Problems with Converting to a Company-Sponsored Roth

Are you still considering converting pre-tax retirement money to a Roth? I wrote about this back in July. There’s another incentive Congress has given to get taxpayers to convert and thereby boost tax revenues … The Small Business Jobs Act of 2010 includes a provision that allows certain 401(k) and 403(b) participants to convert their plan funds to a Roth 401(k) or Roth 403(b) within the plan. Money you convert in 2010 will be eligible for the same tax option as IRA conversions made to a Roth IRA. That means you can split the tax liability over 2011 and 2012. And once you convert you or your beneficiaries will never owe income tax on that money, or the earnings! All of this sounds pretty good. After all the way I see it, taxes are almost guaranteed to go up in the future. So if you can get the tax bill out of the way today while rates are relatively low, you’ll have more to spend when you retire. Plus if you can do it with money that’s in your company-sponsored retirement plan, it looks like a good deal. Right? Well … there could be problem. You see, there are three obstacles you must overcome to take advantage of the tax provision. And even if you get around them, you might find you’d be better off moving the money outside your employer’s plan. Obstacle #1 Your 401(k) or 403(b) has to offer a Roth option. Unfortunately, not many do. Obstacle #2 Does your company’s plan allow in-plan Roth conversions? Your company might be reluctant to take on the additional recordkeeping that’s required. Obstacle #3 Are you eligible to take a distribution from the plan? You just can’t move money from a pre-tax plan to a company-sponsored Roth without taking a distribution. And for most plans the only time you can take a distribution is after you leave the company. So you need to see if you can access your funds while you’re still working. If find, though, that one or more of the above obstacles prevents you from converting a 401(k) to an in-house Roth, all is not lost … You can still transfer money from the company plan to your IRA. Once it’s in your IRA, you simply convert it to a Roth IRA and pay the income taxes as discussed above. And like a company-sponsored Roth, you’ll never have to worry about paying income taxes on that money again. After all is said and done, which is better: A Roth option within your 401(k) or a Roth IRA? Although an in-house conversion could be easier and you get to keep the money with your company, an in-house Roth might not offer as many investment options as you might want. But a bigger concern is that the tax provision does not allow you to re-characterize (undo) a conversion. Therefore for example, if you convert and then realize you don’t have the money to pay the additional income tax, you’d be in a heap of do-do. The bottom line: If you want to move 401(k) pre-tax funds to a Roth, you’re probably better off going to a Roth IRA rather than an in-plan Roth. Best wishes, George

Tax Regulation Makes LTCI More Affordable

Are you reluctant to buy long-term care insurance (LTCI) because it’s not exactly cheap? Or maybe you might not like the thought that if you don’t use the insurance, you’ve wasted your money. However, without some kind game plan, a change in your health could wipe you out! Well, thanks to the IRS, you might be able get a policy while still accumulating bucks for the future. It starts with a fixed, deferred annuity (FDA). Money you put into one of these annuities accumulates tax-free until you withdraw it. When you make a withdrawal, part it is considered a return of your original investment, thus comes out tax-free. The rest is considered earnings and taxed at your ordinary income tax rate. As you can see then, FDAs can be a valuable way to put away money for retirement, much like an IRA. Now, back to LTCI … The Pension Protection Act of 2006 includes two provisions regarding FDAs, life insurance and LTCI that took effect January 1, 2010: 1. Money you withdraw to pay LTCI premiums is distributed free of taxes, therefore your after-tax cost for the policy could be less. 2. Money you transfer directly from an annuity or the cash value in life insurance to pay for long-term care insurance is not taxable. Insurance companies were quick to jump on the second provision by introducing FDAs with a LTCI rider. Very simply here’s how they work: Suppose, for example, you put $50,000 into a FDA. And let’s assume it’s designed to pay you up to 300% in benefits. That means you’d have $150,000 in coverage from day one without paying LTCI premiums. And if you never have to use the benefit, your $50,000 continues to grow tax-deferred. Of course, this perk comes at a cost, which is a reduction in the interest rate you’ll receive on the amount you pay in. So be sure to ask your agent for the details. But at least now you have a basic idea of two more ways to protect your nest egg and leave something for your love ones. To learn more about the many options available to help plan for long-term care expenses, be sure to check out A Boomer’s Guide to Long-Term Care. Best wishes, George

Costa Ricans Squash Border Problem … Without U.S. Help!

I just returned from Costa Rica. This time I went south to the San Isidro area. Beautiful mountains, gorgeous beaches, and friendly Ticos. But I got to witness something that many visitors might not appreciate. There was a clash on the Nicaragua border. It seems that a big-time, Nicaraguan landowner was starting to dig a trench onto a Costa Rican’s property. And apparently he had enough influence to get some soldiers to give him a hand. I won’t go into the details. You can read more here if you’re curious. I can tell you this though: All the locals I met were furious. The reporting was nonstop on TV. After a day or so of negotiations, it didn’t look like this was going to get resolved. And I envisioned that the U.S. would get dragged in one way or another. Then on Friday I watched on TV as Costa Rican police loaded planes and headed to the border. Well, sure enough, they settled the issue and sent the Nicaraguans packing. What impressed me is that Costa Rica hasn’t had a military since 1948! A point most Ticos are very proud of. However, they do have police force, which despite being underpaid and under-equipped, is not afraid to act when needed. And they took care of what could have become a huge international crisis without us sticking our nose into it. Best wishes, George

Congress Wimps Out

Well, no doubt our Congressional members are worried about keeping their jobs. So they decided to sweep important tax issues under the rug until after the mid-term election next month. Then, of course, we’ll have the holiday recess. And hopefully a lot of new cast members. I wouldn’t expect income tax, estate tax and alternative minimum tax to come to anyone’s attention until well into the first quarter of 2011. Congress did, however, pass the Small Business Jobs Act of 2010 before hitting the campaign trail. Here’s a quick overview of a few points that might touch your wallet: Employee cellphones — If your employer provides you with a cellphone, you’ll no longer have to deal with the recordkeeping nightmare of logging your personal cell use. Roth 401(k) plans — You can now transfer 401(k) money into a Roth 401(k) plan. You’ll have to pay income taxes, but Roths allow tax-free buildup and tax-free withdrawals. And if you make the switch this year, you can defer the conversion income taxes into 2011 and 2012. The catch is that your employer's plan must allow for such Roth accounts. Annuity payouts — If you own a tax-deferred annuity outside of a retirement plan, you can now break out part of that money to provide a steady income. The balance will continue to grow tax-deferred. For instance, suppose you have a tax-deferred annuity that’s worth $100,000. And maybe you only need enough income each month to pay for long-term care insurance. You could ask the annuity company exactly how big of a lump sum would you need much to generate $xx a month for the rest of your life. Let’s say it’s $25,000. That amount will set you up with the ongoing income you want and the remaining $75,000 will stay in the original account for you to use in the future. Rental expenses — Those of us with rental properties now have one more government-induced aggravation to deal with. Starting in 2011, we’ll have to fill out 1099’s for anyone who does more than $600 in work for us during the year. Landscapers, plumbers, painters are among those who will have to give you Social Security numbers so you can report the income to the IRS. So you better make sure they’re legal residents with valid Social Security numbers before hiring them. What’s in store for us when Congress gets back to work in January? I place my bet on higher taxes for all. And even if Congress refuses to boost taxes or cut expenses, state and local governments are swimming in a sea of red ink. Good luck! George

How to Pull Some New Life Out Of Old Life Insurance Policies

Do you own any life insurance policies that have outlived their usefulness? It could be a universal life policy that has very little cash value. Or you might have a term policy that is about to renew, but the new premiums are out of reach. And of course, there’s always the possibility you no longer need the insurance. Rather than letting those policies just lapse, there could be some tax benefits that could possibly translate into more income for you or your beneficiaries. One idea worth considering is a 1035 Exchange on the life insurance policy to a tax-deferred annuity. 1035 refers to a provision in the tax code that allows for the direct transfer of accumulated funds in a life insurance policy or annuity to another life insurance policy or annuity without creating a taxable event. For example, let’s say you own a life insurance policy you no longer need. Over the years you had paid in $100,000 worth of premiums, and now it has a $20,000 cash value. Meanwhile, you’ve been looking for a way to get some income sometime in the future. You may think that there couldn’t be much of a benefit if there’s very little cash value in the policy. But for tax purposes, the amount transferred is actually the cost basis. In the above example, since you had put $100,000 into the life insurance and it’s only worth $20,000, you have an $80,000 loss. By using the 1035 Exchange, you’ll increase the annuity’s cost basis from $20,000 to $100,000. This means when you or your beneficiaries make withdrawals, an additional $80,000 of growth will come out income-tax free. The IRS has more info on its Web site. Just click here and insert 1035 Exchange in the search box. Nevertheless, before you take this route, go over the strategy with your advisors. Good luck! George

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