Retirement Watch : Bob Carson

Safe Ways to Give Wealth

Bob Carlson — Fri, 24 Apr 2009 12:49:00 GMT

Gift giving is the surest way to reduce estate taxes, help loved ones of all ages, and establish a legacy. Yet, many people are hesitant to make significant gifts to loved ones, because of some potential pitfalls. Those pitfalls, however, can be avoided with some shrewd and creative giving strategies.

Potential givers see several risks in making substantial gifts. The wealth could be wasted or spent unwisely by the recipients. Simple mismanagement by an unsophisticated heir might cause the money to disappear in scams or unwise investments. The wealth also could be dissipated though gambling, substance abuse, or bankruptcy. A common concern is that part of the wealth eventually could leave the family in a divorce.

While these risks are real, there are ways to give that reduce or eliminate the risks without the expense and inconvenience of trusts. As I have stated in past posts, this is a good time to make estate planning gifts, because asset values are down. Estate and gift taxes are based on the value of property. The lower the value of property is when it leaves your hands, the lower the transfer taxes. The benefits of making gifts today can be reaped while protecting wealth from these and other perils. Consider these strategies for structuring gifts.

529 plans. College savings plans authorized under section 529 of the tax code have become one of the best estate planning vehicles in recent years, while tax law changes have diminished the value of other vehicles. Most states now offer multiple 529 plan options, and any person can set up an account for the benefit of someone else and contribute to it. Contributions qualify for the annual gift tax exclusion, currently up to $13,000 per year. In addition, up to five years' worth of exclusions can be used in one year for a tax free lump sum contribution of up to $65,000. The money given to the account is out of the donor’s estate. Under many state plans the owner has some choices over how the account is invested. The IRS generally restricts investment changes to one per year, though the limit is suspended for 2009.

Income and gains in the account compound tax free. Withdrawals are tax free if they are used for qualified education expenses of the beneficiary.

A distinctive advantage of the 529 plan is the owner can retrieve assets from the account for any reason. There is no tax penalty if the owner asks for the return of the assets, though the plan sponsor can impose a penalty of up to 10%. The owner also can change the plan beneficiary at any time. The return of income and gains earned by the account is taxable if they are not used for qualified education expenses.

Some states limit the duration of an account to a number of years or to the 25th or 30th birthday of the initial beneficiary. Others have no time limit.

A 529 college savings plan provides a tax-free way to remove assets from an estate, place them in a tax-free savings vehicle, and benefit an heir. But the beneficiary has no current control of the assets and can be denied future access if the situation changes. The donor can retrieve the assets if his or her needs change.

Bill paying assistance. Many people hesitate to make gifts because they are concerned the gifts will be wasted. They would like to help loved ones but do not want their gifts funding frivolous expenditures or being lost in unwise investments.

One way to prevent that outcome is to make direct payments on behalf of the beneficiary. The beneficiary never touches the money, and the gifts pay for what the donor intended. For example, checks for education or medical expenses can be written and sent directly to the provider. Some people pay directly for vacations, summer camps, furniture, clothing, cars, and whatever other expenses they want to help with.

Direct payment of gifts qualifies for the annual gift tax exclusion. In addition, qualified education and medical expense payments made directly to the provider qualify for unlimited gift tax exclusions.

Purchasing services is safer than paying for assets. Assets can be divided in a divorce or sold or pawned to fund other spending. Another possible disadvantage is that paying for items might put loved ones in the habit of asking for assistance whenever they want something. A better approach is to have a plan in which gifts for the year are discussed and set or even multi-year plans are developed.

Home equity match. Suppose loved ones need an expensive item, but the parents are not able or willing to part with a large lump sum or want to stay within the annual gift tax exclusion limit. A strategy, if the children have adequate home equity and credit, is for the children to make the purchase with a home equity loan. The parents then can agree to make all or part of the loan payments either directly or by sending money to the children. This allows the parents to help the children, stay within the gift tax exemption amount, and spread the payments over time in manageable amounts. The children deduct the interest.

Expense matching. Some donors to charities make challenge matches. They offer to match, up to a maximum amount, whatever amount the charity raises from other donors for a specific purpose. Parents can do the same with children. If the children need or want a car, for example, the parents can offer to match whatever amount the children spend. The match does not have to be dollar for dollar. The parents can offer to pay fifty cents for every dollar the children pay, for example.

Some parents believe it is important the children have some of their own assets in a major expenditure. The cost sharing makes it more likely that the children will choose wisely and take care of the asset. It also makes the children less dependent on the parents.

Marital agreements. When gifts are not made because the parents do not want to risk that they will be divided in a divorce, parents should discuss this with the children. The problem could be remedied with a premarital or postmarital agreement stating any lifetime gifts or estate bequests received by one spouse will not be considered part of the marital estate to be divided in a divorce. Many parents and grandparents will not make estate planning gifts unless there is such a marital agreement.

Maintaining separate accounts. In many states assets owned before a marriage plus gifts and inheritances are not included in the marital estate if they are not commingled with other assets. Parents should check the state's treatment of the gifts, and then can require that their gifts be kept in separate financial accounts

Trusts. Of course, the classic way to protect assets is by placing them in trusts. In this post we have offered a number of ways to protect assets without the expense and restrictions of a trust. When the strategies discussed here do not meet the donor’s goals, trusts can be fashioned to accept tax-free gifts, take property out of an estate, protect assets, and provide incentives for the beneficiaries.

Estate owners have legitimate concerns about what might become of their estate planning gifts. These concerns can be resolved with some creative gift giving, enhancing the lives of loved ones while protecting hard-earned wealth.

Bob Carlson is editor of the monthly newsletter Retirement Watch and the web site www.RetirementWatch.com. He also is author of numerous books and reports, including The New Rules of Retirement and Invest Like a Fox…Not Like a Hedgehog.

IRA Inheritance Disasters: A Case Study

Bob Carlson — Fri, 10 Apr 2009 20:55:00 GMT

One point I try to emphasize regularly in my newsletter and web site is the importance of the beneficiary designation form for IRAs, pensions, annuities, and a few other assets. Yes, a will or living trust are very important to your estate plan. They do not, however, control the disposition of all your assets. Assets that avoid the probate process are not controlled by your will or trust. Only the beneficiary designation form on file with the IRA sponsor or other custodian of the assets determines who receives the assets after you.

A recent decision from the U.S. Supreme Court shows how important it is to keep your beneficiary forms up to date.

William Kennedy worked at DuPont and had a wife and daughter. He named his wife as beneficiary on the retirement plan's designation form and did not name a contingent beneficiary. Decades later, he and his wife divorced, and Mrs. Kennedy waived her rights to Mr. Kennedy's retirement benefits as part of the settlement. The waiver was not in the form of a qualified domestic relations order as defined in the tax law, which the plan would be required to follow. Since the waiver was not a QDRO, the plan documents controlled the account.

Unfortunately, Mr. Kennedy never changed his beneficiary designation form with DuPont. (He did change the designation form for another retirement plan at DuPont, naming his daughter as beneficiary.) He retired in 1998 and began receiving benefits. He died in 2001. Dupont then paid $402,000 to the former Mrs. Kennedy as beneficiary of the account.

The daughter sued DuPont, saying her father clearly intended that his ex-wife not inherit the retirement benefits. The ex-wife, she said, was compensated by other means and waived any rights to the benefits.

The Supreme Court held DuPont had no responsibility to the daughter. DuPont was bound to follow the employee's instructions on the forms filed with the employer, no matter how old and out-of-date they might seem. The ex-wife's waiver of her rights to the benefits did not amount to an assignment of the rights to the daughter. It was the employee’s job to update the forms if he changed his mind. The plan administrator is not able or required to review anything else to determine who should receive the benefits. Kennedy v. Plan Administrator for DuPont Savings and Investment Plan, US Supreme Court, Jan. 26, 2009.

The bottom line as we have said many times is your beneficiary designation forms control what happens to your retirement benefits, and you need to keep those forms up to date. This is true for retirement plans, annuities, life insurance, and other non-probate assets. You need to review the beneficiary designations at least every couple of years or when there is a major life event. Keep copies of the forms and write “superceded” or something similar on out-of-date forms, in case the custodian loses the forms. Be sure your executor knows where to find your copies of the forms.

Dos and Don'ts of IRA Investing

Bob Carlson — Fri, 03 Apr 2009 14:18:00 GMT

Many people own substantial IRAs and have the bulk of their investment portfolios in IRAs. Some of these investors might not realize there are investments that are prohibited from IRAs and others are allowed but incur tax penalties. The issue of how to invest an IRA is more important in today's climate, because "hard assets" and other nontraditional assets—those that investors prefer today—are primarily those prohibited or discouraged in IRAs.

IRA investment disincentives fall into three categories. There are prohibited investments, taxable investments or transactions, and prohibited transactions.

The prohibited IRA investments are labeled “collectibles.” When an IRA purchases a collectible, the amount used to make the purchase is treated as distribution to the owner. It is included in the owner's gross income, and if the owner is under age 59½ and does not qualify for one of the exceptions, a 10% early distribution penalty is imposed on top of the income taxes. In addition, there is a penalty each year the IRA continues to own the prohibited investment.

Collectibles are defined in the tax code as works of art, antiques, rugs, stamps, coins, metals, gems, and alcoholic beverages. The IRS is allowed to define other items as collectibles but has not done so.

Note that an IRA may purchase securities of firms that produce collectibles, such as mining companies and alcohol producers or distributors. But the IRA may not purchase the collectibles themselves.

There are other investments an IRA may own, but those investments could cause the IRA to owe income taxes on income from the investments or the owner might be taxed as though distributions were made.

An IRA is most likely to be taxed when it earns unrelated business taxable income (UBTI). The UBTI rules apply to all qualified retirement plans, not just traditional IRAs. If an IRA earns UBTI exceeding $1,000 it must pay income taxes on that income. The IRA might have to file Forms 990-T or 990-W. It also must pay estimated income taxes during the year if the UBTI exceeds $500.

The IRA owner essentially will be taxed twice on UBTI. The IRA will be taxed on the income. Subsequently, the owner or beneficiary will be taxed on distributions of that income. There is no deduction or credit available to the owner for UBTI paid by the IRA, and the tax on the IRA does not increase the tax basis of the IRA.

The UBTI rules are supposed to prevent a tax-exempt entity such as an IRA from unfairly competing with tax-paying businesses. The rules are fairly broad, however, and apply to situations in which the IRA is not operating a business. An IRA potentially has UBTI if it does any of the following:

operates a trade or business,

receives certain types of rental income,

receives certain types of passive income from a business entity it controls,

invests in a pass-through entity, such as a partnership, that conducts a business, or

uses debt to finance investments.

A "trade or business" is any activity carried on for the production of income from the sale of goods or performance of service. Any business is considered unrelated to the exempt purposes of an IRA or other retirement plan. Fortunately, the tax code specifically excludes certain types of income from the definition of trade or business income for UBTI purposes. The exempt types of income include interest, dividends, capital gains, and profits from options transactions. Royalties also are generally exempt.

Even exempt income, however, can be converted into UBTI.

Real estate rental income generally is exempt from UBTI, but becomes UBTI if the amount of rent is computed as a percentage of the tenant's profits.

Controlling a business entity also can convert exempt income into UBTI. When an IRA has greater than 50 percent control of a business entity, any rent, interest, or royalties paid by the entity to the IRA is UBTI if the payments have the effect of reducing the business income of the entity. Another way to look at this rule is that if the business entity deducts the payments to the IRA, they are UBTI to the IRA.

When an IRA owns an interest in a pass-through business entity (partnership or limited liability company), the IRA's share of the entity's income is UBTI. Pass-through entities generally do not pay federal income taxes. Instead, their income and expenses are passed through to their owners' income tax returns.

This rule most often trips up individuals who invest in master limited partnerships (MLPs) or real estate partnerships in their IRAs. MLPs are traded on major stock exchanges, and many people think of them as being the same as corporate stock. In fact, these are partnership units, and the income and expenses of the partnerships pass through to the owners at tax time. Individuals generally are urged not to purchase MLPs through IRAs.

It is not illegal to own an MLP through an IRA. The ownership, however, triggers the UBTI rules and the requirement to possibly file a version of Form 990 and pay estimated taxes. There is no tax advantage to owning MLPs through an IRA. Some tax advisors recommend taking the easier and cheaper route of reporting any IRA-owned pass through items on the individual tax return instead of filing a separate Form 990 for the IRA.

An IRA also has UBTI when debt is used to finance investments. Any type of income can become UBTI when debt is used to finance the property that generates the income. For example, if an IRA receives a margin loan from the custodian or broker, income generated by the securities purchased with the loan proceeds would be UBTI. Real estate mortgages also are debts that convert exempt income into UBTI. An IRA can own real estate and earn rental income, and that rental income will be tax deferred. If the real estate is financed with a mortgage, however, the rental income becomes UBTI.

The prohibited transaction rules are the final category of taboo investments. The rules are fairly detailed and can get complicated. Generally they prohibit transactions between the IRA and its owner or a person related to the owner (including businesses).

The penalty for violating the prohibited transaction rule is severe. The entire IRA will be considered fully distributed when the prohibited transaction was made. The IRA owner must include its full value in gross income, regardless of the amount of the prohibited transaction. If the owner has multiple IRAs, only the IRA that engaged in the prohibited transaction is penalized. Other IRAs escape the penalty unless they also engaged in prohibited transactions.

It is easy to state the prohibitions in clear, plain English: No deals are allowed involving the IRA and the owner or a person related to the IRA or its owner. Yet, there are some "prohibited transactions" allowed by IRS regulations or rulings, and IRA owners can receive waivers from the Department of Labor for specific transactions.

A detailed discussion of the prohibited transaction rules would be too much for this posting. While it is possible for an IRA to engage in transactions with the owner’s small business, real estate, or other interests, such transactions should not be considered without good tax or legal advice.

IRAs do not have complete investment freedom. IRA owners who prefer investments other than publicly-traded stocks and bonds and mutual funds need to be wary of the potential pitfalls.

How to Revise Your Spending Plan

Bob Carlson — Fri, 27 Mar 2009 15:24:00 GMT

The swift declines in most asset classes in late 2008 and into 2009 damaged many portfolios. For those who are retired or near retirement, one necessary step after such an event is to re-evaluate retirement spending. Specifically you have to check the rate at which you are withdrawing money from the retirement portfolio and decide if it needs to be adjusted to reduce the risk of running out of money.

In the past I have discussed the safe or sustainable withdrawal rate, especially in my newsletter Retirement Watch. The safe withdrawal rate is the percentage of the portfolio you can withdraw the first year, increase by inflation each subsequent year, and have a high probability the portfolio will last at least 30 years. The biggest risk to a retirement portfolio is a bear market or a long-term flat market in the early years of retirement. The second biggest risk is to withdraw money at an unsustainable rate.

Numerous studies have been done. They all indicate that to be safe, the first year withdrawal rate should be between 3% and 4% of the portfolio. The most commonly-cited sustainable rate is 3.6%. This assumes you invest at least 50% of the portfolio in stocks or assets that earn similar returns and the rest in bonds. If you invest a lower percentage in growth assets, the sustainable withdrawal rate is lower.

If you are fortunate enough to retire at the beginning of a bull market, a higher withdrawal rate is safe. But you won't know until after a few years of retirement the type of market that coincided with the beginning of your retirement.

Whatever withdrawal rate you choose the first year, the rate needs to be re-evaluated periodically. Especially with the current bear market, you need to re-examine the decision. Even the 3.6% withdrawal rate does not allow a portfolio to last 30 years 100% of the time. There still is a risk of running out of money in the case of a severe bear market. You want to be sure today’s nasty market environment does not tip you into that small percentage of times when even the historic sustainable withdrawal rate is too high.

Bear markets are followed by bull markets. Bull markets restore the retirement portfolio by accumulating gains faster than you spend. The key is to be sure the combination of the bear market and your spending does not bring the portfolio balance so low the subsequent bull market gains are not enough to sustain the portfolio through retirement.

If you retired a few years ago and still have a portfolio that is worth more than your starting portfolio, you probably are in good shape. The research shows you should be able to continue your planned withdrawal schedule with a very low probability of outliving your money. You might want to reduce spending a bit for the next few years to be on the safe side, but drastic measures should not be needed unless there is another significant downward leg to this bear market.

What if you now have less money than when you first retired? In that case, you need to consider changes. We will review some potential changes shortly. First, let's look at some more objective benchmarks of your spending rate.

One check is to assume an immediate single-premium lifetime annuity is purchased today with your entire retirement portfolio. Is the annual payout from that annuity similar to the amount you are withdrawing now? If you are withdrawing significantly more than the annuity payment, you are likely to have a problem sustaining the withdrawal rate. Insurance companies spend a lot of resources calculating life expectancies, devising investment strategies, and determining how much they can pay a person and still make a profit. If your withdrawals are significantly higher than what the insurers are paying, then you are assuming a significantly higher investment return or shorter life expectancy than the insurers. Keep in mind if you have a spouse you intend to provide for, the portfolio likely will have to last longer than for a single life annuity. Also, insurers usually do not index annuities for inflation. So if you are withdrawing significantly more than annuities are paying and you are increasing that for inflation, you need to re-evaluate the spending rate. Check annuity payout rates at web sites such as www.ImmediateAnnuities.com

Another objective warning sign is a withdrawal rate well above the historic safe rate. Surveys continue to show many people think they safely can withdraw 8% to 10% annually. Research does not back that up, except in strong bull markets.

Here’s another quantitative measure.

One study found a strong correlation between the safe withdrawal rate for the next 30 years and the current price/earnings ratio of the S&P 500. The higher the P/E ratio, the lower the safe withdrawal rate is for the next 30 years. P/E ratios tend to be high at bull market peaks, followed by years of below-average returns.

A simple rule is that when the P/E ratio is above the historic average, the safe withdrawal rate is on the low side. When the P/E ratio is low, withdrawal rates can be higher. When the P/E ratio is below 12, a withdrawal rate of 6% or more generally is safe. At extreme bear market bottoms, a rate of 10% can be sustained going forward. Right now, the P/E ratio is a little below the historic average but not near historic lows.

If your portfolio has declined and you are concerned how long it will last at the current spending rate, there are steps you should consider. One or more of these steps should put you back on the right track.

Drop the inflation bump. Remember the studies all assume that after the first year the amount taken from the portfolio each year increases with inflation. A simple step is to stop the inflation increase for a while. Insurers generally do not increase annuity payouts for inflation because it is very expensive.

Use a market-based formula. Instead of a formula that steadily increases spending, have spending rise and fall with the portfolio, though not by as much. One simple formula is to set your withdrawal rate, but apply it to the average account value at the end of each of the last five years instead of the current value.

Another option is what I call the Yale Endowment formula. Each year 70% of the distribution is the initial spending amount plus inflation. The other 30% is a fixed percentage of the portfolio's value latest year-end value. More details of the formula are in my book The New Rules of Retirement.

Either of these formulas will smooth distributions and their effect on the portfolio. They have the disadvantage of automatically reducing spending when the portfolio declines, but that makes the portfolio last longer. They also have the advantages of increasing spending as investment returns improve and the cuts are not as drastic as the portfolio’s changes.

The safety fund system. Another approach I have recommended is to create a safety fund at the start of retirement. You put an amount equal to the estimated spending for two to five years in safe investments such as money market funds and certificates of deposit. The rest of your portfolio is invested for the long-term. You take money from the safety fund to pay expenses. At the end of each year you rebalance the long-term portfolio by replenishing the safety fund.

The advantage of the safety fund approach is that you do not feel pressured to sell investments after a steep decline, because you know there is enough money in safe assets to get through the two to five year period. Those who do not have large enough portfolios to create a safety fund should consider purchasing an immediate annuity with a portion of their portfolios. The steady annuity income gives your annual income a floor and can prevent you from taking extreme actions with the rest of your portfolio. Because of low interest rates now is not an optimum time to put a lot of money in an immediate annuity, but as rates rise it is a good long-term strategy.

Change allocations and strategies. Retirees whose past investment strategies have let them down should consider changes. Some portfolios were too heavily weighted to equities instead of being diversified (though there were few asset classes that did not lose money in late 2008). Other investors could benefit by shifting from buy-and-hold to the more active strategies of our Retirement Watch Managed Portfolios. A long-term buy-and-hold strategy often is not a good strategy, because it puts you at risk of substantial losses during long-term bear markets.

Another possibility is to try to earn higher returns by taking more risk after the markets decline significantly.

Spending cycles. For many people spending naturally varies during retirement. Spending tends to be relatively high during the early years as people are physically active and have a backlog of things they want to do. After a few years they settle into more of a routine. Spending tends to ratchet down a notch in this second phase because of less traveling and other big ticket activities. In the third phase people generally are less active as they get older and that leads to lower spending. In response to the bear market you might reduce spending a bit now but assume it will decline more later in retirement instead of taking a larger reduction now.

The wild cards in that plan are medical expenses and long-term health care. If you are well-insured these might not be issues. Otherwise, they might keep overall spending from declining in the second and third phases.

Most retirees are able to vary spending. They can postpone travel, spend less on restaurants and entertainment, and replace cars and other items less often. Spending adjustments are the best way to get a retirement portfolio and spending back on track. It is much better than permanently switching to only safe assets, though that is the temptation.

In our portfolios we reduced risk early and will keep it low until the financial crisis seems to be nearing an end. But we are not permanently switching to safe investments. That is a mistake many people make after a market downturn. Retirement lasts a long time, and your income needs to grow to maintain purchasing power.

When secular bear markets strike early in retirement and put the longevity of your portfolio at risk, adjustments are needed. First, adjust spending. You can reduce it for only a year or two or consider making a permanent change to the spending formula. Second, reconsider your investment policy. Do not give up on growth or risk or take too much risk, but be sure your strategy fits today’s markets.

Time to Stop Deferring Taxes?

Bob Carlson — Thu, 19 Mar 2009 17:34:00 GMT

Conventional investment advice has been turned on its head by changes in the fundamentals of the economy and markets. Now, fundamental changes in the government, demographics, and the economy are forcing changes in tax policy and tax planning advice.

The age-old advice is to defer taxes whenever possible and for as long as possible. Over the years, I have pointed my subscribers to a few exceptions to this strategy discovered in our research. Soon, the classic rule might become a relic. For many people, the best tax planning advice in coming years could be to pay income taxes as early as possible, because rates will be higher later.

The structural changes leading to this conclusion are significant:

We have a new President and Congress. They explicitly campaigned on promises to raise taxes, at least on the wealthiest Americans. "Wealthy" tends to be defined downward after an election, and that is likely to be the case now.

Social Security and Medicare cannot be sustained under current tax and spending policies. Either benefits must be reduced or taxes raised or both.

The policy response to the financial crisis was for the federal government to bailout, subsidize, insure, and otherwise commit to spending a lot of money. There is a chance some money will be recovered from the government's "investments," but most likely the government will have net negative cash flow.

The new government leaders plan to spend a lot more money, especially on medical care, energy, and the environment. The details are not clear at this point, but higher spending by the government clearly is part of the plan.

Environmental policy is likely to include significant tax increases.

A result of the current crisis likely will be less leverage in the economy, leading to lower economic growth. Lower growth means less tax revenue from the current tax structure and a need for higher taxes.

The President proposed a few specific tax increases in his budget plan, but others won't be known for a while. We do have a lot of clues, however, and can begin to plan.

Higher income individuals are likely to face higher income taxes. During the campaign the income cut-off for higher taxes initially was $250,000. But at times lower numbers were used, and Congress traditionally defines “high income” much lower than $250,000. The current plan is to let the 2003 tax cuts expire after 2010, which will affect many taxpayers.

All Americans are likely to be hit with indirect and non-income taxes. These include gasoline taxes, other carbon and energy taxes, and various fees and charges.

Means-testing is another likely form of tax increase. Already upper income people receive a lower return on their Social Security taxes and pay higher Medicare premiums. Benefits from Social Security and Medicare likely will be reduced above some income level. Expect similar actions in other government programs.

Tax benefit reductions also are likely in lieu of tax rate increases. Itemized deductions and personal and dependency exemptions now are reduced at higher incomes, effectively increasing tax rates. Congress likely will search for other tax breaks to phase out as income rises. Many phase outs were included in the economic stimulus law that recently was enacted. Related changes will be "closing loopholes" by eliminating deductions and income exemptions.

A long shot in the short term is imposition of a value added tax or some kind of a national sales tax. This tax can be hidden in the cost of goods and services, raised easily, and will generate a lot of money for the government.

Taxes on long-term capital gains are likely to rise above their current 15% level. A rise to 20% seems almost certain after 2010, and an increase to 28% is possible. Taxes on dividends also will rise. The question is whether they will be taxed the same as long-term capital gains or will return to being taxed as ordinary income.

The bottom line is reduced benefits, higher taxes, and fewer opportunities to reduce taxes. Most people should plan to spend less, save more, and work longer.

A good guess is that most over age 55 won't have to deal with lower benefits from Social Security and Medicare, except those with higher incomes. Those farther from retirement likely will face changes.

What should you do?

The good news is the economic crisis prevents the imposition of higher taxes for a year or more. That gives you time to plan.

IRAs and retirement accounts likely will be hurt by future tax increases. All distributions are ordinary income, and you cannot spend the money without taking a distribution.

In the past I showed subscribers when it makes sense to pay taxes early on an IRA by either emptying it or converting to a Roth IRA (if adjusted gross income is $100,000 or less). These strategies will be profitable now for more people if income tax rates rise. In 2010 and later years under current law anyone will be able to convert a traditional IRA to a Roth IRA.

More people should give serious thought to emptying their IRAs early or converting to Roth IRAs. Details are in the members section of my web site and in my book The New Rules of Retirement.

It is too soon to sell appreciated capital assets to avoid higher taxes. A retroactive capital gains tax increase is unlikely. The government wants to tell investors in advance that the tax will increase, because the announcement will trigger asset sales by people seeking to lock in the lower rate, boosting government revenue. Be ready to sell appreciated assets in a year or two to avoid higher capital gains taxes, and expect lower after-tax returns from capital assets after that.

The same advice applies to dividends. There won't be much you can do to avoid the eventual increase. Factor lower after-tax income from dividends in your plans. As the tax rate on dividends increases higher after-tax income might be available from bonds or other income investments.

Reconsider plans to defer future income. Your income tax rate in the future is likely to be higher than today. You could have more money in the long-term by paying taxes today and investing the after-tax amount.

That means you should review IRA and 401(k) contributions and deferred compensation arrangements. Those earning $50,000 or less probably won't be hit with higher income tax rates and can safely continue tax deferrals. But the higher your income is above $50,000, the greater your risk of paying higher rates in the future. Income tax rate increases might very well be retroactive at some point. In a rising income tax regime, it is better to pay taxes today than in the future.

Forget the notion you will be in a lower tax bracket in retirement. Many of us will be in higher tax brackets, especially when all types of taxes are included. This is another reason to reduce tax deferral.

Retirement spending plans should be revised to reflect higher costs. If you are not already retired, consider working longer and saving more. You might have to pay more for medical care, utilities and other energy-using services, and more. Your Social Security benefits might be reduced because of means-testing. As the tax proposals become more specific and are closer to enactment, investment plans will need to be revised or you will have to accept lower after-tax returns.

Bob Carlson is editor of the monthly newsletter and web site Retirement Watch (www.RetirementWatch.com). He also is the author of The New Rules of Retirement and Invest Like a Fox…Not Like a Hedgehog.

Avoid the Retirement Medical Expense Surprise

Bob Carlson — Fri, 06 Mar 2009 19:42:00 GMT

The wildcard in every retirement plan is the cost of medical care. It probably is the cause of many retirement plan failures. There are several reasons medical expenses disrupt so many plans:

§ Many people are used to employer-paid medical care. Before they retire, they do not realize the full cost of medical insurance.

§ Employers used to provide medical coverage for retirees. Now, few do. As of 2005, only about 20% of companies with 500 or more employees offered at least some retiree medical coverage. Most that do offer retire medical care reduced benefits in recent years, and smaller employers rarely offer retiree medical care.

§ Life expectancy continues to increase, and medical expenses tend to rise with age.

§ The cost of medical care is rising faster than general price inflation.

§ Technology makes more conditions treatable but the treatment comes at a cost.

§ The cost of medical care varies between individuals. Some have minimal expenses until a final illness; others develop chronic conditions and incur above average expenses for years.

§ Retirement medical care is divided into two buckets: regular medical expenses and long-term health care.

§ Medical care is not spread evenly over retirement. The expenses generally increase over time and bulge in the later years.

Estimating the cost of retirement medical care is difficult. Fidelity Investments has an annual survey that attempts to do that. The latest survey estimates that the average married couple age 65 today will pay $225,000 for medical care between ages 65 and 80. That cost includes everything Medicare does not cover: Medicare premiums, deductibles, copayments, noncovered care (including dental care), supplemental insurance, and prescription drugs. This estimated tab was $175,000 only five years ago. For most couples, the expenses will average $10,000 or more in the early years of retirement and be much higher in later years. Many people will live beyond 80, boosting lifetime costs. The Fidelity estimates are an average, so half of retirees will have higher costs.

In 2008 for the first time Fidelity also estimated the cost of long-term care for the average 65-year-old couple. The couple will spend $85,000 over their lifetimes on long-term care. This is in addition to the other estimated retirement medical expenses.

Remember that these are average expenses. Some will spend less; others will spend more.

For a couple retiring at 65 today, a fund of about $207,000 is needed just to fund the medical expenses through 80 (not including the long-term care). That assumes a 7% after-tax return on the fund.

Clearly retirement medical expenses are an important part of the retirement plan, and they also one of the most neglected. Here is what pre-retirees and those in the early years of retirement should do to properly plan for retirement medical expenses.

Prepare early. As soon as possible before retirement determine the level of any employer support for retirement medical expenses.

Estimate expenses. You can use the Fidelity survey numbers or develop your own based on personal and family medical history and costs in your area. Do not forget to include medical cost inflation.

Prepare for contingencies. Employers can reduce retiree benefits. And Medicare could become a wildcard. The annual reports from its trustees make clear that it is financially unstable. Already a means-tested premium is in place that charges higher premiums to higher income individuals. More means-testing is likely in the future as are reductions in coverage. Another likely change is to increase the eligibility age. The full retirement age for Social Security is rising, so the age for Medicare is likely to follow.

Research alternatives. Retirees must know the alternatives available to them if employers or Medicare change the rules. Alternatives include private individual insurance, HMOs, professional or trade association policies, and different forms of Medicare. Returning to work, even on a part-time basis, might be another way to regain medical coverage. One way to research alternatives is ehealthinsurance.com.

Don't retire early. Retiring early is a major source of retirement financing problems. Too many people retire before being eligible for Medicare or employer retirement benefits. They do not realize how expensive or difficult it is to obtain medical insurance for individuals older than 50. Someone who retires early and stays healthy until age 65 might be fine. But significant health problems during the gap period could be very expensive.

Waiting until 18 months before age 65 to retire allows you to purchase health insurance through the employer under COBRA. But the employer can charge the full cost plus an administrative charge, and that likely will be expensive.

Start health savings accounts. Those who are eligible to create health savings accounts should do so before retirement. Contributions are deductible. Investment earnings accumulate tax free. Distributions for qualified medical expenses are tax free. You can make contributions before retirement and let the account accumulate to pay for retirement medical expenses, including premiums.

Evaluate Medicare choices. A Medicare beneficiary in most areas can choose traditional fee for service or from a range of Medicare Advantage plans. You can learn which plans are available in your area on the Medicare web site or from your state insurance commissioner.

Consider a Medicare supplement. The Medicare supplement policies pay Medicare premiums and some items not covered by Medicare. There are a range of policies to choose from. The different policies and the factors to consider are explained in my book, The New Rules of Retirement.

Consider prescription coverage. Medicare Part D covering prescription drugs is getting ready for its third year. You might want to choose one of the plans available in your area. How to evaluate plans is discussed in detail in the Archive of my members-only web site at www.RetirementWatch.com.

Review long-term care coverage. Medicare pays for long-term health care only in limited circumstances. In other circumstances, you fund it yourself, buy private insurance, or try to qualify for Medicaid. Further discussions of this topic are in the web site Archive and in my book.

Have a replacement fund. Ideally there is a cushion in your retirement portfolio in case expected medical expense coverage is reduced or expenses are higher than planned. Your spending and investment goals should reflect the possibility that medical spending will be higher than projected because of higher expenses or reduced coverage.

The cost of retirement medical care is a shock to many retirees. Do not fall into that group. Review the coverage available to you before retirement and know the likely cost to you. Once retired, keep track of the status of and possible changes in your coverage, and of the alternatives available. Getting medical coverage right can make or break your retirement.

Bob Carlson is editor of the monthly newsletter Bob Carlson's Retirement Watch and the web site www.RetirementWatch.com. He also is the author of The New Rules of Retirement and Investment Like a Fox...Not Like a Hedgehog.

The Wealth Effect, Your Portfolio, and Your Retirement

Bob Carlson — Fri, 27 Feb 2009 14:26:00 GMT

The net worth of Americans is declining. That is no secret, though the extent of the decline will surprise many. The decline has affected and will continue to affect the economy, stock market, and your portfolio. The Federal Reserve gives a picture of the net worth of Americans every quarter, in a report known as the flow of funds data, and it is worth periodically studying the report.

The report for the third quarter of 2008 (which does not include the steep declines of October and November) was an eye-opener. It also does not include the losses from the Bernie Madoff scam and other frauds that have come to light, though they are a small percentage of the total.

U.S. household net worth declined by $2.8 trillion in the third quarter of 2008. Not only is that a large number, but it is the fourth consecutive quarterly decline in net worth. When the data for the fourth quarter of 2008 are issued it will be the fifth straight quarterly decline.

Over those four quarters of declines, net worth has declined $7 trillion, a 15.3% decline in net worth in one year. By comparison, the 1974 bear market in stocks generated a 13.8% decline, and the bursting of the technology stock bubble in 2001 led to only a 10.9% fall in net worth.

Remember that this is a report of net worth. All asset values are totaled and liabilities subtracted to arrive at net worth. Despite the high level of debt in the U.S. and substantial decline in asset values, the asset values of Americans still are substantial enough to result in a positive net worth.

Here is the real eye-opener in the report. In the third quarter Americans were so alarmed by the decline in asset values that they actually reduced their debts. This has not occurred since the data were first reported in 1952. In the third quarter, household borrowing, mortgages, and consumer credit fell at a $117.4 billion annual rate. Granted, that is a drop in the bucket compared to the asset values and amount of debt outstanding. But it does show a significant change in Americans' behavior and thinking.

Part of the decline in debt can be explained by defaults shrinking the amount of debt outstanding and by tighter lending standards reducing the amount of new debt. But part of the decline was due to consumer decisions.

For the first time in a while, Americans own less of their home equity than lenders do. A few years ago, homeowners owned roughly 60% of the value of their homes. At the end of the third quarter they owned only 44%. The rest was secured by debt, essentially owned by the lenders.

The decline in debt also reverses a factor that helped boost the economy in the first years of this century. As home equity values increased, Americans borrowed part of the equity and used the proceeds to buy things. These home equity withdrawals allowed spending to increase faster than income. That boosted GDP.

Now that process is in reverse. Shrinking home equity means people cannot borrow against it to increase spending. Paying down debt means there is less spending than income will support. The declines in net worth and debt overshadow by a large amount the recent decline in gasoline prices that many expect to increase consumer spending.

The influence net worth has on spending and borrowing is known as the wealth effect, and it is important to understand.

Many people believe that Americans spend based on their incomes, but a more important determinant of spending is net worth, or perceptions of net worth. As people perceive themselves to be wealthier, they spend more. An increase in asset values stimulates additional spending above income increases. People will spend more than their income if they believe their net worth is increasing. Some analysts estimated that in the boom years Americans were spending about $1 trillion more annually than was supported by income increases.

The key to understanding the wealth effect is that there always is a lag in consumers' perceptions of their wealth. It takes them a while to realize that market prices have changed their wealth. Most people do not follow asset price changes on a regular basis, and they often assume that price changes are temporary. Also, if the decline in one asset is offset with a rise in another asset by the time consumers review their situations, perceptions of wealth won't change.

The lag in the wealth effect is why consumer spending did not decline as much as economists expected after the technology stock bubble burst in the early 2000s. It also explains why consumer spending held up after real estate prices peaked in 2005 and after the credit crunch began in the summer of 2007.

In the third quarter of 2008 consumers finally realized the declines in asset prices were both serious and not likely to be temporary. They reduced debt and increased savings. They will continue to increase savings to make up for these asset declines until asset prices increase.

The wealth effect is another of the ways this economic cycle is different from those of the last 26 years. I believe many consumers will not ignore the recent declines in their homes and portfolios. They won't keep spending in the belief that the net worth decline is short term. Instead, I think we will see changes in consumer saving and spending that will last for at least a few years. This will reduce economic growth below what most models forecast and make it harder for the economy to rebound. It also will be very tough on retailers, luxury goods and services sellers, and others who benefit from high consumer spending.

If you want to know how bad things became in the fourth quarter, the next Federal Reserve Flow of Funds Report is due March 12, 2009.

Because of the wealth effect, we should not expect a sharp recovery in either the economy or equity markets. It also makes it likely that even after the economy reaches a bottom, economic growth and stock returns will be lower than the averages. That means you will want a different portfolio than the one that worked before the markets peaked.

Bob Carlson is editor of the monthly newsletter and web site, Retirement Watch, available at www.RetirementWatch.com. He also is the author of The New Rules of Retirement and Invest Like a Fox…Not Like a Hedgehog.

Asset Declines=A Planning Opportunity - Part 2

Bob Carlson — Fri, 20 Feb 2009 16:46:00 GMT

Last week we discussed how today’s economic distress creates estate planning opportunities. Because of today’s reduced asset values, estate owners can shift assets out of their estates tax at much lower tax cost than they could have a year or two ago. We went over basic strategies for taking advantage of the situation. This week, let’s look at ways to leverage these strategies.

Family loans. Many families like the concept of loans to family members. If you might need the money in the future, a loan lets you provide benefits to family members now while retaining future access to the wealth. The IRS requires you to charge a minimum interest rate on a family loan to avoid income and gift taxes. The minimum rates are based on treasury debt rates. Because the Federal Reserve has been pushing down short-term rates and investors have been reducing intermediate and long-term rates in the flight to safety, the required minimum rates are low. The rates are changed monthly, and depend on the loan's maturity or term. They are known as “federal applicable interest rates” and are published monthly by the IRS in its Internal Revenue Bulletin.

Family loans are very flexible, but here is how one common strategy works. You lend $100,000 to a child for five years. Let's say the law requires you to charge 2% interest. Your child can invest that money for five years. If the investments earn more than 2% annually, the child keeps that excess return. You receive the $100,000 plus 2% annual interest after five years.

Alternatively, you could lend the money to allow a child to buy a home in today's depressed market. You might set the term of the loan at 10 years. There are several actions the child could take by the end of 10 years. The home could be sold at a profit, with the child keeping the return above the interest rate you charge. Or once the credit markets loosen, the child could refinance the home with a traditional mortgage and return the borrowed money plus interest to you.

The benefits of the family loan can be increased with a variation. If you do not need the money to maintain your standard of living, each year you can use the annual gift tax exclusion to forgive the interest and part of the principal. This shifts the money and future appreciation out of your estate tax free over time while enabling your children to benefit from having the cash now.

In some circumstances a minimum interest rate need not be charged on a family loan if the principal is low enough. I won’t go into the details here. They are available in the members’ section of my web site at www.RetirementWatch.com and also from www.irs.gov.

Grantor retained annuity trusts. Today's low interest rates make these trusts a potentially great opportunity.

The grantor creates a trust that pays a fixed income to him for life or a period of years. After that the remainder of the trust goes to the beneficiaries. The present value of the remainder is a gift. The present value is determined by IRS tables, and current interest rates are a factor in determining the amount of the gift. The lower the interest rates, the smaller the value of the gift. If the return actually earned on the asset exceeds the IRS interest rate, the excess becomes a tax-free gift to the heirs.

A GRAT should be created with assets that are expected to appreciate rapidly within a few years or earn high income. Studies show value is maximized by creating a GRAT to last two years. After the trust expires, consider creating a new trust with different assets.

Charitable trusts. If you are inclined to make significant charitable gifts, consider making them now through a charitable trust. In particular, charitable lead annuity trusts are most advantageous when rates are low.

The CLAT pays income to a charity for a period of years. The payments are either a percentage of the trust’s value or a fixed annual amount. After the income period expires, the remainder in the trust goes to the other beneficiaries, usually the children of the trust creator.

The present value of the remainder for the children is a taxable gift when the trust is created. Again, because of today's low interest rates the taxable gift will be less than at other times. In addition, the combination of low interest rates and low asset values create the potential that the appreciation of trust assets will significantly exceed the income paid to the charity and the amount on which gift taxes were paid. The result could mean a significant amount of wealth is transferred tax free to heirs.

The creator of a CLAT can take a tax deduction for the present value of the gift to the charity. Doing so, however, obligates him to pay taxes on the income and gains of the trust. Foregoing the deduction avoids the taxes on the income and gains. The CLAT is irrevocable. Once created, you cannot get the money back or change the terms of the trust.

Today's low interest rates and decline in asset values present estate planning opportunities. Some of these are straightforward and easy to implement. Others, such as trusts and family loans, should be done only with the help of a tax or estate planning expert. Once the current crises end, the benefits from making the moves now could be significant.

Bob Carlson is editor of the monthly newsletter and web site Retirement Watch at www.RetirementWatch.com. He also is the author of The New Rules of Retirement and Invest Like a Fox…Not Like a Hedgehog.

What is Ahead for 2009

Bob Carlson — Tue, 10 Feb 2009 19:32:00 GMT

Major structural changes have occurred in the economy and markets, and more changes are on the way. The failure of Lehman Brothers was a watershed event. Investors stopped making even routine transactions, bailing out of even money market funds. The effects froze the economy and greatly worsened the effects of the credit crisis. We moved from the collapse of housing prices to a widespread economic decline. It is clear now that the effects will not be short-term. There also are longer-term effects beyond the credit crisis that should influence your portfolio choices.

Some of the long-term changes from the crisis I have identified include:

Deleveraging by consumers, investors, and business will continue. The trend persists because asset prices still are declining and credit is tight.

After the crisis, the economy will not return to the pre-crisis levels of leverage. Many people and businesses will not want to take on that level of risk. Even those that do will have trouble obtaining credit.

Less leverage means lower economic growth.

Investment returns are likely to be lower than in the past few decades for several reasons. Economic growth is the driver of long-term investment returns, and GDP growth will be lower. Returns from investments are the risk-free rate, or treasury bill rate, plus a premium for taking risk. The risk-free rate currently is bouncing around zero and even after the crisis ends will be below levels of recent decades.

Also, the negative equity returns of the last 10 years will make investors more risk averse. It will be a long time before investor enthusiasm pushes investment prices to extremely high valuations.

The bottom line is the equity risk premium will be lower than since 1982. The ERP is the return of stocks above the risk-free rate. Investors have been burned and are extremely pessimistic, so they will be less willing to pay high prices for stocks. Also, the aging population alone will make investors more income- and safety-oriented and less equity- and growth-oriented.

Stocks have higher dividend yields than the 10-year treasury yield for the first time since 1958. Through 1958 it was normal for stocks to yield more than bonds, because investors believed they needed to be compensated for the higher risks of stocks. I think dividend yields will be more important to investors in coming years.

Much of the world's economic growth is likely to be in the emerging economies, especially in Asia. For many years these have been high risk, low cost producers that depended on the western economies for growth. They are developing middle classes with internal consumption, and over time that will make them less dependent on the western world for growth. Also, they have decreased risk by improving their financial systems and government financing.

There also have been some structural changes in the markets that favor change in your portfolio. There are a host of new tools that allow individual investors to invest in sectors and assets previously closed to them. These tools enable an investor to come closer to producing a portfolio with true diversification, one in which assets are not highly correlated with each other. There also are new analytical tools and approaches to investing that help reduce risk and better balance portfolios.

I recommend changing your portfolio in two stages.

The first stage is to get us through the current crisis by having a high level of safety in your portfolio. I am not anticipating a near-term turnaround in the economy or the financial crisis. You need to be prepared for continued deleveraging, disruptions in the credit markets, and unpleasant surprises from businesses and in the economic data. There will be bear market rallies, and I suggest you take advantage of them to sell riskier assets at prices above the lows and move into a safer portfolio. It is hard to tell how long you should stay in the safer portfolio. I moved Retirement Watch subscribers there late in December. It might last a few more weeks or a few years. It depends on when the credit markets and economy start to heal.

In the second stage, move into riskier investments. But build a more diversified portfolio than many people generally have. There are four major economic trends: falling economic growth, rising economic growth, falling inflation, and rising inflation. You want to be sure part of the portfolio will do well in each of these environments. We are able to do that like never before because of the new investment vehicles. Plan the portfolio now, but wait for the current crisis to be nearing its nadir before implementing it.

Bob Carlson is editor of the monthly newsletter and web site Retirement Watch at www.RetirementWatch.com. He also is the author of The New Rules of Retirement and Invest Like a Fox…Not Like a Hedgehog.

Taking Advantage of the 0% Capital Gains Tax Rate

Bob Carlson — Fri, 30 Jan 2009 22:21:00 GMT

For the two lowest tax brackets, the tax rate in 2008 through 2010 is 0% for qualified dividends and long-term capital gains. This compares to the 15% top rate others will pay on those types of income. Single taxpayers with taxable income up to around $33,000 and married couples filing jointly with taxable incomes up to about $65,100 qualify for the 0% rate. The 0% rate applies to any long-term capital gains that qualify for the 15% rate for other taxpayers, not to just to gains on publicly-traded stock.

But there is a lot of confusion and misunderstanding about the 0% tax rate.

It is not an all-or-nothing situation. Because the tax rates are graduated, even some taxpayers with incomes above the threshold could have some income taxed at the 0% rate.

Many retired couples have taxable income below $65,100. Suppose a couple normally has taxable income of $30,000. In 2009 they realize a long-term capital gain of $70,000, bringing their taxable income to $100,000. The first $35,100 or so of that capital gain is taxed at the 0% rate. The rest of the gain is taxed at the 15% rate.

Keep in mind that interest from tax-exempt bonds is not counted in determining the threshold, so well-off taxpayers can qualify some or all of their qualified income for the 0% rate.

This situation provides opportunities for low-bracket retirees to realize some long-term capital gains on asset they otherwise might not held and pay a 0% rate on at least part of the gains. There also is an incentive to switch some investments to dividend-paying stocks that qualify for the 15% rate for other taxpayers.

Another opportunity presents itself for taxpayers who are supporting parents in a low tax bracket. The taxpayers could give some appreciated securities to the parents, who sell them and pay 0% tax. The amount given should stay within the annual gift tax exclusion amount of $13,000 to avoid owing gift taxes or using part of the lifetime gift tax exemption.

Gifts of appreciated securities also could be made to children in low tax brackets, but the gifts would have to be made to adult children. Congress changed the law on the Kiddie Tax to prevent high income parents from giving securities to their minor children to sell and pay 0% capital gains taxes. To avoid the restrictions, the children must be over 21, or over 23 if they are full-time students. The restrictions also can be avoided if the children do not qualify as dependents on their parents’ tax return by providing more than 50% of their own support and earning income. Youngsters who do not meet those exceptions must have incomes less than $1,800 to qualify for the 0% rate.

Couples receiving Social Security benefits will have to be careful when executing these strategies. Increasing taxable income through the recognition of long-term capital gains also could make more Social Security benefits subject to income taxes.

In most cases, the additional tax on the Social Security benefits will be quite low and will make the effective tax rate on taking the capital gains just a few percentage points. Even so, one should run the numbers to determine the effect such a transaction would have on the full tax picture.

A taxpayer needs to consider the non-tax picture before plunging ahead to take advantage of the 0% tax rate. There must a reason for selling the asset other than to cash in the gains at a low rate. The difference between the 0% rate and 15% rate is going to be small in actual dollars, especially considering that only the gains below the taxable income thresholds for the lowest brackets qualify for the 0% rate.

Yet, if someone planned to sell the asset in the next few years, needs to reposition a portfolio, or has a new opportunity, taking a look at how to qualify at least part of the gain for the 0% rate is worth doing.

When deciding which assets to sell, one strategy is to sell stocks or other assets with the least amount of capital gains. Normally, with a tax-advantaged strategy one wants to maximize the gains taxed at the low rate. But there is a ceiling on the amount of gain that qualifies for the 0% rate each year. The goal should be to generate the maximum amount of cash at the lowest tax cost. By selling assets with the least appreciation, it is possible to free up more after-tax cash than if assets with higher appreciation were sold. This is a good strategy for retirees who are deciding which assets to sell to pay for their expenses the next few years.

The main problem now for most people will be to find assets that have capital gains in them. But those who have held assets for a long time likely have gains they have not recognized.

The 0% tax rate is tricky. But there are many retirees who qualify for it, and they should review asset sale strategies.

Bob Carlson is editor of the monthly newsletter Retirement Watch and the web site www.RetirementWatch.com.

The Neglected Step: Preparing Your Heirs

Bob Carlson — Fri, 23 Jan 2009 19:17:00 GMT

Many estate plans ultimately fail. The problems are not with the plans. The owners spent a fair amount of time and money preparing and executing the plans. They are sound plans that, if properly executed, would meet the goals.

The problems with many estate plans tend to occur in the final stage. One final stage problem is the heirs are not prepared to receive the wealth. They mishandle it. Or they did not know what was intended, so they do the wrong things. The results are squandered wealth, overpaid taxes, and lost opportunities. Inheritance mismanagement usually falls into one of three categories. Each of these types of mistakes could be avoided if estate owners understand their heirs and take the time to prepare them for the inheritances—or prepare the inheritance for them.

§ Not knowing the rules. Sometimes heirs can reap the full intended benefits of an inheritance only if they know to take certain actions, or to avoid other actions. This often is the case when the tax law is involved, as when an IRA is inherited.

For example, heirs must know not to allow the IRA custodian to retitle the IRA in their names. The deceased owner's name must remain as part of the account name if the heirs want to maximize tax deferral. Heirs also must know when to begin required minimum distributions, how to compute them, and which paperwork to complete. Otherwise, they lose the benefit of the tax deferral. They have to distribute the entire IRA within a short time and pay income taxes on the distribution.

IRAs are not the only area where heirs need to know what to do. They are one major example. Unique assets—businesses, real estate, collectibles—often require special treatment. Or the original owner has unique knowledge about how to maximize the follow of these assets.

An estate plan should ensure that heirs have the advice and information they need to make the right decisions and make them on time. I have long recommended that part of an estate plan include a letter to the executor and perhaps heirs with the basic instructions and supplemented by a notebook containing the appropriate documents, contact information, and any detailed instructions. The executor should know your intentions so these can be explained to the other heirs.

The heirs might not want to follow your advice. They might want to take all the money out of the IRA and spend the after-tax amount, for example. But they should do so knowing the alternatives and fully considering them.

§ Inheritance as a shrine. Some heirs will not use, change, or spend an inheritance. They view it as a legacy their loved one intended or as a memorial of the loved one. They come to believe that any change of the inheritance is a sign of disrespect or a loss of the final connection with their loved one.

Heirs in his mindset might be unwilling to make any changes in an investment portfolio. If they inherited a portfolio overloaded with a particular stock, they feel obligated to hold all the shares of that stock regardless of what is happening with the company. The company might be well past its growth phase and in decline. But the stock is considered the family legacy and not to be sold. Or they believe that the entire portfolio was never supposed to be changed. As the markets and the securities in the portfolio experience changes, the heirs will not allow any changes.

The truth is that many people do not sell long-term holdings during their lives because they do not want to pay the capital gains taxes. They know when heirs inherit they get to increase the tax basis to the current fair market value and can sell without paying taxes. But they do not communicate this to their heirs, so the heirs think the asset had some special value or meaning.

The same attitude might be taken towards assets such as real estate or collectibles. The heir might inherit the family vacation home. Perhaps the heir cannot afford to own and maintain it or does not have the time or money to visit it very often. But he or she believes it would be improper to sell the home. So instead of being a valuable asset it is a cash drain that produces neither financial nor personal benefits.

Once again, the solution is to make clear your thoughts about an asset and your advice. There are few assets that you should expect heirs to hold indefinitely and pass to their heirs. Assets that fall into that category should be clearly identified. You should explain why the asset is unique and should be held, so heirs can tell when circumstances have changed. You also should leave enough other assets so the heirs have sufficient income to pay any costs of ownership. If the heirs do not have the knowledge to properly manage inherited assets, such as an investment portfolio, recommend one or more sources of advice to guide them. Do not let your inheritance to them become a burden.

§ The windfall mentality. There are some people who, after receiving a windfall, do not feel the need to manage it for the long term. They view it as found money that should be used to justify taking higher risks, satisfying short-term desires, or purchasing items they would not buy with their own income or assets. Heirs with these attitudes usually go through an inheritance fairly quickly and spend it in ways that provide little for the future other than memories.

If you do not mind your loved ones treating their inheritance this way, there are no steps you need to take. Leave them what you have and let them do as they please.

You might know your loved ones well enough to realize that they will not take a windfall mentality with their inheritance. Some people are reassured after discussing the issue with loved ones and reiterating their hopes in a letter to heirs.

If you do not want the inheritance treated as a windfall and do not feel assured that your heirs will manage it properly, consider a trust. The trust can limit the spending of the heirs and preserve the assets for the future.

The bottom line is if you have intentions or preferences concerning an inheritance, you should say so. Either discuss it with your heirs now or state it in a letter to them as part of your estate plan.

Some good advice to give heirs is that they first should use an inheritance to eliminate their debts. Next, the assets should become part of their retirement fund or their children’s college funds. If they are well-funded for retirement, they can consider spending it in other ways. But providing a comfortable retirement should be their first use. If the inheritance is spent, the preference should be on items that increase wealth instead of on depreciating items that temporarily enhance life style. If you are leaving IRAs or either tricky assets, be sure the heirs are properly advised on the tax implications and other decisions.

Finally, whatever assets you leave try to ensure they are managed properly. If your heirs do not have enough knowledge, recommend some trusted advisors who can steer them toward good decisions.

Bob Carlson is editor of Retirement Watch and www.RetirementWatch.com where this article originally appeared. He also is the author of The New Rules of Retirement and Invest Like a Fox…Not Like a Hedgehog.

Trustee Strategies for the 21st Century

Bob Carlson — Fri, 16 Jan 2009 17:04:00 GMT

Trusts are part of more and more estate plans. Often trusts are used to hold and manage assets for younger generations.

Sometimes the beneficiaries are too young or inexperienced to manage the assets. Other times the older generation is afraid the younger generation might not resist temptations to spend direct gifts.

The success of an estate planning strategy involving a trust often hinges on the choice of trustee and the structure of the trustee’s job. The intentions of many estate plans have been stymied when the wrong trustees were appointed. A trustee can ignore or misunderstand a trust grantor's intentions. Or after a professional trustee or trust company is appointed, the original professional trustee might disappear in a series of promotions, job shifts, or corporate mergers. The new trustees are not as well-versed in the trustor’s intentions. Changing trustees is an increasingly common problem with all the havoc in the financial services industry.

Trust grantors need to give as much consideration to the choice of trustee as they do to the other details of the estate plan.

One strategy becoming more and more popular is to appoint more than one trustee or to divide the trustee duties among two or more trustees. There are different ways to use this specialization approach.

The original way to divide duties among trustees was simple. An institutional trustee would be appointed to handle the administration and "back office" duties. This trustee would retain custody of the assets, implement the investment transactions, prepare tax returns, and perform other duties of this type. The other trustee often would be a family member or trusted advisor to the family. This trustee would decide on the amount of distributions and make investment decisions or hire investment advisors.

A variation is to appoint co-trustees, usually one family member and an institutional trustee. The trustees have equal power. No action can occur unless each trustee agrees to it. In practice, the institutional trustee defers to the family member on issues of distributions and sometimes on investment strategy. The family member reviews the tax returns and other documents but defers to the institution on their preparation.

Still another variation is to appoint a committee of at least three trustees, usually selected from family members, friends or advisors, and an institution. The trustee agreement might require unanimity for any decision or allow an action to proceed after at least two trustees agree.

More recently, trust creators have been carving the trustee duties into separate compartments or roles and appointing a separate trustee for each role. Each trustee has sole authority over his or her sphere of responsibility.

The most logical division of duties is: investments, distributions, and administration and recordkeeping. The administration and recordkeeping (which includes custody of the assets) normally is assigned to an institutional trustee. Sometimes an account is opened with a broker or mutual fund, and the family CPA handles the taxes and recordkeeping. The other two functions can be assigned to either individuals or to committees of trustees. A committee of family members, perhaps with a third party such as a family advisor, might determine distributions. Another committee or perhaps a trusted financial advisor can make the investment decisions or hire investment managers.

The functions also could be split among institutions. A money management firm could be the trustee that oversees investments, while a bank or trust company could be in charge of custody, administration, and recordkeeping.

A variation is to appoint one or more persons as trustee with oversight of one of the functions, but the trustee is allowed to hire or delegate to others the actual performance of the functions. For example, a person or committee could be the trustees who oversee the trust's investments. Instead of making the individual investment decisions, they could hire money managers or consultants or otherwise delegate the details of the portfolio. Delegation does not relieve the trustees of their fiduciary responsibility for the results. They have to hire carefully, monitor the performance, and make changes if performance is unsatisfactory.

The advantage of splitting the trustee duties is specialists oversee each function. An institution likely is best at administration, custody, and tax preparation. Family members and friends probably best know the grantor's intentions regarding distributions. Specialization of investment management should reduce risk and increase returns.

There also are disadvantages with splitting trustee duties.

Costs are likely to increase with multiple trustees. Friends and family members might serve without compensation. Institutional trustees, however, often offer lower fees for a package deal that includes all trustee duties. They won't proportionately reduce costs to perform only the administration, custody, and recordkeeping, for example. An investment specialist firm also might or might not charge more than an institution would to manage the portfolio.

If something goes wrong with the trust the legal ramifications of dividing trustee duties are not settled. It is important to delineate each trustee's duties and responsibilities in the trust agreement. This could increase the cost of creating the trust. Part of the agreement should include a dispute resolution procedure that eliminates or reduces the risk of court action or of actions not being taken because trustees cannot agree.

Several states have changed their laws to encourage split trustee duties. Delaware, South Dakota, and a few others have laws establishing what they call "directed trusts" that allow a split in trustee duties. Under these laws, trustees in one area are not liable for improper actions of trustees in the other areas.

Income taxes also might rise with multiple trustees. A trust is considered resident in the state where the trustee resides. If there are multiple trustees and they reside in more than one state, each state might claim the trust as a resident and impose income taxes. Research on the issue is needed before trustees are selected.

An increasingly popular tool is to appoint a trust protector. This function is common in foreign trusts and recently made its way to the U.S. A trust protector is not a trustee but is a third party who oversees the trust and trustees and has broad power to protect the trust. The protector may remove and replace a trustee, change the trust's home or situs, resolve disputes between co-trustees, veto investment decisions, change trust distributions, change trust terms under unforeseen circumstances, resolve disputes between trustees and beneficiaries, or even terminate the trust.

Not all states have laws recognizing or defining the protector role. There are unresolved issues such as: What are the trustees' roles when the protector has such broad powers? Who, if anyone, oversees the protector? There also needs to be a mechanism by which a successor protector is appointed.

Trustees can mean the difference between the success and failure of an estate plan. Today, trust grantors have far more options than they did only a few years ago. They must carefully consider not only the choice of trustees but also the structure of the job.

2009 a Key Year for Roth IRA Conversions

Bob Carlson — Fri, 09 Jan 2009 20:05:00 GMT

Converting a traditional IRA to a Roth IRA has been a valuable tool to consider since the Roth was created in 1997. There are two reasons why a conversion is worth far more consideration now than in the past.

First, a brief review of the basics. A Roth IRA has "back-ended tax benefits." There are no deductions for contributions. Like a traditional IRA, earnings are not taxed while they remain in the account. The big benefit is that qualified distributions from the Roth IRA are tax free. A qualified distribution is one that occurs on the later of when the owner turned age 59½ and five years after the owner opened any Roth IRA. The distributions are tax free whether made to the original owner or to a beneficiary who inherits the Roth IRA.

Another benefit of the Roth IRA is there are no required minimum distributions imposed on the owner. The owner does not have to take money out of the IRA unless he needs it. The Roth can compound undisturbed and be left to the next generation if desired. Beneficiaries are required to take minimum distributions based on their life expectancies.

There are a few other benefits of the Roth IRA. Distributions are not included in gross income when determining the amount of Social Security benefits to be taxed. In addition, when nonqualified distributions are taken, contributions are considered to be withdrawn before accumulated income and gains. That means money can be withdrawn tax free if needed, and no taxes are due until all the contributions have been withdrawn.

A Roth IRA can provide higher retirement benefits than a traditional IRA if the tax-free compounding is allowed to work for years. With the traditional IRA, the price of deducting contributions ("front loaded tax benefits") is distributions are taxed as ordinary income. That means long-term capital gains are converted into ordinary income.

Investors with traditional IRAs may convert them to Roth IRAs if adjusted gross income is no more than $100,000. The AGI limit applies regardless of filing status. A married couple filing jointly with a joint AGI above $100,000 cannot convert, even if each would be eligible separately to convert. The AGI limit for marrieds filing separately is $0, so couples cannot become eligible by filing separate returns. Any required minimum distribution for the year does not count toward the $100,000 limit.

The price for converting a traditional IRA to a Roth IRA is to treat the converted amount as though it had been distributed. The amount is included in gross income.

We discussed conversions in some detail in past visits, and those discussions are in the Archive on the web site. Our research points to several conclusions about converting a traditional IRA to a Roth IRA:

A conversion can make sense if the Roth IRA will be allowed to compound for years before distributions begin. If a 6% rate of return is expected, it takes about 10 years of compounding to make up for paying the taxes.

The income taxes should be paid from separate assets instead of from the IRA. You want the full IRA balance to benefit from the tax-deferred compounding and eventual tax-free distributions. Otherwise it takes learn for the conversion to pay off.

The higher the rate of return of Roth IRA, the faster you reach the pay-off from the conversion. You don't want to convert a traditional IRA to a Roth IRA and invest the Roth IRA in certificates of deposit or short-term bonds.

All or part of an IRA can be converted, and there is no limit to the dollar amount that can be converted in a year. If you own more than one IRA, they can be converted in any combination you want: all of one, portions of more than one, or even all of each of them.

A nice feature of the Roth IRA conversion is that you get to reverse it if it turned out to be a bad idea. We will discuss that shortly.

One of the factors that should make a conversion to Roth IRA worth serious consideration is the bear market in investment assets across the board.

Remember the conversion tax is imposed by including the converted amount in gross income. The lower the value of the IRA on the date of conversion, the lower the tax will be. The bear market has decreased the value of many IRAs to their lowest levels in years. You can convert a traditional IRA to a Roth IRA at a much lower cost than in the past.

The benefit of converting a Roth IRA at a low level is that the future appreciation and income will be tax free. As the IRA recovers from the bear market, the value that would have been taxed as ordinary income before the bear market will be tax free after the conversion and recovery.

Converting to a Roth IRA can be an important move in restoring your retirement fund. Take the example of Max Profits, who had a balance of $500,000 in his IRA at its peak. Recently it was worth $250,000. At the peak, Max's IRA had an after-tax value of only $325,000 in the 35% tax bracket. Converting to a Roth now would cost $87,500 in taxes (compared to $175,000 at the peak). After the Roth IRA is converted and returns to its future value, the after-tax value is $500,000.

The trade off in a conversion is that you lose the money used to pay the taxes and future after-tax earnings on that money. As I said, my analysis over the years has shown that someone who expects to earn a return of 6% needs about 10 years of compounding to break even. But the forecast changes based on a number of key assumptions, including your current and future tax rates, the rates of return on the IRA and non-IRA assets, and the amount of time before distributions begin.

The calculations can be complex, and there are a number of web sites with calculators to help you. The quality of the calculators differs, because not all allow you to vary each of the assumptions. Most mutual funds and brokers have calculators on their sites. A good calculator also can be found at www.rothira.com. A few other calculators with no ties to financial products or services are at www.datachimp.com, www.voli-tion.com, www.dinkytown.com, and www.cust-omcalculators.com. (Ignore the hyphens.) Financial planners of course can do calculations for you.

Another reason to consider converting now is that income taxes are likely to rise in the future. Most political observers expect taxes to increase, and the President-elect and the majority in Congress advocated higher taxes on at least some taxpayers. If you have enough time to compound returns to make up for paying taxes early, why not pay taxes at today's lower rates? Doing so shortens the pay off period.

The conversion to a Roth IRA essentially is risk free, because if circumstances change or there is a mistake in your assumptions, you can reverse the conversion, known as a recharacterization.

The two most common reasons to reverse a conversion are that the portfolio continued to decline in value and that AGI income exceeded the $100,000 limit. Some people also recharac-terize when the conversion pushes them into a higher tax bracket or when they no longer have cash to pay the conversion taxes.

A recharacterization can be done any time before the due date of the tax return for the year of the conversion, including extensions. The extension date can be used for the recharacterization even if the taxpayer filed the return by April 15. For example, if an IRA is converted in 2009, the recharacterization can occur any time up to Oct. 15, 2010, regardless of when the 2009 return is filed.

After a recharacterization, it is possible to convert to a Roth IRA again. The second conversion cannot occur in the same calendar year as the first. The second conversion also cannot occur within 30 days after the recharacterization.

Higher income individuals will have a chance to convert their traditional IRAs to Roth IRAs in 2010 and later years, unless the law changes. All taxpayers who convert in 2010 will have the opportunity to defer taxes on the conversion, again unless the law changes. Details about the opportunities in 2010 were in our March 2008 visit, which is available in the web site Archive.

IRA owners with AGI of $100,000 or less must consider whether to convert their IRAs in 2009 or 2010. The benefit of a conversion in 2010 would be the ability to defer taxes on the conversion interest free. The larger benefit, however, is likely to come from converting the IRA at a low value. Watch your portfolio. If it remains stagnant or in a trading range through 2009 as I expect, waiting until 2010 to convert is worthwhile. But if a new bull market seems underway, convert before it goes too far. The tax savings from a low conversion value are more valuable than deferral in 2010 at a higher value.

More details about conversions to Roth IRAs are in my book, The New Rules of Retirement, and are in the member’s-only section of my web site Archive at www.RetirementWatch.com.

Four Estate Planning Mistakes to Avoid

Bob Carlson — Fri, 19 Dec 2008 20:03:00 GMT

Estate planning and tax reduction will be returning to the front burner for many people. Congress was unable to pass a permanent estate tax reduction in recent years, but a permanent law is likely in 2009 or 2010.Changes in Washington made permanent repeal of the estate tax unlikely, but something similar to the law as of 2009 is likely to be permanent.

As readers re-focus on their estate plans, they should take care to avoid the four main types of errors committed by estate owners. These errors do not concern taxes or probate. The most common mistakes involve family dynamics. These mistakes either create harmful relationships within the family or lead to mismanagement of wealth. Even an estate plan that eliminates taxes can fail if it does not avoid these mistakes.

Giving too soon. Many estate owners allow heirs full access to their inheritances when they become adults or shortly thereafter. Some parents or grandparents reason that the heirs are adults. They can drive, vote, and join the military, so they should be trusted with their inheritances. Others believe the heirs have shown themselves to be responsible and will be able to handle the inheritance.

Being mature and responsible is not the same thing as being able to handle a relatively large sum of money. Young adults, even mature ones, rarely think about the long term, or they might treat something given to them differently from the way they treat something they earned.

Some parents and grandparents say they aren't concerned about what happens to their wealth. They are going to give the money to the people they want to have it. Whatever happens to the wealth is not their concern.

Yet, giving an inheritance too soon can be bad for a young person. The heir might believe that the money will last forever and neglect career opportunities or engage in some personally destructive behavior.

The damage from giving money too soon is most likely when the young person has not been involved in discussions about money with the older generations and has not learned how to handle money. Parents and grandparents should realize that managing an allowance is not similar to investing an inheritance and establishing a long-term spending policy. Estate owners need to take care before giving a young person unrestricted access to wealth.

Giving too late. Some estate owners will not make lifetime gifts, no matter how financially comfortable they are. This can create several problems. One problem is that children or grandchildren might not receive anything until they are nearing their own retirement. Receiving the wealth earlier, or at least being certain of receiving it, might have changed life decisions. The wealth could have helped enhance their lives and those of their children. More importantly, giving only through the will leaves the children to manage the estate at the same time they are coping with their grief.

At a minimum, parents and grandparents should discuss their plans with the heirs. The heirs should be given some idea of what they will inherit, when they will receive it, and suggestions about how to handle it. Ideally, children receive portions of their inheritance over time so they get used to it and learn how to manage it.

Too many controls. Some people like to give and retain control at the same time. The classic way is to leave wealth to a trust with controls and incentives. These trusts can be beneficial. They encourage young people to stay in school or hold jobs in order to benefit from the wealth. They also spread out distributions, so people become comfortable with the wealth and learn how to manage it. But the trusts also can go too far.

An incentive trust might penalize someone whose passions do not include higher education or a high-paying job. Or the trust might be written so narrowly that it does not take into account a number of situations that could arise. Some trusts actually are written so that beneficiaries feel encouraged to have additional children. Restrictive trusts also can breed hostility and frustration among the heirs as they get older and realize their parents or grandparents did not trust them to act responsibly.

Incentive trusts can be useful in some situations. But their creators must carefully consider the incentives and how the trust will be administered. An incentive trust generally should be a way of safeguarding assets until the heirs are likely to be mature enough to manage the money. It should not be a way to control people for life or be a substitute for imparting values during life.

Giving too much. Warren Buffett used to say that his goal was to give his children enough money that they can do anything but not so much that they can do nothing. In some estates, the children receive the entire estate without real consideration of other options, including other family members or entities outside the family, such as charities.

If the children have done well on their own, it might be better not to give them everything. Or if the children simply are not responsible, they might be better off with a relatively small inheritance.

There can be benefits to both the family and the estate owner from considering several generations and beneficiaries outside the family when there is enough wealth involved. For example, the charitable contributions can be structured in ways that get the heirs involved in the giving and teach them about philanthropy.

Giving unequal amounts. There is another problem in some estate plans that is not really a mistake but needs to be carefully managed. Estate owners need to be careful when giving unequal amounts to children.

There can be good reasons to give unequally. Perhaps a child has done very well financially and does not need the wealth. Or one child might have demonstrated that he or she cannot be trusted with an inheritance. But unequal inheritances can create hard feelings toward the parents. They also can create animosity and jealously among the siblings. The situation can be more inflamed when there is a family business. Often, one or more siblings are not qualified to have a significant role in the business, or the parents believe that one person needs to be in control.

Most of these problems can be minimized through communication. Parents and grandparents need to make their plans known ahead of time. This gives everyone a chance to become familiar with the plan and allows for questions and discussion. It also gives a child or grandchild the opportunity to demonstrate that the plan is wrong.

Some estate planners recommend having social workers or psychologists help with the discussion, having the discussion moderated by the estate planner, and even videotaping the discussions.

One goal of estate planning is to get assets to the intended beneficiaries in an efficient way. But this should be done in ways that do not harm family members or make family relationships worse. It can be done in ways that improve family dynamics.

Bob Carlson is editor of Bob Carlson's Retirement Watch and author of The New Rules of Retirement and Invest Like a Fox...Not Like a Hedgehog. This posting is adapted from materially previous published in Retirement Watch. www.RetirementWatch.com

A Tricky Year-End for IRA Owners

Bob Carlson — Fri, 05 Dec 2008 14:15:00 GMT

Update Dec. 19: On Dec. 11 Congress passed legislation that suspended the required minimum distribution requirement for 2009. But it did not change the requirement for 2008. the IRS was asked by members of Congress to suspend the requirement for 2008. But on Dec. 17 it sent a letter to key members of Congress saying it would not do so. An IRS official told the Washington Post that it did not have authority to change the rules. Only Congress could do that. In addition, the IRS could not devise a solution that would be fair to those who took their 2008 RMDs before December.

The financial crisis continues to have secondary effects few people anticipated. Decisions are required now, especially with regard to IRAs. Let's take a look at the key issues in question-and-answer format.

Is there relief for IRA owners over age 70½ who have not yet taken their required minimum distributions for the year?

IRA owners must take required minimum distributions by April 1 off the year after they turn age 70½ and by Dec. 31 of each year after they turn age 70½. The RMD is computed based on the IRA balance as of Dec. 31 of the preceding year. The Dec. 31, 2007, balance is used to determine the 2008 RMD. We discussed details of computing the RMD in the April 2008 visit, and that discussion is available on the web site Archive.

The problem for 2008 is that many IRA balances are far below their 2007 levels. Major stock market indexes are down around 35% to 40% from that date. Some investments declined even more. IRA owners who have not already taken their RMDs for the year are required to take RMDs on wealth that no longer exists.

There is only one limited provision in the tax law to reduce the RMD in this circumstance. The RMD is fulfilled when the amount taken from the IRA brings the balance to zero. That does not help many IRA owners. If taking the RMD does not wipe out all your IRAs, you are required to take the full RMD as calculated using the 2007 balance.

Several proposals were put forth in Congress in 2008 to provide some way of altering the requirement for those whose IRAs declined. None was enacted, but there is a possibility of some action in a special session now taking place. If there is a bailout bill for the auto companies there is a chance a waiver for RMDs will be included. But that is not very helpful, since you have to take your distribution by Dec. 31, and IRA sponsors often get backed up this time of year. If you wait to put your RMD order in, it might not be processed by Dec. 31. IRA owners are in a tough spot on this issue, because waiting to see if Congress acts could mean a distribution won’t be made by the Dec. 31 deadline if Congress does not act.

Can the RMD be avoided by converting the traditional IRA to a Roth IRA?

The original owner of a Roth IRA does not have to take RMDs (though beneficiaries who inherit Roth IRAs do). A traditional IRA can be converted to a Roth IRA when the owner's adjusted gross income is no more than $100,000. There are taxes due on the conversion. The converted amount must be included in gross income as though it were distributed. The converted amount and any RMD for the year do not count in determining the $100,000 limit.

This is a good time to convert a traditional IRA to a Roth IRA, because asset values have declined. You can make the conversion at a much lower cost than a year ago, and the future income and gains will be distributed tax free to you and the IRA beneficiary.

A conversion, however, cannot be used to avoid a current required minimum distribution. If the IRA owner is required to take an RMD for the year, the RMD still must be taken even if there is a conversion and regardless of the date during the year the conversion occurred. The conversion, however, will avoid future RMDs.

If I have to take an RMD this year, which assets should I sell to take it?

A common misconception about RMDs is that an asset has to be sold and then the cash distributed from the IRA. In fact, a distribution of either cash or property meets the requirement, as long as the value of the property on the day of the distribution equals the RMD for the year. Or if several distributions are taken over the year to fulfill the RMD, the aggregate of the property values on the dates of their distributions must at least equal the RMD. You don’t have to sell any assets to take an RMD.

Most IRA custodians also offer taxable accounts. It is a simple procedure to set up a taxable account at the custodian. Then, direct the custodian to transfer property from the IRA at least equal in value to the RMD to the taxable account. The transferred property can be bonds, shares of stock or mutual funds, other securities, or any other property in the IRA. The custodian will determine if some of the property is not transferable.

If the custodian does not offer taxable accounts, set up a taxable account at another financial institution that will accept the assets. Then, have the securities or other assets transferred from the IRA to the new taxable account. This transfer might take more time, so the paperwork has to be started earlier in order to meet the Dec. 31 requirement.

If you do not want to sell assets to fulfill the RMD, you do not have to. Instead, distribute property from the IRA to a taxable account. The value of the property at the time of the distribution will be included in gross income and count as the RMD. The tax basis of the assets will be their value on the date of distribution, the same amount included in gross income. Because of the tax treatment, it makes sense to distribute those assets that have declined the most and are likely to appreciate the most in the future. Once those assets are in a taxable account, future appreciation is likely to be taxed as long-term capital gains. If the assets remained in the IRA, future appreciation would be taxed as ordinary income when distributed. Also, if the assets continue to decline in value after being distributed, the assets can be sold and the loss deducted on the tax return. Losses in an IRA cannot be deducted in most cases.

I need at least part of the RMD in cash to pay expenses. How should I determine which assets to sell and distribute? Those that have declined the most, the least, or some other measure?

One step investors fail to take on a regular basis is to rebalance their portfolios. A portfolio should have a target asset allocation that meets your return goals and risk tolerance. Over time the markets move the portfolio out of balance because the investments will have different rates of return. The portfolio should be rebalanced to bring it back to its original allocation target.

RMDs can be used to rebalance the portfolio. Sell or take distributions of assets in ratios that bring the portfolio to its target allocation. Sell assets that are above or closest to their targets. That is the fastest way to bring the portfolio back to target. Other changes can be made within the IRA to bring it back to your target allocation, such as selling those that have declined the least to buy more of those that are farthest from their targets. You can choose to make sales and distributions in other ways, but recognize that those would be a change in your portfolio strategy.

Another approach is to use tactical asset allocation to choose the RMD assets. For example, you might choose to hold the assets that have held their value best. Or you might hold those that have declined the most, believing they are likely to appreciate the most when things turn around. Either move would be a bet on coming market trends. The first strategy would be an assumption that recent trends will continue. The second move would be based on a belief that we are near a bottom and you want to capture the following rally. There is nothing wrong with either move. Be aware that you would be straying from your initial strategy and effectively making a forecast about the market.

I sold an asset in my IRA to take a distribution. Can I buy that same asset in my taxable account?

This question is a reference to the "wash sale" rules which prevent a taxpayer from selling an asset to deduct a loss but immediately buying the same asset so that the portfolio position has not changed. The wash sale rules say that a loss deduction is deferred if a substantially identical asset is purchased within 30 days before or after the sale. The wash sale rules apply whether the substantially identical asset is purchased in an IRA or taxable account.

Since a loss incurred in an IRA is not deductible, however, the wash sale rules do not discourage or prohibit you from purchasing a substantially identical asset in a taxable account after selling it in an IRA.

What are the rules for making charitable donations directly from an IRA?

For most people, there is no good reason to make a charitable contribution from an IRA. If you do, the amount is treated as a distribution and included in gross income. You can take a charitable contribution deduction for the identical amount. But you must itemize deductions on Schedule A to benefit. In addition, if your income is high enough, the itemized deduction reduction reduces the amount of your charitable contribution. So, you might not have a full offset of the amount included in gross income.

Those who are over age 70½ receive special treatment. This provision was in effect for 2007 only but recently was extended to the end of 2009.

The special treatment is that a charitable contribution can be made directly from the IRA without including it in gross income. There is no offsetting deduction, but there is no gross income either. Only the first $100,000 of charitable contributions from IRAs each year receives this treatment. In addition, the contribution must be made directly from the IRA to the charity. You must direct the IRA custodian to make the transfer or issue a check.

Another bonus is that the donation can count as part of your RMD for the year. You still are required to take the full amount of the RMD based on the 2007 balance. But by giving all or part of the RMD to charity, the amount does not have to be included in gross income.