May 31

On a Personal Finance and Money board within the Stack Exchange Network, I’m a frequent poster, answering questions as they come up. On occasion, I’m struck by a question that’s so well thought out, it’s worthy reading in its own right. The question asked was “One should save about 15% of their income for retirement.” What assumptions are tacit in that statement? and the clarification follows:

What assumptions are tacit in the statement that “saving and properly investing 15% of one’s income over a lifetime is a pathway to a successful retirement?”

By this, I mean items along the lines of:

  • Single, married, or single and dating at time of retirement?
  • Retire at 55, 60, 65, 80?
  • 25K/yr income, 50K/yr income, 150K/yr income?
  • That 15% goes to a tax advantaged account? (i.e. 401k, IRA, Roth, your nephew’s 529?)
  • Kids or no kids?
  • Paying for said kids’ college or not paying?
  • 2003 to 2007 returns, 2008 to 2009 returns, or “I averaged the whole S&P500 over 2 world wars and order of magnitude technology advances” returns?
  • Dual incomes the whole time?
  • Making a lot more money at time of retirement, or making about the same money as early to mid career at or about the time of retirement?
  • Renting a house the whole time, or owning a house as early as possible?
  • Obscene ROR’s on that house, or assuming it loses money?
  • Your expenses go down at retirement, stay the same, or go up?
  • Medicare exists? Social security exists? Tax rates go up, down, stay the same?
  • You’ll never get laid off, you might get laid off, you get laid off often?
  • Family helps you out with major purchases, or does not?
  • No, big, or modest inheritance?
  • Live in a cheap area, or live in a “statistically average for costs, land, CPI, wages” area of the US?
  • Taxes go up, taxes go down, taxes stay about the same?
  • Leaving a nest egg when you die? Or, dying broke?
  • Living to the statistical average age of men and women in the US, or, living to be 101.2?
  • Inflation under control? Inflation to the moon? Has it considered deleveraging and deflation?
  • State with an income tax? Or only a state with sales tax?

The truth is that no answer could really address this list. 22 items to consider, each of which might greatly impact the money you’ll need to retire in the manner you’d like. In general, I think many people will prefer a downsize, if they hadn’t done it soon after the kids took off for college. In which case, money for housing expenses might drop and can be used for travel or other things that the retiree might want to do.

What do you think of this list? What’s missing? Is it possible to plan for every variable decades away or does the picture only get clear as retirement gets closer?

written by Joe \\ tags: ,

Apr 17

Some comments are worth highlighting as they make a great Q&A. A question I received on my article Inheriting or Bequeathing an IRA follows:

Dear Joe,
My Mom passed away in December 2011. Her wishes in her Will were for her assets to be divided equally between myself and my 2 sisters. At some point my Mom listed me as beneficiary of her traditional IRA. The custodian has refused to abide by the instructions in the Will as the beneficiary form supersedes the Will. This is in the state of Tennessee. Is there a way to get the balance of the IRA divided 3 ways without cashing it in for a lump sum payout. We all would like to stretch out the payout. If I choose to disclaim a portion of the balance would it go to my Mom’s estate and enable my other 2 sisters to receive their portion? The tax attorney says to talk to the CPA, and the CPA says to talk to the tax attorney….The amount is around $170,000, so the taxes would be substantial on a payout. Any guidance would be appreciated.
Anne

Dear Anne,
If you are the listed beneficiary, and there is no other, by disclaiming the money, it would revert to her estate. The five year rule then applies, all funds must be depleted within 5 years after the owner’s passing. I can’t say whether the custodian will permit a partial disclaiming.
If it were me – I’d take the RMDs each year, pay the tax, and gift the siblings their “share.” You can view Pub 590 to see your RMD, but for example, at 50, the divisor to use is 34.2, so 170,000/34.2 is $4971. You can withdraw more if you wish, but be mindful of where you are in your marginal rate.


Right after I posted the response, The Wall Street Journal published Inherited IRAs: a Sweet Deal / A Generous Benefit for Families Survives a Senate Challenge. This is a great article that discusses the benefit of inheriting an IRA along with some of the pitfalls. But the key thing was that the article introduced me to M.D. Anderson, a tax preparer in Chandler, Ariz who has his own site InheritedIRAHell.com was kind enough to support my advice. M.D.’s response to my request for help follows:

On your reader’s question -

I will generally assume the parent or relative we lost here was older, 70.5 + older is what I will assume in this answer. If THAT is true, there is no 5 year rule but instead, the account can continue to pay out based on the life expectancy of the decedent. Disclaiming with no Contingent beneficiary other than the estate (controlled with or without a Will or Trust) has to be timely done no later than 9 months after the year of death. And, the disclaiming benificiary may not control what happens to the money as well or it would be possibly disqualified under IRS rules.
Of course if the decedent is older than 89 under the newest mortality tables, less than 5 years could apply for year left to pay out while tax deferring and if really old — well the mortality table collapses down to 1 year or less to pay tax on death benefits received.
However, if the person wasn’t yet 70.5 at death, then yes, 5 years is the longest the estate can take to pay out the funds to estate beneficiaries which I assume, are all 3 siblings. Agree, this would equalize minus fees and estate expenses, and help fund the desired result.
But adding in those Executor/trix and statutory percentage of the legal fees, you increase the loss of good money here trying to go that route along with the higher risk a disclaimer action can be questioned by later tax authorities.
So, you got it 100% right in your advice. The gifting idea may be “as good as it gets”, hoping the one designated beneficiary asking these questions isn’t in too high of a tax bracket. The net $ received defeats the stretch potential we have with properly set up inherited/beneficial IRA accounts.
M.D Anderson, InheritedIRAHell.com

Thanks, M.D. ! There are a few things to learn from all of this. If the mom truly meant to have her three children as beneficiaries of all of her assets, her retirement accounts should have reflected this before her passing. The sibling trying “to make it right” has her work cut out for her given the rules surrounding IRAs and their inheritance. The concept of the IRA and Roth IRA is pretty simple. It’s when the owner passes that things get really messy, and as Anne states above, CPAs and Tax Attorneys even have issues understanding the rules. If you have any questions or concerns regarding your IRA or Roth IRA, why not post a question at my RothMania site and I’ll answer it for you.

written by Joe \\ tags: , ,

Mar 27

Today is a special day in the world of Personal Financial Blogging. As my regular readers know, I’ve expressed mixed feelings about the Roth IRA. When I read articles telling me that a couple converted a million dollars to Roth, slamming themselves into the top bracket (35%, and possibly higher, through the effect of AMT) and then financing the tax due, I realized that some sanity was in order. Level headed discussion about how to best benefit from this type of retirement and not go too far in the other direction. I realized that far more discussion was in the future than I’d want to write in one place as I’m trying to maintain a variety of topics here. So, I planned to launch RothMania, a new blog dedicated solely to the Roth IRA and Roth 401(k) and how they can help you reduce your lifetime tax bill.

Today is the launch of the new RothMania site. Coincident to this, Jeff Rose of Good Financial Cents has coordinated The Roth IRA Movement a day in which Personal Financial Bloggers are all writing articles on the Roth.

At RothMania, to celebrate the occasion I’ll be giving away copies of Ed Slott’s The Retirement Savings Time Bomb. All you need to do to be eligible is ask your question regarding the Roth IRA.

If you are new the Roth, Let me start getting you up to speed. The Traditional IRA typically is funded with pre-tax money. If you are in the 25% marginal bracket, this means you are out of pocket $3750 in order to put away $5000 into your IRA. It grows tax-deferred, but is then taxed on withdrawal. The assumption is that you will be in a lower bracket at retirement and therefore save money. That said, the Roth IRA is the mirror image of this. A Roth lets you deposit money you’ve already paid tax on, but then the growth and eventual withdrawals are not taxed again.

That simple, Joe? Uh, hardly. You see, both flavors of IRA have Phaseouts, where for the traditional, you may not be permitted to deduct the IRA deposit from your income, and for the Roth, where you can’t deposit at all. Then there are the choices that come with being able to convert the traditional IRA to Roth, and the tax implications of these conversions. In the end, there’s no “one size fits all,” but there is a best strategy for each individual situation, and that’s what needs to be determined on a case by case basis. Let’s look at a short few examples of the IRA no-brainer, the times it’s not tough to decide what’s right.

  • You are just above the AGI limit ($112K MFJ, $68K Single) for a Traditional IRA deduction. Time to make that Roth deposit.
  • A dependent child has low income, and would otherwise have no tax due. She can deposit up to the lesser of $5000 or her total income to a Roth, and jump start her retirement savings.
  • A retiree, single, with a 2012 taxable income of $25,000. She can convert from Traditional IRA to Roth enough to get her taxable income up to $35,350. This would tax the difference of $10,350 at 15%, and avoid the potential of having ever increasing RMDs put her into the 25% bracket.

written by Joe \\ tags: , ,

Mar 01

First, what is a stretch IRA? It’s actually not an IRS term, but more like a nickname. It refers to the fact that an IRA inherited by a non-spouse can be withdrawn over the beneficiary’s lifetime. The beneficiary refers to the IRS publication 590 to find their minimum withdrawals which must be taken each year based on their age. For example, a 20 year old has a divisor of 63, which means his withdrawal is based on the prior December 31 IRA balance divided by 63 or just over 1.5% of that balance. The divisor drops by one each year, so this fellow will see that divisor drop to 25 a full 38 years later at age 58. 1/25 is 4%, so for all this time and years to come it’s possible the account will grow far faster than the withdrawals. Most important, taxes are only due on the amount withdrawn, so even a starting windfall value of $1 million requires a minimum distribution of $15,873 for this 20 year old. Now, for the news…

Just a few weeks ago, the Senate Finance Committee was reviewing a new highway bill and the committee chairman Max Baucus saw fit to tack on a provision that would eliminate the favorable terms for inherited IRAs. Spouses would be permitted to withdraw over their lifetime, as would the disabled. Minor children would also get the stretch, but older children or other beneficiaries would have 5 years to take their withdrawals. Even people of modest means could easily be thrown into the top tax bracket based on these forced withdrawals.

The story ends with good news, however. There was enough public outcry that the senate removed this provision.

I know that there’s a feeling that the inherited IRA favors the rich, but this is no different than any benefit. Mortgage interest deduction offers a higher benefit for a million dollar mortgage compared to a hundred thousand dollar mortgage. The capital gain rate assumes that one has such investments, and the rich are more likely to have stocks to take advantage of the cap gain rates. What the senate might have considered is a permanent fix to the estate tax, a reasonable exemption that most would consider fair, and as the estate includes retirement account assets, the stretch for beneficiaries can be left intact for good. It’s behind us, but only for now.

written by Joe \\ tags: ,

Feb 09

Didn’t you know? The 401(k) loan is broken. On one hand, it’s a cheap way to borrow, the rate is currently about 4%, a great way to put more return into your retirement account, as other risk free rates are far lower, but with these benefits comes great risk, the risk that if you lose your job, you have a short amount of time to replace the money or pay both a 10% penalty and tax at your marginal rate. To make matters worse, even if you change jobs, it’s quite the trick to transfer the 401(k) from the old job to the new one and take the new loan out in time to pay the old. I’ve heard of people doing it, but it’s not as easy as it should be.

I don’t view routine borrowing as something to encourage. However, as part of the big picture prudent borrowing can help jump start one’s savings. For example, a $60K earner with a newborn finds that the budget is pretty tight, and being risk averse decides his emergency funds are too low. As the wife isn’t working and may not return for a year, he decides to stop his retirement contributions. Since the first 5% of his income would have been matched, this decision to not deposit this $3000 results in a loss of $6000 for his retirement. With different loan rules, he might view the loan risk a bit differently, and keep up the deposits, knowing he’s able to borrow the half he deposited.

When it comes to the 401(k) loan, there is nothing stopping congress from passing new rules. “If separated from the employer, the plan participant’s loan payments are suspended for as long as the unemployment lasts.  When employed at a new company, the remaining balance is directly transferred along with the fact that there is a loan in place with the same terms and remaining balance as the original loan.” Congress, are you listening? What if the worker doesn’t regain employment? I’d suggest it’s bad enough to have someone out of the workforce, do we really want to chase them for the tax due on their loan?

I did one calculation, $10,000 owed to a credit card at 18% paid over 5 years will cost $254/mo. The same $10,000 taken as a 401(k) loan would be paid in 42 months using the same payment. 3-1/2 years instead of 5. And during that time, 4% going into the account instead of the sub 1% a short term government bond fund will return. In the big picture this may seem a small issue, but it’s one way those without the ability to borrow at low rates are getting the short end of the stick. On one hand, these loan are available and can be used to one’s advantage, but the flip side is the risk is too high for many. This small change can fix the 401(k) loan.

 

written by Joe