Alternatives for Stretch IRA Strategies

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The majority of many people’s wealth is saved gradually from a lifetime of work and stored in their IRAs. For most of these people, a primary goal is to leave their IRAs to their children, says a recent article from Think Advisor titled “Three Replacements for Stretch IRAs.” The ability to distribute IRA wealth over years, and even decades, was eliminated with the passage of the SECURE Act.

The purpose of the law was to add an estimated $428 million to the federal budget over the next 10 years. Of the $16.2 billion in revenue provisions, some $15.7 billion is accounted for by eliminating the stretch IRA.

Existing beneficiaries of stretch IRAs will not be affected by the change in the law. But going forward, most IRA heirs—with a few exceptions, including spousal heirs—will have to take their withdrawals within a ten-year period of time.

The estate planning legal and financial community is currently scrutinizing the law and looking for strategies that will minimize the tax consequences of this new rule. Here are three estate planning approaches that are emerging as front runners:

Roth conversions. Traditional IRA owners who wished to leave their retirement assets to children may be passing on big tax burdens now that the stretch is gone, especially if beneficiaries themselves are high earners. An alternative is to convert regular IRAs to Roth IRAs and take the tax hit at the time of the conversion when the IRA owner is presumably in a lower tax bracket than their working children.

There is no guarantee that the Roth IRA will never be taxed, but tax rates right now are relatively low. If tax rates go up, it might make converting the Roth IRAs too expensive.

This needs to be balanced with state inheritance taxes. Converting to a Roth could reduce the size of the estate and thereby reduce tax exposure for the estate as well.

Life insurance. IRA owners can take distributions from an IRA to pay for a new life insurance policy to be distributed to their beneficiaries. When the beneficiaries receive the death benefit, it will not be included as the beneficiary’s income. This is being widely touted as the answer to the loss of the stretch, but like all other methods, it needs to be viewed as part of the entire estate plan. While this method is not a new strategy, it may be used more frequently due to the elimination of the stretch.

Charitable Remainder Trusts (CRT). The IRA could be used to fund a charitable remainder trust. This allows the person setting up the trust to establish an income stream for heirs with the IRA assets, and then have any amounts remaining upon the heirs’ deaths going to a named charity. The trust can grow assets tax-free. There are two different ways to do this: a charitable remainder annuity trust, which distributes a fixed annual annuity and does not allow continued contributions, or a charitable remainder unitrust, which distributes a fixed percentage of the initial assets and does allow continued contributions.

Speak with your estate planning lawyer about what options may work best in your unique situation.

Reference: Think Advisor (Jan. 24, 2020) “Three Replacements for Stretch IRAs”

Gig Workers, Don’t Forget Retirement Savings

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For better or worse, the gig economy is here to stay. It offers flexible hours, choice in their clients and projects, and the benefits of working remotely. However, freelancers and other gig workers miss out on the benefits offered by more traditional employment, says Forbes in the recent article “What Gig Workers Should Know About Self-Directed Retirement Accounts.” One aspect that can have significant implications is that they are completely responsible for their own retirement savings, health care expenses and any other forms of long-term savings.

How can a freelancer build a nest egg? It can sound quite simple: establish a retirement account early on and start contributing, no matter what the amount. There is no lack of retirement plans available today for self-employed professionals and part-time workers, including traditional IRAs, self-employed 401(k) plans, and simplified employee pension IRAs, among others. The challenge comes from having the income and the discipline to do this.

IRAs: Freelancers may set up individual retirement accounts directly with a custodial institution, contributing up to $6,000 annually. For those who are 50 and over, there’s an additional catch-up contribution of $1,000 permitted. A freelancer can decide to go with a traditional IRA or a Roth IRA.

SEP IRAs: Simplified Employee Pension IRAs allow freelancers to contribute up to 25% of their income, or $56,000, whichever is less. This may be a good option if you are a one-man show and intend to keep it that way. If you are an employer, you have to contribute to the SEP-IRA of every eligible employee whenever you contribute to your own SEP-IRA.

Self-employed 401(k) or solo 401(k): This plan offers the most flexibility for retirement contributions. The person can contribute up to $62,000 each year. These plans also have a lower maintenance cost and investment options that go beyond the stock market, since there is no requirement that the plan has a custodian. The accounts can include real estate property, commercial property, private lending, tax liens or multifamily syndication.

The Good and the Bad of Self-Directed Retirement Plans

Self-directed retirement accounts allow participants to invest in alternative investments. That can be a good thing; for example, a self-employed professional can leverage their industry experience to make long-term limited period investments, and not be limited to the offerings of a traditional custodian. For a self-directed IRA, the plan holder does need a custodian to act as a trustee of the account. That could be a bank, brokerage firm, insured credit union or a legal entity approved by the IRS. The custodian is not authorized to provide investment advice to plan participants.

The self-directed solo 401(k) is structured with a 401(k) trust, used as a vehicle to hold the assets. The account holder is the trustee and has total control over how the assets are used. Solo 401(k) plans allow post-tax Roth contributions to be made to a separate designated Roth account under the same plan. That lets investments grow tax-free, as well as tax-free qualified distributions.

However, with all this freedom comes risk. If investments don’t work out, there’s no safety net.  There are also many regulations around these self-directed accounts. Some transactions are prohibited and there are rules regarding withdrawals and participant loans. If you are a freelancer, you should consult with an attorney or financial advisor to figure out the best way you can contribute to your own future.

Reference: Forbes (December 5, 2019) “What Gig Workers Should Know About Self-Directed Retirement Accounts”

Another Good Reason to Update Your Estate Plan: Taxes

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Gift, estate and generation-skipping transfer tax (GST) exemptions have doubled as a result of the Federal Tax Cut and Jobs Act, raising them to historic highs. The exemptions, which are all linked in a unified estate and gift tax, had been scheduled to increase to $5.6 million per person in 2018, but they were modified to reach the current level of $11.2 million per person, or $22.4 million per couple. The inflation-adjusted exemption for 2019 is $11.4 million per person or $22.8 million per couple.

In the article “Updating estate plan could save heirs in taxes,” the Atlanta Business Chronicle asks why this matters to an individual or couple whose net worth is nowhere near these levels.

When the most that could be transferred to heirs was under a million dollars, everyone worried about the estate tax. Since the estate tax was so much higher than the capital gains tax, it was never considered a big deal if a person paid the capital gains tax on selling, because it was less costly than paying the estate tax.

Now with the new exemption, trying to move assets out of estates and into trusts may not be the best solution to preserve wealth and minimize taxation.

In the past, a trust would be created, and the maximum amount of funds placed into the trust for use when the grantor (the person who created the trust) died. The goal was to provide income for the spouse until the spouse’s death, at which point the money bypassed the estate and went directly to the beneficiaries, who would pay income tax on the funds.

If a person owned $10,000 worth of stock at their death and the trust required it to be placed into a bypass trust instead of transferring it to the spouse, the heirs would pay taxes on gains upon the sale of stock. In a case where the stock held in the bypass trust increased to $100,000, then $90,000 of that would be considered taxable gain. If, instead, the stock was transferred to the surviving spouse and it was sold upon the spouse’s death, that stock would receive a stepped-up basis of $100,000 and there would be no income tax on the sale of the stock.

Note that the law creating the present $11.4 million limit is currently set to end at the end of 2025 when the tax exemption will return to $5 million (adjusted for inflation).

Another aspect of estate tax planning relates to the source and account types of the inheritance. For instance, heirs who receive money from Individual Retirement Accounts (IRAs) have to pay taxes when they withdraw funds from the account. IRA money is not taxed when it goes into the account, but the growth is taxed when the money is taken out.

As an alternative, IRAs could be converted to Roth IRAs, although they would be taxed immediately on conversion. If the Roth IRA is held for five years, funds withdrawn are tax-free and can be taken out whenever the owner wishes.

However, because current exemption amounts may not be available after 2025, or if further changes to tax laws are made, another strategy for individuals who wish to make significant lifetime gifts is to make those gifts with the current high levels. Because of the way the transfer tax systems interact, those lifetime gifts will not be taxed at death if the total of taxable gifts is less than the exemption amount in the year the gift is made.

Some experts advise that wealth be distributed between tax-deferred accounts, like 401(k)s, after-tax money, like the Roth IRA and taxable accounts, which include brokerage accounts. The goal is to be able to respond when changes are made to the tax code.

Reference: Atlanta Business Chronicle (May 31, 2019) “Updating estate plan could save heirs in taxes”

Stretch IRA May be Disappearing Soon

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Short of calling your representatives in Congress and hollering, there’s not much any of us can do about a proposed change to the rules that govern stretch IRAs, reports nj.com in the article “Your kid’s inheritance could take a giant tax hit if these bills become law. Thanks, Congress.”

For years, non-spouse beneficiaries who inherit IRAs have had the ability to stretch out required distributions over their lifetimes. That meant that inherited IRAs could say safe and sound out of the IRS’s reach, except for annual distributions that were quite small. If a grandchild inherited the IRA, the wealth stretched even further.

Depending on the final details of the legislation, the only people who will be able to stretch an IRA will be spouses.

Current rules require non-spouse beneficiaries to take required minimum distributions (RMDs) every year over the course of their life expectancy, as per the IRS life expectancy tables. Because they are taken over the lifetime of a younger beneficiary, they can be small. This means the impact of the distribution on the individuals’ income taxes are minimal and the IRA can grow tax-deferred over a long period of time.

Congress is looking for revenue, and the wealth of Americans in IRA accounts is in their sight lines.

First, the House passed the SECURE Act, which says that beneficiaries must completely empty their inherited IRAs within 10 years of ownership. The Senate then passed the RESA Act, which is a little different. It would allow a stretch for the first $450,000 of aggregated IRAs, then anything over that would have to be distributed within five years.

Both bills call for changes to apply to inherited IRAs and inherited Roth IRAs for deaths after December 31, 2019. What’s the bottom line? The Joint Committee on Taxation expects that these changes, if they become law, will yield $15.7 billion—with a “B”—in additional tax revenue through 2029.

The government would eventually get this money anyway, but this speeds things up considerably.

Let’s compare and contrast. An 80-year old woman has a traditional IRA worth $1 million. She dies and her 55-year-old daughter is the primary beneficiary. Under the current rules, the daughter’s first RMD is roughly $35,000. If the 25-year-old granddaughter was the beneficiary, the RMD would be roughly $18,000.

If the account earns an average of 5% annually, under the current rule, the granddaughter would have distributions of some $220,000 over ten years. If she had ten years to take the money out, she’d have about $1.3 million in distribution. Under the current rule, the account would have a $1.3 million balance after ten years, since the principal would continue to appreciate. Under the proposed rules, after ten years, it would be zeroed out.

The forced larger distributions will push heirs into higher tax income brackets. That will be followed by increased Medicare premiums, as heirs retire with higher income. Add to that: higher capital gains rate, from as low to zero to as high as 20%. If that’s not bad enough, it could also trigger the 3.8% net Investment Income tax.

One option is to move funds from a regular IRA to a Roth IRA, assuming the investor meets all the requirements to do so. The Roth IRA distributions would not be taxable (unless those laws change) but that also requires the current owner to pay taxes on funds moved to the Roth IRA.

Another option is to consider a Charitable Remainder Trust (CRT) that names a charity as the IRA beneficiary. Upon the death of the owner, the IRA is distributed to the CRT, and the IRA owner’s heir would receive a fixed percentage of the CRT’s value for the remainder of their lives. When the heir dies, the money in the CRT goes to a charity or charities designated by the IRA owner, when the trust was created.

For now, these are proposed pieces of legislation, but chances are good they will be passed soon. Now is a good time to meet with your estate planning attorney to do what you can to protect your IRA and the stretch IRA of your children’s inheritance.

Reference: nj.com (June 10, 2019) “Your kid’s inheritance could take a giant tax hit if these bills become law. Thanks, Congress”

Why Should I Start a Roth IRA Now?

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When you’re younger, contributing to an IRA sounds a bit crazy, making it that much easier to delay starting.

CNBC’s article, “The one thing no one tells you about investing in a Roth IRA,” says that what you almost never hear, is the regret retirees have that they didn’t start saving sooner. It’s wise to start investing as early as possible, so your investments will have more time to grow.

Millennials seem to really like Roth IRAs, which show an across-the-board increase in all age groups.

In looking at investor data, Fidelity concluded that more than 50% of IRA contributions go into Roth IRAs, especially from people age 23 to 38. Millennials opened 41% of new Roth IRA accounts in 2018, and 74% of their contribution dollars are going into Roth’s. These accounts are especially valuable when they’re the sole source of retirement savings.

For younger people, 30 or 40 years seems like a super long time to not be able to use that money.  However, because Roth contributions are made with after-tax dollars, that’s not a big concern.

The benefit is that you can use the contributions you’ve made without taxes or a penalty. You have to forfeit the immediate tax break, but you’ll receive something better in return: the contributions and years of earnings that will be tax-free in retirement.

Fidelity believes that this year millennials are estimated to be a larger population than boomers. Older millennials are in their 30s, stable in their careers and saving.

Since the IRS has upped IRA contribution limits, you can contribute $6,000 annually. If you are over age 50 and making catch-up contributions, you can add in an additional $1,000, for a total of $7,000 per year.

The income cutoff for contributing to a Roth IRA is $137,000 for single filers, up from $135,000 for single filers in 2018.

If you’re still unsure which type of IRA to choose, go with a traditional IRA, which has instant gratification because of the upfront tax refund. However, if you’re thinking long term, and what will be better for you and your family many years from now, select a Roth IRA. But make sure you ask your financial advisor what is best for your individual situation before making any financial decisions.

Reference: CNBC (March 31, 2019) “The one thing no one tells you about investing in a Roth IRA”

 

What Will The Taxes Be on My IRA Withdrawal?

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If you wonder what the taxes will be on an IRA withdrawal, sometimes, the amount of taxes will be zero. However, in other cases, you will owe income tax on the money you withdraw and sometimes an additional penalty, if you withdraw funds before age 59½. After a certain age, you may be required to withdraw money and pay taxes on it.

Investopedia’s recent article, “How Much are Taxes on an IRA Withdrawal?” says there are a number of IRA options, but the Roth IRA and the traditional IRA are the most frequently used types. The withdrawal rules for other types of IRAs are similar to the traditional IRA, but with some minor unique differences. The other types of IRAs—the SEP-IRA, Simple IRA, and SARSEP IRA—have different rules about who can start one.

Your investment in a Roth IRA is with money after it’s already been taxed. When you withdraw the money in retirement, you don’t pay tax on the money you withdraw or on any gains you made on your investments. That’s a big benefit. To use this tax-free withdrawal, the money must have been deposited in the IRA and held for at least five years, and you have to be at least 59½ years old.

If you need the money before that, you can take out your contributions without a tax penalty, provided you don’t use any of the investment gains. You should keep track of the money withdrawn prior to age 59½, and tell the trustee to use only contributions, if you’re withdrawing funds early. If you don’t do this, you could be charged the same early withdrawal penalties charged for taking money out of a traditional IRA. For a retired investor who has a 401(k), a little-known technique can allow for a no-strings-attached withdrawal of a Roth IRA at age 55 without the 10% penalty: the Roth IRA is “reverse rolled” into the 401(k) and then withdrawn under the age 55 exception.

Money deposited in a traditional IRA is treated differently because you deposit pre-tax income. Every dollar you deposit decreases your taxable income by that amount. When you withdraw the money, both the initial investment and the gains it earned are taxed. But if you withdraw money before you reach age 59½, you’ll be assessed a 10% penalty in addition to regular income tax based on your tax bracket. There are some exceptions to this penalty. If you accidentally withdraw investment earnings rather than only contributions from a Roth IRA before you are 59½, you can also owe a 10% penalty. You can, therefore, see how important it is to maintain careful records.

There are some hardship exceptions to penalty charges for withdrawing money from a traditional IRA or the investment portion of a Roth IRA before you hit age 59½. Some of the common exceptions include:

  • A required distribution in a divorce;
  • Qualified education expenses;
  • A qualified first-time home purchase;
  • The total and permanent disability or the death of the IRA owner;
  • Unreimbursed medical expenses; and
  • The call to duty of a military reservist.

Another way to avoid the tax penalty, is if you make an IRA deposit and change your mind by the extended due date of that year’s tax return, you can withdraw it without owing the penalty (but that cash will be included in the year’s taxable income). The other time you risk a tax penalty for early withdrawal, is when you’re rolling over the money from one IRA into another qualified IRA. Work with your IRA trustee to coordinate a trustee-to-trustee rollover. If you make a mistake, you may end up owing taxes.

With IRA rollovers, you can only do one per year where you physically remove money from an IRA, receive the proceeds and within 60 days subsequently deposit the funds in another IRA. If you do a second rollover in the same year, it’s 100% taxable.

You shouldn’t mix Roth IRA funds with the other types of IRAs, because the Roth IRA funds will be taxable.

When you hit 59½, you can withdraw money without a 10% penalty from any type of IRA. If it’s a Roth IRA, you won’t owe any income tax. If it’s not, there will be a tax. If the money is deposited in a traditional IRA, SEP IRA, Simple IRA, or SARSEP IRA, you’ll owe taxes at your current tax rate on the amount you withdraw.

Once you reach age 70½, you will need to take a Required Minimum Distribution (RMD) from a traditional IRA. The IRS has specific rules as to the amount of money you must withdraw each year. If you don’t withdraw the required amount, you could be charged a 50% tax on the amount not distributed as required. You can avoid the RMD completely if you have a Roth IRA because there aren’t any RMD requirements. However, if money remains after your death, your beneficiaries may have to pay taxes.

The money you deposit in an IRA should be money you plan to use for retirement. However, sometimes there are unexpected circumstances. If you’re considering withdrawing money before retirement, know the rules for IRA penalties, and try to avoid that extra 10% payment to the IRS.

My best advice is to contact your financial advisor before making any withdrawals on your retirement accounts.

Reference: Investopedia (February 9, 2019) “How Much are Taxes on an IRA Withdrawal?”