Financial Frontlines ™

In 2010 the IRS will remove the income limit on conversions from Nondeductible IRAs and Traditional IRAs to a ROTH IRA. We anticipate the tax law change to create a marked increase in conversion activity in 2010. Undoubtedly, savvy individuals and investment managers will take advantage of this opportunity to insulate themselves and their clients against possible future higher income tax rates. Previous to 2010, households with Modified Adjusted Gross Income (MAGI) exceeding $100k were ineligible to make conversions to ROTH IRAs. This change is welcomed news for those households who have been unable to invest in deductible Traditional IRAs or ROTH IRAs due to income limitations.

The Tax Increase Prevention and Reconciliation Act of 2005, signed into law on May 17, 2006, created the loophole which takes effect in 2010. To demonstrate the potential benefit of this loophole, a previous ineligible household who has not made contributions to an IRA this year could ultimately fund a ROTH IRA with $20k by April 15, 2010. That number increases to $24k for qualified wage earners, married filing jointly, and at least 50 years old. How can this be done? It’s really a simple process. First, establish a Nondeductible IRA and contribute $5k for each spouse for 2009 and again in 2010, then convert the balance into a ROTH IRA in 2010.

Washington’s unabated printing of the U.S. Dollar is setting the stage for future income tax increases. Policy makers have already zeroed in on those earning $250k/year and we anticipate that number to creep lower as spending continues and the deficit surges. The federal debt for Fiscal Year 2009 was $1.4 Trillion. Enacting a conversion strategy now and in future years (until Congress changes the law) enables investors to keep more of their hard earned money as converted ROTHs will provide tax free growth and tax free distributions (as long as distributions are qualified).

Conversions of Traditional IRAs to ROTHs may also be a timely option for those impacted by the current economic downturn. Individuals who have seen a drop in their personal income can benefit from converting their Traditional IRA to a ROTH in 2010 as well. Reduced income levels and low current tax rates equate to a lower tax bill if converted now as opposed to the future when personal incomes recover and tax rates increase. In addition to personal income levels, many retirement accounts have also seen a significant drop in value. Converting now makes sense, as lower current account values translates into lower tax liabilities. The market has rallied nicely this year and as it continues to recover and account balances increase all the gains made over the ensuing years will be tax free when withdrawn as qualified distributions. As if it couldn’t get any better, the IRS is providing an additional benefit in 2010 by extending the timeline for payment of taxes.

Conversions completed in 2010 can be paid over a two year period, reducing the immediate income tax burden for those who convert. This can help offset cash flow concerns for investors in these tough economic times. Understanding the three possible taxation methods is critical and must be reviewed to ensure proper calculation of tax liability. Taxation is based on the type of IRA accounts you own, Nondeductible, Traditional or a combination of both.

1. Investor owns only a Nondeductible IRA: Taxation is based on the gain above contribution. If the investor previous to this year did not own an IRA, he could apply the strategy outlined in paragraph two and incur only a minimal income tax liability, (gain above contribution) while fully funding a ROTH IRA for 2009 and 2010. This is a significant benefit for those who were previously ineligible and made no prior IRA contributions.
2. Individual owns only a Traditional IRA: The entire conversion amount is taxed at their income tax rate.
3. Individual has both a Traditional and Nondeductible IRAs: The balances of each type of account must be aggregated to determine the applicable income tax liability. Example, if an individual has $20k in Traditional IRAs and $10k in Nondeductible IRAs, 2/3 of the conversion amount would be subject to the individual’s income tax rate.

The decision of converting a Nondeductible and/or Traditional IRAs to a ROTH IRA is one that must be analyzed. There are numerous assumptions and planning factors that should be considered to make an informed decision. If one can foresee the future and know that they will be in a higher tax bracket in retirement then the tax free growth and tax free qualified withdrawals are a convincing option for conversion. One should thoroughly research the 2010 conversion tax laws and assess their personal circumstances prior to making a decision and/or seek professional assistance.

• Typically conversions will benefit those who anticipate being in a higher tax bracket in retirement
• IRA Conversions which have not been taxed are includible in your gross income in the year of conversion (Taxes on conversions made in 2010 can be paid over a 2 year period)
• If funds are not available to pay the taxes it is not advisable to use retirement funds to pay the taxes
• You MUST submit IRS Form 8606 for Non-deductible IRA contributions each year a contribution is made
• Converted ROTH can play an effective role in Estate planning for taxes and minimum withdrawals

A perennial estate planning horror story is the one in which a man dies before revising his will leaving everything to his ex-wife instead of to his current spouse as he intended.  While none of us would allow this to happen, we could have other potential horror stories lurking in our retirement plans.  

 Beneficiary designations should be reviewed annually and updated whenever there is a significant “life event” such as birth, death or divorce.  That single document is more powerful than you might think because it can override the instructions in your will or trust.  Your plan administrator is responsible for maintaining these instructions but paperwork can get lost and what counts is the physical document itself not the electronic entry on a computer screen.  That is why you should keep an updated copy with the other important papers your executor will need.  

 Who you name as beneficiary is another important consideration.  Naming your estate or trust as beneficiary may not be the best choice since it can force heirs to take taxable distributions they might otherwise defer.  Naming a contingent beneficiary can be another important estate planning tool.  These issues are best discussed with your attorney. 

 While updating legal documents may be inconvenient it isn’t a whole lot of work.  More importantly, it is one more way to take care of your heirs.

Some of our most cherished family possessions are those that have been passed down, generation to generation. An old pocket watch or military decoration may not possess any intrinsic value but it can be a priceless memento of a beloved relative. Unfortunately sentimental value can be misapplied.

Take, for example, inherited shares of stock. The deceased may have been a savvy investor or may simply have acquired shares from his employer. How or why he bought the shares may have been important at one time, but no longer.

His heir has now become an “accidental investor.” It is doubtful that this heir would have chosen these shares on his own. In fact, it is likely that he has very different investment objectives than did the deceased. Elderly investors generally own income-oriented investments which are appropriate for their circumstances but are really not suitable for younger investors who can benefit more from growth-oriented securities.

Nevertheless, having inherited these shares, some people mistakenly begin to treat these securities like family heirlooms. There have been times when I have advised clients to sell inappropriate investments only to hear “Aunt Minnie left those shares to me so I could never sell them.” But if I asked if that would also apply to Aunt Minnie’s 2% passbook savings account the answer was generally “of course not!”

Sentiment has its place but not when it comes to investments.

I was recently asked to help an elderly couple find an estate planning attorney and to accompany them to the meeting to draw up the Will.  I did some checking around and found someone who could help them.  Their estate was relatively simple and they wanted to leave everything to each other and then when the second spouse passed away to distribute the estate to their children and grandchildren.  The attorney drew up the Will and the couple signed it.  Not that different from what many of us would do.

I asked the couple if I could look through their assets to make sure everything was o.k.  This is when I discovered they had a potential problem.  Even though they intended to leave everything to each other, their liquid assets (bank savings accounts and US Savings bonds) which were the majority of their non-real estate portion of their estate were held in joint tenancy with one spouse and one of their children.  For example, one savings account was a joint account with husband/father and son.  The couple did this so that the son could access the money if the husband was incapacitated.  However, this arrangement did not meet the couple’s goal to leave everything to each other.  Assets held in joint tenancy do not transfer in accordance with the Will, but become the property of the joint tenant.  This would mean that the surviving spouse (wife) would not inherit the funds but the joint tenant (in the example above the son) would.  This could put the surviving spouse (wife) in a difficult financial situation.  I immediately notified them of my concern and they started to rectify the problem.

Unfortunately, the husband died before all the assets could be re-titled.  The good news is that the children were informed of the intent of the couple and they are supporting that intent by a gifting program back to the surviving spouse, so in this case it turned out o.k.

There is a lesson here for all of us.  Check how your assets are titled and make sure that your Will and titling plan complement each other.  Remember, your Will only disposes of assets that you “control” such as those owned “fee simple” (like a car titled in your name only) or tenancy in common (similar to a partnership where you control your portion of the asset).  If joint accounts or joint tenancy with right of survivorship (JTWROS) assets are shared with someone other than who you want to inherit the asset it is time to take action to change the account ownership arrangement.

As an investment adviser, it concerned me when survivors were left unaware of their financial state of affairs or without the ability to manage their financial obligations.  The surviving spouse is suddenly at the mercy of someone else to manage the finances.  A spouse relying on someone else whether family or stranger makes for uncomfortable or risky partnerships.  Many spouses I worked with were sensitive about being perceived as a burden or felt foolish about being so uninformed about their own business.

To illustrate my point, I have known survivors who knew absolutely nothing about their family accounts.  Some couldn’t write a check or pay a bill.  One survivor thought that $200 in a checking account would last indefinitely as long as each check written was for less than $200.  These were intelligent people.  It was just that they didn’t get involved for whatever reason or weren’t allowed to get involved.

So now I ask, does your spouse know about your family financial programs and how to manage those programs?  You know…things like sources of income after you are gone, banking and investment accounts, paying bills, insurance policies, credit cards, wills, etc.

Please get your spouse involved in your financial situations enough to handle the basics and be a savvy consumer.  Train him/her if you have to.  You don’t want to cause a hardship after your death because you didn’t involve your spouse in your family finances.  At the very least, appoint a financial manager to run things after you are gone and introduce your spouse to the person.  Share the master financial game plan.