Retirement Watch : iras

What Your Heirs Should Know About IRAs

Bob Carlson — Thu, 12 Nov 2009 18:28:00 GMT

Heirs routinely lose a large percentage of inherited IRAs to unnecessary taxes. The rules are simple, but they aren't obvious and most heirs don't know about them or to ask about them. If you don't want a large portion or your hard-earned wealth and careful plans wasted, be sure your heirs know how to manage their new IRAs. Here are some key points.

* Spouses vs. non-spouses. A spouse who inherits an IRA has one big advantage over other beneficiaries. He or she can roll over the IRA to an IRA in his or her own name, providing the spouse with a fresh start for the IRA. The beneficiaries and required minimum distribution schedule can be reset. This often is a good idea for an inheriting spouse. But non-spouses who are beneficiaries cannot rollover the IRA to a new IRA.

* Naming the IRA. Other than a spousal rollover, heirs should not make the mistake of changing the IRA to their own names or allow the custodian to do so. That would require a rapid distribution of all the IRA. An inherited IRA needs three things in its title: the name of the deceased owner; the word "IRA"; and the statement that it is "for the benefit of" the beneficiary. An appropriate title is "Max Profits IRA (deceased), F/B/O Hi Profits, beneficiary.

* Deadlines. After inheriting an IRA, beneficiaries have options and reuirements. Required minimum distributions must begin, for example, and joint beneficiaries can split the IRA into separate IRAs for each beneficiary. But these actions must be taken by the end of the year after the year in which the owner died. Failure to act by the deadline ends the right to take an action and can result in higher taxes than would otherwise be paid.

* Splitting the IRA. A single IRA can be left to multiple beneficiaries. For example, Max Profits can name his three children as equal beneficiaries. If they decide to share the IRA, required minimum distributions are based on the age of the oldest beneficiary. The owners also would have to agree on how to invest the IRA and on rules for taking distributions beyond the required minimums. An alternative is to split the IRA into a separate one for each beneficiary. Most IRA custodians allow the IRA to be split in this way. Beneficiaries need to know this option is available and how to exercise it.

* Distributions. Most heirs tend to withdraw all the money from an inherited IRA quickly, pay taxes, and spend the after-tax amount. When beneficiaries prefer to use the IRA’s tax deferral, they should know how to compute required minimum distributions. The amount of the RMDs depends on whether or not the original owner was already taking RMDs, and the beneficiary also has two options in each case.

Suppose the deceased owner was not over age 70½ and had not begun RMDs.

The first option for the beneficiary is to begin taking distributions using the beneficiary's life expectancy. The second option is to distribute 100% of the inherited IRA to the beneficiary by the end of the fifth year following the year of the original owner's death. In the second option, the distributions can be taken on any schedule the heir wants. For example, the entire amount could be left in the IRA until the end of the fifth year. Or roughly equal amounts could be taken each year. Or money could be withdrawn as needed, with whatever is left in the IRA distributed by the end of the fifth year.

The first option is best for an heir who wants to use the IRA's tax deferral for as long as possible. Remember, an amount exceeding the RMD for the year can be withdrawn at any time. The second option is for an heir who doesn't intend to use the long-term tax deferral of the IRA. The five-year period gives the beneficiary time to search for ways to reduce income taxes on the distributions.

The options are a little different when the deceased owner already started RMDs.

The first choice again is for the heir to take annual installments over the beneficiary's life expectancy. The second option does not include a five-year rule. Instead, the heir can continue the RMDs on the schedule begun by the deceased owner, using what would have been the deceased’s age and life expectancy each year. The IRS says that the second method is the default method if the beneficiary does not make a selection or the IRA custodian does not name the other method as the default.

* An overlooked deduction. Most taxpayers and even many tax advisers are unaware of the deduction for "income in respect of a decedent.” Many people who inherit a substantial IRA are eligible for this deduction, which essentially is a deduction for the estate taxes that were paid on the IRA. The deduction is best explained with an example.

Suppose someone left a large estate with an IRA. The estate tax accountant computes that the IRA was responsible for 36.7% of the estate tax paid, and that the IRA's dollar share of the estate tax was $175,000. When the beneficiary takes distributions from the IRA, a miscellaneous itemized deduction (not subject to the 2% floor) of 36.7% of each distribution is allowed. This continues until the beneficiary has deducted a total of $175,000 over the years.

The estate tax accountant should determine the data for the deduction. Details can be found in the IRS Publication 559, Survivors, Executors, and Administrators, available free on the IRS web site, www.irs.gov.

* Disclaimers. The details of who should inherit an IRA can be left to your executor who, along with family members, can determine from both a financial and tax standpoint who should be the Designated Beneficiary. The Designated Beneficiary does not have to be selected until Sept. 30 of the year following the year of the owner's death. The first required distribution does not have to be made until Dec. 31 of that year. But the Designated Beneficiary must be one of a group of primary and contingent beneficiaries named by the account owner.

The way to take advantage of this provision is for you to name both primary and contingent beneficiaries. After your heirs and executor decide who should inherit, those who are ahead of that person in the beneficiary chain can disclaim their interests.

There is a procedure in the tax law for making qualified disclaimers. Your heirs and executor should be aware of your intentions and this process, and you should give the executor guidelines for making the decision and advising the beneficiaries.

All your work of growing and preserving the IRA over the years and planning your estate could come to naught when your heirs mishandle the IRA. Be sure they know their options and obligations and have good advice on how to handle the inherited IRA.

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

When It Pays to Mix Annuities and IRAs

Bob Carlson — Fri, 02 Oct 2009 14:25:00 GMT

Most of the time it’s not a good idea to combine an IRA with an annuity. The IRA already has tax deferral, so why take on the costs and limitations of an annuity? But there are a couple of times when it may make sense to mix an annuities with an IRA. We take a look at two such situations.

Managing RMDs

When it is time to take distributions from an IRA, there are two goals of most IRA owners. One goal is to make the income last at least a lifetime, hopefully leaving something for a spouse or younger heirs.

The other goal is compute the required minimum distributions (RMDs) due after age 70½ so penalties are avoided.

The two goals can conflict. RMDs increase the risk of depleting the IRA early. That’s why a goal of many IRA owners is to minimize RMDs.

One way around this conflict is to purchase an immediate annuity about the time RMDs must begin. An immediate annuity begins distributions within a year of purchase and pays the same amount every year for a guaranteed period. Most people purchase an annuity that makes payments for life or for the joint life of the IRA owner and his or her spouse.

The insurer takes care of the RMD compliance, and purchasing an immediate annuity usually is considered to be fulfilling the RMD rules. The IRA owner does not have to worry about computing distributions or consulting the rules.

The annuity comes with the insurer's guarantee that payments will continue for the chosen period. If the insurer has financial difficulties it might not be able to make good on the guarantee. So, it is important to choose an insurer that seems financially secure.

A downside to the annuity is less flexibility. If you have an emergency financial need, your ability to draw additional money from the annuity is limited. With a straight IRA, you can take out as much money as you need above the RMD. Many insurers have loosened distribution rules so that you can take as much as 10% of the annuity balance in a year. The provision increases costs and reduces the annual payouts. It is better to have other assets available outside the IRA to handle unexpected expenses.

Another downside to the annuity is that payments are fixed. They do not increase with inflation, interest rates, or anything else. There are some inflation-indexed annuities available, but they have substantially lower initial payouts. Again, it is good to have assets other than the IRA that can be invested for growth and be available to increase annual spending as costs increase.

The annuity payments can continue to beneficiaries if you select such a payment schedule. That will result in lower payouts during your lifetime, but it ensures something is available to your heirs and the insurer does not profit if you die before life expectancy. The insurer also would manage distributions to beneficiaries. That relieves you of the burden of ensuring they understand how IRA inheritance rules work and can prevent your heirs from spending the entire amount quickly.

Charitable annuity

Taxpayers who are charitably-minded also have a problem with IRAs. The tax advantages of making gifts from the IRA are not great. You can take a distribution from the IRA, include it in gross income, issue a check to the charity, and deduct the contribution. That could result in no taxes, if you itemize deductions on Schedule A and are not in the higher tax brackets for which itemized deductions are reduced.

There is a temporary provision that allows a taxpayer who is at least age 70½ to have up to $100,000 transferred directly from an IRA to a charity. The money is excluded from gross income and no deduction is allowed. But that applies only to a few taxpayers and for a limited time.

One strategy to cope with these problems is the charitable gift annuity. Here is how this strategy works.

The IRA owner takes a distribution from the IRA of any amount, including the entire IRA, which is included in gross income.

The distribution is used to purchase a charitable gift annuity. This is an annuity contract purchased from a public charity. The charity will make regular payments to the owner for life, just as an insurer of a commercial annuity will. The owner can choose from different payment options, such as for life or for the joint life of the owner and a beneficiary.

The amount of the payouts is less than from a commercial annuity. The difference is a gift to the charity, and the owner receives a charitable contribution for the amount of the gift in the year the annuity is purchased.

The amount of the gift is determined from IRS tables that use current interest rates and the owner's age to set the deduction amount. The older the owner is, the greater the deduction. The deduction offsets some of the distribution that was included in gross income. The deduction depends primarily on your age and might offset up to half the distribution.

When payments are received from the annuity, a portion is tax free as a return of your basis or investment in the annuity. The basis is considered to be received pro rata over your life expectancy. Contrast that with when an annuity is purchased directly by the IRA. In that case, all of each distribution is likely to be included in gross income.

The charitable gift annuity strategy should be used only by someone who has charitable intentions. But for such people when the charitable contribution is considered along with the partial tax-free treatment of each payment, the after-tax cash is likely to be comparable to that of simply purchasing an annuity with the IRA.

The promise to make the payments is backed by the charity. If the charity founders financially, it might default on the annuity payments and you would be an unsecured creditor. We have seen a number of smaller charities suffer financially in the bear market or because they invested with con artists such as Bernard Madoff. Take care when determining the charity with which you do business. Favor a long-established charity with a diverse funding base and years of experience with gift annuities. Some charities purchase annuities from commercial insurers to back up their obligations. But you would not have ownership rights in that annuity or be entitled to take title to it if the charity defaults or runs into financial trouble. One popular option is to purchase the annuity from a donor-advised foundation or community foundation. These charities support a number of causes and sometimes give donors input into how their gifts are used.

There is no need to shop around for the best payout. Almost all charities agree to use the same payout formula.

When the annuity owner has other sources of income to pay living expenses, the annuity payments might be used to purchase life insurance. The life insurance can pay estate taxes or increase the inheritance of the heirs. The inheritance would be tax free, so that would leave the heirs with a better after-tax position than if they had inherited the IRA. Combining the charitable gift annuity with life insurance could leave the heirs and charity with more after-tax money than the alternatives.

Annuities are attracting more people because of their security and steady, guaranteed income. Some IRA owners will find that annuities can make retirement easier and be a powerful complement to their IRAs.

Who Will Benefit from Your IRA?

Bob Carlson — Fri, 25 Sep 2009 00:17:00 GMT

One of the most important decisions about an IRA is naming the beneficiary or beneficiaries. There are many candidates for the biggest mistake made by IRA owners, and a leading contender is the failure to name a beneficiary or naming the wrong beneficiary.

If no beneficiary is named, the estate is the beneficiary. When an estate or another non-individual is a primary beneficiary, the entire IRA must be distributed within five years after the original owner's passing. The estate, as the beneficiary, will owe income taxes on the distributions, in addition to any estate taxes due on the value of the IRA. An IRA owner should never fail to designate at least one qualified individual as primary beneficiary and should never name the estate or other non-individual as a primary or contingent beneficiary. The only exceptions are when there is no interest in allowing heirs to use the tax deferral of the IRA and for certain trust that are allowed to defer distributions.

Since new regulations were issued in 2001 and 2002, the choice of beneficiary is not fixed and does not affect required minimum distributions. The major consideration in naming the beneficiary is: Who should receive the IRA in light of the goals, tax issues, and any other factors that are important to the owner?

After deciding on the primary beneficiary or beneficiaries, the owner also should name contingent beneficiaries. These are people who inherit if the primary beneficiaries are not available or disclaim the inheritance. Naming contingent beneficiaries can be part of a good strategy. The estate executor names the Designated Beneficiary of an IRA by the end of September of the year after the owner passed away. The DB's age determines the required minimum distributions for the IRA. The DB must be on the list of primary or contingent beneficiaries.

Naming contingent beneficiaries allows the executor and heirs to adjust the estate plan if circumstances have changed. Primary beneficiaries who believe it is best for the family that someone else inherit the IRA can disclaim their rights. Disclaimers can continue until the "right person" is available to be named DB. That cannot happen unless contingent beneficiaries are named.

Customized Beneficiary Forms

When naming beneficiaries, it often can be best not to use the Beneficiary Designation forms provided by IRA custodians. A number of estate planners draft their own forms and have them reviewed and approved by the custodians.

One value to a custom beneficiary form is it allows the owner to name more than one primary beneficiary and leave them unequal shares, something that often is difficult or not possible with standard forms. A custom form ensures that the form lists all the beneficiaries the owner wants named. Another benefit to a custom form is, if there are disclaimers or premature deaths of beneficiaries, contingent beneficiaries will succeed primary beneficiaries in the desired order and not in an order dictated by the IRA custodian.

While a standard form might work for many people, those with multiple beneficiaries or less-than-standard situations should consider having their estate planners draft custom forms and file them with the IRA custodian.

The IRA owner also should consider who would receive the share of a beneficiary who dies prematurely — either before inheriting a share of the IRA or after distributions to heirs begin. Should the share go to the children of the beneficiary, or should it be shared by the other primary beneficiaries? Or should it go to a different contingent beneficiary?

The choice is up to the IRA owner, but it has to be stated in the designation form. Otherwise, most IRA custodians have a default position they implement absent instructions from the IRA owner. State law also might establish a default position. The IRA owner should consider the issue and make the choice clear in the designation form.

Another issue: Suppose a beneficiary or contingent beneficiary is young or cannot be trusted to handle the IRA properly. Then, it might be appropriate to name a trust as the beneficiary of the IRA. Naming a trust also is appropriate when the intended beneficiary has special needs.

A trust that is an IRA beneficiary must have precise terms in order to take advantage of the IRA’s tax deferral. With the wrong trust terms, the IRA balance must be distributed and taxed on an accelerated schedule. The help of an experienced estate planner is needed to set up the trust properly.

Splitting IRAs

When there are multiple objects of affection, one option is to name them as joint primary beneficiaries. An alternative is for the IRA owner to split the IRA into separate IRAs, naming a separate beneficiary and a group of contingent beneficiaries for each. IRS regulations allow beneficiaries who jointly inherit an IRA to split it. Yet, not all beneficiaries know about this right or are able to agree to execute it. The owner might find it wise to split the IRA now rather than leaving that to the estate administration process.

I frequently emphasize that an estate owner who plans to leave something to charity should consider using the IRA to do so. Unlike other beneficiaries, the charity will fully benefit from the IRA. Charities are tax-exempt. A charity can withdraw the entire IRA balance and not owe income taxes on it. In addition, naming a charity as beneficiary avoids the estate tax. The IRA is included in the estate, but there is an offsetting charitable contribution deduction for the amount left to the charity.

Because non-charitable heirs benefit more by receiving non-IRA assets, leaving the IRA to a charity can be a good deal for all involved. When the estate owner plans to leave part of the estate to charity and there are enough non-IRA assets for other beneficiaries, the owner should consider leaving all or part of the IRA to charity while leaving the other assets to non-charitable beneficiaries.

When considering IRA beneficiaries as part of an estate plan, there are a couple of other strategies I frequently recommend that you should consider as alternatives.

One strategy is to avoid all this by emptying your IRA early. Distribute all or most of the IRA, pay the taxes, and invest the after-tax amount. That gives you more flexibility over how to give away the balance and probably gives the heirs a larger after-tax amount in the long term. This can be appropriate for someone with a large IRA and other income or assets to maintain the standard of living. It also is best if you expect the after-tax account to have 10 years or more to growth and compound before money is withdrawn.

Another strategy is to convert the traditional IRA into a Roth IRA. This does not avoid the choice of beneficiary, but it makes the distributions tax free. Keep in mind it costs money to convert to a Roth IRA.

I have discussed the details of both of these strategies in past issues of Retirement Watch and in my book, The New Rules of Retirement.

Designating IRA beneficiaries is a neglected step in many estates. Take care to designate beneficiaries with care and use a custom beneficiary designation form if necessary. Taking these steps can increase the after-tax wealth of your heirs by tens of thousands of dollars. A will or living trust has no influence on who inherits your IRA or other qualified retirement account. Only the beneficiary designation form counts. Make your designations carefully, update them as needed, keep copies of all forms, and be sure the executor knows where the forms are.

Avoiding Estate Planning Mistakes

Bob Carlson — Thu, 17 Sep 2009 19:40:00 GMT

The success or failure of an estate plan often depends on small details. Amid all the big picture issues (taxes, trusts, gifts, business interests), these matters may seem too small to deserve much time. Don’t have that attitude. It could cost you and your heirs.

Don’t make these very common estate planning mistakes.

* Overlooking non-probate assets. These assets are excluded from the “probate estate” and avoid the probate process, so their disposition is not covered by the will. (They likely are included in the gross estate for tax purposes.) They are covered by law or by contract. These assets include IRAs, employer retirement plans, life insurance, and annuities. Living trusts and all the assets in them also avoid probate.

Retirement plans, annuities, and life insurance have beneficiary designations that must be completed, either as a section of the account application or contract or in a separate document. For each of these non-probate assets, the custodian or account sponsor looks only at the forms in its records. Whoever is listed as beneficiary gets the asset. Often, a beneficiary designation form was completed many years ago, perhaps before the owner was married or had children. In the ensuing years, the owner’s marital or family situation could change. Yet, many people forget about their designation forms and do not update them.

Every estate owner should keep a copy of all beneficiary designation forms and review them every couple of years. More frequent updates are necessary as family situations, goals, and objects of affection change.

A related mistake is not to name contingent beneficiaries. These are needed because a beneficiary might pre-decease the owner or otherwise be unable to inherit. Another reason to have contingent beneficiaries is the primary beneficiaries might realize that due to changed circumstances it would be better for all concerned if someone else inherits the asset. The named beneficiary (or beneficiaries) could file a document known as a disclaimer, refusing the inheritance. The account then would go to the next contingent beneficiary.

* Many people set up living trusts but neglect to fully implement them or update them as needed.

One often overlooked detail with living trusts is that ownership of assets must be transferred to them. Only the assets legally owned by the trust avoid probate and are controlled by the trust’s terms. Too many people do not do the work of transferring the legal title of homes, vehicles, and financial accounts to their trusts, making the trusts useless.

It also is important to check with financial institutions to determine if they need a copy of the trust on file. A number of financial institutions are hesitant to recognize succession clauses in a living trust unless a copy of the trust agreement was filed with them in advance or they have other proof of the initial trustee's intent before transferring power over the accounts.

As with a will, there also might be a need to change trustees and beneficiaries. There should be successor clauses for beneficiaries and trustees that automatically make changes in certain circumstances. The clauses should be carefully written, updated as needed, and the successors made aware of the situation.

* A financial power of attorney is essential to every estate plan. Most estate plans focus on one's demise, but the possibility of disability also must be considered. Someone should have legal authority to manage the finances during a period of disability. If plans haven't been made, loved ones must go to court to have someone appointed. At that point, the owner has no control over the choice.

One reason to get started on the POA is that most financial institutions require that a copy of their own POA form be signed and on record to be effective. They might not accept the form drafted by an attorney or might delay its acceptance for some time. They also might not accept a form that is not filed with them until the principal is disabled.

* There are other details that are part of a complete estate plan. Parents of minor children should designate guardians in case of the demise of both parents. An estate owner also should create a beneficiary book that contains most important financial documents, plus descriptions and locations of other assets and records. There also should be instructions for the estate executor and those who inherit special assets. Funeral, memorial service, and burial instructions can be suggested by the estate owner and should be included in the book. I have discussed all these issues in more detail in regular issues of my newsletter, Retirement Watch.

Over the years estate planning has become synonymous with tax planning. There are other issues that are as least as important as taxes. A goal of estate planning is to manage assets and transfer them as efficiently as possible to the objects of one’s affection. Reducing taxes is part of that process, but there are other aspects that also affect how much of the assets reach loved ones and how efficiently that transfer occurs.

Your IRA and Your Heirs

Bob Carlson — Fri, 29 May 2009 20:22:00 GMT

The unfortunate fate of many IRAs shows why everyone needs an estate plan, even when the value of the estate is far below the taxable level. Few people are aware of what could happen to their IRAs when the next generation inherits them. Most people, and discussions of IRAs, focus on building the balance through contributions and investments. If your IRA is a meaningful portion of your estate, however, you better consider what will happen to it. Effective estate planning strategies for IRAs tend to be different from the rest of the plan.

An estate plan for IRAs should answer these questions: What will be the bills for estate taxes and income taxes? Who will pay those taxes? Who will receive the IRA? In what form will the IRA be received?

There is a great deal of confusion about how inherited IRAs are taxed. The value of the IRA will be included in the owner's estate. Unlike other assets, ownership of the IRA cannot be given away during life or put into a trust for the benefit of others. If the IRA owner's estate will be large enough to incur estate taxes, the owner has to use other assets to reduce the tax or purchase life insurance to pay the estate tax. Most likely the IRA also will incur any state death or inheritance taxes.

Estate taxes can be avoided when the surviving spouse is the sole primary beneficiary of the IRA. The IRA’s value will be included in the owner’s estate, but there will be an offsetting marital deduction when the spouse inherits.

When estate taxes are incurred on an IRA the next issue is: Who pays the taxes attributable to the IRA?

Most standard wills provide that estate taxes are paid from the residuary estate or from the surviving spouse's share. Other estates apportion the taxes against specific assets or shares of the estate. If the IRA is a large percentage of the estate and taxes are paid from the residuary estate or surviving spouse's share, the taxes attributable to the IRA could really shrink the after-tax value of the shares paying the taxes.

Having the taxes attributable to the IRA paid by the beneficiaries of the IRA could create problems. If the beneficiaries do not have sufficient other assets to pay the taxes, they will have to take a distribution from the IRA to pay the taxes. The distribution will be included in their gross income for income tax purposes, so they will have to take an extra amount to pay the income taxes on the distribution they take to pay the estate taxes.

The best solution depends on the particular estate and the beneficiaries. The IRA owner should take care to consider how much the estate taxes will be and which part of the estate will pay them or whether life insurance should be purchased to pay the taxes.

After the payment of estate taxes isre resolved, or even if estate taxes are not an issue, there are income taxes to consider.

Unlike when other assets are inherited, there also will be income taxes due when the beneficiary takes distributions from the IRA. The beneficiary pays the same income taxes on distributions that the owner would have paid. These taxes cannot be avoided, and the fact of them might influence who is named beneficiary of the IRA or how much is left to different beneficiaries.

A non-IRA asset is more valuable to an heir than an IRA of equal value is, because there will be income taxes due on distributions from the IRA. The heir really inherits only the after-tax value of the IRA. The non-IRA asset, on the other hand, can be sold and no capital gains taxes would be due on the appreciation that occurred during the owner's holding period.

The income taxes due on IRA distributions are a reason to consider making charitable gifts with the IRA instead of other estate assets. The IRA will be included in the estate, but there will be an offsetting charitable contribution deduction, for no net estate tax. In addition, a charity that is named beneficiary of an IRA will not owe income taxes when it takes distributions, so it will benefit from the full value of the IRA. If there is an inclination to make charitable gifts through the estate, it often is better to make the gifts through an IRA and maximize the non-IRA assets left to other heirs.

You do not have to leave the entire IRA to a charity. If the IRA’s value exceeds the amount you want to leave to charity, leave a portion of the IRA to charity and a portion to other heirs. Or split the IRA into two, leaving one entirely to charity and the other to other beneficiaries.

Another issue is the beneficiary selection, if it is not to be a charity. An IRA owner wants to be sure to name one or more beneficiaries. Failure to do so, or naming the estate as beneficiary, removes the tax deferral benefits of the IRA. Distributions will be required from the IRA on an accelerated schedule.

Naming the beneficiary is not as complicated as it used to be. Before 2001 and 2002 regulations, the beneficiary choice greatly influenced the amount of the required minimum distributions during the owner’s lifetime. Now, an IRA owner should consider only which beneficiary he or she really wants to receive the IRA.

In most cases, the surviving spouse is the primary beneficiary and the children are contingent beneficiaries. In larger estates, the owner might name a charity to receive at least some of the IRA as discussed above.

Yet, it makes a lot of sense for an IRA owner to have a back up plan for the beneficiary selection. The regulations allow the estate executor to name the Designated Beneficiary by September 30 of the year after the year of the IRA owner's death. In most cases, there won't be any reason to change from the standard practice of naming the surviving spouse as beneficiary. But circumstances can change, and the regulations allow the executor to adapt to changing circumstances.

For the executor to take advantage of the flexibility, the IRA owner must name contingent beneficiaries on the beneficiary designation form. The Designated Beneficiary named by the executor must be on the list of primary and contingent beneficiaries named by the owner.

When more than one person is beneficiary of an IRA, the beneficiaries can split the IRA into separate ones, but they might not realize this or the IRA custodian might be resistant to it. If the beneficiaries do not split the IRA, the age of the oldest determines the required minimum distributions from the IRA. In addition, the beneficiaries have to agree on management of the IRA and on the policy for taking distributions that exceed the required minimum.

The IRA owner should ensure that the beneficiaries know they can split the IRA. The owner also should check the IRA custodian’s policy for splitting inherited IRAs. Some discourage it or charge fees. Some IRA owners decide to split their IRAs themselves, naming one primary beneficiary for each.

Instead of leaving the IRA directly to individual beneficiaries, the owner might want to name a trust as beneficiary. The trust can control when distributions are made to the beneficiary. This arrangement might increase income taxes, however, and tricky rules must be followed when drafting the trust. Do not name a trust as IRA beneficiary without working with an estate planning attorney who is experienced in this area. The wrong language in the trust can terminate the tax deferral benefits of the IRA and require distributions on an accelerated schedule.

Because of the income and estate taxes and the nuances of naming beneficiaries, some IRA owners choose to empty their IRAs early, pay the taxes, and invest the after-tax assets in taxable accounts. Once out of the IRA, the assets can be given away as part of the estate plan or can be invested for long-term gains.

Emptying the IRA early generally is a strategy for those who have sufficient assets outside the IRA to support their standard of living or have such large IRAs that they consider the IRA primarily a savings account or something to be left to the next generation. If the strategy is used, it is best to empty the IRA as early as possible, because time is needed to make up for paying the income taxes early. I discuss the strategy in detail in my book, The New Rules of Retirement and have discussed it in past issues of Retirement Watch.

For similar reasons, people convert traditional IRAs into Roth IRAs, which also is discussed in those sources.

IRA owners need to know that wills and living trusts have no effect on an IRA. Only the beneficiary designation form on file with the custodian determines who inherits an IRA. IRA owners need to keep copies of the form and review it regularly. They also should check with the IRA custodian to be sure it has the current form on file.

A Dangerous Retirement Myth

Bob Carlson — Fri, 17 Apr 2009 14:15:00 GMT

Many retirement plans fall short of their goals because they were built on myths and misunderstandings. Most of my work at Retirement Watch falls into two categories. The first category is determining changes that should affect retirement plans. The second category is correcting the myths that have built up around retirement planning. One of the great myths of retirement planning is: Taxes will be lower in retirement. Last week we had tax return deadlines and tea parties, so this is a good time to discuss the issue of taxes in retirement, and a new survey proves a point I have made for years about retirees and taxes.

There was a time when taxes really did decline in retirement. When income tax rates were higher and there was a heavily graduated tax system, there were 13 tax brackets. Many people received less income in retirement than during their working years, and it did not take much of a drop in income to push a new retiree into a lower tax bracket. In addition, there were numerous tax breaks for seniors.

Things are different now.

We have only a few tax brackets. One needs to have a significant drop in income after retiring to drop into a lower bracket.

More importantly, retirees are making up a larger share of the taxpaying public as the Baby Boomers age. Governments cannot afford to let them pay less in taxes, and they do not.

Social Security benefits once were exempt from income taxes. For a while now, the benefits have been taxable to “upper income” recipients. The number who pay taxes on the benefits rises each year, because the income levels at which the benefits are taxed are not indexed for inflation.

Many retirees also are likely to be caught in the alternative minimum tax. Each year, more middle income retirees pay higher taxes under the AMT than under the regular income tax. That is usually because income declines after retirement but tax deductions remain the same. The combination can trigger the AMT.

In fact, unknown to many pre-retirees, taxes are likely to be your largest expense in retirement. While most people worry about medical expenses and long-term care, the biggest drain of your retirement income will be taxes. Income taxes are likely to take the largest share. There also will be sales taxes, real estate taxes, personal property taxes, and taxes on capital gains.

The new survey of retirees between ages 70½ and 75 with a net worth of at least $1 million, by Securian Financial Group, found taxes were the largest expense by a wide margin. Taxes, in fact, took about 4% of net worth every year. That is 4% of net worth, not of income. The percentage of income taken by taxes is much higher. It is tough to have net worth increase or remain stable when one expense is taking such a large portion.

Tax planning needs to be an integral part of your retirement money management. Strategies that effectively reduce taxes for many retirees include:

Tax-exempt bonds instead of taxable bonds. These won’t help reduce taxes on Social Security benefits, but they will reduce income taxes. Tax-exempt bonds carry attractive yields relative to treasury bonds now, but they also carry extra risks because of the economic distress of many state and local governments. Don’t take high risks to reduce income taxes.

Monitor the stealth taxes each year. Relatively small adjustments in income or expenses in the last part of the year might avoid higher taxes due to the itemized expense reduction, the personal and dependent exemption phaseout, and the alternative minimum tax.

Investments. Simple strategies such as minimizing trading, holding investments more than one year so the capital gains are long-term and not short-term, and buying mutual funds that traditionally make low annual distributions are easy ways to boost after-tax investment returns.

IRA management. Once distributions begin, managing the IRA is more complicated than many people realize. Taxes can be reduced and the life of a portfolio extended by withdrawing money from your different accounts in the right order and carefully calculating which assets are held in which accounts. Some retirees reduce lifetime taxes by taking money out of their IRAs faster than required under the law or converting a traditional IRA to a Roth IRA.

Maximizing deductions, such as those for charitable contributions and medical expenses, also are key to reducing taxes for many retirees.

Many retirees are surprised by the amount of taxes they pay. They believed the myth that taxes decline in retirement. The truth is without some planning taxes will stay the same or even increase during retirement. Tax breaks specifically for seniors are rare these days. Tax traps and a retirement tax ambush are more likely. You need to continue tax planning through retirement to ensure your retirement fund lasts a lifetime.

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.

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.

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.

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.

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.

Your Retirement Plan and the New Washington

Bob Carlson — Fri, 07 Nov 2008 17:44:00 GMT

Come January, Democrats will be in charge all over Washington. They campaigned on a theme of change, and we should expect major changes. The questions are which changes and how will they affect your retirement finances?

I will focus on the changes I think are most likely to occur. When evaluating the prospects for change, it is important to keep in mind the tension that will exist in the New Washington. Congress will be run by very liberal politicians who have a long list of legislation they wanted to pass for many years. These wish lists generally involve higher spending, more government control and regulation, rewarding favored activities and punishing others, and of course higher taxes. The new President, on the other hand, wants to be re-elected and probably recognizes that the country is center-right, not liberal, on most issues. There will be tension between the President and Congress, and the great unknown is which one will prevail. I assume that for at least the first couple of years the President will have the upper hand and will be able to move the more extreme liberal measures to the back burner.

Here are things you should prepare for over the next year or two. Other changes might be coming after that.

Medicare: This health program for those over 65 is approaching bankruptcy. Social Security will begin spending more than it receives in a few years. Medicare passed that point long ago. It soon will have exhausted the “trust fund” set up for it and rapidly is taking a larger share of the federal budget.

A few years ago “means-tested” premiums began as we discussed in Retirement Watch. Premiums increase as a beneficiary’s income rises. Similar changes are likely to occur. Premiums for higher income beneficiaries could rise even more and some types of care might not be covered for higher income beneficiaries. Or deductibles and co-payments also might be means-tested. Higher income beneficiaries might be required to cover the first $5,000 to $10,000 of their medical expenses in addition to paying higher premiums.

The government might have a stronger role in “negotiating” drug prices. Medicare prices are a basis for prices providers charge to private insurers. If the government negotiates very low prices, manufacturers might conclude that some drugs are unprofitable to produce or reduce research spending on new drugs.

The government also might take over the Part D prescription drug program instead of allowing private insurers to compete for beneficiaries.

Medicare Advantage plans also might take a hit. Democrats in Congress have targeted these since returning to the majority after the 2006 election. These plans run by private insurers receive higher reimbursements than other Medicare plans but usually offer greater benefits. Democrats want to eliminate them and bring everyone back into traditional Medicare.

Greater use of technology is likely to be mandated across the medical profession, and the government will assume cost savings from this move. It also is a way of pushing costs from the government to the private sector. That could affect the quality or availability of care for a while and increase costs on care not covered by Medicare.

Estate tax: Congress has to address the estate tax soon. The current law eliminates the estate tax for 2010 and returns to the 2001 law beginning in 2011. Congress is unlikely to let either the expiration or return to 2001 law occur.

The most likely outcome is, after a great deal of debate, something similar to current law will be enacted. That means the estate tax exemption will be fixed at $3.5 million and might be indexed for inflation. The top estate and gift tax rate will be 45% or 46%, though it could go up to 50%. It will be interesting to see if the lifetime gift tax exemption remains capped at $1 million or is allowed to rise. Also unclear is whether the current step-up in basis that is allowed for inherited assets will continue or whether heirs will have to take the deceased’s basis and pay capital gains taxes on appreciated that occurred during the deceased’s ownership.

Retirement plans: Here is a sleeper issue that came up only in the last month. Many in Congress do not like President Bush’s “ownership society” concept, and they view 401(k) plans as part of that. They are looking at ways to change qualified retirement plans.

A longstanding goal was to require private employers to provide minimum pensions. That might be replaced by a plan to have the government take over private pensions. Recent committee hearings highlighted a plan that eventually would eliminate tax breaks for 401(k) plans and give individuals a window during which they would receive some benefits for converting their private 401(k) plans into government retirement plans. This approach clearly has support from congressional leaders, but its support beyond that is unclear.

Investing: Anticipate some surprises here. Presidents are not able to implement all their campaign proposals. Congress and circumstances can change the plans. Don’t invest based on campaign rhetoric. Wait until proposals are closer to becoming laws.

There could be a positive surprise in the change of power. The financial problems largely have developed into a confidence problem. People do not trust current leadership or the information it puts out. Financial companies do not know what to expect from the government, so they are hoarding cash to protect themselves. Investors simply are not buying anything with risk, and financial firms are not doing business.

Some shrewd moves by the new President in the next few weeks could start to restore confidence at least temporarily. Appointment of a popular choice for Treasury Secretary and announcement of an effective tax cut and regulatory reform plan could spur optimism among investors.

Of course, stumbles on any or all of these issues could extend the crisis. Further down the road, higher taxes, spending, and regulation could reverse any positive trends. But there is an opportunity now to restore optimism even as the economic slump deepens for the next quarter or so.

Congress also could squander the opportunity. There is a movement to expand the government rescue plan to include a range of industries and to impose very tight regulations on financial and other firms taking government money that effectively nationalizes them. A move in that direction would further diminish investor confidence.

Don’t believe simple analyses of how the new administration will affect investments. It is normal for analysts to look at campaign proposals and target companies they believe will benefit from the proposals. Those forecasts almost never work out. Ignore analysts who recommend that you buy “green companies” and short defense contractors and health care companies. Wait for detailed plans to be proposed and make their way through Congress.

Taking action simply on the new election of politicians can be a risky business. I have outlined what I think are the most likely changes over the next few years. But be prepared for surprises. You need to build a cash cushion in your retirement plan for the possibility of paying a higher share of medical expenses. Be ready to revise your estate plan sometime next year or early in 2010. Keep an eye out for early signs of changes in retirement plans and be ready to move your assets into other types of accounts in case a major change is in the works. With your portfolio, don’t fall for obvious analysis. There is the potential for surprise in the next few weeks.