Financial Topics Newsletter Archive
SBT Investment Services, Inc. through its relationship with Infinex Investments, Inc., member SIPC/FINRA, offers a range of educational resources to help customers achieve their life goals. These include the personal attention of our Advisors, registered representatives of Infinex Investments, Inc., periodic educational forums, and topical articles in our Financial Newsletter.
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July 2007
In This Issue:
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Plan for 2010 Roth Conversions
Starting in 2010, all taxpayers, regardless of the amount of their adjusted gross income (AGI), can convert a traditional individual retirement account (IRA) to a Roth IRA. Before 2010, your AGI cannot exceed $100,000 to convert, not including any income resulting from the conversion. Amounts converted must be included in income if taxable when withdrawn (i.e., contributions and earnings in deductible IRAs and earnings in nondeductible IRAs), but are exempt from the 10% early withdrawal penalty.
If you make a conversion in 2010, the tax can be paid in two installments in 2011 and 2012, with no tax due in 2010. However, if you prefer, you can elect to pay the tax in 2010, which may make sense if the current lower tax rates are not extended beyond 2010 or you expect much higher income in 2011 and 2012. Taxes on conversions made after 2010 must be paid in the year of conversion.
Even though this tax rule does not go into effect until 2010, you should start planning now. For instance, you should consider making the maximum IRA contributions to a nondeductible IRA in 2007, 2008, and 2009, and then convert the nondeductible IRA to a Roth IRA in 2010. The maximum IRA contribution is $4,000 in 2007 and $5,000 after that, plus an additional $1,000 catch-up contribution for taxpayers age 50 and older. After 2008, the contribution amount will be adjusted for inflation in $500 increments.
By using this strategy, you would only have to pay income taxes on earnings within the IRA because the contributions are nondeductible. However, be aware that if you also have other traditional deductible IRA funds, even in another IRA account, you cannot just convert the nondeductible IRA. You have to assume that a pro-rata portion of both the deductible and nondeductible IRA funds are being converted.
Find out whether your 401(k) plan accepts rollovers from an IRA. If it does, you could roll over your deductible IRA and earnings in your nondeductible IRA to your 401(k) plan. You would then just have nondeductible contributions remaining in your IRA, which could be rolled over to a Roth IRA without paying any income taxes. Check with your plan to see if you can later roll the funds back to an IRA.
This new conversion provision will effectively remove the income limitations for contributions to a Roth IRA after 2010. In 2007, Roth IRA contributions can be made by single taxpayers with AGI less than $99,000 (contributions are phased out with AGI between $99,000 and $114,000) and by married couples filing jointly with AGI less than $156,000 (contributions are phased out with AGI between $156,000 and $166,000). It doesn’t matter whether you participate in a company-sponsored pension plan. Starting in 2010, individuals with incomes over the limits can make contributions to a nondeductible traditional IRA and then immediately convert the balance to a Roth IRA.
There are a variety of factors that should be considered before deciding whether to convert a traditional IRA to a Roth IRA. Factors that favor converting to a Roth IRA include:
- You can pay the income taxes due from the conversion with funds outside the IRA. By doing so, you are in essence increasing your IRA’s value by the tax amount.
- You expect your marginal tax rate at withdrawal to be equal to or greater than your current marginal tax rate. When your rates are equal at both times, the financial results from either IRA will be similar. Increasing income tax brackets generally make it advantageous to convert to a Roth IRA.
- You won’t make withdrawals from your Roth IRA for many years. Estimates indicate that you generally need five to 10 years of tax-free compounding to compensate for the current payment of taxes.
- You don’t expect to take withdrawals from your IRA. Since you aren’t required to withdraw funds from a Roth IRA, even after age 70 1/2, your IRA balance can continue to grow on a tax-free basis.
- You want to leave your IRA balance to heirs. With a Roth IRA, your heirs receive the proceeds free of federal income taxes. Also, if you don’t withdraw funds from the Roth IRA after age 70 1/2, you could potentially leave your heirs with a much larger balance than from a traditional IRA.
Once the balance is converted, a qualified distribution cannot be made until after the five-tax-year holding period. Distributions before then are subject to the 10% early withdrawal penalty, unless one of the exceptions applies.
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Rollovers for Nonspouse Beneficiaries Are Complicated
The Pension Protection Act of 2006 contained a provision allowing nonspouse beneficiaries to roll over funds from an employer pension plan to an inherited individual retirement account (IRA), starting in 2007. This was viewed as a significant development for nonspouse beneficiaries, since they would be able to extend distributions from employer pension plans over a longer period. However, recent guidance by the Internal Revenue Service (IRS) indicates that this provision may be difficult for nonspouse beneficiaries to implement.
Prior Law
Prior to 2007, spouses were the only beneficiaries who could make a nontaxable rollover of a deceased’s interest in an employer retirement plan to an IRA. Nonspouse beneficiaries had to take taxable distributions from the plan according to the plan’s terms, which typically required the entire balance to be paid out by the end of the fifth year following the decedent’s death. No payouts were typically required in years one through four, but the entire balance had to be distributed by the end of year five. Income taxes had to be paid on the distributions, and there was no way for nonspouse beneficiaries to extend payouts beyond the plan’s terms. Some plans allowed a life expectancy payout for nonspouse beneficiaries, but this option was not very common.
New Law
Starting in 2007, nonspouse beneficiaries can make a direct rollover (a trustee-to-trustee transfer) of inherited employer plan funds to an inherited IRA. The IRS recently provided guidance on how to apply this provision. Funds can be rolled over from 401(k), 403(b), and section 457 plans. When funds are rolled over, they must go to a properly titled inherited IRA that retains the decedent’s name in the title. However, a plan does not have to give nonspouse beneficiaries the ability to roll funds over to an inherited IRA. It is up to the plan.
Funds must be made via a trustee-to-trustee transfer. If the funds are issued to the beneficiary via check, it is considered a distribution and those funds cannot be rolled over to an IRA. If a plan won’t make a trustee-to-trustee transfer, a check can be made out to the inherited IRA and still meet the requirements.
Once funds are rolled over, the distribution rules that applied when the funds were in the employer’s plan continue to apply, unless a special rule is followed. To escape the plan’s rules, the beneficiary must take the first required distribution using the beneficiary’s life expectancy by the end of the year following the decedent’s death. If this is not done, the beneficiary must take distributions based on the plan’s rules, which generally require the entire balance to be withdrawn in five years.
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Take Another Look at Section 529 Plans
While section 529 plans always had significant tax benefits, there was concern because many of those benefits were scheduled to expire after 2010. However, the Pension Protection Act of 2006 made many section 529 plan provisions permanent. Thus, if you are looking for a way to fund your child’s college education, you should definitely take a look at section 529 plans. Consider these basic facts about section 529 plans:
- There are two basic plan types. Savings plans and prepaid tuition plans are both forms of section 529 plans. Prepaid tuition plans allow you to pay a fixed amount now for a guarantee that your child’s tuition will be covered in the future. Many states offer these plans, and this is the only option private universities can offer. With college savings plans, you place money in a state plan to be used for the beneficiary’s higher-education expenses at any college. Your money is invested in stocks, bonds, or mutual funds offered by the plan, with no guarantee as to how much will be available when the beneficiary enters college.
- The tax benefits of section 529 plans are significant. When used to pay for qualified higher-education expenses, earnings in the plan are withdrawn tax free. Distributions from plans are now permanently excluded from income.
- Significant sums can be saved through section 529 plans. While you can also make fairly small contributions, most plans allow significant contributions. There are also no income limitations for contributions to these plans. From a tax standpoint, you can contribute up to $60,000 to a qualified plan ($120,000 if the gift is split with your spouse) in one year and count it as your annual $12,000 tax-free gift for five years. However, if you die within the five-year period, a pro-rata share of the $60,000 returns to your estate. Grandparents can set up accounts for grandchildren, transferring large sums from their estates while providing for their grandchildren’s education.
- Section 529 plans are treated favorably for financial aid purposes. Section 529 plans are no longer considered the child’s asset. If the plan is set up by the parent, up to 5.6% of the value will be counted toward the expected family contribution. Withdrawals from the plans are no longer considered income for financial aid purposes. This includes prepaid tuition plans, which until July 2006 reduced financial aid on a dollar-for-dollar basis.
- Funds aren’t lost if the beneficiary does not go to college. A significant advantage of section 529 plans is that you remain the account owner. Thus, you can change the beneficiary or even take the money back, if permitted by the plan. If you take the money back, you will owe ordinary income taxes on earnings and the 10% federal tax penalty. The money can be withdrawn without penalty if the beneficiary dies or becomes disabled.
- Many plans are now available. Many states offer state income tax benefits to residents who contribute to their plans, but you can invest in any state’s plan. Each plan has different investment options and fees, so review several carefully before making a choice.
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Why Aren’t 401(k) Balances Larger?
Originally, 401(k) plans were viewed as a supplement to defined-benefit plans. Since it was presumed that employees would have their basic retirement income needs covered by Social Security benefits and employer-provided pension benefits, they were given significant responsibility in 401(k) plan decisions, such as deciding whether to participate, how much to contribute, which investments to select, and how to take withdrawals.
However, retirement plans have changed dramatically. As of 2004, 63% of workers with a pension plan have only a 401(k) plan, 20% have only a defined-benefit plan, and 17% have both (Source: Center for Retirement Research, March 2006). In 25 years, 401(k) plans have gone from a supplement to other pension plans to the main retirement plan for most workers. Yet, participants still make most of the choices in 401(k) plans, often making mistakes with those choices:
- Not participating. Approximately 21% of workers eligible to participate in a 401(k) plan do not do so. Younger workers are more likely than older workers not to participate.
- Not making adequate contributions. Only 11% of 401(k) participants contribute the legal maximum to their 401(k) plans. However, those with higher incomes are more likely to contribute the maximum. For instance, less than 1% of those with incomes between $40,000 and $60,000 contribute the maximum, while 58% of those with incomes in excess of $100,000 contribute the maximum.
- Not diversifying investments. In 2004, 32% of participants had no equity in their 401(k) plans, while 21% had 80% or more in equities. Approximately 47% had a diversified portfolio.
- Overinvesting in company stock. Approximately 15% of 401(k) plan assets were invested in company stock in 2004. However, most 401(k) plans do not offer company stock as an investment option. Plans with 5,000 or more participants typically offer this option, with 34% of total assets in those plans invested in company stock.
- Not letting balances grow. Approximately 45% of participants changing jobs cashed out their 401(k) balance rather than rolling it over into an IRA or another employer’s 401(k) plan. Most of the participants who cashed out were younger employees with relatively small account balances, who did not realize that allowing these sums to grow could result in a significantly larger balance at retirement age.
These mistakes significantly affect the amount that workers accumulate in their 401(k) plans. For instance, a typical worker who reaches retirement age with $58,000 of annual wages and has contributed 6% to the 401(k) plan with a 3% employer match should have an accumulated balance of $380,000. However, in 2004, the median balance for workers between the ages of 55 and 64 was only $60,000 (Source: Center for Retirement Research, March 2006).
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Common Investor Mistakes
Avoid these common investor mistakes when making decisions about your investment portfolio:
- Chasing performance. Investors often move out of sectors that are not performing well, investing that money in high performing investments. But the market is cyclical, and often those high performers are poised to underperform, while the sectors just sold are ready to outperform. A classic example is technology stocks in early 2000. Many investors rushed to purchase technology stocks just as they reached their peak and were headed for a long slide down. Rather than trying to guess which sector is going to outperform, broadly diversify your portfolio across a range of investment sectors.
- Looking for “get-rich-quick” investments. When your expectations are too high, you have a tendency to chase after high-risk investments. Your goal should be to earn reasonable returns over the long term, investing in high-quality investments.
- Avoiding the sale of an investment with a loss. When selling a stock with a loss, an investor has to admit that he/she made a mistake, something that is psychologically difficult to do. When evaluating your investments, objectively review the prospects of each one, making decisions to hold or sell on that basis rather than on whether the investment has a gain or loss.
- Selecting investments that don’t add diversification benefits to your portfolio. Diversification helps reduce your portfolio’s volatility, since various investments respond differently to economic events and market factors. Yet, it’s common for investors to keep adding investments that are similar in nature. This does not add much in the way of diversification, while making the portfolio more difficult to monitor.
Not checking your portfolio’s performance periodically. While everyone likes to think their portfolio is beating the market, many investors simply don’t know for sure. So analyze your portfolio’s performance periodically. Compare your actual return to the return you targeted when setting up your investment program. If you aren’t achieving your targeted return, you risk not achieving your financial goals. Now honestly assess how well your portfolio is performing. Are major changes needed to get it back in shape?
Letting market predictions cause inaction. No one has shown a consistent ability to predict where the market is headed in the future. So don’t pay attention to either gloomy or optimistic predictions. Instead, approach investing with a formal plan so you can make informed decisions with confidence.
Expecting the market to continue in its current direction. Investors have a tendency to make investment decisions based on current trends in the market. Thus, if the stock market has been performing well for a period of time, investors tend to move more and more funds into that area. However, there is a tendency for markets, when they have an extended period of above- or below-average returns, to revert back to the average return. For instance, following an extended period of above-average returns in the 1990s, the stock market experienced a significant downturn, helping to bring the averages back in line.
- Not understanding that saving and investing are two different concepts. Saving involves not spending current income, while investing requires you to take those savings and do something with them to earn a return. Saving often becomes easier when separated from the choice of where to invest. Find ways to make saving as automatic as possible, then take your time to research and select specific investments.
- Considering only pretax returns. One of the most significant expenses that can erode your portfolio’s value is income taxes. Thus, don’t just consider your pretax returns, but look at after-tax returns. If too much of your portfolio is going to pay taxes, look at strategies that can help reduce those taxes.
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Copyright &© 2007. This newsletter intends to offer factual and up-to-date information on the subjects discussed, but should not be regarded as a complete analysis of these subjects. The appropriate professional advisers should be consulted before implementing any options presented. No party assumes liability for any loss or damage resulting from errors or omissions or reliance on or use of this material.
FR2006-1025-0052 Retirement is in the midst of being redefined once again. The last generation was able to retire to a life of total leisure due to the generosity of company pension benefits and Social Security. But longer life expectancies and less generous benefits mean that it is time to redefine retirement. What many are seeking is not so much total leisure as more leisure or a more meaningful life. Many are finding that those goals can be accomplished while still working, and that those additional working years can provide more financial security. |
