As Goes California, So Goes the Nation?

For better or worse, California is known as a trendsetter. From cool cars to the Beach Boys to legalized pot growing in Mendocino County, California often leads the rest of the country in new directions. But the other day, I came across a poll of California voters age 40 and older on long-term care published by UCLA that got me thinking: Were Californians exposing a problem that other Americans ignore? Let me give you some highlights:

• Fifty-seven percent say they could not afford more than three months of in-home care. One in three say they could not afford even one month of in-home care.
• Sixty-six percent say they could not afford more than three months of nursing home care, while 42 percent say they could not afford even one month of care.
• Thirty-five percent of Republicans, 38 percent of Democrats and 26 percent of independents say they would not be able to pay for even one month of in-home personal care; 43 percent of Republicans, 48 percent of Democrats and 33 percent of independents say they could not afford even one month of nursing home care.
• Only 15 percent report having long-term care insurance.
• Just 20 percent were aware that Medicare does not cover ongoing in-home personal care; similarly, only 30 percent knew that Medicare does not cover prolonged nursing home care.
• Ninety-five percent say they prefer having affordable care options in the community in order to avoid going to a nursing home.

You can click here to read the complete findings. So what should all this mean to other Boomers? You need to ask yourself: Are you as ill-prepared as these Californians, but you stick your head in the sand? You better have a plan of action in case your health changes during retirement, which it almost certainly will. Otherwise you could end up somewhere you don’t like and be flat broke, too. Best wishes, George P.S. To understand your options, check out my book A Boomer’s Guide to Long-Term Care.

How to Avoid the 10% Penalty on IRA Withdrawals

Are you under 59½ and considering an early retirement? So what’s holding you back? Is it because the majority of your money is tided up in your IRA, and you don’t like the idea of paying the 10% penalty for early distributions? There might be a way around that … IRS Rule 72(t). Section 72(t) of the Internal Revenue Code allows taxpayers of any age to take a series of substantially equal periodic payments without a 10% penalty. The payments must continue for five years or until you reach 59½, whichever period is longer. While you’re receiving the money, you cannot make any changes to the payments. Each IRA stands on it own, meaning that taking 72(t) distributions from one account has no effect on the others. Therefore, if one IRA will produce more income than is needed, you could set up a smaller, segregated account to withdraw from. And in the future, if you need more income, you could begin equal distributions from another account as well. This could provide greater flexibility in meeting your immediate and future income needs. There are three ways to calculate 72(t) distributions:

• The Minimum Distribution Method is calculated the same way as required minimum distributions when account owners reach their required beginning distribution date. This method will generally produce the lowest annual 72(t) payments since it is based on the longest life expectancy.
• The Fixed Amortization Method consists of an account balance amortized over your life expectancy. Once an annual distribution amount is calculated under this fixed method, the same dollar amount must be distributed in subsequent years. This produces higher payments than the Minimum Distribution Method and gives some security in that the payments are fixed. But the calculation is complicated and there is the risk that the payments will not keep pace with inflation.
• The Fixed Annuitization Method consists of an account balance, an annuity factor, and an annual payment. Once an annual distribution amount is calculated under this fixed method, the same dollar amount must be distributed under this method in subsequent years. This method may at times provide the largest payments, depending on the size of the account and interest rates used. And like amortization method, the payments are fixed.

Is taking advantage of Rule 72(t) a good idea? It could be. After all, it gets you out of paying the 10% penalty. But remember: You’ll still have to pay ordinary income taxes on the distributions, and money you withdrawal from your IRA means that much less for your future needs. And in case you don’t stay with the plan, or modify the payments in any way, you will no longer qualify for the exemption from the 10% penalty. Furthermore, the 10% penalty will be reinstated retroactively, to all prior years.

So before you take advantage of Rule 72(t), I suggest you get a second or even third opinion before signing on the dotted line. Best wishes, George

Reader with 401(k) question …

A reader sent in a question about his 401(k) plan that I think is worthwhile passing on … “Hi George, I am looking forward to retiring in the next 1-2 years. I have a 401(k) with my former employer, another 401(k) with my current employer, a small cash balance plan pension fund with my current employer, and an IRA into which I rolled my prior cash balance plan into. “My former employer’s 401(k) plan requires that I come up with a distribution plan of equal annual distributions, or take the entire amount in one distribution. “So now, I’m trying to determine the most rational way to take those distributions, such as rolling it all into my IRA, or to do a series of (say, 10) annual distributions into my IRA. “It is my understanding that I can take the distributions from my IRA at any time, in any amounts, as long as I begin the required minimum distributions (RMD) when I reach 70½. Therefore, by moving the money in my 401(k) to my IRA, I gain flexibility in the amount I take each month, and am not stuck being required to take more than I need because of a prior distribution election Am I thinking right? “If not, what is the right way to deal with these various accounts and allow myself flexibility in how I take distributions as the years go by? Please help! Thanks! Brian” Here’s my answer to Brian: To me, it looks like the simplest solution is to just move all the funds from the 401(k) into your IRAs. That could reduce the number of accounts to keep up with and give you the most flexibility as time goes on. So as far as I’m concerned, I'd say that you're thinking is right on. Good luck! George

Don't Forget to Use Your Passive Real Estate Losses!

Like me, some readers must finally be getting around to working on their 2009 income tax, because I’ve have several questions recently about passive losses, particularly on real estate. First of all, you cannot deduct every dollar you lose on a passive activity from your other income, such as salary and dividends. The IRS plugged that hole shut back in 1986. Generally speaking, you can only deduct passive losses against passive income. For example, passive losses you have as a limited partner in an oil drilling venture could only be used to offset passive income you might receive from another passive investment, like a windmill farm. And if you have no passive income, the losses could be used against any future income you might receive from the partnership. However, there is an exception for individuals who actively participate in passive real estate investments ... Rental real estate losses up to $25,000 may be deducted if your modified adjusted gross income (MAGI) is less than $100,000. To qualify for this offset, you must actively participate — meaning you make management decisions — own at least 10% and not be a limited partner. The $25,000 exception is phased out at the rate of 50 cents for every dollar of MAGI over $100,000. Suppose your MAGI is $110,000. The $25,000 allowance would be cut by $5,000 to a $20,000 maximum allowance. When MAGI exceeds $150,000, the $25,000 offset is not allowed Any of your passive losses that are disallowed can be carried forward indefinitely until there is passive income to offset or you sell the property. Like everything else in the IRS code, there’s a boatload of exceptions when it comes to passive income and losses. A big one is that real estate professionals don’t have to worry about the MAGI limitation. But if you’re like many investors, you probably have a rental property or two and want to make the most of any tax breaks. So be sure not to miss out on this one! Best wishes, George

Annuity Income and Tax on Social Security

A reader sent in a question about how annuity income could affect his tax on Social Security benefits: “George, I’m considering purchasing an immediate annuity. I’m 81 years old and in excellent health. The funds would come from my IRA, so I would not receive the tax break from the exclusion ratio. “I am considering this purchase because I’m currently drawing out about $1,400 a month from my IRA, or about $16,800 a year. This is affecting the tax on my Social Security income. What I don't know is if the payout from the immediate annuity would be included in the calculation of income in terms of calculating my Social Security tax? “I am aware that I’d have to pay ordinary income on the funds received. The payout on the annuity is $517 per month for life, so it reduces my income by about $10,000 a year. The question is: Will I have to include the annuity income in my Social Security calculations. “Thanks so much for any thoughts you have on this matter.” My answer: “You are correct in saying that the annuity would not qualify for the exclusion ratio since the money is coming from your IRA. And since all of the annuity’s income is taxable, it must be included in the calculation to determine how much of your Social Security benefits are taxable.” Many boomers entering retirement are not aware that their Social Security benefits could be taxable. This can apply if you are single and earning at least $25,000 a year or married and earning $32,000 or more. Earnings include one-half of your benefits and all other income, including tax-exempt interest. So before you make the decision to start taking Social Security, make sure you understand how much of those benefits will be taxable. For information, go to IRS Publication 915. Best wishes, George P.S. I’m now on Twitter. Follow me at http://twitter.com/efinancialwrite for frequent updates, personal insights and observations on how to have a healthy retirement.

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Have You Ignored this Piece of Your Retirement Plan?

Do you keep up-to-date with your retirement plan? I’m speaking of plans like your 401(k) and IRA. Hopefully you’re on top of the investments in the accounts and not just tossing unopened, quarterly statements in a dresser drawer. There is, however, an aspect of these plans that even many savvy investors completely ignore after the accounts are opened. And that is: What happens to the money when they die. Will yours go to your spouse … an ex-spouse … your children? And if no one is named, it could end up in your estate. Then the state will hand it out as they see fit. That’s why the account beneficiary form is one of the most important forms you should review regularly. Particularly, if there has been a big change in your life. And the best part is that unless you need special legal advice, it doesn’t cost you a single penny to make changes. For instance, have you recently divorced, gotten married or both? Imagine the turmoil if your ex-spouse inherited your IRA instead of your new bride? I saw that happen to a friend on mine ... He went through a long and tumultuous divorce. Then got remarried. He changed his will and trust documents, but didn’t bother with his IRA, which was in the seven figure range. Apparently he though it was covered through the will or trust. Poor guy died. Guess who ended up with the IRA? His ex-wife and her children from a prior marriage! His new wife took the issue to court … and lost. What about children or grandchildren, any new ones? Or have any become compulsive shoppers and now have bill collectors hounding them day and night? You might have to set up special provisions for them, such as a spendthrift trust, so creditors can’t get at any of their inheritance. Have any of your beneficiaries died? If so, you should name replacements. Maybe now you have a favorite charity you’d like to help out. Updating your IRA beneficiary form to leaving it a piece of your IRA is a simple way to accomplish that. Do you have minor children named as beneficiaries? Who will receive the money on their behalf? Is that person still available? And suppose one of your adult children dies before you. Does your beneficiary form use the “per stirpes” language, which passes the deceased child’s portion to his or her children? Or will it be divided among your other children? You might want to double-check the documents. What about estate and income taxes. IRA and other retirement plan assets will be included in your taxable estate. And estate taxes are due nine months after you die. Have you discussed with your beneficiaries how to come up with the cash to pay those taxes? Income taxes can often be spread out over the beneficiary’s life expectancy. However, your beneficiaries must know how to take advantage of this provision. Otherwise, they could face a huge tax bill. Finally, does anyone know where you keep important papers, like your will and deed for your home? If so, you better put a copy of the beneficiary form there, too. Nothing is static in today’s world. Not the tax laws, not the investments inside your retirement accounts and certainly not your personal situation. So for your love ones’ sake, be sure to keep on top of your beneficiary designations. Best wishes, George

Five Questions to Ask Before You Convert

There’s a good chance you’ve been given a pitch to convert. No, not to some off-the-wall religion or cult, but by your financial advisor, insurance agent or broker to move your traditional IRA to a Roth IRA. And this can be a good thing ... After all, once your money hits the Roth you and your heirs will never have to worry about paying income taxes on it again. Plus unlike a traditional IRA, you won’t have to hassle with required minimum distributions beginning at 70½. So what’s not to like! One obstacle is that you’ll have to pay income tax on the amount you convert. That means, for example, coming up with $25,000 on a $100,000 conversion assuming you’re in the 25% tax bracket. But if you think you’ll be in a higher bracket when you retire or rates will go up in the future, paying the tax now could be a good choice. Think about your kids, too. Will they be in a higher bracket years down the road? Also, where will you get the money to pay the tax if you do convert? Your IRA custodian will ask if you want tax withheld from the distribution. This is generally a bad idea because you’ll end up paying taxes on those dollars, too. Moreover, it reduces the amount available to grow tax-free inside your Roth. A much better idea is to use money from outside your traditional IRA, such as from a money market or savings account. The second obstacle is dealing with the unknown ... How much do you trust Congress? Do you think they’ll revoke the tax-free status of Roths after they pocket the tax dollars you’ll fork over when you convert? The $1.4 trillion deficit they’ve rung up for 2010, plus $109 trillion Washington has promised to pay in Social Security and Medicare benefits, should be a clear warning that higher taxes are ahead. Already, House Majority Leader Steny Hoyer (D-MD) told reporters that raising taxes on middle class families will be necessary to tackle the debt. So where does this leave you if you’re thinking about converting? Consider these five points … 1. Do you have non-IRA money available to pay the taxes for the conversion?

2. Will your tax bracket be higher when you retire?

3. Is your beneficiaries’ tax bracket higher than yours?

4. Do you think Congress will raise income taxes in the future? What about your state taxes?

5. Do you think Congress will double-cross voters and tax Roths? If you answer “yes” for the first four questions, you’re probably a good candidate for a Roth conversion. It could pay off big time for you and your love ones. And if you answer “yes” for #5, then a Roth and any other tax-favored investment might be off the table for you. Best wishes, George