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Financial Life Advisor
Roth Conversion Strategies
In 1997, the U.S. Congress established a new type of retirement account named after Senator William Roth. Although this account did not provide an immediate tax deduction, it did offer a powerful and simple concept-- all growth, if kept until retirement age, would be TAX-FREE. For many years, higher income Americans were unable to participate in either annual Roth contributions or Roth conversions due to income limits of the account. In 2006, because of the Pension Protection Act (PPA), employers began to amend their 401(k) & 403(b) plans to include Roth contributions without income restrictions, and in 2010, the income limit was lifted for Roth conversions. So with this new found Roth freedom, what planning opportunities are available to maximize investment and tax value?
The reasons for Roth conversions can vary widely; some strategies are more appropriate for high net worth individuals, while others can help people of very modest means. Let us explore some of these strategies and see which ones might be applicable to your situation.
Income Smoothing
When you have a year or period of years where you anticipate lower earned income, Roth conversions can help smooth out the annual income number to take advantage of lower income tax brackets in low earning years.
For example, if someone goes back to school, takes time off of work, or retires before pensions and Social Security payments begin, Roth conversions can raise income during the low earning years to take advantage of marginal rates which could be much lower than if that income is paid out of the IRA at a later date on top of other income.
“Back Door” Roth Contributions
Though high income earners are not allowed to contribute to Roth IRA accounts annually, there is no income limit on making non-deductible IRA contributions. There is also no income limit on making Roth conversions. Thus, high income earners can make non-deductible contributions and immediately convert them to Roth accounts. Since there is no gain and no deduction was taken on the contribution, the conversion produces no taxable income. It is a “back door” to making Roth contributions.
The major hurdle to this strategy is that if an individual has a traditional, SEP, or SIMPLE IRA, he must aggregate all accounts together to calculate the taxable portion. So if you have $5,000 in a non deductible IRA, $45,000 in an IRA and make a $5,000 conversion, regardless of which account you convert, only 10% ($5,000 of $50,000 total) will be considered tax free on the conversion. Accounts are aggregated by individual, so a spouse without an IRA could still benefit from this strategy even if the other spouse has an existing IRA.
Increase Retirement Savings
Take, for instance, a $1,000,000 traditional IRA example. After paying tax (35%) on the distributions, the value may only be $650,000 after Uncle Sam gets his share. If that IRA is converted to a Roth, then the balance is still $1,000,000, but because the Roth is tax-free, the value to the owner is much higher than it was before.
In this example, the conversion has boiled down to a large $350,000 retirement plan contribution from after-tax assets. The Roth has a higher value than the traditional IRA but no annual contribution limits were used for the conversion. Just like an employee defers taxable income to fund an IRA, the conversion uses after-tax assets to fund the conversion and increase the value of the retirement account.
Social Security Taxation Avoidance
Many modest income retirees can find themselves in a tax squeeze involving Social Security benefits. Social Security is only taxable if other sources of income are high enough to exceed specific thresholds. Once that income threshold is crossed, Social Security income, which would not have been taxable, is made taxable by other income sources.
To illustrate, a retiree may have Social Security benefits of $2,000 per month, have no pension, but have a traditional IRA he can draw on for extra income. If he draws nothing from his IRA, he pays $0 in tax on his Social Security benefits. If he draws $3,000 per month from his IRA to live on, then 85% of the Social Security benefits become taxable. Therefore when calculating taxes, 85% of the Social Security benefits are added into the $36,000 of IRA distributions, for total taxable income of $56,400 per year in this example.
The retiree is only adding $3,000 to his monthly income, but is paying income tax on $4,700 because 85% of his Social Security becomes taxable. It is not uncommon for retirees to face up to 40% effective tax for taking IRA distributions in this modest income range. Even if the retiree doesn’t need to take additional distributions from an IRA, at 70 ½, all taxpayers are required to take Required Minimum Distributions (RMD’s) from their traditional IRA accounts, which could push someone into this territory.
Roth IRA distributions, on the other hand, are not counted as income for this calculation, and RMDs are not required for Roth IRAs. You are not forced to take taxable income in the future and when you do take distributions; it will not subject your Social Security to being taxable.
Estate Shrinkage
For those facing a possible estate tax, a Roth conversion can shrink the size of a taxable estate, but not decrease the value of the estate. Take, for instance, the same $1,000,000 traditional IRA example used previously. If that IRA is converted to a Roth, then the balance for estate tax purposes is still $1,000,000.
The conversion creates a large tax bill which will be paid with other assets. By “pre-paying” the tax on the IRA, those other assets (used to pay the tax) have been removed from the estate. The Roth IRA is now after-tax and worth more than the $1,000,000 traditional IRA by approximately the tax paid on the conversion. If estate tax is a problem, paying income tax once is better than paying estate tax and then having the beneficiaries pay income tax when they withdraw the asset.
No matter what your situation, it may make sense to look at Roth conversions. Some strategies take years to execute, some can be performed in one quick conversion. You should look carefully at your situation and consider if Roth conversions make sense for you.
Posted by Ben Gurwitz on 12th January, 2012 | Comments | Trackbacks | Permalink
Tags: Jan 12, Social Security, Financial Planning, Investments, Retirement Accounts, Estate Planning, Tax Planning
Tax Efficient Investing Strategy
What would you say if I told you that you can increase your long-term investment portfolio returns without increasing the risk or even changing which investments you use? You would probably call me crazy or a liar. The fact is, it is relatively easy to do. It has to do with being tax efficient and lowering the tax bill those investments generate.
Many people have investments in various accounts like 401(k), IRA, Roth, annuities, and brokerage accounts. Each of these account types have their own unique taxing structure. By matching up investments by tax efficiency, you can lower the tax bill which keeps more money invested to compound and grow.
Corporate Bonds vs. Growth Stock Mutual Fund
Let us look at a corporate bond. This particular bond earns an annual coupon of 7%. That 7% is taxed entirely at ordinary income tax rates. That rate is whatever the marginal tax rate at the time. For this example we will use someone in the highest current tax bracket (35%) but this is applicable to all tax brackets.
The growth stock mutual fund pays a relatively low dividend (which are mostly qualified) and occasionally sell stocks which have (hopefully) grown in value. When the sales of stock are recorded and the dividends are paid, the tax rate for most people will be 15%. So if the mutual fund has a long-term overall gain of 10%, 1% may come from dividends and the rest from capital gains. If the fund buys and sells about 30% of their stocks every year and most are long-term capital gains, then about 3% of the annual 10% long-term gain would be taxed annually.
So let us look at an example:
$10,000 investment in a corporate bond earns 7% or $700. The total tax bill would be $245 (35% x $700). After tax, the new value would be worth $10,455.
$10,000 investment in the growth stock mutual fund earns 10% or $1,000 for the year. $100 (1%) of the return is qualified dividends and $300 (3%) is long-term capital gains. At the 15% long-term capital gains and qualified dividend rate the total tax bill would be $60 ($400 x 15%). After tax, the new value would be $10,940.
This example illustrates the tax treatment in a brokerage account. If this person had both of these investments in an IRA, the growth stock mutual fund and bond would have no tax due and be worth $11,000 and $10,700 respectively. People often though have multiple account types. If they put the growth stock mutual fund in their brokerage and the bond in their IRA the total tax bill would be $60 because the tax inefficient bonds would not be taxed currently and the tax efficient growth stock would have minimal current taxation. By splitting the investments between a brokerage and IRA, the combined value would be $21,640 vs. $21,395 if it was all brokerage. No difference in investments, just lower taxes.
Another tax issue to consider is when the growth stock mutual fund is sold, it could have lots of long-term capital gains built into it. At that point the tax would be at 15%, if the gain was in the IRA, it would be taxed at ordinary income tax rates when it comes out to be spent. So it is possible to get better long-term tax treatment for growth assets outside a traditional IRA structure than in it. This is not always the case because tax is only paid on distribution from the IRA, if it stays in long enough, the compound interest can outweigh the benefits of long-term capital gains treatment.
The bottom line is that understanding the tax characteristics of your investments and matching those up efficiently with your available investment accounts can mean real tangible tax savings. Long-term if you can add .25% - .50% in additional return without adding risk by executing this strategy. Over many years the savings add up.
Posted by Ben Gurwitz on 8th December, 2011 | Comments | Trackbacks | Permalink
Tags: Tax Planning, Retirement Accounts, Dec 11, Investments
Identity Theft Protection
I recently received an email from a concerned client who had just found out there was $18,000 in unauthorized transactions on his credit card. His credit score had dropped 43 points already and he was worried that he was a victim of identity theft. Here is some of the advice I gave him.
The fact his credit card was stolen doesn't necessarily indicate that his identity had been stolen. It simply means that card was compromised. With VISA/MASTERCARD you have zero liability. They issue you a new card, remove the charges and you go on your merry way. The same protections exist on a debit card when you use it like a credit card, not when you use your PIN code. So it is always better to sign when using a credit or debit card.
The real danger in identity fraud is where criminals open new lines of credit without your knowledge and then run them up. If this happens you are proving that you didn't even open the accounts. You often have collections agencies after you and it can become a real mess. I have seen estimates that the typical identity theft can require upwards of 40-50 hours of work to clear your name. That is a serious amount of time and headaches.
The easiest way to avoid someone hijacking your credit is to "freeze" it. The credit bureaus then cannot release information until you "thaw" your report. I have the link below which shows you state by state the cost and procedures. If you have suffered from identity theft, the fees are often waived.
http://www.consumersunion.org/campaigns/learn_more/003484indiv.html
You can also order a free credit report annually through www.annualcreditreport.com. This will let you know if someone has hijacked your identity. If everything is copasetic, then you could move forward with a credit freeze. Then you can thaw it when you are looking to open new lines of credit.
I will warn you that the freeze can have unintended side effects. It prevents companies which you do not already have a relationship from getting any credit information on you. Potential employers or even changing insurance companies now look at credit. So to apply for new line of credit or a myriad of other things, you will have to thaw it.
Posted by Ben Gurwitz on 27th July, 2011 | Comments (1) | Trackbacks | Permalink
Tags: July 11, Identity Theft
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ABOUT THIS BLOG
Reason for Blog
Financial advice is everywhere. The problem is that often someone who is giving that advice is selling a specific product or insurance policy. This blog is different! The firm I work for provides fee-only advice to all new clients. In fee-only advice, no commissioned products are sold. Our goal is that after reading the advice we dispense and seeing our competence, you will want to hire us to give you advice full time. If you don’t hire us, our hope is that you will learn something valuable from the blog postings which helps you make one of the myriad of financial decisions in your life.
We will not have paid advertising on the blog, nor will we charge for any responses we give in the blogosphere. Our goal as a firm, and in this blog, is to remove as many of the conflicts of interest in helping people make financial decisions as possible, committing to always having your best interests above our own.
Format of Blog
Random musings about financial topics as well as reader submitted questions will be fielded. Only the first and last initials of submitters along with their hometown will be displayed on the blog.
In submitting a question, it is important to include as much background information as possible. Oftentimes, the subtle background details can make a huge difference in a financial decision. It is always better to include too much information than too little. From time to time certain information may be omitted from a blog question when it is not needed to answer the question.
Comments may be submitted, but due to regulatory concerns, they must be reviewed prior to posting. Most of the blog postings will be answered by Ben Gurwitz or Jim Oliver, and from time to time, a subject matter expert may be invited to answer the question. Moreover, as pertinent events occur, a general blog posting will be added.
Firm Background
Financial Life Advisors (FLA) is a Registered Investment Advisory firm based in San Antonio, TX catering to retirees and professionals who need assistance with wealth management and financial planning. FLA has been in operation since 2003.
Ben Gurwitz is a CERTIFIED FINANCIAL PLANNER TM or CFP® professional with a background in insurance and investment sales and consulting. Jim Oliver is a practicing CPA/PFS and CFP® professional. In addition to FLA, Jim founded and has operated the CPA firm Jim Oliver & Associates, P.C. since 1981. See their bios.
This firm is not a CPA firm.
Blog Disclosures
Financial Life Advisors, LLC (“FLA”) is a state registered investment adviser located in the State of Texas. FLA and its representatives are in compliance with the current registration requirements imposed upon state registered investment advisers by those states in which FLA maintains clients. FLA may only transact business in those states in which it is registered, or qualifies for an exemption or exclusion from registration requirements. FLA is neither a law firm nor accounting firm, and nothing contained herein should be interpreted by you as legal or accounting advice. We recommend that you seek the advice of a qualified attorney and/or accountant for legal or accounting services. All information submitted to FLA for the blog and website (“Blog”) is the sole intellectual property of FLA and may be published on the Blog.
The information provided on the Blog is provided for informational purposes only and should not be used as a substitute for personalized professional investment advice. Participation in any way with the Blog does not constitute an investment advisory or financial planning engagement. You should consult with your investment advisor or another financial professional before making any investment decisions. While all information on the Blog is gathered from sources that we deem to be reliable, we cannot guarantee the completeness and/or accuracy of such information. From time to time general investment guidance may be given in the Blog in response to questions asked by readers of the Blog. There is no guarantee as to the risk, returns, and performance of those investments referenced. No compensation is received by FLA for answering Blog questions and FLA does not endorse any particular investment products.
None of the information published by FLA Advisor is intended to be used, nor can they be used, for purpose of avoiding U.S. tax penalties.
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