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Dear Liz: I am a CPA and fairly knowledgeable about investing, but I have a question about my IRAs. I am 58 and my husband is in his mid-80s. We both are retired with federal pensions and no debt other than a mortgage. My plan is to start taking money annually from my traditional IRA in two or three years. I want to reduce the required minimum distribution I will need to start taking at age 701/2 and lessen the tax impact at that time. Should I put these annual withdrawals in my regular investment account or should I put them in the Roth IRA? My goal is to lessen the tax impact on my only child when he ultimately inherits this money. Does my plan make sense?
Answer: Your letter is proof that our tax code is too complex if it can stymie even a CPA. Still, it’s hard to imagine any scenario where you’d be better off accelerating withdrawals from an IRA and putting them in a taxable account.
A required minimum distribution “is merely a requirement to take the money out anyway,” said Certified Financial Planner Michael Kitces, an expert in taxation. “All you’re doing by taking money out early to ‘avoid’ an RMD [required minimum distribution] is voluntarily inflicting an even more severe and earlier RMD on yourself.”
In other words, you’d be giving up future tax-advantaged growth of your money for no good reason.
What might make sense, in some circumstances, is moving the money to a Roth. You can’t make contributions to a Roth if you’re not working, because Roths require contributions be made from “earned income.” What you can do is convert your traditional IRA to a Roth, either all at once or over time. You have to pay taxes on amounts you convert, but then the money can grow tax-free inside the Roth and doesn’t have to be withdrawn again during your lifetime, since Roths don’t have required minimum distributions. Whether you should convert depends on a number of factors, including your current and future tax rates and those of your child.
“In other words, if your tax rate is 25% and your child’s is 15%, just let them inherit the [traditional IRA] account and pay the lower tax burden,” said Kitces, who has blogged about the Roth vs. traditional IRA decision at http://www.kitces.com. “In reverse, though, if the parents’ tax rate is lower … then yes, it’s absolutely better to convert at the parents’ rates than the child’s. In either scenario, the fundamental goal remains the same — get the money out when the tax rate is lowest.”
If you do decide to convert, remember that the conversion itself could put you in a higher tax bracket.
“It will be important not to convert so much that it drives up the tax rate to the point where it defeats the value in the first place,” Kitces said. “Which means the optimal strategy, if it’s to convert anything at all, will be to do partial Roth conversions to fill lower tax brackets but avoid being pushed into the upper ones.”
Dear Liz: I found your recent discussion of Roth IRAs informative. But I’ve been told that one of the main advantages of a Roth vs. a traditional IRA is that a Roth is a safer investment when it comes to creditors trying to attack it. How can that be? Is one type of IRA safer than another?
Answer: The short answer is no.
Employer-sponsored retirement plans, including 401(k)s and 403(b)s, typically have unlimited protection from creditors in Bankruptcy Court. The exceptions: The IRS and former spouses can make claims on such plans.
Individual retirement accounts, including IRAs and Roth IRAs, lack the protection afforded by the Employee Retirement Income Security Act, or ERISA. But the bankruptcy reform law that went into effect in 2005 protects IRAs of all kinds up to a certain limit (which in April rose to $1,245,475).
Short of bankruptcy, the amount of your IRAs or Roth IRAs that creditors can access depends on state law.
If there’s any chance you’ll be filing for bankruptcy or the target of a creditor lawsuit, you should talk to an experienced bankruptcy attorney about your options.
Dear Liz: None of the Web-based tools I’ve seen really get at the heart of the problem of how much I really need in retirement. For example, if I am diligent and save 20% of my income (I earn over $150,000), why would I need to replace 95% or even 80% of my income to maintain my standard of living in retirement? If I subtract the 20% going to savings, another 10% for the costs of working (clothes, lunches, gas) and reduce my income tax 5%, shouldn’t I be living the same lifestyle at 65% of my current income? Now, if I have a pension that will replace 10% of my pay, and if Social Security benefits for my spouse and me replace 30%, don’t my investments have to produce only the remaining 25%? Or am I missing something?
Answer: The further you are from retirement, the harder it can be to predict how much you’ll need when you get there.
Financial planners often use an income replacement rate of 70% to 80% as a starting point. It’s just that, though. Planners will tell you some of their clients’ spending actually increases in the early years of retirement as they travel and indulge in other expensive hobbies. Those who are frugal or used to living well below their means are often able to retire comfortably with a much lower income replacement rate.
A big wild card is the cost of medical and nursing care in your later years. The U.S. Bureau of Labor Statistics’ Consumer Expenditure Survey shows average overall spending tends to drop after retirement and continues to decline as people age. Serious illness or a nursing home bill can cause spending to surge late in life, however, leading to a U-shaped spending pattern for many.
Taxes also are hard to predict. While most people drop into a lower tax bracket once they stop working, those with substantial retirement incomes and investments may not. Tax rates themselves could rise in the future, even if your income doesn’t.
Social Security benefits may change, as well. Although it’s highly unlikely the program will disappear, some proposals for changing Social Security reduce checks for higher earners.
Once you’re within a decade or so of retirement, you should have a better handle on what you’ll spend once you quit work. Before that point, err on the side of caution. Assuming a higher income replacement rate gives you wiggle room once you’ve retired — or the option to retire earlier if it turns out you need less.
Dear Liz: My partner passed away a little more than a year ago. I inherited his 401(k) and life insurance. I opened an IRA in which to place the amount of the 401(k), but the company told me that after a year (which is now), I have to withdraw the money over five years. Is that really required? I’d like to be able to have it on hand in case of an emergency but at the same time save it for our 2-year-old son’s college education.
Answer: Since you weren’t married, you don’t have the option of treating this inherited account as your own. That would have allowed you to delay withdrawals until after you turned 70 1/2 , if you wanted.
The fact that this is a non-spouse inherited IRA, however, doesn’t necessarily mean you’re bound by the five-year rule. That rule requires the IRA be distributed by Dec. 31 of the fifth year following the year of the original retirement account owner’s death. You may also have the option of beginning distributions based on your life expectancy. That would allow the bulk of the money to remain in the IRA, continuing to earn tax-deferred returns, and is usually a better choice.
Whether you have this second option depends on the terms of the IRA and the original 401(k) plan.
“It is important to check the IRA terms rather than rely on oral statements since the five-year option may be pushed when it is not required,” said Mark Luscombe, principal analyst for CCH Tax & Accounting North America. “It is also important to make a determination on the availability on the life-expectancy rule in the year after death since distributions must start under the life-expectancy rule in that year. Waiting too long could force one into the five-year rule by default.”
Dear Liz: Everyone talks about Roth IRAs and how beneficial they are. But I am self-employed, my husband contributes 16% toward his 401(k), our house is paid off, and we no longer have dependents to deduct on our 1040 tax return. My contribution to my traditional IRA is the only tax deduction we have left. Should I consider a Roth anyway? If so, why?
Answer: A Roth would give you a tax-free bucket of money to spend in retirement. That would give you more flexibility to manage your tax bill than if all your money were in 401(k)s and traditional IRAs, where your withdrawals typically are taxable. Also, there are no minimum distribution requirements for a Roth. If you don’t need the money, you can pass it on to your heirs. Other retirement funds require you to start taking money out after you turn 701/2. If you need to crack into your nest egg early, on the other hand, you’ll face no penalties or taxes when you withdraw amounts equal to your original contributions.
So is it worth giving up your IRA tax deduction now to get those benefits? If you have a ton of money saved, you want to leave a legacy for your kids and you’re likely to be in the same or a higher tax bracket in retirement, the answer may be yes. If you’re like most people, though, your tax bracket will drop once you retire. That means you’d be giving up a valuable tax break now for a tax benefit that may be worth less in the future.
You may not have to make a choice, however, between tax breaks now and tax breaks later if you have more than $5,500 (the current annual IRA limit) to contribute. Since you’re self-employed, you may be able to put up to $51,000 in a tax-deductible Simplified Employee Pension or SEP-IRA. At the same time, you could contribute up to $5,500 to a Roth (assuming your income as a married couple is within or below the phase-out range for 2013 of $178,000 to $188,000).
This would be a great issue to discuss with a tax pro.
Dear Liz: I am a 67-year-old college instructor who plans to teach full time for at least eight more years. Last year I began collecting spousal benefits based on my ex-husband’s Social Security earnings record. Those benefits give me an extra $1,250 each month above my regular income. I have been using the money to pay down a home equity line of credit that I have on my condo. The credit line now has a balance of $29,000. I have about $200,000 in mutual funds and should have a small pension when I retire. (I went into teaching only a few years ago.) Would it be better for me to split the extra monthly $1,250 into investments as well as paying off my line of credit? The idea of having no loan on my condo appeals to me, but I wonder if I should try to invest in stocks and bonds instead.
Answer: Paying down debt is important, but opportunities to save in tax-advantaged retirement plans are typically more important. Fortunately, you probably have enough money to do both.
First investigate whether your college offers a 403(b) or other retirement program that offers a match. If it does, you should be contributing at least enough to that plan to get the full match.
Your next step is to explore an IRA. Since you’re covered by at least one retirement plan at work (your pension), you would be able to deduct a full IRA contribution only if your modified adjusted gross income as a single taxpayer is $59,000 or less in 2013. The ability to deduct a contribution phases out completely at $69,000.
If you can’t deduct your contribution, consider putting the money into a Roth IRA instead. Roth contributions aren’t deductible, but withdrawals in retirement are tax free. Having a bucket of tax-free money to draw upon in retirement can help you better manage your tax bill, which is why some investors opt to contribute to Roths even when they could get a deduction elsewhere.
People 50 and older can contribute up to $6,500 this year directly to a Roth if their income is under certain limits. (For singles, the limit for a full contribution is a modified adjusted gross income of $112,000 or less.) If your income is over the limit, you can contribute to a traditional IRA and then immediately convert the money into a Roth IRA, since there’s no income limit on conversions. (This is known as a “back door” Roth contribution.)
Since you’re so close to retirement, you don’t want to overdose on stocks, but you still need a significant amount of stock market exposure so that your money has a chance to offset future inflation. You might consider a balanced fund that invests 60% in stocks, 40% in bonds.
Once you’ve taken advantage of your retirement savings options, you can direct the rest of your Social Security benefit to paying off your home equity line. These credit lines typically have low but variable rates. Higher interest rates are likely in our future, so paying this line down over time is a prudent move.