Retirement Plans For Smart People

Retirement Plans for Smart People
By Lance Wallach

Reduced values make it a great time to move dollars out of IRAs to taxable Roth IRAs. The value of the funds you move is taxable now – which means you can more easily move a greater amount of equity value.

A Roth conversion lets you prepay the taxes based on today’s low prices and at a low tax rate. Later, when investment values rise and if your tax bracket is higher, you won’t have to take minimum distributions, and you won’t pay any taxes on distributions you do take.

If you converted a traditional IRA to a Roth in 2008 when stock prices were higher, the law allows for something call a Roth Re-characterization – the equivalent of a do-over. You can undo a conversion before you file your 2008 tax return so that you won’t pay tax on value that has been wiped out by the market.

Additionally, if you’re over age 70½, normally you’d need to take a required Minimum Distribution form from your traditional IRA or 401(k) funds and report it as income. But Congress suspended the RMD for 2009 in order to help battered investors recover from the market meltdown. Without a distribution this year, there will be less tax liability as well. Seniors who don’t take an RMD this year will likely be in their lowest tax bracket that they’ll see for the rest of their lives.

If you inherited an IRA in 2008 and took distributions from it – and the person you inherited from had an estate that paid federal estate taxes – you are entitled to a major income tax deduction that’s generally overlooked by beneficiaries. It’s called the “Income in Respect of a Decedent” deduction, or IRD. You take it as a miscellaneous itemized deduction, not subject to the 2 percent adjusted gross income limitation. The IRD deduction is also exempt from alternative minimum tax.

Obama is going to raise rates on Americans. The Bush tax cuts likely will expire at the end of 2010. From an investment standpoint, this likely means higher tax rates, so think about this if you put money into retirement plans.

The Retirement Plan for Smart People

You will be faced with a problem if you are near retirement and in a retirement plan. It will cost you a lot of money, and take a lot a way from your heir’s inheritance if you retire before acting on what I have written.

People who are in retirement plans have a decision to make – to take a full pension benefit and expose their spouse to a loss of benefits at their death, or take less than the maximum benefit in exchange for continuing benefits after they die for their spouse. These are known as pension options one, two or three.

Another option clients rarely are made aware of is known as doing the smart thing.

The concept of the smart thing is easy. Let's say you are entitled to a $3,000 a month pension benefit at retirement. That's the value of your benefit and the amount you will receive under the "single life option." The only problem is that your benefits will be paid only as long as you live. At death, the pension benefits decrease to zero. That's fine if you are single, but not if you are married. Should you die first, your spouse loses $36,000 a year in income. That's why most married people select a "joint and survivor option," which pays benefits as long as either is alive. Since your spouse has a legal claim to your benefits, this is the option automatically offered by law to married retirees.

The cost of this option can be high. For example, if a joint and full survivor option is selected, that "single life option" benefit of $3,000 could be reduced by as much as $750. That adds up to $9,000 a year -- $90,000 over a 10-year period – in lost benefits. The client purchases a sufficient amount of life insurance on himself prior to retirement and names his spouse as beneficiary. The death benefit is informally earmarked to replace the lost pension benefit if he dies first.

2. At retirement, you and your wife choose to take the single-life benefit option -- receiving the maximum pension benefit for as long as you live.

3. Use a portion of the additional pension funds -- the after-tax difference between the amount for a single versus a joint and survivor benefit -- to pay the life insurance premiums. Check your pension option form and review projected benefits under the straight life option. Then check what the decreased after-tax amount will be each month to add the wife under a survivorship option. The amount of premium required to keep the policy active should be no larger than the difference between the amount for a single versus a joint and survivor benefit -- after all applicable income taxes on the pension benefits are taken into account.

An extremely critical issue that must be determined is whether or not the pension plan requires you client to select the joint and survivor option in order to continue post-retirement medical benefits.

There are some other technical problems, so an expert who does this all the time, needs to do this for you. If it is not done properly, a lot of problems can happen.

In the right type of situation with the right help, the idea of using a portion of the full pension benefit to pay the cost of life insurance premiums can potentially result in a better financial result for you, your wife and heirs.

If done properly you may receive more net monthly income after the cost of life insurance premiums are taken into account, using a single life option combined with life insurance than you would buy, using a joint life benefit option alone.

Your wife may share in the benefits. Should you die first, even though the pension stops, your spouse's income continues in the form of insurance proceeds. You can choose these insurance proceeds to be set up as an annuity -- with income benefits guaranteed for life.

Should your wife die first, your retirement benefits will continue, giving you options for the life insurance policy, including cashing in the policy, or changing the beneficiary.

If both spouses live a long time the insurance may help protect other estate assets, allowing you to pass them on to your heirs.

I set this up years ago for my parents. Unfortunately, my father died a few years after retiring and my mother got one large amount of life insurance, tax free. The pension benefit that my father was receiving was taxable. The life insurance plan, the smart plan that I had set up for my parents, was tax free. I then worked on it so that when my mother passes away it will bypass estate taxes.

Lance Wallach, the National Society of Accountants Speaker of the Year, speaks and writes extensively about retirement plans, Circular 230 problems and tax reduction strategies. He speaks at more than 40 conventions annually, writes for over 50 publications, is quoted regularly in the press, and has written numerous best-selling AICPA books, including Avoiding Circular 230 Malpractice Traps and Common Abusive Business Hot Spots. Contact him at 516.938.5007 or visit www.vebaplan.com.

The information provided herein is not intended as legal, accounting, financial or any other type of advice for any specific individual or other entity. You should contact an appropriate professional for any such advice.