Retirement Watch : retirement plan

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.

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.

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.

How to Revise Your Retirement Plan

Bob Carlson — Thu, 03 Sep 2009 17:25:00 GMT

Despite the rally in stocks and other risky assets since March 9, many portfolios are still damaged from the events of the last few years. For those who are retired or near retirement, one step you have to take after such an event is to re-evaluate your retirement plan, especially your spending. Specifically you have to check the rate at which you plan to withdraw money from your retirement portfolio and decide if it needs to be adjusted to reduce the risk of running out of money.

Financial planners spend a lot of time contemplating the safe or sustainable withdrawal rate. This is the percentage of the portfolio you can withdraw the first year, increase the dollar amount by inflation each subsequent year, and have a high probability the portfolio will 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 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. 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. 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.

When portfolio returns are disappointing, you need to re-evaluate the plan to be sure you aren’t on track to run out of money. Bear markets are followed by bull markets, eventually. 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 are not needed unless there is another significant downward leg to for your portfolio.

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 more objective benchmarks of your spending rate.

One way to evaluate your spending rate is to assume an immediate single-premium lifetime annuity is purchased 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 likely will have a problem sustaining the withdrawal rate unless investment returns increase. Insurance companies spend a lot of resources calculating life expectancies 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. Check annuity payout rates at web sites such as www.ImmediateAnnuities.com

Another objective warning sign is a withdrawal rate approaching 10%. Surveys continue to show that 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 around the historic average and 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. The studies of the safe withdrawal rate 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. With consumer prices falling, that makes sense anyway.

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.

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. More details of the formula are in my book The New Rules of Retirement.

These formulas smooth distributions. 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 the 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. 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.

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.

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.

Pay Off Debt or Continue Owing in Retirement?

Bob Carlson — Fri, 21 Aug 2009 14:13:00 GMT

Paying off the mortgage used to be part of the American dream and a prerequisite to retirement. Then, times changed. Debt management and the use of leverage spread from businesses to personal finance. It was not unusual for people to enter retirement with mortgages and other debt with no plans to become debt free. Some did not hesitate to increase debt during retirement.

Now, the pendulum seems to be swinging the other way. The financial crisis and economic downturn are causing Americans in general to deleverage. They are reducing debt and increasing saving.

What is the best approach? Should you try to pay off the mortgage as soon as possible or use debt as a financial tool?

The first factor to consider is subjective. Some people are not comfortable with debt, especially in retirement when they no longer have steady working income. They want to be debt free as soon as they can and will sleep soundly knowing that they do not owe substantial sums to anyone. If that describes you, paying off the mortgage probably should be a priority even if the numbers we will discuss shortly show it might be better to carry some debt.

Another factor to consider is the level of your cash or liquid asset reserves. Emergencies arise from time to time. Everyone should have cash or liquid assets to be drawn from in case of unplanned expense such as medical expenses or home repairs. It could be risky to use part of your emergency cash reserves to pay off the mortgage. Shortly after the mortgage is paid, there might be an unexpected need for cash. Alternatively, it might be possible to set up a home equity line of credit to be tapped for such emergencies. Before paying off a mortgage, consider how any emergency needs would be covered.

Once those factors are considered, take a hardnosed look at the numbers.

Someone considering paying a mortgage has a source of funds from which to make the payment. The question is: What is the best use of that money?

First, estimate the rate of return you expect to earn from investing that money over the remaining term of the mortgage. A conservative investor might estimate a return of 3% or so from money market funds, certificates of deposit, or conservative bonds. Other investors might estimate a higher return, and aggressive investors might project a return of 7% or more annually. Then, apply your tax rate to the investment return to arrive at the after-tax rate of return.

Next, verify the interest rate on the mortgage. If you itemize deductions, the mortgage interest will be deductible, so determine the after-tax interest rate. The after-tax rate will be less than the stated rate on the mortgage because of the deduction. (Most lenders will provide an estimate of how each future payment will be divided between interest and principal. As a mortgage gets older, more of each payment is applied to principal and less is interest.)

If the after-tax investment return exceeds the after-tax interest rate on the mortgage, you are better off keeping the mortgage and leaving your money invested. You are earning more income on your capital than the mortgage is costing, so it is better to keep the cash invested and pay the mortgage over time.

If the situation is reversed with the mortgage interest rate exceeding the investment return after tax considerations, the best use of the money is to pay the mortgage. You are earning less than the mortgage is costing you, so your wealth is increased over time by paying the mortgage and saving the interest payments.

Example. Suppose your mortgage has an interest rate of 6% and your combined federal and state income tax rate is 40%. The after-tax interest rate is 3.6%. Tax-exempt bonds yield more than that. Investment grade corporate bonds yield around 7%, which is 4.2% after taxes. If you invest the money in either of those vehicles, you are better off doing that and instead of paying down the mortgage. The same would be true if you plan to invest in a diversified portfolio or even primarily in stocks and expect to earn more than 3.6% annually after taxes. Keep in mind, however, that for these investments the rate of return is not guaranteed over the life of the mortgage, and there is a risk of losing principal.

If you invest in money market funds, certificates of deposit, or treasury bonds you probably will be earning less than 3.6% after taxes. Also, if you are bearish about stocks for the duration of the mortgage, you probably are anticipating a return less than 3.6% annually. In those cases, the better use of your capital is to pay the mortgage.

Suppose you already own a home debt free and are considering how to pay for repairs or improvements. Your choices are to take money from the portfolio or borrow against the home. The same analysis should be done. Compare the mortgage interest rate with the portfolio's investment return to decide on the best use of your money.

There are other factors for some people to consider.

If you still are working, the best use of income might be to maximize the contributions to your 401(k), or at least contribute enough to receive the full employer matching contribution. Taxes are deferred on the income contributed to the 401(k), as are taxes on the account's earnings. To the extent the employer makes a matching contribution, the rate of return on the 401(k) contributions is very high.

If the wealth that would be used to pay the mortgage is not in cash or near-cash, transactions might be needed to convert it to cash. Those transactions could trigger taxes. Selling stocks or mutual funds could trigger capital gains taxes, while withdrawals from annuities or IRAs would be taxed at ordinary income rates. The transactions also might push you into a higher tax bracket or even trigger the alternative minimum tax. In effect, you would need a greater amount than the mortgage balance to pay off the mortgage, because of the taxes incurred. The interest rate on the mortgage would have to be substantially higher than your investment return to justify taking the extra money from investments to pay the mortgage and the taxes.

Are the wealthy smarter than other people about using debt? Data from before the crisis show that the percentage of older Americans with mortgages is rising, and wealthy Americans have a disproportionate share of the nation's debt. This could be an indication of what financial advisors call strategic debt—using debt as a tool to increase net worth.

Strategic debt works like this. Suppose you have $500,000 of investments. You want to buy a home for $500,000. You could pay cash for the home and be debt free. Or you could make a down payment of $100,000 and take a mortgage of $400,000. Then, you own a $400,000 investment portfolio and a $500,000 house, controlling $900,000 of assets. The strategy works as long as income is high enough to pay the mortgage and is smart when the portfolio’s return is at least as high as the mortgage interest rate.

But a further probe into the data also shows that a lot of the debt among the wealthy probably is incurred to maintain a lifestyle people really cannot afford. The top 1% by wealth owe much less debt than those just below them on the wealth scale. It appears that a lot of the debt is not so much strategic as it is to stretch a lifestyle to keep up with even wealthier people.

One final factor to consider is prepayment penalties. Some states prohibit them, but in others penalties can be imposed on principal prepayments. This is another cost to factor into the equation.

Deciding whether to keep or eliminate debt is a simple exercise, requiring a few simple calculations. There are web sites that help make the calculations, such as www.mtgprofessor.com.

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.

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.

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.

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.

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.

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.

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.

The Wealth Effect, Your Portfolio, and Your Retirement

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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.