November, 2009
by Dr. Thomas E. Bell, CMG Member, Michelson Awardee (Retired)
Tom received his Ph.D. in Management from UCLA many years ago, and was a consultant for about 25 years before he retired. He is a recipient of the A.A. Michelson award (in 1975), has served CMG as its Treasurer and its Secretary, and has repeatedly been on the CMG Board of Directors. He retired at the end of 2005.
About the Author
Dr. Thomas E. Bell
Last month's article dealt with the RMD (Required Minimum Distribution) that applies to tax-deferred accounts (e.g., Traditional IRAs, 401(k)s). One way to deal with the challenges of the RMD is to ignore it and hope you'll be OK. This is the way many people deal with all retirement issues, but it's a bit like taking your hands off the steering wheel while driving down the freeway. You can save some energy, but you may not like the result.
A closely associated issue is taxes. To meet the RMD in your later years (after age 76) you may need to distribute more money than you require - and to pay taxes on it. Even if the RMD doesn't get you, taxes will certainly impact you. If your saving and investment efforts are successful, you'll probably need to examine carefully what your future tax situation will be (especially if income taxes go up as I anticipate).
There are different categories of investment alternatives available to you, each with its own set of issues involving taxes. Given our uncertainty about how politicians will change the various tax provisions and rates, diversification[i] across the alternatives is needed to avoid being catastrophically impacted by any one change[ii].
Alternatives for Holding Retirement Assets
The places where you can hold retirement assets are primarily:
1. Taxable accounts, e.g., a normal personal brokerage account, a checking account, a saving account;
In addition, you do not pay taxes on the income each year. However, when you take out money (called a "distribution"), you are required to pay taxes on it as normal income. In addition, you must pay a 10% surcharge if you take a distribution before you are 59½ years old (with some exemptions).
If you have a 401(k) - or several of them at different employers - you'll probably be urged by those employers to roll over your accounts into IRAs when you approach retirement. The firms you've worked for would like to avoid any further responsibility for your retirement. Actually, it may well be in your best interest to do the roll over so you won't need to worry about what may happen if a firm goes bankrupt, gets merged with another, or gets sloppy with paperwork. In general, you can roll over a tax-deferred account (e.g., 401(k)) into another tax-deferred account (e.g., traditional IRA) without any tax consequences.
Tax-deferred accounts are the ones that must deal with the RMD (Required Minimum Distribution). You might be able to just leave your assets in a tax-deferred account and then have it go to your heirs in a "Stretch IRA" after you die. However, much of the assets may need to be distributed long before that time due to the RMD. In that case, your assets may be in a taxable account when you die and leave your heirs with a large tax bill.
The income on such accounts is added to your other income (e.g., salary) to determine how the progressive income tax is applied. However, different types of investments may have unique tax implications.
Investments in tax-exempt bonds pay interest which may not be taxed by either the State or Federal Governments, even if they are in taxable accounts. The interest rates typically paid on these bonds (usually called Municipal bonds or "Munis" because they are issued by municipalities, counties, and states) are less than paid on taxable bonds. In general, the tax-exempt characteristic only applies to residents of the state in which the bonds are issued. (Tax exemption applies to all US residents if the bonds are issued by a US territory, e.g., Puerto Rico.[iii])
Although interest is tax exempt, any profit from selling tax-exempt bonds over their purchase price is taxable. In addition, some tax-exempt bonds are subject to the AMT (Alternative Minimum Tax), so they may still impact the amount of income tax that is paid.
The interest on Federal Government bonds (sometimes called "Governments") is taxable at the Federal level, but not below that level.
Different (generally higher) tax rates apply to normal income (including short-term capital gains) than to long-term capital gains. This is irrelevant in tax-deferred accounts, but it may be very important in taxable accounts.
And on and on. These comments about taxable accounts may not apply to you due to many particulars, and they keep changing. Deciding how to make investments in a taxable account requires an extra level of analysis beyond investing in a tax-deferred account.
2. Tax-deferred accounts allow you to contribute money without paying tax on it in the year it is earned and contributed to the account[iv].
In addition, you do not pay taxes on the income each year. However, when you take out money (called a "distribution"), you are required to pay taxes on it as normal income. In addition, you must pay a 10% surcharge if you take a distribution before you are 59½ years old (with some exemptions).
If you have a 401(k) - or several of them at different employers - you'll probably be urged by those employers to roll over your accounts into IRAs when you approach retirement. The firms you've worked for would like to avoid any further responsibility for your retirement. Actually, it may well be in your best interest to do the roll over so you won't need to worry about what may happen if a firm goes bankrupt, gets merged with another, or gets sloppy with paperwork. In general, you can roll over a tax-deferred account (e.g., 401(k)) into another tax-deferred account (e.g., traditional IRA) without any tax consequences.
Tax-deferred accounts are the ones that must deal with the RMD (Required Minimum Distribution). You might be able to just leave your assets in a tax-deferred account and then have it go to your heirs in a "Stretch IRA" after you die. However, much of the assets may need to be distributed long before that time due to the RMD. In that case, your assets may be in a taxable account when you die and leave your heirs with a large tax bill.
3. Tax-Exempt Accounts (e.g., Roth IRAs) allow you to contribute to them, but you can't use your contribution as a deduction for income tax purposes; distributions are tax exempt.
For a Roth IRA or a Roth 401(k), you need to pay the income tax on the amount that you contribute. Then you may need to leave the principal in the account for at least 5 years before distributing it.
The RMD does not apply to tax-exempt accounts, so you can distribute assets on your own schedule, and without paying income taxes on the distributions. Both the income from the account, and any increase in the value of the principal, is not taxable. A series of rules applies to distributions from Roth accounts.[v] If you are considering a Roth account, I strongly recommend reviewing those rules so you can project the options open to you.
If you anticipate that income taxes will increase (as do most sentient beings), paying income taxes now instead of later can make sense, depending on your rate of return on assets and the rate of increase in taxes. In addition, you may suspect that, one day, you will die; Roth accounts provide advantages for estate planning[vi].
I haven't taken advantage of Roth IRA accounts for several reasons:
1. They didn't exist until long after I started saving for retirement.
2. I suspect that some politicians will decide (in the public interest, of course) that at least the earnings should be taxed as normal income after some selected date. Perhaps they'll also decide that taxes will need to be paid on the distributions as well (sort of like they tax our "contributions" to Social Security and then tax the benefits too).
3. A restriction has existed on converting to a Roth IRA account that limits them to couples with "Modified Adjusted Gross Income" of less than $100,000[vii]. Because I didn't plan the incomes of my wife and me (which I could have done because we own our company), we exceeded that limit.
Fortunately, the limit on Modified Adjusted Gross Income for conversions will be permanently removed on January 1, 2010 (unless the law is changed again) as will the limitation for couples filing individual returns[viii]. In addition, you can convert in 2010 and pay the taxes on distribution from a tax-deferred account in 2010, or you can spread the taxes over 2011 and 2012. If your computation of probable RMD effects shows that you need to worry, you'll have Roth IRA accounts as an alternative that may help.
The Tax Increase Prevention & Reconciliation Act (TIPRA), signed into law in May2006, removed the limitations. However, the removals only go into effect in 2010. I'm hoping that no additional law will reverse the change and limit my ability to diversify.[ix]
One of the most challenging issues for concerned people (e.g., ME) is projection of the income tax rates over the next few years. It the rates go up dramatically, the better alternative may be to take the income tax hit in 2010 or 2011/2012 to avoid a potentially larger hit later. However, note that your reported income will be much higher during a year when you do a conversion, so the tax rate on the "income" due to the conversion will likely be much higher than you have previously experienced. In addition, some exemptions may phase out so you'll end up paying even more than just the (possibly) higher tax rate for the converted amount. Finally, the rate for Medicare Part B may be higher two years[x] after the conversion (if you're over 65 and are enrolled for Part B).
4. Real Estate (e.g., your home).
You need a place to live and raise your family. And in addition, the best safe investment is California real estate.
I heard that from academicians while I was in graduate school many long years ago. A few of them seemed to recognize the boom-and-bust nature of real estate, but I had lived the roller-coaster of real estate prices as the son of a real estate entrepreneur, so I've been a bit skeptical about depending on real estate to fund my retirement. Thankfully! The prices of residential real estate have proven to be far more volatile than most people expected, and I'd be in very serious trouble if I'd placed all my retirement bets on real estate.
Nevertheless, the mortgage cost of your primary residence is deductable on your Federal income tax. If you were renting, the cost of the mortgage would not be deductible by you. Of course, there is no RMD on real estate, but property taxes usually apply.
When nearing their retirement years, a couple's need for a large house will probably decline because the kids have established their own homes. As a result, selling their expensive home and moving to a less-expensive one - or renting - may be an attractive alternative. Apparently, many people have been anticipating this action and believed that the appreciation of their homes would provide a major part of their retirement funding. Oops.
Real estate, like other assets, may decline in value. Over-dependence on this one type of asset can be dangerous to your retirement future.
Basically, there are no easy answers to what types of accounts and investments are best. You need to do your personal assessment based on your own strengths, extent of assets, years to retirement, family requirements, and probable geographic location(s). And when you've finally drawn together the data for your own assessment, you'll need to forecast what changes will likely occur in the important matter of taxes.
Possible Tax Changes
If you have some magical means to know what the politicians will do to the tax system, you can put it in bottles and sell each bottle at a huge price. We don't know which changes will actually occur, and different actions would likely be appropriate for each of the changes. It's not very safe to ignore what the current system involves because much of it will probably remain unchanged. A whole bunch of rules may be important to you, so spending a few happy hours going through IRS Publication 590 would be a good idea.
Some of the potential changes in laws and regulations important to you include the following:
1. Increase in income tax rates (does anyone believe they will decrease?);
2. Inflation (especially after 2012 when baby boomers have started receiving Medicare, lots of them are on Social Security, and the economy won't suppress inflation any more);
3. Decrease in Social Security benefits (which would increase your need for distributions);
4. Reduction of Medicare benefits (or increases in fees);
5. Changes in the rules for traditional and Roth IRA accounts;
6. Introduction of new taxes like a Net Worth Tax or a Value Added Tax.
Yes, all of this political stuff is a real pain to think about, but the Federal and State governments have a never-ending desire for increased revenue (because politicians have just so many families, friends, and contributors who want favors - as well as so many favorite causes they want to fund). If you sort of sit there and hope for the good faith of elected or appointed personnel to protect you, then you may be their favorite target. (Oh boy, here's a turkey that hasn't done anything to limit our ability to satisfy our desire for more revenue. Let's go get him.) The appendix suggests some potential changes that may occur and what they might mean.
Tax Diversification
All kinds of taxes (including new ones) may have significant changes in rates, exemptions, and applicability. In addition, changes will likely occur in Social Security benefits, Medicare benefits, and Medicaid benefits. Even extensive analysis of all the current taxes and benefits won't assure that you'll be able to find the best alternative. Instead, planning should recognize the uncertainty through diversification[xi].
If you count on a specific set of tax rates and Government benefits, you may be severely hurt by changes that are different than you anticipated. Instead, you need to diversify your holdings across tax coping mechanisms so that any one (or two or more) "modifications" to taxation or benefit availability will not destroy your retirement funding. This approach is very similar to investment diversification; you don't know which projection may come true, so you don't bet all your chips on any one of them.
Deciding to use tax diversification won't be adequate in making allocation decisions. You still need to 1) decide how much weight to put on each possible change in taxes or benefits and 2) determine whether responding to the most important changes is feasible and practical. For example, I put great weight on an increase in income tax rates for family income above $175,000 and/or significant reductions in deductions. In response to this, I want to distribute a significant portion of our tax deferred account this year (before rates go up); this is feasible. On the other hand, I expect to encounter increased limitations on my receiving benefits from Social Security and Medicare. However, I don't know many feasible actions to take, so I don't have any actions planned for that.
My Actions
The RMD and potential tax increase effects may be so compelling that I'll take the risk about politicians changing the rules on me. If I have assets in a Roth IRA account, then I don't need to take required distributions (because I've already paid the taxes), but I can't do a penalty-free withdrawal of the interest on the rolled-over money for 5 years[xii]. However, I can earn returns on those assets tax-free, at least unless the politicians decide to change that rule.
I'm tracking the politics of the situation, and I'll decide in 2010 whether a Roth IRA conversion is a good alternative; I expect it will be. The primary criteria are the tax rate in 2010 and my assessment of how much income taxes will increase. If I use a Roth IRA account in the future, I'll probably invest its assets in taxable bonds and/or equities (on which profits are otherwise taxable). If you're also considering converting some retirement assets from a Traditional IRA (or other tax-deferred account) to a Roth account, I recommend you consider the various issues carefully and get some expert tax assistance.[xiii]
In addition, I am distributing some funds (perhaps a significant amount) from our tax-deferred accounts this year and putting them into a personal (taxable) account. I'm doing it now because I suspect that we'll have significant increases in State and Federal income tax rates before long. The funds in this account are in the name of our Family Trust, and I'm hoping to put them into tax-exempt bonds. However, I may need to keep those assets in cash so I can pay the taxes on conversion of some of our tax deferred assets to Roth IRA accounts.
I'm scrambling to make decisions because the progressive Federal and State tax rates will result in a hefty tax bill if I act too fast and distribute too much value in any one year from our tax-deferred account. One of my problems was the limitation on conversion of assets to a Roth IRA, but we shouldn't have that problem starting in 2010. Even though I'm skeptical about politicians leaving Roth IRA incomes and distributions tax exempt, tax diversification pretty much dictates that I convert some tax-deferred assets to Roth IRAs unless the situation changes in the next year.
Some Suggested Actions for Younger CMGers
The driving issues in this article have been the income tax and the Required Minimum Distribution from tax-deferred accounts that can force me to distribute more than I'd like. If you have retirement assets that are not subject to the RMD, then you don't need to brood on the issue; such assets might be in pensions, in Roth IRA accounts, in taxable accounts, or in your home. If your entire tax-deferred retirement assets are less than $100,000, don't spend too much time on the topic; there are more important things for you to do.
If you have a traditional IRA or a traditional 401(k) and your retirement assets are above $100,000, here are some suggestions:
1. Practice safe tax. None of us knows what the politicians may come up with next, so we need to keep ourselves and our families as safe from excess taxes as possible. Therefore, we need to manage our retirement assets in accounts so that a dramatic change in taxation for one type won't destroy us. Keep track of what the alternatives are, at least every 5 years when you're under 50, every 3 years when you're between 50 and 60, and each year when you're over 60. To a reasonable extent, plan to use tax diversification to manage your risk.
2. Implement tax diversification. Contribute to a tax-deferred account, a tax-exempt account, and a taxable account during your working career. However, you'll get far better after-tax appreciation of your assets in tax-deferred accounts and tax-exempt accounts than taxable accounts. Your ability to contribute to different types of accounts will be dependent on changing laws, regulations, and your employer's retirement plans.
3. Compute RMD effects. Make estimates of the distribution requirement for you and your spouse at age 76 (and later) based on a guess of the amount you'll have in tax-deferred accounts at that time (probably ignoring inflation). This is really a gross guesstimate, but if the amount is much greater than you'd like to distribute, then get serious about moving assets into other types of accounts.
4. Decide when to do conversions. About 5 years prior to retirement, decide what conversions will need to be undertaken during the next 5 to 10 years. Then perform these conversions incrementally (assuming that's allowed by the law at that time). Doing these in just a 3-year period (like me) can result in higher taxes than expected.
5. Reassess estate plan. After deciding what kinds of retirement accounts will hold your assets, reassess your estate plan to make sure it deals with the results of your conversions. You probably need to obtain expert help from estate planners and estate attorneys to get this right.
6. Create spreadsheets. Keep doing retirement spreadsheets. The discipline of doing computations helps enormously in directing your attention to the most important topics.
If you'd like to email Joe Delano or me, please put [CMG] at the beginning of your Subject Line for an email. You can also call us on that old fashioned telephone. Our email addresses and phone numbers are:
joseph.delano@wellsfargoadvisors.com 800-825-9877
TBell@RivendelConsultants.Com 310-377-5441
APPENDIX
Potential Changes In Taxes & Benefits
Lessons Learned:
1. The possibility of converting some assets from traditional tax-deferred accounts to a Roth account will improve significantly in 2010.
2. Each of us needs to examine the potential revisions to Federal and State tax and benefit provisions repeatedly in order to cope effectively with changes.
3. Given the political situation, tax diversification seems well justified, and I should have done it previously.
And In Conclusion:
This final career is far more complicated than I had anticipated. To do well at it I need to function as part tax accountant, part government benefits specialist, part psychologist, part political analyst, and part predictor of the economy. To meet the job requirements I'm continually studying books, pamphlets, notices, summaries, news bulletins, newspapers, and economic assessments from the various Federal Reserve Banks around the country.
There really should be a six-month course to learn about all this stuff. If you hear about one, please let me know. In the meantime, you might look at Joe Delano's web site.
The revenue aspirations of politicians and bureaucrats will never be satisfied, even if they raise taxes dramatically. And their desire to juggle benefits to favor their own constituents, contributors, and friends isn't about to end.
Somehow, they need to control the growing deficit. All people planning for the future should identify the changes most likely to impact them and then make changes to minimize the impacts. Ignore these issues if you'd like to be a turkey ready for plucking.
An initial list of potential changes is given below - along with some comments about impacts. I make no claim that all (or any) of these will come to pass; politicians (who are far more clever about increasing taxes than I am) will probably develop other alternatives. However, if you believe that the politicians hold your protection as their primary concern, you just haven't been watching the news.
I've tested myself on the alternatives listed below by writing explanations for most of them that would appeal to populists, even though their economic justification isn't very great. However, I have no idea about whether any of them would ever get through Congress. Unless you have incredibly good insight, tax diversification is probably your best strategy.
Reduce Benefits
1. Reduce benefits by introducing monthly fees on Medicare Part A for families with gross Modified Annual Gross Income (MAGI) of more than $50,000 (above the US average) to cover 90% of their total average cost.
2. Reduce benefits by increasing the monthly fee for Medicare Part B for families with MAGI of more than $50,000 (above the US average) to cover 100% of total cost.
3. Phase out Medicare for families with MAGI of more than $250,000 with elimination of benefit at MAGI of $500,000 and above.
4. Cap Social Security benefits by making the second "bend point" go flat (no increase in benefits after that point.) An explanation of bend points is given at http://www.socialsecurity.gov/OACT/COLA/piaformula.html. This change might apply to all beneficiaries, or just to those who began receiving benefits before their "full retirement age".
5. Reduce Social Security benefits by $1 for each $3 of TOTAL income (not just earned income) received in any year. This change would impact people with pensions and retirement accounts especially hard.
Increase Revenue
1. Phase out deductions and exemptions for personal income tax when family MAGI is above $100,000; complete phase out at $250,000.
2. Increase corporate tax rates and decrease allowable deductions. This change would decrease corporate after-tax profits and drive down stock valuations.
3. Eliminate the personal capital gains tax rate and the personal dividend tax rates. Have those sources of personal income be considered normal income (with a higher income tax rate).
4. Refrain from providing another temporary "fix" to the Alternative Minimum Tax so its payment will be required by many more people.
5. Remove the limit on Social Security taxes (previously called contributions) when earnings reach $106,800.
6. Apply the Social Security and Medicare taxes to all income instead of just earned income.
7. Eliminate the non-taxable nature of Tax-Exempt Bonds.
8. Tax the income after a certain date on Roth IRA accounts.
9. Encourage defaults on municipal bonds to reduce expenses of issuers (effectively increasing the revenue that can be applied to other things like retirement benefits).
10. Introduce a Value Added Tax (VAT) as implemented in Europe. Although this is sometimes discussed as an alternative to the income tax, the worst case would implement this in addition to the current income tax rates.
11. Introduce a Net Worth Tax. (This is called a "Solidarity Tax" in France.) This might be devastating to some retirees, but the tax might exempt (perhaps) the first $250,000 or $500,000 of net worth. Even the AARP might endorse it on the theory that it is "egalitarian". This tax might be applied to all assets equally around the world, including tax-deferred accounts. Application to tax-deferred accounts would likely result in lots of people (especially those over 59½) distributing their IRAs and 401(k)s so they could avoid a Net Worth Tax on the money that will need to go to pay income tax. Therefore, the Federal Government would be able to show a huge increase in immediate revenue as people scramble to do distributions. State taxes would also go up dramatically. Who in the Government wouldn't love this result?
12. Force the incorporation of all retirement accounts into the Social Security System (in other words, nationalize all accounts and replace their assets with Social Security bonds as in Argentina).
[i] "Tax diversification" means investing in several ways that have different tax implications. "Tax diversity" usually means having tax accountants of different races, creeds, and colors.
[ii] If you want (or need) to examine the current tax rules involving retirement accounts, you can go to the following URL: http://www.irs.gov/pub/irs-pdf/p590.pdf
[iii] If you're interested in how this came about, you can look in at page 22 of a pamphlet published in 1921 by Hoffman and Wood titled "Taxation of Federal, State, and Municipal bonds". It can be found at the following URL: http://www.archive.org/stream/taxationoffedera00hoff#page/n1/mode/2up
[iv] In addition, contributions can be made to non-deductible IRAs, and after-tax contributions can also be made to traditional IRAs.
[v] An article titled "Roth Distribution Rules Fact Sheet" is provided on Joe Delano's web site. Its URL is: http://www.josephdelano.wfadv.com/
[vi] An article on Joe Delano's web site titled "Reasons why you may consider a Roth Conversion" explains the estate planning and other advantages of Roth accounts. The URL of his site is: http://www.josephdelano.wfadv.com/
[vii] Other limitations continue to exist, including income and maximum contributions. Before implementing any plans to use Roth accounts, check with an expert to make sure you don't violate the rules.
[viii] A description and discussion of the changed rules provided by The Wall Street Journal can be found at the following URL: http://online.wsj.com/article/SB10001424052970204612504574193480955034164.html
A short summary is given at the following URL:
http://mentoradvisors.com/articles/tax-planning/tax-diversification-made-easier-by-new-tax-law
[ix] Of course, conversions from traditional IRAs to Roth IRAs require paying the income tax, and the additional reported income may be at a higher income tax rate than otherwise would apply.
[x] The rate for Part B is dependent on the income you reported on the last available return. If you convert in 2010, the higher income will be reported on your 2010 income tax return that is filed in 2011. Therefore, your Part B rate will be higher in 2012.
[xi] Many articles have appeared discussing tax diversification. The URLs of a sample are as follows: http://www.businessweek.com/magazine/content/08_06/b4070070804443.htm http://www.thetaoofmakingmoney.com/2007/05/29/381.html http://spwfe.fpanet.org:10005/public/Unclassified%20Records/FPA%20Journal%20December%202007%20-%20Focus_%20Tax%20Diversification.pdf http://money.cnn.com/2004/03/25/retirement/investing_taxes_0404/index.htm http://findarticles.com/p/articles/mi_hb5248/is_37_25/ai_n31444114/ http://www.nagdca.org/content.cfm/id/contributor22007when_discussing_financial_diversity_with_your_adv...
[xii] If you're under age 59½, you'll need to wait until you reach that age for a penalty-free withdrawal of income from a Roth account.
[xiii] In addition, you might read the article titled "Roth IRA Conversion" on Joe Delano's web site at the following URL: http://www.josephdelano.wfadv.com/