3 retirement strategies whose days may be numbered

105182624Social Security used to offer a “do over” to people who erred by starting benefits too early. Instead of being locked into substandard payments for life, those who had the cash could pay back all the benefits they had received and start over with a new, permanently higher payment. Advisors to the wealthy discovered their clients could start payments early, invest the money and pay the principal back at age 70, getting in effect an interest-free loan from the government plus a higher benefit.

As awareness of the tactic spread, Social Security moved to shut it down. Today Social Security recipients can still reset their payments, but they can only do so within 12 months of starting benefits.

A similar fate may await three other retirement “loopholes”–backdoor Roths, stretch IRAs and certain Social Security claiming strategies–that have become increasingly popular as financial advisors learned how to exploit kinks in the law. Read more in my Reuters column this week, Three retirement loopholes likely to close.

Elsewhere on the Web, I wrote two pieces for Bankrate about aging parents: Caring for Elderly Parents When They’re Far Away, based in part on experiences with my dad, and How to Sell Your Late Parent’s Possessions, where I interviewed a woman faced with disposing a massive amount of stuff accumulate by her dad.

Thursday’s need-to-know money news

download (1)Today’s top story: Be on the lookout for deceptive balance transfer options. Also in the news: How to retire without a large nest egg, how to work less as you approach retirement, and how to raise a financially savvy teenager.

Credit Card Companies Warned of Deceptive Balance Transfer Offers
If it looks too good to be true, it probably is.

3 Effective Ways to Retire Without a Large Nest Egg
Eliminating your debt is key.

How to Work Less as You Approach Retirement
Time to start using those sick days.

When Bad Things Happen To Good People With IRAs
Understanding beneficiary designations.

How Financially Savvy Is Your Teenager?
The earlier they learn, the better off they’ll be.

How to start investing

Zemanta Related Posts ThumbnailA reader recently posted this question on my Facebook page:

Liz, I’m 30 years old and looking into starting [to invest in] mutual funds and IRAs and have no idea where to start. I know I really need to invest for the future and am eager to do so, but again, have no knowledge on any of this nor know where to start. Any advice or pointers would be more than appreciated.

I suggested he start with reading two really good books for beginning investors, Kathy Kristof’s “Investing 101” and Eric Tyson’s “Personal Finance for Dummies.” But here’s a summary of what you’ll learn:

Get started investing as soon as possible, even if you don’t quite know what you’re doing. You’ll learn along the way, and you really can’t make up for lost time.

Invest mostly in stocks. Stocks over time offer the best return of any investment class, and provide you the inflation-beating gains you’ll need for a comfortable retirement.

Don’t try to beat the market. Few do consistently. Most people just waste a lot of money. Instead, opt for mutual funds or exchange traded funds that try to match the market, rather than beat it.

Keep fees low, low, low. Wall Street loves to slather them on, but fees kill returns. Here’s an example: An annual IRA contribution of $5,000 can grow to about $1 million over 40 years if you net a 7 percent average annual return. If you net 6 percent, that lowers your total by a $224,000. That’s a heck of a lot to pay for a 1 percentage point difference in fees.

If you have a workplace retirement plan such as a 401(k), that’s where you should start investing. If you don’t, then an IRA you open yourself is the next best thing.

So here’s a prescription for getting started: Open an IRA at Vanguard, which prides itself on its low expenses. Send them a check for $1,000 (the minimum to get started with an IRA). Choose a target date retirement fund that’s close to the year when you expect to retire (in this reader’s case, that would be the Vanguard Target Retirement 2050). Target date funds take care of everything: asset allocation, investment choices, rebalancing over time for a more conservative mix as you approach retirement age. You can get the $20 annual account fee waived if you sign up for online access and opt for electronic delivery of account documents.

There you go–you’re on your way.

How long will “back door” Roth conversions be allowed?

DoorWealthier taxpayers are doing a two-step around Roth income limits by putting money into regular IRAs and then promptly converting the accounts to Roths.

They’re taking advantage of Congress’ decision to remove the previous $100,000 income limit for conversions. That decision, which took effect in 2010, led to a conversion boom: $64.8 billion transferred from regular IRAs to Roths that year, compared to $6.8 billion the year before.

The rich know a good deal when they see one: more than 10% of those earning $1 million or more converted to a Roth in 2010, Bloomberg reported.

Moving money from a regular IRA to a Roth usually requires paying income taxes, but the converted money gets to grow tax-free from then on. Roths also don’t have minimum distribution requirements, so the money can be passed free of income taxes to heirs.

Removing the $100,000 income limit for conversions also opened the door for what’s known as a “back door” Roth contribution.

Your ability to contribute directly to a Roth phrases out with if you’re single and your modified adjusted gross income is between $114,000 and $129,000 in 2014. For married couples filing jointly, the phase out range is $181,000 to $191,000.

People whose incomes are too high to contribute directly to a Roth can get around those limits, however, by contributing to a regular IRA and then converting that money to a Roth. The conversion can happen essentially tax-free if you don’t already have money in an IRA and you convert the money soon after contributing it.

If you already have a fat IRA account, such a conversion can trigger a tax bill, since you have to include all of your IRA assets when figuring the taxes on a conversion. The “pro rata” rule requires you to pay a proportional amount of taxes on the original account’s pretax contributions and earnings. If 90% of your IRA accounts are pretax contributions and earnings, then 90% of your conversion amount would be subject to tax. (Ever-helpful Bankrate.com has a conversion calculator to figure out whether paying the tax might be worthwhile.)

But there’s even a way around the pro rata rule, apparently. If your 401(k) allows you to “roll in” an IRA account, which some do, you can essentially make your existing IRA disappear from the conversion tax calculation.

None of this is exactly secret. This Vanguard video discusses how to do backdoor Roth contributions, as does this Wall Street Journal post, this post from MarketWatch and these piece from Forbes, among many others. This article from the Journal of Accountancy, the “flagship publication” of the American Institute of Certified Public Accountants, discusses the roll-in strategy for avoid the pro rata rule.

But some smart people, like financial planner Michael Kitces, have argued that there’s a risk to backdoor Roth conversions that’s not as well publicized: that IRS could step in at any time and invalidate the conversions, perhaps even imposing a 6% “excess contribution” tax on the money. “The IRS can still call a spade a spade,” Kitces wrote on his blog Nerd’s Eye View, “and the rising abuse of this ‘loophole’ may bring about its permanent end.”

“In the end, the contribute-and-then-convert strategy is not expressly prohibited by the tax code, but the IRS does have the right to tax a transaction according to its true economic reality,” Kitces wrote. “And if the express goal and intent of the client is merely to circumvent the clear intent of the law, and is done in a manner that blatantly disregards it, beware.”

Other smart people, such as IRA expert Ed Slott, have argued that the “step transaction doctrine” that allows the IRS to unwind economically bogus transactions doesn’t apply in this case.

“My general advice to clients who cannot make contributions directly to a Roth IRA (due to high income) is to make the contribution to their IRA first, let it stay there for at least a day or two – so it shows up on at least one traditional IRA statement – and then convert it to a Roth IRA,” Slott wrote.

This is not a new discussion, by the way. You’ll note the blog posts above are a few years old. The IRS has yet to clear up the mystery.

My take: since the IRS hasn’t officially weighed in, there’s a risk involved in these transactions. High earners may feel the risk is well worth taking, given the huge benefits Roths offer.

Beware the hidden risks of self-directed IRAs

Dear Liz: My 401(k) plan has grown exceptionally well this year. I think we all know that it can’t last. I just recently heard about self-directed IRAs. I was intrigued at the possibility of opening one by rolling over a portion of my 401(k) money directly. The problem is, my company’s 401(k) provider will not allow the direct rollover of funds. Is there an alternative means of withdrawing 401(k) funds without penalty and still get them into a self-directed IRA?

Answer: You can quit your job. Otherwise, withdrawals while you’re still employed with your company will trigger taxes and probably penalties.

Your premise for wanting to open a self-directed IRA is a bit misguided, in any case. Your 401(k) balance may occasionally drop because of fluctuations in your stock and bond markets, but over the long term you should see growth.

You may have been sold on the idea that self-directed IRAs would somehow be less risky. Some companies promote self-directed IRAs as a way to invest in real estate, precious metals or other investments not commonly available in 401(k) plans. The fees these companies charge as custodians for such accounts are usually much higher than what they could charge as traditional IRA custodians, so they have a pretty powerful incentive for talking you into transferring your money to them.

The problem is that you could wind up less diversified, and therefore in a riskier position, if you dump a lot of your retirement money into any alternative investment. It’s one thing for a wealthy investor to have a self-directed IRA that invests in mortgages or gold, assuming that he or she has plenty of money in more traditional investments. It’s quite another if all you have is your 401(k) and you’re putting much more than 10% into a single investment.

Also, there’s a lot less regulation and scrutiny with self-directed IRAs than with 401(k)s, which increases the possibility of fraud. (Southern California investors may remember First Pension Corp. of Irvine, a self-directed IRA administrator that turned out to be a Ponzi scheme.) So you’d need to pick your custodian, and your investments, carefully. You also would need to understand the IRS rules for such accounts, because certain investments — such as buying real estate or other property for your own use — aren’t allowed.

If you’re determined to diversify your investments in ways your current 401(k) doesn’t allow, you can open a regular IRA at any brokerage and select from a wider variety of investment options. Or you can look for a self-directed IRA option with low minimum investment requirements to start.

No earned income? No IRA contribution

Dear Liz: In recent columns you’ve been discussing mandatory withdrawals from IRAs. Since these minimum required distributions are treated as income for tax purposes, can I use that money as the income necessary to make an IRA contribution this year? I am retired and lucky enough not to need the funds for current expenses.

Answer: Sorry. You need earned income, not just income, to make IRA contributions. For the purposes of an IRA, earned income includes wages, salaries, commissions, self-employment income, alimony and separate maintenance and nontaxable combat pay. It does not include earnings and profits from property or income from interest, dividends, pensions, annuities, deferred compensation plans or required minimum distributions from IRAs.