Steven L White

Although Roth IRAs have been in existence for several years, they have not been available to many higher-income people due to restrictions imposed by Congress. Under the Tax Increase Prevention and Reconciliation Act, Roth IRA conversions will be allowed for everyone starting in 2010. This change in the law creates a significant planning opportunity for high-income retired people.

To take advantage of this opportunity, individuals can prepare by consolidating all Traditional IRAs into one. Depending on the taxpayer’s Adjusted Gross Income, it also may be possible to begin making annual contributions to a Roth IRA prior to 2010. For reasons discussed in this article, such contributions can accelerate the tax benefits of assets that will be converted from a Traditional to a Roth IRA later.

 There are two main ways to participate in Roth IRAs – annual contributions or conversions. First, annual contributions – Taxpayers whose adjusted gross incomes (AGIs) do not exceed limits may make an annual contribution to a Roth IRA. Contributions are made with after-tax dollars and earnings compound tax-deferred. Withdrawals of Roth contributions may be taken tax-free at any time. Withdrawals of earnings are tax-free, provided the Roth has been in existence at least five years and withdrawals are taken after age 59 ½. Tax penalties apply on withdrawals of earnings prior to age 59 ½ unless an exception applies such as death, disability, medical expenses, first-time home purchase, or higher education expenses.

Secondly, conversions – Currently, any taxpayer (single or joint filer) with AGI under $100,000 may convert money from a Traditional IRA to a Roth IRA. The amount converted is added to taxable income in the year of the conversion and taxed as ordinary income. Since converted amounts then may qualify for tax-free withdrawals under the same terms as Roth contributions, conversions are a way of pre-paying income taxes in an IRA.

Starting in 2010, the $100,000 AGI limit for conversions will no longer apply, according to current law. For conversions made in 2010 only, half of the converted amount may be included in taxable income in each of 2011 and 2012.  
A Roth IRA conversion can help to accumulate tax-advantaged assets during retirement, simplify tax compliance, and pass on estates. In a Traditional IRA, contributions are not allowed after age 70 ½. However, a Roth owner may continue to make post-tax contributions at any age, and this benefit can increase the IRA account value in older ages. As there are no required minimum distributions from Roth IRAs during the owner’s lifetime, a conversion also avoids the annual calculation of the minimum distribution that is required in most Traditional IRAs after age 70 ½.
Finally, since no income tax is due on qualifying distributions from a Roth IRA during the owner’s life or after death, a Roth can make life easier for heirs by leaving them tax-free assets. Although heirs are subject to minimum distribution requirements from Roths (after the owner’s death), they have some flexibility to “stretch” these distributions over several years, thus continuing tax-deferred growth for some time.
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Tax rates can make a difference! One of the more challenging questions to consider is this one: “Do you think that, on the whole, tax rates will increase or decline during your retirement?” Because Roth contributions and conversions effectively pre-pay income taxes, they may make sense for individuals who believe tax rates will increase during their retirements. Some people think it is a mistake to pre-pay taxes because they will lose the “time value of money” on the taxes paid. However, this is not the case, due to the following rule:

A pre-tax dollar in a tax-deferred investment will have exactly the same after-tax future value as a post-tax dollar in a tax-free investment, if you assume that tax rates stay constant.

For example, suppose you put $1 of pre-tax money into a Traditional IRA and over 10 years it compounds (@ 8% annual return) into $2.16. You then pay federal/state income tax at a hypothetical 30% rate, leaving $1.51 after taking a taxable withdrawal. In comparison, suppose that you put 70 cents of post-tax money ($1 less 30 cents tax) into a Roth and it compounds over ten years at the same 8% to produce $1.51. Since the full amount can be withdrawn tax-free, the amount available for retirement security is exactly the same as in the Traditional IRA.

It is impossible to know whether federal, state and local income tax rates will go up or down in the future. Due to this uncertainty, one strategy is to hedge against tax rate changes by dividing retirement money between Traditional and Roth IRAs.

Even for those who aren’t sure about the wisdom of Roth conversions, it can be useful to contribute or convert a small amount to a Roth now. People over age 59 ½ are allowed to take tax-free withdrawals from Roth IRAs starting five years after the account was opened. Even a small amount put into a Roth now starts the “five-year clock” ticking.

In summary Roth IRAs have become a viable planning tool that can help to increase tax-advantaged asset accumulation and increase simplicity during retirement. Recent changes in the tax law will make Roth conversions “universal” starting in 2010, and that makes this a good time to begin evaluating their pros and cons.

Steven L. White

Wealth Strategies Group

Most people face a variety of unknowns in planning ahead for retirement. They include future inflation, interest rates, medical costs and investment market performance. Also, many of today’s retirees are questioning whether the benefits promised by Social Security and Medicare will materialize years from now. While these issues can determine retirement planning success, the biggest “question mark” of all may be longevity – how long retirement may last.

A good starting point for estimating longevity is a standard life expectancy table. According to these tables, women in the U.S. are outliving men by about 3-4 years on average. For example, a 60-year old woman currently has an average life expectancy of 23.1 years, to about age 83, while an average man of the same age can expect to live another 19.8 years, to about age 80. (This data is drawn from the Social Security Administration’s Period Life Table.)

Life expectancy tables are reliable guides for estimating the average longevity of large populations, but they have a flaw in personal planning. By definition, half of all people will outlive the average, and a small minority will live well beyond the average. For example, for every 100 U.S. women age 60, about 26 will reach age 90; for every 100 men, about 14 will survive to 90, according to Social Security.

Clearly, the retirement planning challenge changes when an individual’s “longevity horizon” shifts from age 80 to 90. If retirement assets and income must stretch a decade longer, the need to make good choices and smart decisions increases, as does the risk of mistakes.

Of course, longevity is determined by more than life expectancy tables and chance. Each person’s profile and lifestyle decisions also influence how long retirement may last. People who don’t smoke, have normal blood pressure, exercise regularly, and are of normal weight stand the best chance of living longer.

The Impact of Inflation on a Fixed Income-An important goal of retirement planning is to avoid depleting assets or running short of income in old age. If retirement planning decisions are based on an average life expectancy, individuals have a 50% chance of outliving their money. A more conservative approach is to plan for a retirement that will last several years beyond average life expectancy. Of course, the longer a retirement lasts, the greater impact inflation may have on the purchasing power of a fixed income. The table below shows the probability of living from age 60 to various ages and also the reduction in purchasing power for each dollar of fixed income that starts at age 60. It assumes that inflation averages a constant 3.5% in retirement, using $100 in this examply.
 
  Male      Female 
70 82.6%   88.6%    $70.89
75 68.8%   78.6%    $59.69
80 51.5%   64.9%   $50.26
85 32.1%   46.8%   $42.31
90 14.5%   26.3%   $35.63
95 3.9%      9.7%     $30.00
100 0.5%    1.9%    $25.26
Source: Social Security Period Life Table updated 6/27/06. Social Security Administration.
 
Income Sources That Can Last a Lifetime-Fortunately, it is possible to build retirement security on a base of income sources that can last a lifetime. These sources can form a foundation of longevity planning, especially for individuals who believe they may live well beyond an average life expectancy:

• Social Security – Under current law, Social Security retirement benefits will be paid for life to covered workers and their spouses. But changes in the Social Security system are probable in the years ahead, and it is not yet clear how retired people will be affected. Until changes are resolved, it may not be prudent not to count on Social Security for most of lifetime financial security.

• Pensions – In the past, many employers have paid lifetime pensions to workers and their spouses. But pensions have lost favor in recent years as more companies have shifted to personally-funded retirement plans, such as 401(k)s.

• Guaranteed Income Annuities – Life insurance companies offer guaranteed income streams payable for life, and the income can include annual increases that help to offset inflation. Because income annuity decisions may be irrevocable, it’s wise to compare the choices carefully with professional help.

In summary, it is possible to factor personal heredity and healthy living habits into your retirement outlook, along with a desire to plan for a period of time somewhat greater than average life expectancy. In this process, a qualified financial professional with experience in retirement issues and exit planning  can be a valuable resource.

Steven L White

Wealth Strategies Group