashed out of the account.  If this is possible, then the trust is treated as a See-Through trust and RMDs are calculated as describe in that paragraph above.

Charity

If the beneficiary is a charity, distributions are handled exactly the same as the non-qualified trust, using Method E or Method C, depending on the age of the original owner.  The difference is that these are the only options available to the charity.

Estate

The estate as the beneficiary uses the same methodology as a charity.

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2 Good Reasons to Use Direct Rollover From a 401(k) Plan

Aug 10th, 2011
by jblankenship.
1 comment

If you have a 401(k) plan (or any Qualified Retirement Plan (QRP) such as a 403(b) plan), when you leave employment at that job you can rollover the plan funds to an IRA or another QRP at a new job.  Listed below are 2 very good reasons that you should use a Direct rollover (also known as a trustee-to-trustee transfer) instead of the 60-day rollover.

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A 60-day rollover is where the former plan distributes the funds from your account to you, and in order to make the rollover complete you must deposit the entire distributed amount into the new plan or IRA within 60 days.

Reasons to Use a Direct Rollover

  1. You must complete the rollover to the new account or IRA within 60 days.  There is little if any leeway on this 60-day period – and though it seems as if this is a simple task to accomplish, there are many cases where well-intentioned individuals missed the bus on this one.  All it takes is a lost letter in the mail, or the check falling through the cracks, or any of myriad ways to miss the deadline.
  2. When funds are distributed from a QRP to an individual, the plan administrator is required to withhold 20% of the distribution for income tax.  This presents a problem if you were planning to rollover the full amount of the QRP into your new plan or IRA, since you’ll now need to come up with the missing 20% from other sources.  Granted, if all things remain the same you should get the withheld 20% back from the IRS when you file your taxes, but that could be a long wait if you don’t have a lot of excess cash lying around.

Using the direct rollover eliminates both of the issues listed above.  When then QRP administrator enacts a direct rollover for you, most often the distribution is directly to the administrator or custodian of the new plan or IRA.  Sometimes the QRP administrator will send a check to you, the plan participant, made out to the new administrator or custodian, so you’ll still need to make sure that the check gets to the new plan within the 60-day window.  You’re in a much better position to get around the 60-day window if the check is made out to the new custodian, since technically the 60-day rollover requires that you have the funds at your disposal (for use or deposit in another account).

In addition, using a direct rollover eliminates the 20% withholding requirement altogether.  There’s no amount to make up later.

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UBTI in an IRA

Aug 3rd, 2011
by jblankenship.
2 comments
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I’ve mentioned before about various types of transactions that are not allowed in your IRA, but we’ve not actually covered the topic of Unrelated Business Taxable Income (UBTI) in your IRA.  UBTI isn’t prohibited within an IRA, but it does pose problems and adds a great deal of complexity to your account.

Unrelated Business Taxable Income

So, what is UBTI anyway?  The concept of UBTI pre-dates IRAs – it was originally developed in relation to charitable organizations, trusts, and other tax-exempt entities.  The IRS developed this concept to ensure that tax-exempt organizations didn’t have a competitive advantage over taxable organizations, such as for-profit corporations.  The way that income is determined to be “unrelated” is by checking these two tests:

  • Is the income from a trade or business that is regularly carried on?
  • Is the trade or business unrelated to the tax-exempt entity’s exercise of the entity’s tax-exempt purpose?

If these two tests are met, then the income may be UBTI.  Here’s an example that may help you to better understand the concept of UBTI (taken from IRS Publication 598:

An exempt vocational school operates a handicraft shop that sells articles made by students in their regular courses of instruction. The students are paid a percentage of the sales price. In addition, the shop sells products made by local residents who make articles at home according to the shop’s specifications. The shop manager periodically inspects the articles during their manufacture to ensure that they meet desired standards of style and quality. Although many local participants are former students of the school, any qualified person may participate in the program. The sale of articles made by students does not constitute an unrelated trade or business, but the sale of products made by local residents is an unrelated trade or business and is subject to unrelated business income tax.

The concept of UBTI covers many more situations, and you can find out much more about other types of activities that can generate UBTI by going to IRS Publication 598.

IRAs

Since IRAs are, until distribution, exempt from tax, UBTI applies to certain types of income received within an IRA account as well (all of this applies to Roth IRAs as well as traditional IRAs).  The IRS Code defines any active trade or business to unrelated to the IRA’s tax-exempt purpose.

There are exceptions as well (of course there are!).  The exceptions for tax-exempt organizations are numerous and complicated.  The following is a partial list exceptions specifically for IRAs:

  • dividends
  • interest (includes “points”)
  • royalties
  • rent from real property (real estate)
  • sales proceeds from real property, as long as the property is not held as inventory or held in the normal course of a business (e.g., flipping)

This is nowhere near an exhaustive list – see Publication 598 for more details.

Examples of ways that an IRA investment could generate UBTI include: full ownership of a pass-through business, such as a limited partnership or S-Corporation; use of IRA funds to loan to a business – and the terms of the loan include participation in the profits of the business (as opposed to simple loan payments); and use of IRA funds to flip properties (via a partnership or LLC, for example), since the property is considered inventory and not investments.

Another way that UBTI is generated is through debt-financed income (also known as UDFI).  UDFI occurs in a case like this:  An IRA purchases a piece of real estate to be held for rental property.  In the purchase of the property, the IRA put 50% down in cash and financed the remaining 50% through the seller.  Even though rental income is considered to be exempt (see the list above), since debt was used to acquire the property, half of the rental income (reducing as the debt is paid off) would be considered UDFI, and therefore subject to taxation.  The good news is that the proportional part of the expenses associated with the debt-financed income would offset the income.

Okay, so my IRA has UBTI.  Now what?

If your IRA generates UBTI, it doesn’t disqualify the IRA (like prohibited transactions would).  No, what UBTI does is requires your IRA to file an income tax return.  This is unusual since an IRA is supposed to be tax-exempt, but since the UBTI is generated, income tax will be owed on the income if it reaches certain levels.

If the IRA generates gross income of $1,000 or more during the tax year, the IRA must file Form 990-T by April 15 of the following year, just like individual tax returns.  The issues that arise with this include:

  • The IRA must have a federal tax id (EIN).
  • The custodian is considered responsible for filing Form 990-T, but most self-directed IRA custodians transfer this responsibility to the account owner.
  • The IRA custodian may not have all of the information required to file the return, as much of the information in these privately-held investments is given directly to the account owner.
  • The account owner ultimately has the final responsibility to file the Form 990-T, and lack of understanding of the rules can cause major issues for the account owner.
  • The account owner also will be required to file quarterly estimated tax payments as long as the investment is in place.  Every three months, a tax payment must be made to the IRS if the total tax for the year is expected to be greater than $500.

Form 990-T is a four-page form, and filling it out can be a fairly complex undertaking – one that you’re not likely to enjoy filling out (as I’m sure you do most tax forms).

Lastly, UBTI is one of those cases where income within an IRA is actually destined to be double-taxed.  Even though you pay tax on the UBTI as it is earned within the IRA (at trust rates, not individual rates, which are more compressed), when you take the money out of the IRA you’ll be taxed again.  Paying tax on UBTI doesn’t create non-taxable basis in the IRA, in other words.

With so many other eligible investment options, why not stick with the simple, non-UBTI investments for your IRA?  If you must invest in one of these investments that could trigger UBTI if it were in an IRA, just go ahead and invest your taxable monies in the endeavor – you’ll save yourself a lot of grief.

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Spouse May Be Your Best Option for IRA Beneficiary

Jul 27th, 2011
by jblankenship.
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Since a surviving spouse gets the most tax breaks of all possible beneficiaries (other than a charity, perhaps), it seems that choosing your spouse as the beneficiary of your IRA may be the best way to go.

This is partly due to the availability of delaying taking distributions.  Any other beneficiary must begin taking Required Minimum Distributions (RMDs) by the end of the year following the year of the original IRA owner’s death.  The spouse beneficiary may defer distributions to the year in which the deceased would have reached age 70½, without taking any action.

In addition, any other beneficiary besides the spouse is required to take the RMDs over his or her fixed-term single-life expectancy, while the spousal beneficiary can choose to take the RMDs over his or her single-life expectancy recalculated annually, so that the distributions will actually stretch out over his or her entire life.  The fixed-term single-life expectancy winds up ending sometime in the beneficiary’s 80’s.

And the best part of all is that the surviving spouse beneficiary can choose to rollover the IRA to an IRA in his or her own name, which could have the effect of delaying the start of RMDs even further, if the spouse beneficiary is younger than the decedent.  When this option is chosen, the surviving spouse could also choose to roll the IRA into a Qualified Retirement Plan (QRP) such as a 401(k).  If the surviving spouse is still working for this employer past age 70½, RMDs could be delayed even further – up until the surviving spouse retires.

An added bonus to the option of the surviving spouse using a rollover, he or she can name another designated beneficiary of this rolled over IRA, providing flexibility to the overall process.  Plus, with an IRA in his or her own name, when the time comes to begin RMDs, the surviving spouse can use the Uniform Lifetime Table (instead of the Single Life Table) which will allow for further stretching of the benefits, potentially far beyond his or her lifetime.

Estate tax on such a move is likely to be nil, due to the marital deduction.

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One Way to Use IRA Funds to Invest in Your Business

Jul 6th, 2011
by jblankenship.
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As you know, it is against all the rules to use your IRA to invest in anything which benefits you or a related party.  This is one quick way to get your entire IRA disqualified, quite likely owing a big tax bill and penalties as well.

However – and there’s always a however in life, right? – there is one possible way that you could use funds from an IRA to invest in your own business.  It’s a bit tricky, but it is a perfectly legal, in fact encouraged, method.

Howzat?  The IRS encourages the use of IRA funds for your own business?  Not exactly.  There’s more to it than that.  The IRS encourages by preferential law the use of Employee Stock Ownership Plan (ESOP) funds to invest in your business.  An ESOP is a type of qualified retirement plan that is designed specifically to invest in the stock of the employer.

So, if you have a small business and it’s incorporated, you can adopt an ESOP and roll your IRA into the plan, then use the ESOP funds to invest in your business.  You have to make certain that the ESOP follows all the usual rules – the plan has to be primarily designed to provide retirement benefits, it must be permanent in nature, you must make substantial and recurring contributions, and the plan must not discriminate against employees.

This is definitely not for the faint of heart. Although all the statutes allow the method as legal, the IRS is well aware of the method and they don’t seem to like it much.  They’re referring to this activity as “rollovers as business startups”, or ROBS, and they are siccing their auditors on abusers of the option.  I suspect that the main reason that folks run afoul of the IRS on this is if they don’t stick with the requirements for a valid plan and abuse the privilege.

As with many of these sorts of schemes, I don’t recommend it for regular use.  It could work for special circumstances though – but you should definitely be very careful if you decide to give it a shot.  The downside could be significant and painful.

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NonDeductible IRA Contributions: Good or Bad Idea?

Jun 29th, 2011
by jblankenship.
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If you find yourself in the position of having too high of an income to make a deductible contribution to your IRA for the year ($110,000 for joint filers in 2011, $66,000 for Single and Head of Household), you may be wondering if it’s a good idea to make a non-deductible contribution to your IRA.

There are two opposing camps on this issue, and the deciding factor is how you’re intending to use the funds in the near term.

It’s a Good Idea

If you’re intending to convert your IRA to a Roth and your income is too high to just make the contribution directly to the Roth account, the non-deductible IRA may be the right choice for you.  This way you’re effectively working around the income limitations of the Roth contribution ($179,000 for joint filers in 2011 or $122,000 for single or head of household filers).

You also have more funds available in your IRA account, which provides you with the ability to take advantage of economies of scale – certain mutual funds have higher minimum purchase amounts, for example.  Since the money is in an IRA you don’t have to track holding periods, non-qualified dividends versus qualified dividends, and your paperwork is reduced.

In addition, depending upon your state laws your money may be protected against creditors since it’s part of an IRA.

No, It’s a Bad Idea

If you’re not planning to convert this IRA to Roth, you’re effectively increasing the tax cost of your investment gains (under today’s law).  Since withdrawals of investment gains from your IRA are taxed at ordinary income tax rates (up to 35% under today’s rates), you’re effectively giving yourself a tax increase over the capital gains rate which is 15% at the maximum these days.

Instead of making a non-deductible contribution to your IRA, you could just make your investment in a taxable account.  Then within this account you could make investments geared toward long-term gains rather than income or dividends, therefore deferring tax until you sell the investment.  And when you do sell the investment it will be taxed at the currently much lower capital gains rate versus the ordinary income tax rate (which would be applied if you made your contribution in the IRA).

Conclusion

So – depending on what you’re planning to do with the account, a non-deductible contribution could be a good idea or a bad idea.  You will have to make that call.  Hopefully the information above will help you with your decision.

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Withholding Tax Without Income?

Jun 8th, 2011
by jblankenship.
1 comment

We’ve discussed in the past how it’s possible to eliminate quarterly estimated tax payments by using a withdrawal from your IRA.  But did you realize that you can actually put this method in motion without actually increasing your income?

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Wait a minute… did you just catch that?  I’m telling you that you can eliminate your withholding or quarterly estimated taxes by using a withdrawal from an IRA – and that you can do this without having to recognize income from the IRA withdrawal.

It’s a little tricky, but if you’re not too faint of heart, this could actually be a cool little maneuver.  What you do is to take a withdrawal from your IRA, and on the withdrawal slip indicate that you want the entire withdrawal withheld for taxes.  Then, within 60 days, replace the funds (from another, non-IRA source) into either that same IRA or another IRA – effecting a sixty-day rollover.  End result: taxes withheld, no income, no penalty.

While it might seem crazy to assert that you can have taxes withheld from a distribution that was negated by a 60-day rollover, but the IRS allows you to do a tax-free rollover of a distribution that has been sent to the IRS as withheld income tax, by using substitute funds (see Rge 1.402(c)-2, A-11).

How could this be a cool maneuver?  Take the factors into account:

  • When you withhold tax from an IRA distribution, the IRS considers that it has been withheld over the course of the year, so timeliness of withholding isn’t important: you could have your entire tax burden withheld on December 31 if you wanted.
  • If you are self-employed or otherwise in complete control of your income, you can eliminate withholding and/or estimated tax payments completely, by saving up the equivalent of withholding through the year and then pulling the trick outlined above toward the end of the year.

You’d be able to very accurately calculate your tax payments, reducing the loss of income that comes along with over-withholding through the year.  This way you can invest the money that you’d otherwise be sending in quarterly installments, and at the end of the year make one large payment from your IRA, and roll-in your withholding stash.

It should be noted that, while this is a valid option to consider, there are pitfalls that could really cause you problems.  Just forgetting to do the IRA withdrawal (withholding the withdrawal to pay tax) one time can result in some very serious penalties.  Furthermore, missing the 60-day deadline for completing the rollover could penalize you further with the 10% early withdrawal penalty.

I would not suggest doing this maneuver on a regular basis – it should be one of those tools that you have available if you get caught in a pinch.  The penalties for screwing it up are too severe, and the chances of screwing it up are plenty.

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