Obama’s Proposals Reminds Us To Reduce Our Legislative Risk Through Tax Diversification

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By Senior Attorney Dan Vu

We have all heard of the saying, “Don’t put all your eggs in one basket.” In the investment world, this means don’t put everything you have into one stock. Apple might be doing great now, but no advisor would want your entire portfolio to consist of Apple stock alone. The reason is obvious: one bad iPhone release and your retirement nest egg goes down the toilet. However, what is not as obvious, is that many retirees do have all of their eggs in one basket because they heavily rely on a single tax type of investment, the pre-tax retirement account. Too many have the overwhelming majority of their investments in pre-tax retirement accounts like IRA’s, 401K’s, and 457’s (Deferred Compensation). These accounts are very popular because they went in pre-tax and earn interest compounded and tax deferred. However, when you take money out is when you feel the pain. You will pay tax on the amount you withdraw at your ordinary income tax bracket rate. You also need be careful that the amount doesn’t push you into a higher tax bracket, increase taxes on your Social Security or increase your Medicare premium.

Now this is NOT advice to stop using pre-tax accounts altogether. They obviously have their tax advantages and they can be enormously beneficial. Instead, the advice is to take a second look at the allocation of your investments – but with a tax diversification lens. Tax diversification means balancing the use of traditional IRAs with Roths, which grow tax free on after tax money, along with investments taxed at the capital gains rate, and investments that are bought with after-tax money but are tax deferred like certain annuities. Tax diversification is important because it allows you to more effectively manage your legislative risk. That is, the risk we all have when politicians decide to change the rules on us mid-game. Pre-tax retirement accounts are more at risk of being attacked than other types of investments because of the sheer size of un-taxed dollars that could be available to our legislators.

According to Jeffrey Levine from The Slott Report, Americans currently hold well north of $20 trillion dollars in retirement accounts. “To put that into perspective, the National debt is ‘only’ about $18 trillion. The overwhelming majority of the $20+ trillion that’s held in retirement accounts is pre-tax money, meaning that it has yet to be taxed. To a broke government, it would be hard not to look at these accounts as a big, juicy steak.”

The President's proposalsProposals attacking the benefits of pre-tax retirement accounts have been passed around before. More recently, we were reminded of the importance of reducing your legislative risk through tax diversification, when President Obama announced his 2015 budget proposals. The President’s proposals attack some of the pillars that many have relied on when deciding to heavily invest in pre-tax retirement accounts.

The First Pillar – Ability to “Stretch the IRA”

The first and arguably the most important pillar, is the ability for heirs to “stretch” inherited retirement accounts. Currently, if your child inherits your IRA, he/she will not have to pay taxes on the entire amount in one lump sum. Rather, they can choose to take only the annually required minimum distribution based on the their own life expectancy. This is an incredible amount of tax savings for your child and it allows you to leave your retirement accounts to your child without an overwhelming tax burden. The President proposes the death of this stretch rule. With Obama’s proposal, a child inheriting a retirement account would have to withdraw the entire amount and pay taxes within 5 years! Imagine the tax hit on a single child inheriting $500,000 in retirement accounts. It would almost certainly propel that child into a higher tax bracket for the next 5 years and could cost them close to 45% of the inheritance in State and Federal income taxes.

The Second Pillar – Ability to take a NUA deduction

The President also proposed eliminating the NUA deduction (net unrealized appreciation). This deduction allows those with employer sponsored plans to pay the capital gains rate on company stock. Since the capital gains rate is lower than the tax payers ordinary income, the deduction can be a significant amount. The loss of the NUA deduction simply means higher taxes for all employer sponsored plans that also provide company stock.

The Third Pillar – Ability to Preserve a Roth IRA for Life

When you turn 70 ½ you must start drawing your RMD (required minimum distribution based on your life expectancy) on your pre-tax qualified accounts. Roths have never been subject to this requirement and it is the main reasons why tax payers have converted their IRAs to Roths. With this rule change, Roths would also be subject to the RMD rules like traditional IRAs. This ultimately means less tax savings and less tax-free inheritance being left to spouses and children. It is also another reminder not to rely on a single type of taxable investment -not even Roths.

Other proposed changes include placing a cap on contributions to retirement accounts and a cap on the deduction that certain tax payers would receive when making this contribution. All of these proposals amount to one idea: let’s attack the savings of retirees to help close the massive gap in our national budget. Certainly most of the proposals, if not all, will never see the light of day. The President and Congress are at odds on almost every subject, but all laws began as a simple proposal, sometimes decades before they became law. These proposals are a reminder to us, that tax diversification is key to reducing the risk of a change in the law.

So what if you are already heavily invested in pre-tax retirement accounts? Consider, converting them into other types of taxable investments. Of course consult with a competent tax and financial advisor. A blind conversion can cause unintended consequences, like increased tax on Social Security, higher Medicare premiums, and a spillover to a higher tax bracket.

Will you get an IRA penalty this year?

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The Tax Policy Center reports that 68% of IRA owners over age 70 1/2 have not yet taken their required minimum distributions this year.  If they don’t take these distributions by the end of the year, they will pay a 50% penalty on the distributions they should have taken!
Will two out of three IRA owners pay a huge tax penaltyTime keeps on slippin.’ Will two out of three IRA owners pay a huge tax penalty? New research from Fidelity offers a wake-up call to IRA holders over age 70 and a halfTime reports the findings: Among the 750,000 IRA holders required to take distributions and pay taxes by December 31, 68 percent have yet to take their full amount. More than half—56 percent—have so far taken nothing. If the money is not taken out, the IRS assesses a hefty penalty equal to half the amount to be distributed out of the account. As many as 250,000 IRA owners each year miss the end-of-year distribution deadline, according to the Treasury Inspector General. This generates potential tax penalties totaling $175 million.

What is a stretch IRA?

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By Robin Crouch

The term “stretch” does not represent a type of IRA, it refers to a financial strategy that allows people to stretch out the benefits from an IRA as well as receive income tax advantages. By using this strategy, an IRA can be passed down from generation to generation while beneficiaries enjoy the income as well as tax deferred growth for as long as possible.

Not all IRA custodial agreements allow the stretch strategy, you should check with your IRA custodian or financial institution to determine if beneficiaries will be allowed to take distributions over a life-expectancy period.  Most IRA providers would rather make such allowances than have their customer transfer his or her IRA to another financial institution.

Please note, the average inheritance, when received by a beneficiary, is completely consumed within one year.  The reasons are numerous but here are a few:  Beneficiary wants to spend it; Creditors, Predators, and Divorce; Not understanding the rules and choices. . . when the money is gone, it’s gone.  With an IRA, not only would the money be gone, but there will be a huge tax bill to pay.

The good new is that the choice can be yours to make.  If you wish to remove some of the roadblocks and ensure that your beneficiaries take the stretch and provide them with asset protection to avoid losing what you have worked a lifetime to earn, please ask about our Heritage Trust.

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Don’t let Retirement Benefits go down the drain!

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By Robin Crouch

If there is no beneficiary named on your retirement account, who inherits and how is the the required distribution calculated?

Unfortunately, there are cases where Dad died, Mom was the named beneficiary, but she predeceased him. OR, Mom inherited the IRA and died before naming her own beneficiary.

Each IRA has it’s own rules and each IRA custodian has their own agreement with language that will indicate who inherits the IRA when there are no named beneficiaries. Most agreements default to the estate of the deceased IRA owner.

A designated beneficiary is a living, breathing person who can stretch distributions over their own life expectancy and pay the income tax accordingly. Traditional IRAs are typically funded with pretax dollars. Distributions out of the account after age 59½ are taxed as ordinary income at each individual’s tax rate.

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