IRA Rules | Portnoff Financial LLC- Blog

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IRA Rules

IRAs 401ks or both?

I  just answered a  question on www.Nerdwallet.com  which was "You can have a Traditional IRA and a Roth IRA; but can you also have a 401k and a Roth 401k, all 4 at the same time?" and thought I'd put this on my blog since it is a common question. Here is my answer:

Yes, you most certainly can have a Traditional IRA, a Roth IRA, a 401k, and a Roth 401k all at the same time. The issue will be which you can contribute to and how much.

For example, the annual contribution limit for IRAs is $5,500 plus $1,000 catch up (CU) if over 50. Let’s assume you are under 50 for my explanation. You can contribute any combination of amounts between a Traditional IRA and a Roth IRA as long as the total does not go over the limit, $5,500. So you could put $3,000 in your Traditional IRA and $3,500 in your Roth, or $1,000 in your Traditional IRA and $4,500 in your Roth.

Anyone can contribute to an IRA regardless of income but your ability to deduct it would be limited if your Adjusted Gross Income (AGI) is over $98,000-$118,000 if you file a joint tax return ($61,000-$71,000 Single/Head of Household) being that you are covered by an employer plan. If you make too much to make a deductible contribution then you might want to look to the Roth IRA however your ability to contribute to a Roth IRA is limited if your Modified AGI is $184,000 to $194,000 for joint filers ($$117,000 to $132,000 single/HOH). If you are over this amount then you would consider a non-deductible IRA and potentially convert it to a Roth (no income limit to convert) supposing you have no other IRA funds (if you do a pro-rata rule applies and may not be worthwhile).

The 401k contribution limit is $18,000 with a $6,000 catchup if you are over 50 (which I’ll assume you are not for purposes of this answer). Similar to the answer above on contributing to a Traditional IRA and a Roth IRA, you can contribute to both your 401k and your Roth 401k as long as the total does not go over $18,000. The amount you contribute to the 401k or Roth 401k has no impact on the amount you can contribute to an IRA (but does affect whether you can deduct it or not).

So if you have the money you can put $5,500 ($1,000 CU) to any combination of IRA and Roth IRA plus $18,000 ($6,000 CU) to any combination of 401k and Roth 401k for a total of $23,500 ($30,500 if over 50).

Now whether you should put more in the pre-tax versus the Roth (tax-free) is essentially a function of what your marginal tax bracket is now versus what you think it will be when you take the funds out. If you think you will be in a lower bracket in the future then pre-tax is the way to go, however if you think you will be in a higher bracket and/or you think tax rates are going up (due to terrible government debt) then Roth can be the way to go. If you’re not sure you can diversify to both which is not a bad idea. The pre-tax vs. Roth is really like any other investment except that you are betting on tax rates. One will be better than the other but you won’t know until the future arrives which is the same reason we diversify between stocks and bonds, between US and international and emerging markets, and Large cap and small cap, and growth and value, etc. 

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2015 IRA Contribution Reminder

It's not too late to make an IRA contribution for 2015. The deadline is the tax filing date which is Monday 4/18/2015 this year however generally it is not a good idea to wait until last minute.

Individual Retirement Accounts (IRA) are tax deferred, or in the case of a Roth IRA, tax-free savings/investment accounts. Tax deferral allows your money to grow faster without losing some of the growth annually to taxation. Having investments in an IRA also allow you greater investment flexibility to make changes without having to worry about generating any taxable capital gains transactions.

The IRA contribution limit for 2015 is $5,500 to any combination of IRAs and/or Roth IRAs as long as the total doesn't go above $5,500 unless you qualify for the catch-up contribution which is an additional $1,000 if you reached age 50 by year-end 2015.

Anyone is eligible to make an IRA contribution as long as you have earned income and you are under 70 1/2; whether you can take a deduction for a traditional IRA depends of a few factors described below. Eligibility to contribute to a Roth IRA depends on income which is also described below; there is no age limit to make Roth IRA contributions.

 

Phase-Out Range for IRA Deductibility: If you are considered an active participant in a company retirement plan, your deductibility for an IRA may be limited. If you are married filing jointly the phase-out for deductibility begins for adjusted gross income between $98,000- $118,000; above that there is no deduction. If you are a single or head of household filer the phase-out for deductibility begins for adjusted gross income between $61,000- $71,000; above that there is no deduction. If you are not covered by a company plan but your spouse is, the phase-out range for you is $183,000 - $193,000. If you file married-separate, your phase-out range is $0 - $10,000. If your income falls between the phase-out range, your ability to deduct your IRA contribution will be limited. There is a specific calculation to determine the amount you can deduct so if this applies to you, consult your tax advisor to determine how much you can deduct.

Even though you may not participate in the company plan, you may be considered an "active participant” so it is important to verify before attempting to take a deduction. If you and your spouse (if applicable) are not covered by a company plan, then there is no income limitation to take a deduction for an IRA contribution. SEP and SIMPLE IRAs are considered company plans for these purposes but are not included in the maximum contribution amount as they have their own limits.

Eligibility for Roth IRA Contribution: If you are married filing joint, the phase-out of eligibility to contribute to a Roth IRA is between $183,000 - $193,000 of adjusted gross income; above that you cannot make a Roth IRA contribution. For single or head of household filers, the phase-out for eligibility is $116,000- $131,000. If you file married-separate, your phase-out range is $0 - $10,000. As mentioned above, if your income falls between the phase-out range, then your ability to contribute to a Roth IRA is limited. If you are above, then you cannot contribute directly to a Roth IRA however you are still able to convert IRA funds to a Roth IRA which is discussed below.

Non-deductible IRAs: If you wish to make a deductible IRA contribution but make too much income to be eligible to take a deduction, consider a Roth IRA instead. If your income is above the threshold to make a Roth IRA contribution, you can still make a regular IRA contribution however that contribution will not be deductible. In such a case of a non-deductible IRA contribution, your money goes in after tax but still grows tax deferred and your contributions when withdrawn are not taxable however the interest/gains will be taxable upon withdrawal.

These non-deductible contributions create "basis” in your IRA which when withdrawn come out tax-free in a pro-rata distribution relative to the amount of pre-tax money in your IRA. For example, if you have $100,000 in your IRA, $10,000 of which is after-tax basis, your ratio would be 10%. If you then took a distribution/conversion of $25,000, $2,500 of that would be considered a return of your basis tax-free while the $7,500 would be taxable.

IRA to Roth Conversions: Since 2010 anyone regardless of income can convert an IRA to a Roth IRA. This means that you could make a non-deductible IRA contribution and convert it to a Roth thereby getting after-tax funds in a Roth IRA which is in essence the same as making a Roth IRA contribution. This strategy is referred to as the “Back Door Roth.” It only works if you do not have other IRA funds because if you do, the pro-rata rules described above would apply. It is unknown if this loophole will be closed by congress or if they will allow anyone regardless of income to make a Roth IRA contribution; only time will tell. For now it is still there and people who this applies to should consider taking advantage of this great tax planning opportunity.

Mega Backdoor Roth:  The “Mega Backdoor” Roth is similar to what is described above however it is related to employer plans. There are many rules and details to be aware of but the basic idea is this: if the employer plan allows for after-tax contributions, you can theoretically contribute after tax funds up to the maximum Defined Contribution plan limit which is $53,000 for 2015 and 2016 plus $6,000 catch up contribution if over 50. Then, if the plan allows, you can request a distribution of only the after-tax funds paid to you and then deposit to a Roth thereby completing a Roth conversion of after-tax funds which means getting a whole lot of money in a Roth IRA, far more than the statutory annual contribution limit which also is limited by income levels.

For example, suppose you are maxing out your 401k at $18,000 and your employer provides a $6,000 contribution for you. That means $24,000 has been contributed leaving an additional $29,000 that could be put in using after-tax funds ($35,000 if over 50). If you had the ability to, you could contribute that $29,000 from your paychecks and at some point then request a distribution of those after-tax funds and convert to your Roth IRA. That would mean getting $29,000 in a Roth IRA in one year! Well you might say, “I have bills to pay and can’t take that much out of my checks.” Well obviously if you don’t have the funds you can’t do this but suppose you do have $29,000 in a savings or taxable investment account. In that case you would increase your contributions to the plan and use your savings to pay the bills and essentially shifting those taxable savings/investments into tax-free Roth IRA accounts. That’s why this is called the “Mega” backdoor Roth. Certainly many details are left out but this is the basic idea. If you think this could apply to you be sure to give us a call to discuss.

2016 IRA Limits: For 2016, IRA contributions limits stay at $5,500 if under 50 with the additional $1,000 catch-up contribution if you reach age 50 by year end. The phase-outs for IRA deductibility and Roth IRA stayed mostly the same from 2015 with a few exceptions:

  • IRA deduction phase-out for active plan participants
    • Single $61,000-$71,000
    • Married filing jointly $98,000-$118,000
    • Married filing separately $0-$10,000
    • Spousal IRA $184,000-$194,000 (you are covered but your spouse is not)
  • Roth IRA phase-out
    • Single $117,000-$132,000
    • Married filing jointly $184,000-$194,000

If you have any questions about IRA contributions or wish to make an IRA contribution for 2015 give us a call.

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President Obama’s Retirement Account Provisions in Final Budget Proposal

As President’s Day approaches we take a look at President Obama’s final budget proposal which contains 15 provisions related to retirement accounts. All but one of the proposals are simply a repeat of those proposed last year none of which were enacted. The only new proposal would allow certain employers to pool resources to create multi-employer (defined contribution) retirement plans which would create economies of scale and encourage more small business to participate.

Below is a list of the proposals but if you would like to read a full explanation you can go to the (Ed) Slott Report at https://www.irahelp.com/slottreport/final-obama-budget-proposal-heavy-retirement-account-changes-again.

#1 – Allow Unrelated Employers to Participate in a Single Multi-Employer Defined Contribution Plan

#2 - Eliminate the Special Tax Break for NUA

#3 - Limit Roth Conversions to Pre-Tax Dollars

#4 - “Harmonize” the RMD Rules for Roth IRAs with the RMD Rules for Other Retirement Accounts

#5 - Eliminate RMDs if Your Total Savings in Tax-Favored Retirement Accounts is $100,000 or Less

#6 - Create a 28% Maximum Tax Benefit for Contributions to Retirement Accounts

#7 - Establish a “Cap” on Retirement Savings Prohibiting Additional Contributions

#8 - Create a new “Hardship” Exception to the 10% Penalty for the Long-Term Unemployed

#9 - Mandatory 5-Year Rule for Non-Spouse Beneficiaries\

#10 - Allow Non-Spouse Beneficiaries to Complete 60-Day Rollovers for Inherited IRAs

#11 - Require Retirement Plans to Allow Participation of Long-Term Part-Time Workers

#12 - Require Form W-2 Reporting for Employer Contributions to Defined Contribution Retirement Plans

#13 - Mandatory Auto-Enrollment IRAs for Certain Small Businesses

#14 - Facilitate Annuity Portability

#15 - Eliminate Deductions for Dividends on Stock of Publicly-Traded Companies Held in ESOPs

These proposals are just that; proposals, many of which most likely will not be enacted however it does give us a sense of what lawmakers may be going after in the coming years.

 

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IRA Alert: Converting After-tax 401k money directly to Roth IRA

Good news from the IRS! (yes I know this is strange that I am excited about this news)

First a bit of background on after-tax funds in an IRA. Suppose you have an IRA worth $500,000 of which $50,000 is after tax funds. Any distribution from the IRA would be a portion of after-tax and pre-tax, whether that distribution is a withdrawal or Roth conversion. For example if the IRA owner took out $10,000, 10% or $1,000 would be considered after-tax. For all practical purposes the pre-tax and after-tax amounts cannot be separated just like cream in a coffee; every sip is a bit of cream and some coffee. Some people who have made after tax contributions to an IRA have mistakenly assumed that they can simply convert that IRA to a Roth tax free however this pro-rata rule applies because all IRAs of the owner are considered one for this purpose.

Ok so here's the situation with 401k's: Suppose instead of an IRA, you have a 401k plan with $500,000 of which $50,000 is after-tax funds same as above. Prior to 2009 it was common for the administrator of the 401k plan to issue two checks; one representing the after-tax funds and one representing the pre-tax funds. Then you would (assuming you were eligible at the time) convert the after-tax funds directly to your Roth IRA by simply depositing the after-tax check into the Roth account while depositing the pre-tax check in your pre-tax IRA. This strategy seemed to be a loop hole to the pro-rata rule above because IRA and employer plan rules while they seem similar do have notable differences.

Then in 2009, IRS issued some guidance on this common strategy (which I won't go into the details here) that basically indicated that the above loophole was not allowed, at least if you wanted to do this you had to go to great lengths to do it right (again I'll skip the details for now) which were essentially not practical thus the common strategy of getting the two checks to convert the after-tax funds directly to a Roth was not allowed. There remained some debate on the subject but most practitioners preferred to go the conservative route with clients and advise that this strategy was no longer allowed however many plans continued to offer the separate checks unaware of the IRS notice that went out in 2009.

Well 5 years later we finally have a definitive answer to this question from IRS notice 2014-54 which is an emphatic YES! This is really great news and makes things quite simpler for those who have after-tax funds in their 401k. It also opens up some planning opportunities that were not previously allowed which I will provide more detail on in the coming weeks after I myself learn more about this new ruling. Expect to hear more about this, and other topics after I attend the Ed Slott Master Elite IRA Advisor Group workshop in the first week of November.

If you have any questions on whether this may apply to you please feel free to contact me directly. 

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2013 IRA Contribution Reminder

It's not too late to make an IRA contribution for 2013. The deadline is the tax filing date which is Tuesday 4/15/2014 this year however generally it is not a good idea to wait until last minute.

Individual Retirement Accounts (IRA) are tax deferred, or in the case of a Roth IRA, tax-free savings/investment accounts. Tax deferral allows your money to grow faster without losing some of the growth annually to taxation. Having investments in an IRA also allow you greater investment flexibility to make changes without having to worry about generating any taxable capital gains transactions.

The IRA contribution limit for 2013 is $5,500 to any combination of IRAs and/or Roth IRAs as long as the total doesn't go above $5,500 unless you qualify for the catch-up contribution which is an additional $1,000 if you reached age 50 by year-end 2013.

Anyone is eligible to make an IRA contribution as long as you have earned income and you are under 70 1/2; w hether you can take a deduction for a traditional IRA depends of a few factors described below. Eligibility to  contribute to a Roth IRA depends on income which is also described below; t here is no age limit to make Roth IRA contributions .

 

Phase-Out Range for IRA Deductibility

If you are considered an active participant in a company retirement plan, your deductibility for an IRA may be limited. If you are married filing jointly the phase-out for deductibility begins for adjusted gross income between $95,000- $115,000; above that there is no deduction. If you are a single or head of household filer the phase-out for deductibility begins for adjusted gross income between $59,000- $69,000; above that there is no deduction. If you are not covered by a company plan but your spouse is, the phase-out range for you is $178,000 - $188,000. If you file married-separate, your phase-out range is $0 - $10,000. If your income falls between the phase-out range, your ability to deduct your IRA contribution will be limited. There is a specific calculation to determine the amount you can deduct so if this applies to you, consult your tax advisor to determine how much you can deduct.

Even though you may not participate in the company plan, you may be considered an "active participant” so it is important to verify before attempting to take a deduction. If you and your spouse (if applicable) are not covered by a company plan, then there is no income limitation to take a deduction for an IRA contribution. SEP and SIMPLE IRAs are considered company plans for these purposes but are not included in the maximum contribution amount as they have their own limits.

 

Eligibility for Roth IRA Contribution

If you are married filing joint, the phase-out of eligibility to contribute to a Roth IRA is between $178,000 - $188,000 of adjusted gross income; above that you cannot make a Roth IRA contribution. For single or head of household filers, the phase-out for eligibility is $112,000- $127,000. If you file married-separate, your phase-out range is $0 - $10,000. As mentioned above, if your income falls between the phase-out range, then your ability to contribute to a Roth IRA is limited. If you are above, then you cannot contribute directly to a Roth IRA however you are still able to convert IRA funds to a Roth IRA which is discussed below.

 

Non-deductible IRAs

If you wish to make a deductible IRA contribution but make too much income to be eligible to take a deduction, consider a Roth IRA instead. If your income is above the threshold to make a Roth IRA contribution, you can still make a regular IRA contribution however that contribution will not be deductible. In such a case of a non-deductible IRA contribution, your money goes in after tax but still grows tax deferred and your contributions when withdrawn are not taxable however the interest/gains will be taxable upon withdrawal.

These non-deductible contributions create "basis” in your IRA which when withdrawn come out tax-free in a pro-rata distribution relative to the amount of pre-tax money in your IRA. For example, if you have $100,000 in your IRA, $10,000 of which is after-tax basis, your ratio would be 10%. If you then took a distribution/conversion of $25,000, $2,500 of that would be considered a return of your basis tax-free while the $7,500 would be taxable.

 

IRA to Roth Conversions

Since 2010 anyone regardless of income can convert an IRA to a Roth IRA. This means that you could make a non-deductible IRA contribution and convert it to a Roth thereby getting after-tax funds in a Roth IRA which is in essence the same as making a Roth IRA contribution. This strategy only works however if you do not have other IRA funds because if you do, the pro-rata rules described above would apply. It is unknown if this loophole will be closed by congress or if they will allow anyone regardless of income to make a Roth IRA contribution; only time will tell.

 

2014 IRA Limits

For 2014, IRA contributions limits stay at $5,500 if under 50 with the additional $1,000 catch-up contribution if you reach age 50 by year end. The phase-outs for IRA deductibility and Roth IRA contributions go up a bit: 

  • IRA deduction phase-out for active plan participants
    • Single $60,000-$70,000
    • Married filing jointly $96,000-$116,000
    • Married filing separately $0-$10,000
    • Spousal IRA $181,000-$191,000 (you are covered but your spouse is not)
  • Roth IRA phase-out
    • Single $114,000-$129,000
    • Married filing jointly $181,000-$191,000

If you have any questions about IRA contributions or wish to make an IRA contribution for 2013, contact me directly.

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IRA UPDATE: APRIL 2013

Generally speaking you can contribute the maximum to an IRA (references to IRAs will include Roth IRAs as well) of $5,500 (for 2013) plus $1,000 catch-up contribution if you reach age 50 during the year as long as you have at least that amount of income to make the contribution. Most people generally focus on their ability to make IRA contributions for themselves. But what about making IRA contributions for other people?

Spousal Contributions

If you have a non-working spouse (or the spouse does not have income high enough to make the contribution), you can make a contribution for your spouse as long as the total income for the couple is at least the amount of the contribution. The spouse must meet all contribution requirements except for the fact that they do not have compensation. For example, the spouse must be under age 70 ½. In order to make a spousal IRA contribution, you must file joint tax return.

Participation in an employer provided retirement plan does not impact eligibility to make an IRA contribution however it is the deductibility of the IRA contribution that would be in question. When only one spouse is active participant in an employer plan, the deductibility is figured on different threshold amounts which you can find by going to http://tinyurl.com/2013RetirementChart.

There is no order requirement for spousal IRA contributions. For example, the taxpayer can make a spousal contribution without one for themselves, a partial for themselves and full for the spouse, or partial for both. There is also no requirement that both spouses contribute to the same kind of IRA. One can contribute to a Roth (if eligible) while the other to a traditional IRA.

Same-sex married couples will face a different set of rules however. Same-sex spouses who are legally married in their state are currently not considered married at the Federal level under DOMA (Defense of Marriage Act) and therefore cannot make spousal IRA contributions until this law is changed (as of 6/26/2013, the Supreme Court has struck down DOMA allowing legally married same-sex couples to receive federal benefits. It may be some time until we know how this affects other tax issues such as spousal IRA contributions).

Contributions for Children

Suppose your 15 year old gets a summer job and makes $2,000. Are they likely to save any of that money; probably not because young people typically are not good savers. Teaching children to same money however is certainly an excellent idea but aside from the point today.

The main requirement to contribute to an IRA is having enough earned income. In my example, the child has made $2,000 and while the maximum IRA contribution is $5,500, the child would only be able to contribute $2,000. The tax code does not specify where the money must come from thus you as a parent (or grandparent) could make the contribution for the child (or grandchild). For those who want to help out their children or grandchildren, this is an excellent way to give a monetary gift. If the child is a minor, then a custodial IRA must be set up and the child would have full access once they reach that age of majority however this gives the child a huge boost in retirement savings.

Most young people will not even start to think about saving money well into their late 20's and early 30's and that assumes they find savings to be important. Many people do not take savings seriously until they reach their 40's. So let's assume the age of 30 for when an individual would start saving on their own and assume that they will make a maximum Roth IRA contribution of $5,500. Assuming an 8% average rate of return (over a 35 year period is reasonable), their Roth IRA would grow to $1,023,562 ($198,000 of contributions). If you contributed $2,000 per year for 15 years starting at age 15 for the child, assuming the same 8% return, the child would have $58,649 at age 30 when they start saving on their own which would grow to $867,146 by the time they reach age 65. That's a huge bonus especially considering that the original contributions only added up to $30,000 in total! This shows the importance of the time value of money. Together this child would have $1,890,707 at age 65.

For a child that is probably in a low tax bracket, a Roth IRA probably makes the most sense. It would allow them to grow a tax free account for decades, the contributions of which would be accessible at anytime for any reasons free of tax or penalty. This makes an IRA contribution for a child a great idea! One way to encourage the child to save on their own would be to match any savings they do (could be any amount such as $5 for every $1 they save) into the IRA, subject to the maximum limits of course.

 

IRA Contributions for Parents

There are a couple of potentially good reasons to make an IRA contribution for a parent. Suppose you are not eligible to make a Roth IRA contribution, you could gift money to a parent to put into a Roth IRA in their name. Or if they are in a lower tax bracket than you, provide money to contribution to a regular IRA which they could convert at a lower tax bracket. Or you could simply provide a gift of cash to help pay tax on a conversion of their own IRA to Roth. Either way, you help your parent build tax free income which could lower their tax liability and also possibly increase the value of the inheritance you may one day receive. While there are no Required Minimum Distributions for Roth IRA owners, there are RMDs for Roth IRA beneficiaries, so when you inherit the Roth IRA you helped build, you will be forced to take distributions starting the year after death however those distributions would be tax free and could then be used for any number of potential needs.

Keep in mind that making an IRA contribution for a parent or child means loss of control of the funds which may impact your decision to engage in such a gift.

 

 

Widow's Penalty

After one spouse dies, the survivor is likely to be subject to higher marginal and average tax rates. Generally speaking, there will be an expectation of lower income due to loss of the spouse's social security benefit and a pension if there is one (and it is not set as a survivor benefit) and thus income can be expected to go down. However, even with a loss of income, the survivor still may be subject to higher tax.

Once the surviving spouse starts filing as a single taxpayer, he/she will be faced with lower brackets but similar income at least and until (if) the spouse remarries. For example, a married couple with $60,000 of income will be subject to the 15% tax bracket however if one spouse dies, even with a loss of say $10,000 from Social Security, the survivor will now be in the 25% tax bracket. In such a case, there is lower income and higher taxes! Not only does the marginal tax rate increase, so does the average tax rate (the average % they pay on every dollar of income).

Other potential tax changes include lower thresholds for phase-outs, the new 3.8% surtax on net invest income, Alternative Minimum Tax (AMT), and Medicare Part B stealth tax. For example, the survivor would lose a personal exemption, part of the standard deduction (if they do not itemize) or itemized deductions may be lower. Now with the 10% threshold for deducting medical expenses, the survivor will have a harder time hitting that since there would be medical expense for only one person but possibly similar income.

Income may not be much lower for some survivors. If the survivor inherits retirement accounts for example, the required minimum distribution may push the survivor into brackets higher than they might normally be subject to if it were not for the death of their spouse. While there would be a loss of social security, that loss may not be much if one of the spouses was collecting 50% of their spouses amount via the spousal benefit which means Social Security income would only go down by 1/3 at the death of the first spouse. For those who have pensions, especially if a 100% survivor option is chosen, the pension income will not change. If there is a life insurance policy that pays out, that would then cause an increase in investment income (life insurance is income tax free but the future earnings are not) which could offset any loss in income from Social Security or pension reductions.

This widow's penalty can make Roth conversions very attractive to the surviving spouse. Consider converting and paying tax now to reduce the future potential tax increase. This may not work for everyone however and thus you must determine if your surviving spouse would face this increased tax situation.

If after analyzing your own situation, you come to the conclusion that your surviving spouse may be subject to higher taxes, Roth conversions may make sense for you. If you assume tax rates will be the same, then converting now locks in the current tax rate to hedge against tax rates going up (due to US fiscal problems). Even if tax rates stay the same, by using taxable assets to pay for the conversion for money that would be taxed at the same rate anyways, you reduce the tax drag on those investments and reduce required minimum distributions. Remember that Roth conversions are not an all or nothing proposition; you can convert small amounts each year to keep you in the same tax bracket. For some that have a very low income (or even negative income) due to deductions, you may be able to do tax free Roth conversion which in my opinion there is no reason not to, or conversions at very low tax rates such as 10% and lock in that tax rate now.

For those who do not want to pay the tax on conversions now, life insurance can be a viable strategy. For a relatively small premium, the survivor would have liquid cash that could be used to do conversions after death, or simply extra funds to pay potentially higher taxes. Investments in life insurance can provide a reasonable IRR (internal rate of return) similar to a bond portfolio that would not bear the same risks of rising rates that traditional bond portfolios now face.

As is the case with tax planning concepts, they will not apply to everyone. Be sure to discuss these matters with a properly trained financial planner and tax professional to determine if these strategies are right for you. If you would like to discuss how these strategies may apply to your individual situation, please contact me directly or schedule a meeting at http://booknow.so/PortnoffFinancial.
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IRA Update: March 2013

With the American Taxpayer Relief Act of 2012 that was passed in 2013, there are some new tax considerations to be aware of.

NUA planning with ATRA

NUA or Net Unrealized Appreciation has to do with employer stock within a 401k plan. NUA allows the plan participant to take the employer stock out of the plan in-kind and transfer to a taxable brokerage account while only realizing ordinary income on the original cost of the shares. The gains, or NUA is taxed at long-term capital gains (LTCG) rates but only when the shares are actually sold. See http://portnofffinancial.com/blogc57.php?postID=46&article=Net-Unrealized-Appreciation-%28NUA%29-tax-breakfor more details on NUA.

Previous to 2013, the difference between the top rate of 35% and the LTCG rate of 15% meant a 20% potential tax savings when using the NUA strategy. With the new top rate of 39.6% and 20% top capital gains rate; difference is 19.6% which is close however one must consider the 3.8% surtax on net investment income. The surtax would be applied on the income generated from the sale of shares after the distribution and thus the tax would be 23.8% which is 8.8% higher than in 2012. In other words the potential tax savings is reduced to 15.8% from 19.6%.

As an aside, almost no one will actually pay 20% capital gains because if your income is high enough to be in the 20% capital gain territory, you are probably also subject to the 3.8% surtax which is why you would pay 23.8%.

It is important to look at the potential tax savings but also important to consider that any future growth of distributed stock would no longer have the protective shell of tax deferral. Once the stock is sold, the capital gain would be realized. Any future income derived from the stock such as dividends would be taxable in the year received. Also the stretch IRA for beneficiaries would no longer be applicable to distributed NUA stock.

A key consideration: Is there significant appreciation on NUA stock and when will you need the NUA funds? If the gain on NUA is not significant, the benefit is less because it may cost a lot in having realized the ordinary income to get the NUA out at ordinary rates if there is a relatively small amount of NUA that would get the LTCG treatment. However if you are going to use the funds soon after distribution, the benefit is high because some of the money that would have been taxed at ordinary rates gets the long-term capital gains treatment instead. If holding for a long time before selling the shares, you have to evaluate whether it makes sense or not.

Roth Conversion Strategies

Roth conversion strategies need to be review and revised in light of the new tax rates. Taxpayers who are subject to the return of the 39.6% bracket obviously pay more tax and need to consider whether they want to convert at this rate. Since the Bush tax cuts for most taxpayers were made "permanent," those who converted into higher tax brackets in 2012 may want to revisit and determine if they should recharacterize and begin to reconvert over a longer period to keep their marginal tax rate lower.

Even with higher rates for high income, taxable assets are still subject to the 3.8% surtax and thus Roth conversion will help to reduce taxation on those types of funds if you were to use those funds to pay the tax on conversions. There certainly is no guarantee that congress won't come back and raise tax rates even more which is already being discussed and this should be factored into your decision to what income tax bracket you will convert to.

 

Planning with new estate tax threshold

With the estate tax being set at $5 million with portability and inflation adjustments means only the wealthiest will pay estate taxes, that is unless and until this level is brought back down. The Generation Skipping Tax (GST) exemption is set at $5.25 million instead of going back to $1 million. The estate tax rate went up to 40% from 35% but this is only on the amounts about the exemption.

Wealthy IRA owners may want to consider naming grandchildren as beneficiaries of IRAs to take advantage of the $5.25 million GST exemption and the stretch for the younger generation. Trusts may be necessary for grandchildren so watch the wording and the type of trust used so as to not affect the stretch and force small amounts of income to trust and estate tax rates which hit the highest bracket very quickly.

If the estate is potentially large enough, strategies to reduce the estate size such as gifting, Roth conversions, and life insurance via ILITs (Irrevocable Life Insurance Trust) should be considered. You must also consider even though there is a large federal exemption amount, some states still have their own estate tax with different thresholds such as NJ which sits at a $675,000 exemption amount.

Gifts can be given to family members who may be in lower tax brackets to help them convert their own IRAs to Roth IRAs. This can also mean gifts to parents who are in lower tax brackets. Helping a parent or even a grandparent convert their IRA to Roth means that Required Minimum Distributions cease and when you inherit, you can get a tax free stretch, or if you don't need it, have the younger generation named as beneficiaries so that they get lifetime tax free distributions.

Misc Tax Planning

  • Itemized deductions begin to phase-out at $300,000 for Married filing joint ($250,000 for single filers) up to $422,500 ($372,500 for single filers).
  • AMT exemption amount has been permanently indexed to inflation. For 2013 the amount is $80,800 ($51,900 for single filers).
  • Qualified Charitable Distributions temporarily extended for 2013.
  • In-plan Roth conversion rules have expanded.
  • Top trust tax rates starts at $11,950 which means that distributions from inherited IRAs to discretionary trusts that can retain those distributions hit the 39.6% tax rate very quickly.
  • Salary deferrals for 401k, 403b, etc, can reduce the MAGI for the 3.8% surtax however cannot reduce income for purposes of the 0.9% Medicare surtax.

 

As always, please consult with a qualified tax professional and financial advisor to determine if these strategies are right for you.
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American Taxpayer Relief Act of 2013

Summary of key (IRA) points:

Three new income thresholds that high income taxpayers need to plan for and four different ways income is calculated to compare against the new thresholds.

  • New (return of old) 39.6% tax bracket for joint filers with taxable income over $450,000 ($400,000 for single filers) and a top long-term capital gains and dividend tax rate of 20% which actually becomes 23.8% because such a taxpayer would be subject to the 3.8% surtax on net investment income.
  • Phase-out of itemized deductions up to 80% and personal exemptions for taxpayers whose AGI (Adjusted Gross Income) exceeds $300,000 ($250,000 for single filers)
  • 3.8% surtax on net investment income for those whose MAGI (Modified Adjusted Gross Income) exceeds $250,000 ($200,000 for single filers). At the same levels, earned income in excess of these thresholds will incur an additional 0.9% surtax.

Qualified Charitable Distributions return for 2012 and 2013

New in-plan Roth 401k conversion rules

  • Since 2010 a 401k participant who had a Roth 401k available could do an in-plan Roth 401k conversion IF they were eligible to take a distribution which typically means reaching the age of 59 ½. The ARTA modified this rule to allow participants that are not eligible to take a distribution to do an in-plan Roth conversion.
  • Ability to do an in-plan Roth conversion requires that the plan offers a Roth 401k and while plans are beginning to adopt the Roth 401k in greater numbers, they are not commonplace just yet.
  • If the plan offers a Roth 401k, in order to convert, the plan must also allow for in-plan conversion and there is no requirement that a plan offer this feature.
  • If the option is available, a plan participant must still analyze their tax status to determine if it makes sense to do the conversion, determine whether a Roth IRA conversion is better, wait, or not do it at all.
  • It is critical to keep in mind one of the MAJOR differences between a Roth IRA conversion and a Roth 401k conversion is the ability to recharacterize. When you convert an IRA to Roth, you have until October 15th of the following year to change your mind and reverse the transaction however in a Roth 401k conversion, there is no mechanism for recharacterization so once you execute the transaction, there is no turning back.

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Important IRA Rulings for 2012

In Charles Grant Beech et ux. v. Commissioner, T.C. Summ. Op. 2012-74; No. 1948-11S, 7/26/12, a non-spouse beneficiary, the decedents daughter botched an inherited IRA by not doing a trustee-to-trustee transfer and the whole inherited IRA was taxable all in one year. Remember, a non-spouse beneficiary CANNOT do a (60 day) Rollover; funds must only be moved via direct (trustee-to-trustee) transfer.

In Herring v. Campbell, Administrator of Marathon Oil Company Thrift Plan, U. S. Court of Appeals for the Fifth Circuit, 8/7/12, a $300,000 pension was not inherited by the intended beneficiaries. The decedent, John Hunter named his spouse, Joyce and the primary beneficiary of his pension plan but did not name any contingent beneficiaries. Joyce predeceased John and he never updated his beneficiary form. The plan administrator followed the rules of the plan and eventually the funds were distributed to Mr. Hunter's living siblings, not his "beloved stepsons" who inherited his estate through the Will. Unfortunately for the stepsons, a Will does not cover retirement plans, the beneficiary form does.

In Seeling, U.S. Bankruptcy Court, District of Massachusetts, Western Division, Case No. 11-30957, 5/24/12, the taxpayer received a favorable ruling protecting her inherited IRA from bankruptcy. In Clark, 2012, DC WI, 109 AFTR 2d 2012-733, 1/5/12, another bankruptcy involving an inherited IRA, the bankruptcy court ruled in favor of the creditors initially however a district court later overturned the ruling in favor of the debtor. More and more of these inherited IRA bankruptcy cases seem to be coming up and it appears a precedence is being set in many states in favor of debtors.


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IRA Tax Planning: Qualified Charitable Distribution (QCD)

A Qualified Charitable Distribution or QCD allows an IRA owner who is over the age of 70 ½ to make a charitable contribution up to $100,000 directly to a qualified charity using IRA funds and have that contribution satisfy their Required Minimum Distribution (RMD) for that year. The distribution must be made directly to the charity. If the IRA owner takes the distribution payable to him/herself, they would realize the income on their own tax return. In this case they would be allowed to take the applicable charitable deduction however in many cases, especially for higher income taxpayers, the charitable deduction may be limited as might other tax deductions due to higher thresholds. With the QCD, the funds are transferred directly to the charity so the IRA owner does not realize the income on their return thus the QCD is much more tax efficient.

There are several key points to understand about QCDs:

  • The limit is up to $100,000 per person. A married couple could affectively give $200,000.
  • Applies to IRAs, Roth IRAs, inactive SEP and SIMPLE IRAs; it does not apply to distributions from any employer plan. If a plan owner wishes to do a QCD, an IRA rollover may help accomplish that objective.
  • Roth IRAs are a poor choice to use for a QCD because they would normally be tax free and have no RMDs.
  • The distribution can (partially) satisfy the IRA owner's Required Minimum Distribution depending upon the amount.
  • The distribution must be made directly to the charity from the IRA. A check made payable to the charity from the IRA is acceptable.
  • The income from the distribution is not included on the taxpayer's return thus their AGI is less than what it would be if the distribution were included.
  • A lower AGI (adjusted gross income) means that more tax deductions and credits may be available (lower thresholds due to lower income) to meet.
  • A lower AGI may help avoid the 0.9% Medicare tax and the 3.8% surtax on net investment income.
  • No charitable deduction is allowed if the QCD is used because the distribution is not counted as income.
  • QCDs are made only from pre-tax IRA funds, not basis. If the IRA owner has after-tax basis in their IRA, the pre-tax funds are deemed to come out first leaving behind basis. This is an exception to the pro-rata (Cream-in-the-coffee) distribution rules for IRAs.
  • The charity must be a public charity; grant making foundations, donor advised funds, or charitable gift annuities to not qualify nor do split interest gifts.
  • When a QCD is made, the IRA custodian will still generate a 1099-R; the taxpayer must take appropriate steps on the tax return to avoid the inclusion of income.
  • IRA owner's may not receive anything in exchange for their donation.

QCDs have been extended retroactively to 2012 as part of the American Taxpayer Relief Act of 2013. QCD's have expired and been reinstated for several years now and most likely will continue to be a viable tax planning strategy for those who are subject to Required Minimum Distributions and are charitably inclined. With the top marginal rate now "permanently" set at 39.6% plus the 3.8% surtax on net investment income, a QCD strategy should be considered for especially for those in high tax brackets.

Check out this great article on Qualified Charitable Deductions by Robert Powell in which I was quoted: http://www.marketwatch.com/story/donating-retirement-assets-to-charities-2013-01-08?pagenumber=1


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