The other night a buddy of mine invited me over to help put together a wall unit from IKEA. As good as the instructions were, he was vastly confused and needed a bit of help making heads and tails of some diagrams.

As complicated as it at first might have seen, I told him it was easy compared to the rules and regulations surrounding inherited IRAs. While this short article won’t be of any help in setting up wall units or desks, it might very well be of some assistance in helping you understand a few things about inherited IRAs.

Transferring inherited IRA assets

If you inherit an IRA from someone who isn’t your spouse, your options are fairly limited. You can’t roll the proceeds over to your own IRA, treat the IRA as your own, or make any additional contributions to the IRA. What you can do is transfer the assets to a different IRA provider, as long as the registration of the account continues to reflect that the IRA is an inherited IRA and not your own.

If you inherit an IRA from your spouse, you have many more options. You can roll all or part of the IRA proceeds over to your own IRA. You become the owner of the IRA assets, and the rules that apply to IRA owners, not beneficiaries, apply from that point on. If you’re the sole beneficiary of the IRA, you can also generally treat the inherited IRA as your own by retitling the IRA in your name. But you aren’t required to assume ownership of an inherited IRA. You can instead continue to maintain the inherited IRA as a beneficiary. You might want to do this if you inherit a traditional IRA and you’ll need to use the funds before you turn 59½ (distributions from inherited IRAs aren’t subject to the 10% penalty that typically applies to early distributions from IRAs you own).

Required minimum distributions (RMDs)

Nonspouse beneficiary: Federal law requires that you begin taking distributions (called required minimum distributions, or RMDs) from the inherited IRA after the IRA owner dies. If the IRA owner died after turning 70½ and didn’t take a required distribution for the year of death, you’ll need to make sure to take that distribution by December 31 of the year of death in order to avoid a 50% penalty.

Spouse beneficiary: If you roll the inherited IRA over to your own IRA, or treat it as your own, then the RMD rules apply to you the same way they apply to any IRA owner–you’ll generally need to begin taking RMDs from a traditional IRA after you turn 70½; no lifetime RMDs are required at all from a Roth IRA. If you don’t roll the IRA assets over or treat the IRA as your own, then the same rules described above for nonspouse beneficiaries generally apply to you, except that you can defer receiving distributions until your spouse would have turned 70½.

Special rules–inherited Roth IRAs

Qualified distributions to a beneficiary from an inherited Roth IRA are free from federal income taxes. To be qualified, the distribution must be made after a five-year holding period. The five-year period begins on January 1 of the year the deceased IRA owner first established any Roth IRA, and ends after five full calendar years. If you take a distribution from an inherited Roth IRA before this five-year period ends, any earnings you receive will be subject to federal income taxes (earnings generally come out last). If you’re a spouse beneficiary, and you roll the inherited Roth IRA over to your own Roth IRA or treat the inherited IRA as your own, then you’ll be eligible to take tax-free distributions only after you reach age 59½, become disabled, or have qualifying first-time homebuyer expenses. You’ll also need to satisfy the five-year holding period, but a special rule applies–the five-year period for all of your Roth IRAs will be deemed to have started on January 1 of the year you or your spouse first established any Roth IRA, whichever is earlier.

And speak to a financial professional if…

• You’re sharing the inherited IRA with other beneficiaries. This can impact when and how you must begin receiving RMDs from the IRA.

• You don’t want or need the IRA funds. You may be able to disclaim the IRA and have it pass to another beneficiary. This must be done in accordance with strict IRA rules.

• Any estate taxes were paid that are attributable to the inherited IRA. You may be entitled to an income tax deduction equal to the estate taxes paid.

Everyone remembers certain things in their life such as their first kiss, High School graduation, their first car, girlfriend, job, etc.. But when it comes to the real important things in life, hearing about the Trusteed IRA certainly tops most people’s list, including mine.

The first time I heard of this was likely right around this month many moons ago, so I figured it’s a fantastic time to once again celebrate this very important event in my life. After writing this, I’m going out to celebrate. Care to join?

If you’ve never heard of a Trusteed IRA, then before you can go out and celebrate with me, you’ll need to read this article to learn a little about them, otherwise, you just might feel a bit empty partying with myself and all those around me who will spend a nice evening over at Spago’s discussing this.

To begin with, the tax code allows IRAs to be created as trust accounts, custodial accounts and annuity contracts. Regardless of the form, the federal tax rules are generally the same for all IRAs. But the structure of the IRA agreement can have a significant impact on how your IRA is administered. This article will focus on one type of trust account commonly called a “trusteed IRA,” or “individual retirement trust.”

Why might you need a trusteed IRA?
In a typical IRA, your beneficiary takes control of the IRA assets upon your death. There’s nothing to stop your beneficiary from withdrawing all or part of the IRA funds at any time. This ability of your beneficiary to withdraw assets at will may be troublesome to you for several reasons. For example, you may simply be concerned that your beneficiary will squander the IRA funds.

Even if your beneficiary doesn’t deplete the IRA assets, in a typical IRA you normally have no say about where the funds go when your beneficiary dies. Your beneficiary, or the IRA agreement, usually specifies who gets the funds at that point. So, in a typical IRA, if you name your spouse as your primary beneficiary, your spouse could name children from a previous marriage, or a new spouse if he or she remarries, as the ultimate beneficiary of your IRA assets. A trusteed IRA allows you to control the ultimate beneficiaries of your IRA, by letting you specify contingent beneficiaries that cannot be changed by your primary beneficiary.

With a trusteed IRA, you can’t stop the payment of required minimum distributions (RMDs) to your beneficiary but you can restrict any additional payments. You can direct the trustee to pay only RMDs to your beneficiary. Or you can provide the trustee with discretionary authority to make payments to your beneficiary in addition to RMDs, e.g., for your beneficiary’s health, welfare, or education. Or you can impose restrictions on distributions that last only until your beneficiary reaches a specified age. Trusteed IRAs can also be set up to qualify as marital, QTIP, and credit shelter (bypass) trusts, potentially simplifying your estate planning.

A trusteed IRA can also be a valuable tool during your lifetime. It can be structured so that if you become incapacitated, the trustee will step in and take over the investment of assets and distribution of benefits on your behalf, ensuring that your IRA won’t be in limbo until a guardian is appointed.

Is a trusteed IRA right for you?
While trusteed IRAs can be as flexible as a particular trustee will allow (not all provide the same level of IRA planning services), they aren’t right for everyone. The minimum balance required to establish a trusteed IRA, and the fees charged, are usually significantly higher than for other IRAs, making trusteed IRAs most appropriate for large IRA accounts. You may also incur attorney’s fees and other costs.

And in some cases, another approach might be more appropriate. For example, you may be able to assure that your IRA “stretches” after your death by instead naming a trust as the beneficiary of your IRA. If specific IRS rules are followed, RMDs can be calculated using your trust beneficiary’s life expectancy (this is commonly called a “see-through” trust).

See-through trusts are generally more expensive, and more complicated, than trusteed IRAs. It’s important that you consult an estate planning professional who can explain your options and make sure you choose the right vehicle for your particular situation.

With my NY Jets now out of the running for this year’s SuperBowl title, what else is there to think about other than some little known “new” retirement issues this year? (And you thought it was going to be a boring year).

Let’s take a closer look at some of this year’s new laws:

Nonspouse rollovers must be permitted

The Pension Protection Act of 2006 allowed, for the first time, nonspouse beneficiaries to make a direct rollover of inherited funds from an employer plan to an IRA.

How good is that?!?

While the provision seemed fairly straightforward at the time, confusion arose as to whether plans were actually required to allow these rollovers. Congress addressed this in the Worker, Retiree, and Employer Recovery Act of 2008– beginning in 2010, employer plans must let nonspouse beneficiaries make a direct rollover to an IRA if they so choose. The new law also clarified that prior to 2010 employer plans could, but were not required to, allow the rollovers.

IRA conversions for (almost) everyone!

Beginning in 2010, if you own a traditional IRA, you’ll be able to convert it to a Roth IRA. The income limits and marital status requirements that previously applied to Roth conversions were repealed by the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA).

In addition, if you convert a traditional IRA to a Roth IRA in 2010, you’ll be able to report half the income on your 2011 tax return and half on your 2012 return. Or, if it’s to your benefit, you can instead elect to include the entire amount in income on your 2010 return. It’s up to you.

If you inherit a traditional IRA from your spouse, and you elect to treat that IRA as your own, you’ll also be able to convert the inherited IRA to a Roth IRA in 2010, regardless of your income or marital status. Nonspouse beneficiaries, however, still can’t convert an inherited traditional IRA to a Roth.

Note that the income limits for contributing to a Roth IRA haven’t changed for 2010. If your income is high enough, your ability to make regular contributions to a Roth IRA in 2010 may be limited, or even eliminated. The ability to convert a traditional IRA to a Roth without income limits, however, provides a potential workaround–you can make your annual contribution to a traditional IRA, and then immediately convert that traditional IRA to a Roth. You’ll have to aggregate all your traditional IRAs when calculating the tax effect of the conversion, so speak with a financial professional first to make sure this strategy works for you.

Care for an analysis for your own situation (whether or not you might consider converting)?

For more information, you might also want to check out the recent article I wrote for The American Institute of Certified Public Accountants.

Employer plan conversions for everyone!

Beginning in 2008, employees and beneficiaries were permitted for the first time to essentially “convert” employer plan distributions by rolling the funds over to a Roth IRA. This was allowed, however, only if the payee satisfied the income and marital status limits that applied to traditional IRA conversions. The elimination of those restrictions by TIPRA, described above, also applies to distributions from employer plans–so beginning in 2010, anyone who receives an eligible distribution of non-Roth funds from an employer plan can roll those funds over to a Roth IRA, regardless of income or marital status. This applies even to nonspouse beneficiaries–but only if the transfer to the IRA is done in a direct rollover.

Here comes the DB(k) …

Beginning in 2010, “small employers” (those that generally employ at least 2 and no more than 500 employees) can adopt a DB(k) plan– a single plan that incorporates both a 401(k) plan and a defined benefit plan (including a cash balance plan). A single trust is used, but there is separate accounting for the defined benefit and 401(k) portions of the plan.

The plan must meet certain benefit, contribution, vesting, and nondiscrimination requirements. In return, the plan will be exempt from top-heavy rules and certain 401(k) testing.

Because the DB(k) plan is one plan instead of two, it is expected that the plan will be simpler to administer and less costly than maintaining two separate plans. This, in turn, may provide an incentive for employers to begin offering defined benefit plans to their employees in addition to 401(k) plans. Whether this proves to be the case, however, remains to be seen.

Beginning in 2010, if you own a traditional IRA, you’ll be able to convert it to a Roth IRA. The income limits and marital status requirements that previously applied to Roth conversions were repealed by the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA).

Which is more attractive? Brad & Angelina or 2010 & The Roth?

While at first the answer might seem simple, by reading on you’ll quickly see why it’s most likely not.

To begin with, let’s take a quick step back and recap the Roth. While I’m sure for most this might be a bit basic, sometimes the busy days get the best of us so I figured I’d start off by quickly refreshing one’s memory.

Thanks to the late, legendary Delaware senator William Roth leading the charge, back in 1998 Congress gave us American taxpayers the precious gift known as the Roth IRA. I find the quickest way to describe a Roth is to compare it against the more familiar Traditional IRA; some basic points summarized as follows:

Of course, some of the above are subject to certain conditions and restrictions, but for the moment, I’m trying to keep this simple. For example, subject to various exceptions, withdrawals from a Roth are tax-free only when taken after the greater of 5 years from the time the contribution or conversion was first made or when the person making the contribution or conversion turns 59 1/2, otherwise, penalties and taxation could apply.

While the above may sound well and good, not everyone can contribute into a Roth. For example, in tax year 2010 one cannot make a contribution if their Modified Adjusted Gross Income exceeds the following amounts:

* For taxpayers filing single or head of household: $120,000
* Married filing jointly: $177,000
* Married filing separately: $10,000

In addition, if one qualifies for a Roth, there are limits to the amounts that can be contributed. For tax year 2010, one can contribute up to $5,000 and an additional “catch-up” contribution of $1,000 if they are over the age of 50.

Furthermore, as long as one’s modified adjusted income is lower than $100,000, an IRA can be “converted” into a Roth. Doing so will incur full taxation on the amount converted but once done, you will then reap the benefits of a Roth noted above.

This all brings me to the challenging question, “which is more attractive, Brad & Angelina or 2010 & The Roth?

The answer can be found buried deep inside 2006‘s Tax Increase Prevention and Reconciliation Act that states in tax year 2010, although income limits that allow or deny a contribution into a Roth do remain, converting one’s IRA into a Roth can be done by anyone. Prior to this year, if one’s modified adjusted gross income was greater than $100,000, a conversion would not be permitted. However, from this year forward, the $100,000 rule is completely lifted.

How good is that? … It gets better.

In years prior and after this, when one converts an IRA into a Roth, they would be required to include the entire amount converted (less nondeductible contributions) into one’s gross income for the tax year in which the conversion was made. This year, however, you have the choice to report all or half the income from the conversion in 2011 and the remaining half in 2012.

Keep in mind, the same rules apply for SEP IRAs. As for SIMPLEs, they be converted as long as one has contributed a minimum of two years prior to the conversion taking place.

HOW TO CONVERT

Thankfully, a conversion doesn’t require priests, rabbis or some sort of nuclear fusion process over at JPL. “Doing” a conversion merely requires contacting the custodian holding the IRA and asking for a Roth conversion form. Custodians likely call it different things, but what you’re looking for is the form that you nee to sign and submit that will convert your IRA into a Roth and that’s basically it.

ALL OR NOTHING?

Speaking of the conversion, I often find people mistakenly believe converting an IRA into a Roth is an “all or nothing” deal, when in fact it’s not. With a qualified advisor’s assistance, you might find that converting only a portion of your IRA into a Roth is the more effective road to pursue.

Should that be the case, all one needs to do is transfer the portion of the IRA they wish to convert into a separate IRA and then convert this “new IRA” into a Roth. True, one can often save themselves the additional step in the process by simply transferring the portion of their IRA they want to convert directly into their current or new Roth (and avoid the extra step), but I get a bit anal about this stuff and like to keep clear records of what was done, and I find the extra step could help resolve any issues that might later arise. That said, this additional step becomes that much more important when factoring in the “best kept secret” about Roths…

THE BEST KEPT SECRET

One of the least known provisions of the Roth is also one of the most attractive.

Let’s suppose I own stock within my IRA and at some point this year I decide to convert the account (or a portion of it) into a Roth. Come April 2011, I’ll owe tax on the conversion. But looking at my statement, let’s suppose that no thanks to a bad market, my “new” Roth lost quite a bit of value since the conversion took place. If I was unaware of the best kept secret, I’d go ahead and pay taxes based on the higher stock price(s) when the conversion was done.

However, because I’m aware of this little known secret, as long as it’s done before October 15, 2011, I can actually “re-characterize” my Roth back into an IRA, and then once again “re-convert” it back into a Roth, but this time, pay tax on the lower stock price(s).

CONCLUSION

Should everyone convert? No way. There’s many reasons one should or should not convert. Some that come to mind is how much time a client has until the IRA and/or Roth may or may not be used, where the taxes will be paid from and a number of other important factors not mentioned here. If you need assistance in running an analysis on key decision points, I have some simple and fantastic software at my fingertips that could be of help. Feel free to drop me an email if you’d like and I’d be glad to lend a helping hand.

So, which is it? Brad & Angelina or 2010 & The Roth? By now you most likely know my answer, but the better question at this moment is, “what’s yours?”

Interested in getting an analysis on whether or not you should consider converting to a Roth IRA?

This is Part III in a series. If you have not read Part I and Part II, I would highly suggest first reading them in sequence.

Opening this final installment of the trouble with 401k retirement plans (and others like it) with a slice of financial history may not seem all that relevant but in a moment you’ll see why it’s pertinent.

Put a trivia whiz on Jeopardy, ask what the relevance of 1933’s Glass-Steagall Act was and they’ll most likely answer that it created the FDIC. While this is certainly accurate, a lesser known fact was that it also placed a clear division between banks, brokerages and insurance companies.

But since 1999 when the act was officially repealed, the lines between financial institutions are now overlapped and completely blurred. Because of the repeal, unbeknownst to many, the pursuit of market returns is no longer confined within the framework of brokerages but is now also available within the banking and insurance industries as well.

Why is this relevant?

Well, while all three industries now offer at least some form of access to the market, the characteristics of our money within the framework of the industry we select can be vastly different from one another.

Specifically, the characteristics I am referring to are:

• Taxes: when and how we pay them.
• Losses: how the account is protected, if at all.
• Fees: how costs are structured.

While no institution can control the returns we receive, we do have control over the above and when we exercise such control, the difference it can make to the amount of income we can expect to receive at retirement can be quite dramatic.

Let’s take a closer look.

THE EFFECT OF FEES

Ironically, out of all characteristics, fees often bear the least effect on the retirement income we receive but because the subject seems to attract the most media attention, I’ll start with it first.

Many of us have heard something to the effect, “if you lower your fees you’ll have more money for retirement,” and there’s no doubt this is true. In fact, back in March, 2007, it was well documented in congressional testimony (see end footnote) that showed during the course of accumulating money and distributing it over a retirement, a lower fee would result in a higher compounding rate that could provide well over $500,000 more money to the individual; an amount that is certainly nothing to sneeze at.

But how can one possibly lower fees inside a retirement plan? The answer we often hear from the likes of Warren Buffet and a long list of other sources is to invest in the indexes rather than having professionals pick stocks for us inside the structure of a mutual fund or typical brokerage accounts. Not only would indexing significantly lower the fees, but it would also likely increase the performance of the account as well.

For example, the testimony above cited that “the S&P 500 index consistently outperformed 98 percent of fund managers over the past 3 years, 97 percent over the past 10 years and 94 percent over the past 30 years.” As for costs, “since index funds do no research and little trading, the costs of holding their portfolios are extremely small, some ranging as low as .10 percent a year.”

So, why do nearly all retirement plans fail to offer index investments? The answer, as stated in the testimony, is that the plans “are guided to particular decisions by non-fiduciaries in pursuit of compensations which very frequently is in the form of hidden and excessive fees.”

In a vacuum there is therefore little doubt that indexing would be the optimal choice in terms of lowering fees and increasing performance. But how likely is it that retirement plans will follow the advice of Buffet along with many others and offer these low cost indexes? Given the historical Wall Street and political landscape, the answer is very likely, “not much.”

As such, most people will continue paying the brokerage industry’s common percentage based fees that start off small but typically increase over time as the balance of the account rises, often peaking to its most expensive amount at the point just where it matters most: when we need to generate income from the account.

Most people will shift from accumulation into the distribution stage and continue to remain within the framework of the brokerage industry. At retirement, to try and minimize potential loss, individuals are often told to diversify their portfolio into a basket of stock and bond funds. While this will could very well help minimize loss, it will also serve to likely dilute returns as well.

If we assume average fees between 1.5 to 3 percent and one earns a conservative average of 6 percent, this translates into 30-50 percent of the earnings being lost just to pay the annual costs of the account itself.

Conversely, the insurance industry offers a variety of fee structures to choose from, two of which I want to address here:

• One can structure fees that generally remain level and fixed. These fees are based on the amount being contributed, not the account balance, so the effect is that over time, these fees get proportionately smaller in relation to the account balance. When compared to percentage based fees, a level fee structure could not only provide tax-free distributions but it is often at its lowest point when one needs to generate income from the account, thereby allowing an individual to realize more income instead of losing significant portions of it to fees. In fact, over the lifetime of an account, cumulative fees within this structure will often be considerably less costly than percentage based fees.

• One can also choose to eliminate management, transaction and maintenance fees. In this structure (as well as the above), there is no market risk to principal and in exchange, earnings are capped but at levels that have the potential to produce comparable long term average market returns commonly associated with the brokerage industry. After a period of at least ten years or more, eliminating fees will generally increase an account value by roughly 10 to 20 percent. Although relevant, the more pertinent point is that when in the distribution stage of retirement, this higher account balance can translate into a 50 to 75 percent increase in the amount of income over that of a traditional retirement plan nested within a brokerage account.

How so? Well, when taking distributions from the framework of the brokerage industry, if we assume a 7 percent average return less typical fees of 1.5 percent, this leaves earnings of 5.5 percent. To cushion against potential loss, the commonly referenced Withdrawal Rate states a person should withdraw no more than 4 percent of the account value per year. However, if one eliminates fees, earns the same 7 percent average return and has no possibility for market loss, most or all of these earnings can be taken for income, thereby increasing retirement income by a factor of 50 to 75 percent.

Bottom line: when in the distribution stage of retirement where percentage based fees are typically at their highest point, the proportionate effect of fees is far greater when compared to the effects during the accumulation stage.

THE EFFECT OF LOSS

As mentioned, a transition from the accumulation stage into the distribution stage commonly results in diversifying a brokerage account into stock and bond funds. Here, one might prudently follow “The Rule Of 100” which recommends subtracting one’s age from 100, resulting in the suggested percentage of stock exposure one should generally have in their portfolio.

While prudent in practice, market years such as 2008 were a disaster for both of these frequently suggested guidelines. With the exception of cash positions, in that year and others like it, just about everything went down in value; hence the reason the heavily scrutinized Withdrawal Rate understandably recommends taking no more than 4 percent of a brokerage account’s value for income. While earnings might exceed 4 percent, when an account is exposed to loss, one obviously needs to maintain a reserve for periods when losses occur.

But when an account is (a), protected from market loss, (b), fees are generally level or eliminated and (c), market returns are still possible, then one would not have to hold back earnings to cushion against market downturns; one could use most or all of the earnings for income, and this particular set of characteristics is available only within the insurance industry and is therefore the main reason I am focusing on it for this post.

In the insurance industry’s structure where they offer protection from market loss, if we assume an average return of 7 percent, then withdrawing anywhere between 6 and 7 percent equates to a 50 to 75 percent increase in income when compared to the brokerage industry/Withdrawal Rate’s recommended 4.

THE EFFECT OF TAX

While fees and protecting an account against market loss are of course quite important, the characteristics that will bear the most effect on our retirement income is by far taxation.

This is because year after year, taxes effect:

• The amount of income one actually gets to spend, and,
• The overall account value given that taxation causes the need to withdraw the gross amount of income which often exceeds the returns the account is actually earning.

For example, suppose one retires with $1,000,000 and the desired spendable income is $50,000. In a one-third tax bracket, one would have to withdraw roughly $75,000 to actually spend $50,000. If one diversifies their portfolio, receives an average return of 6 percent less 1.5 percent fees, the account can be out of money in approximately 20 years.

Furthermore, and something that is often not factored into this area of discussion: withdrawals from a traditional retirement account will likely expose one’s Social Security income benefits to taxation, up to the tune of 85 percent. While many focus on taxation issues regarding income taken from a taxable, brokerage retirement account, when factoring in indirect taxation, withdrawals from these retirement accounts can also cause increased taxes on Social Security income as well.

For example, if one withdraws $20,000 from a taxable retirement account, they would obviously be paying taxes on this full amount. In a one-third tax bracket, that would equate to approximately $6,000 owed in taxes. However, this income could also trigger 85 percent of the equivalent Social Security income to be exposed to taxation as well, resulting in an additional $5,000 – $6,000 that could be owed in taxes as well.

If, however, one eliminated the tax by utilizing the characteristics available within the insurance industry, they would only have to withdraw $50,000 from a $1,000,000 account earning 5 percent to actually spend the same amount. In this case, the balance of the account could have far greater longevity than that of a typical taxable brokerage retirement account. And finally, within this structure, Social Security income might not be exposed to taxation as a result of these withdrawals as well.

Eliminate the tax, and depending on one’s bracket, an individual can typically increase their income by 50 to 65 percent as well as potentially eliminate up to 85 percent of Social Security exposure to taxation as well.

It’s as simple as that.

CONCLUSION

If within the insurance industry one chooses to:

• Generally level out the fees, whereby costs are often at their lowest at the point of distribution,
• Eliminate the possibility of market loss, whereby one can withdraw most or all of the earnings for income, and,
• Eliminate the tax, it is therefore possible to potentially increase one’s retirement income by a factor of three times the amount when compared to distributing money from that of a taxable, brokerage retirement account such as a 401k, 403b, IRA and others.

Inversely, when utilizing the characteristics available within the insurance industry, one can potentially achieve the same results realized within the brokerage industry but with three times less the amount being contributed.

In summary, the choices we have when controlling taxes, losses and fees are highlighted below. Keep in mind, these results assume the same annual contributions ($16,500), the same market returns (7 percent), the same period of time, net of all fees and the shared mindset to preserve one’s account over a typical retirement:

After outlining the above, I am often asked, “should everyone utilize the insurance industry for their retirement?” My answer is always, “absolutely not.” One should never consider utilizing the insurance industry and its products for their retirement any more or less than they should consider utilizing the brokerage or banking industry.

Each industry and its products serves its own unique function and purpose, and only when one’s situation is well assessed and all facts are completely understood should any decision or approach ever be made.

That said, I often find there are gross misconceptions about the insurance industry, many of which are archaic in nature and based on outdated beliefs including, but not limited to, fee structures available and that the only access our money has to potential market returns is through the framework of the brokerage industry. The use of insurance policies and other products in a modified, suitable and legal manner that emphasizes living benefits takes an individual who thoroughly understands the new evolution of these products and designs the plans only in the best interest of the client and no one else.

Should you decide to pursue further investigation of this direction, I would highly advise speaking with someone who understands this new evolution of the insurance industry as well as someone who also understands the brokerage and banking industries as well. After all, what could be good for one person can be awful for another and only when one’s personal situation is well understood should a direction as important as one that relates to our retirement income (or any other matter) be made.

The sole intention of this three-part series has been to try and open the realm of possibilities many people don’t know exist that could help one realize a more peaceful, comfortable and prosperous retirement regardless of the path we select.  

‘1 Testimony of Matthew D. Hutcheson, “Congressional Testimony 401ks” US House of Representatives, March 6, 2007, p6

The entire three-part series of The Trouble With Retirement Plans appeared in the American Institute of Certified Public Accountant’s newsletter. You can download the entire three-part series here: The Trouble With Retirement Plans

This is Part II in a series. If you have not read Part I, I would highly suggest reading that first.

In my last post, I discussed the trouble with qualified IRS retirement plans such as 401ks, IRAs, 403bs, SEPs, etc..  At its conclusion, I mentioned I’d continue this three-part series by addressing conventional solutions that claim will improve the results of these plans.

Before addressing them, I’d like to first begin with a brief recap of several important points:

• Most qualified plans were never meant to replace pensions, they were only meant to supplement them and that’s it.
• As a result, we are now being asked to retire on plans that even if funded and invested to perfection, they will leave many of us with completely inadequate retirement income.
• The contribution limits of these plans are low and restrictive.
• If one cannot make contributions, an individual is not permitted to make up for missed contributions in later years.
• Fees are typically quite high.
• Fund choices are limited and often below average.
• The value of the tax deductions one receives when making a contribution is often over estimated. In reality, the tax deduction one receives is actually a loan against future income whereas a true tax deduction is something that does not have to be paid back. Furthermore, it should be noted that the tax deduction is almost always spent rather than reinvested.

Conventional solutions that strive to improve upon these shortcomings typically revolve around discussions about the quality of the investments, fees and/or the amount being saved. However, I would like to begin by first focusing on the issue I consider of paramount importance and one that is often neglected: the issue of one’s behavioral mindset.

In the past, most people retired with a pension, and as basic as it may sound, it’s important to ask, “what exactly is a “pension?” It has nothing to do with the value of the account one has when they retire, rather, the pension is all about the income one receives.

Back in the seemingly ancient days of pensions, the retired individual didn’t know nor did they likely think much about the value of the account that was busy generating a lifetime of monthly retirement checks. Similarly, does anyone receiving Social Security really know or care about the value of the account generating their benefits? Not at all. Most people receiving Social Security are only concerned about the income they receive.

When it comes to retirement plans, however, today’s mindset is completely different: the primary focus is inverted. Given today’s age where pensions are basically extinct and the retirement plan is often the only account an individual has to carry them through retirement, the individual’s priority is most often focused not on the income the account will produce but rather on preserving its value as much as possible while taking out whatever amount of income it can support.

On the contrary, pension managers of the past had a distinct advantage over us. In the past, over a 30 year working career, the pension manager needed to set aside roughly 15% of an individual’s wages in order to provide them with 70% of their current income at retirement (60% if married). If the pension manager was faced with the additional burden of needing to preserve the account while generating the 70% target income, they would need to set aside not 15% of the wages but rather an astonishing 30%, which would have been a feat just short of impossible. As opposed to the behavioral mindset of today, the pension manager wasn’t required to preserve the account, rather, they would use the principal and its earnings in order to generate a reasonable income for the retired individual who statistics show will rarely do this for themselves given the mindset of preservation that exists today.

For most people, this might be a lot to comprehend but evidenced by the recent market disaster that prolonged many retirements, it’s critical for us to address these important points without delay.  After all, with rare exception, today’s individual is completely responsible for their own income at retirement and the need to take responsibility for this is a harsh reality most people need to face.

This leads me to the conventional solutions we often hear about that are said could increase a our chances for heightened retirement income success. Let’s take a closer look:

SAVE MORE

Some say one solution to generate more income at retirement is to simply save more money. Doing so would obviously increase the balance of an account at retirement and therefore the amount of income it can produce, but how many people can really save the 30-50% of their paycheck that would be necessary to produce a comparable amount of income that a pension would have provided?  The answer is, “not many.” Most people could never stash away 30-50% of their paycheck necessary to preserve their account while generating a comparable pension, so to me, this “solution” is really just a moot point.

WORK LONGER

Sure, working into one’s 70s or part time during retirement could obviously improve the amount of income one can expect to generate at retirement but unless voluntary, many people would simply not elect this path. While for many this might end up being their reality, it certainly wouldn’t be an optimal choice.

INCREASE THE RETURN

Betting on a higher return would certainly increase the account value at retirement and thereby the amount of income it can produce, but not only do we have no control over the return, most would agree the chances of sustaining a high return over a lengthy period of time is highly improbable. As such, when projecting how much an account will be worth at retirement and the amount of income it can produce, many would be far better off assuming a moderate rate of return and treat higher results as a welcomed plus rather than anticipating higher rates and regretting a lower return.

LOWER THE FEES

I often hear to better the end results of retirement plans, Wall Street and the third party administrators that oversee them should lower their fees. Given we have no direct control over this issue, while it certainly sounds like a solution that could help our results, the politics of Wall Street and Washington make the chances of this happening distant and remote. Besides, even if fees were reduced, the effect they would have on the amount of income we can expect to receive at retirement is minimal at best.

CONCLUSION

So, is all hope lost?

Not quite.

Congress and many economic support groups are well aware of these issues and have recently proposed some interesting solutions such as:

• Giving tax incentives to people who convert their plan into pension type of income at retirement via an annuity.
• Limiting access to accounts before retirement.
• Developing a system that can protect against loss of principal.

While these are ideas being proposed for the future, some are actually available today but are not widely known or promoted because they do not support the traditional system currently in place. Ironically, as a result of the repeal of the Glass-Steagall Act (which I’ll detail more in the next post), the competition is now coming from the insurance industry which is the very organization that handles the payouts from lotteries, pensions, structured settlements and other forms of distribution that require at least some form of income guarantees.

By planning ahead, we can use the distribution capabilities of the insurance industry to:

• Eliminate or minimize tax.
• Protect the account from market loss.
• Eliminate or reduce fees.

In my final post of this three-part series, I will cover the proper techniques for doing this and show how employing them can increase the efficiency of retirement income dollars by two to four times the amount when compared to the traditional retirement plans I’ve been discussing.

Stay tuned, and until then, feel free to email me with any questions you have.

Proceed to Part III here.

The entire three-part series of The Trouble With Retirement Plans appeared in the American Institute of Certified Public Accountant’s newsletter. You can download the entire three-part series here: The Trouble With Retirement Plans

Here’s a trivia question: what does Jay Leno, prescription drugs, the iPhone and the 401k all have in common? Answer: they’ve all appeared on recent covers of Time Magazine. 

Although I can sing lots of praise for my iPhone, I can’t say I share similar enthusiasm about 401ks and other retirement accounts like it.

Surprising to many, the 401k was never designed to be the vehicle meant to carry people through their retirements. Quite the contrary, the 401k was originally only meant to be nothing but a cash supplement to pensions, not a replacement of them.

Back in the seemingly ancient days of pensions, many workers retired with their pensions well intact but a problem existed in that they often had limited cash reserves to supplement their monthly checks. To solve this problem, back in the late 70s Congress created what was supposed to be nothing but a minor provision in the tax code that allowed employees to take a percentage of their income, contribute it into a 401k and defer the tax so that when they retired, they’d have this “side fund” of savings to draw from.

The theory of giving workers a retirement side fund sounded great until corporate America found a self serving opportunity nested within it. After all, designing and managing pensions required additional staff, they were costly, risky and carried lots of responsibility. As such, many corporations found a way to cut costs and risk by shifting the responsibility of lifelong retirement income to their workers through the framework of the 401k (and other types of IRS qualified plans such as 403bs, TSAs, etc.).

I don’t know about you but if I wasn’t in the profession I’m in, I highly doubt I’d have much time to understand how to essentially be my own pension manager. To place this responsibility into the hands of the public who understandably has limited time and resources to be their own pension managers is just simply unfair and negligent. Furthermore, as we’ll soon find out, even if someone does successfully manage their own 401k to perfection, the chances of success are minimal at best given these plans are now being asked to do a job they were never intended on doing in the first place.

Let’s take a closer look.

1. INADEQUATE INCOME

Let’s take a hypothetical 40 year old named “Dave” who earns $80,000 per year and who is doing a heroic job of contributing the maximum amount allowed into his 401k. Contributing $16,500 per year (inclusive of a match) and miraculously achieving a steady 7% return each year less fees (soon to be discussed), at retirement age 65, Dave should end up with around $780,000 in his 401k.

Once retired, an important question then arises: how much income can he expect to receive from his account without outliving it?

The answer can be found in something called the “Withdrawal Rate,” a general rule of thumb that market historians and financial planning professionals generally agree to. The answer as to how much income one could safely generate from their account without outliving it is approximately 4% of its value. Any more than that percentage, then the chances for success are significantly decreased. True, an account might very well earn higher returns, but one needs to maintain a cash cushion for the bad years as well as the good, hence the lower-than-market-average Withdrawal Rate.

With the Withdrawal Rate in mind, the income Dave can expect to receive comes out to approximately $33,000 per year, which comes in at far less than a typical pension would have likely produced at around $58,000 per year (70% of his current income of $80,000; less if the pension is also established to cover a spouse).

If you’re interested in some quick rules of thumb that can help you determine the end result of your efforts, just follow this simple guideline:

Assuming a 7% growth rate less fees of 1.5%, simply take the amount being contributed into the retirement plan, then follow the math:

* If retirement is 15 years into the future, the gross amount of income you can expect to receive is 1x the amount being contributed. As an example, if $10,000 is being contributed, based on the 4% Withdrawal Rate and other assumptions just mentioned, you can expect to receive a before-tax income of $10,000 in your first year of retirement.

* If retirement is 20 years into the future: income will be 1.5x the contribution amount.
* 25 years in the future: 2x the contribution amount.
* 30 years: 3x the contribution amount.
(If there is a company match, simply increase the results by the match percentage).

Although not perfect and exact, the results will at least give you a general idea as to the results your efforts can generally be expected to produce. Of course, all this should be considered hypothetical and for example only.

Doesn’t sound too good? … It doesn’t end there. There’s something else that obviously needs to be taken into account:

2. TAXATION

The above income is all before-tax. Given money withdrawn from these plans and others like it are usually fully taxed as ordinary income, let’s assume when Dave retires he is in a modest 30% bracket. With this factored in, the net income for Dave would be somewhere around a mere $20,000, which basically equates to purchasing power of around $10,000 when adjusted for 3% inflation.

What chances does he have to survive on this level of income? The answer is most likely, “not much,” and hence, the conclusive reason why even in his near perfect situation of maxing out his contributions and achieving steady market returns without loss, using a supplemental plan such as a 401k to replace a pension can’t be expected to yield much success.

3. MARKET RISK

In a recent segment addressing the problems with 401ks, 60 Minutes summarized the risk issue quite well when asking, “What kind of retirement account allows people to lose 50% of their money the moment they are due to retire?”

4. COSTS

Different sources report varying costs but if I had to filter through all my research, I feel comfort in estimating total annual costs in the typical 401k, 403b, TSA, etc. coming in at around 1.5% – 2% per year. In many cases I’ve seen much higher. Just check out this astonishing Bloomberg report. To some, 2% might not sound like much, but if you earn an average gross return of 7% each year, 2% of those earnings equates to giving up nearly 30% of your gains. Ouch.

5. PERFORMANCE

Most retirement accounts such as 401ks, 403bs and others are comprised of a menu of professionally managed mutual funds. While I am not here to say negative things about funds, the fact of the matter is that the majority of them fail to outperform the static, low cost and unmanaged indexes they are benchmarking their returns to.

SOLUTIONS?

Some say pointing out the problems is easy, but what about the solutions? I have a couple of ideas to share, some of which are basic and others I know are creative and things you may have not heard before.

Stay tuned. I’ll detail them in my next post soon to come….

Proceed to Part II here.

The entire three-part series of The Trouble With Retirement Plans appeared in the American Institute of Certified Public Accountant’s newsletter. You can download the entire three-part series here: The Trouble With Retirement Plans

If you’ve lost your job, or are changing jobs,you may be wondering what to do with your 401(k) plan account. It’s important to understand your options.

What will I be entitled to?

If you leave your job (voluntarily or involuntarily), you’ll be entitled to a distribution of your vested balance. Your vested balance always includes your own contributions (pretax, after-tax, and Roth), and any investment earnings on those amounts. It also includes employer contributions and earnings that have satisfied your plan’s vesting schedule. In general, you must be 100% vested in employer contributions after 3 years of service (“cliff vesting”), or you must gradually vest 20% per year until you’re fully vested after 6 years (“graded vesting”). Some plans have 100% immediate vesting. You’ll also be 100% vested if you’ve reached your plan’s normal retirement age.

Special vesting rules apply to certain plans, so make sure you understand how your particular plan’s vesting schedule works. This is important, because you’ll forfeit any employer contributions that haven’t vested by the time you leave your job. If you’re on the cusp of vesting, it may make sense to wait a bit before leaving, if you have that option.

Don’t spend it, roll it!

While this pool of dollars may look attractive, don’t spend it unless you absolutely need to. If you take a full distribution you’ll be taxed, at ordinary income tax rates, on the entire value of your account except for any after-tax or Roth 401(k) contributions you’ve made. And, if you’re not yet age 55, an additional 10% penalty may also apply to the taxable portion of your payout. (Because of the 5-year holding period requirement, there won’t be any taxfree qualified distributions from Roth 401(k) accounts until 2011 at the earliest. And special rules may apply if you receive a lump-sum distribution and you were born before 1936, or if the lump sum includes employer stock.)

If your vested balance is more than $5,000, you can leave your money in your employer’s plan until you reach normal retirement age. In many cases, however, your best bet will be to roll the funds over to an IRA. Your investment alternatives will be almost limitless, and you’ll have better control over when and how to take distributions from your account.

Your employer must allow you to make a direct rollover to an IRA. As the name suggests, in a direct rollover the money passes directly from your 401(k) plan account to your IRA. This is preferable to a “60-day rollover”– where you get the funds and then roll them over to an IRA yourself–because your employer has to withhold 20% of the taxable portion of a 60-day rollover. You can still roll over the entire amount of your distribution, but you’ll need to come up with the 20% that’s been withheld from other funds until you recapture that amount when you file your income tax return.

If you really do need to use some of the money, and you have nontaxable after-tax or Roth contributions in your account, keep in mind that you may be able to roll over the taxable portion of your distribution to an IRA, and take a distribution of just the nontaxable portion of your account.

What if I have an outstanding plan loan?

In general, if you have an outstanding plan loan, you’ll need to pay it back, or the outstanding balance will be taxed as if it had been distributed to you in cash. If you can’t pay the loan back before you leave, you’ll still have 60 days to roll over the amount that’s been treated as a distribution to your IRA. Of course, you’ll need to come up with the dollars from other sources.

With recent market declines, many investors are taking a new look at converting their traditional IRA to a Roth IRA. For many, the tax cost of converting has dropped significantly, making this a more attractive option.

You can convert your traditional IRA to a Roth IRA in 2009 if your modified adjusted gross income (MAGI) is $100,000 or less. If you file a joint federal tax return with your spouse, the $100,000 limit applies to your combined income. If you’re married filing separately, you’re not allowed to convert at all in 2009.

You generally have to include the amount you convert in your gross income for the year of conversion, but any nondeductible contributions you’ve made to your traditional IRA won’t be taxed.

If you’re not eligible to convert in 2009, there’s always next year–literally, in this case. Starting in 2010 anyone can convert, regardless of income level or marital status. Plus, if you convert in 2010, you’re allowed to spread the income tax hit over two years: you report half the taxable income from the conversion in 2011, and half in 2012. So, even if you’re eligible to convert in 2009, you should discuss with your financial professional whether it makes sense in your particular case to wait until 2010 to convert in order to take advantage of this special tax rule.

If you’re eligible, converting is easy. Simply notify your IRA provider that you want to convert your existing IRA to a Roth IRA, and they’ll provide you with the necessary paperwork to complete. You can also transfer or roll your assets over to a new IRA provider.

Remember that you can also convert SEP IRAs (and SIMPLE IRAs that are at least two years old) to Roth IRAs. And, if you’re eligible for a distribution from your employer retirement plan (for example, a 401(k) or 403(b) plan), you may also be eligible to transfer or roll over those distributions to a Roth IRA, subject to these same conversion rules.

In most cases, yes. If you converted your traditional IRA to a Roth IRA in 2008, before the recent market downturn, you may find that you now owe taxes on a conversion amount that’s significantly higher than what your investments are now worth. If that’s the case, you may find it advantageous to undo your conversion. The IRS refers to this process as a “recharacterization.”

You may also want to recharacterize if you converted in 2008, and now find that you weren’t eligible because your 2008 income is higher than you expected.

A recharacterization is essentially a do-over. You’re treated as if you never converted your traditional IRA to the Roth IRA. You accomplish this by transferring the Roth IRA assets, and any earnings, back to a traditional IRA (in a trustee-to-trustee transfer if you’re using a new traditional IRA provider).

To undo your 2008 conversion, you need to carefully follow these steps:

• Inform your IRA providers (the one holding the Roth IRA and the one providing the traditional IRA, if different) that you intend to recharacterize your Roth IRA to a traditional IRA. You must provide this notice on or before the date the assets are transferred back to the traditional IRA.

• Make sure the transfer is completed by the due date for filing your federal income tax return for 2008, including extensions. For most taxpayers, that can be as late as October 15, 2009. (If you’ve already filed a timely 2008 tax return, you can still recharacterize by making the transfer and filing an amended return by October 15, 2009. Be sure to write: “Filed pursuant to Section 301.9100-2″ on your Form 1040-X.)

• Report the recharacterization to the IRS (see Form 8606 for more information).

If you undo your 2008 conversion in 2009, you generally won’t be able to convert back to a Roth IRA until 31 days after the recharacterization.

Roth conversions

Individuals who would like to contribute or convert to a Roth IRA in
2009 but don’t qualify because of income limitations might benefit from making nondeductible contributions to a traditional IRA today, and converting the funds to a Roth IRA in 2010, when the income limits no longer apply. Additionally, for Roth conversions in 2010 only, any resulting taxable income will be deferred until 2011 and 2012 (with 50% taxed in each year).

No doubt, 2008 was one of the worst years in the history of the stock market, and one of the worst for retirement savings. Here are four things you can do now to help make the best of a bad situation.

1.Review your retirement plan Review your overall retirement plan with your financial professional. What, if any, adjustments can you make to help you reach your retirement goals? If you were planning to retire in a certain year, determine if that’s still realistic, and calculate how much longer your assets might last if you work a few years longer. Can you reach your goals by using a smaller withdrawal rate assumption, or by increasing your IRA or 401(k) savings? Does your asset allocation still make sense? And if you don’t have a plan for your retirement, now is a good time to think about establishing one.

2.Convert your traditional IRA, or transfer 401(k) plan securities, to a Roth IRA

Due to declining values, the tax cost of converting to a Roth IRA has dropped dramatically for many investors. Consider whether converting to a Roth IRA makes good financial sense for you. The taxable portion of your traditional IRA will be subject to ordinary income tax in the year of conversion, but qualified distributions from your Roth IRA will be entirely free from federal taxes.
For 2009, you’re able to convert only if your modified adjusted gross income is $100,000 or less (this dollar limit applies whether your tax filing status is single or married filing jointly). If you’re married filing separately, you can’t convert at all in 2009. But if these rules preclude you from converting, there’s always next year–literally. These limitations are repealed in 2010, so anyone will be able to convert a traditional IRA to a Roth, regardless of income level or marital status.
Similarly, if you’ve decided a Roth IRA makes sense for you, and you’re entitled to a distribution from your 401(k) plan, keep in mind that you can roll over (that is, essentially convert) your non-Roth assets to a Roth IRA (hardship withdrawals, certain periodic payments, and required minimum distributions (RMDs) can’t be rolled over). This may be especially attractive if you’re entitled to an in-kind distribution of employer stock whose values are seriously depressed–you’ll pay tax on this reduced value and any additional appreciation may be
tax free.(The same income and marital status limitations that apply to traditional IRA conversions also apply to rollovers from 401(k) plans to Roth IRAs in 2009.)

3.Undo a 2008 conversion in 2009

What if you already converted your traditional IRA to a Roth in 2008,and your IRA balance has taken a significant hit since then? The tax cost of converting was probably much greater than if you had waited until 2009 to convert. Well, don’t fret–you can undo a 2008 conversion up until the due date for filing your 2008 tax return, including extensions. Technically called a “recharacterization,” this procedure allows you to treat the conversion as if it never occurred.

To undo your 2008 conversion, you need to carefully follow these steps:

•Inform your IRA providers (the one holding the Roth IRA and the one providing the traditional IRA, if different) that you intend to recharacterize your Roth IRA to a traditional IRA. You must provide this notice on or before the date the assets are transferred back to the traditional IRA

Make sure the transfer is completed by the due date for filing your federal income tax return for 2008, including extensions. For most taxpayers, that can be as late as October 15, 2009. (If you’ve already filed a timely 2008 tax return, you can still recharacterize by making the transfer and filing an amended return by October 15, 2009.Be sure to write:”Filed pursuant to Section 301.9100-2″on your Form 1040-X.)

•Report the recharacterization to the IRS (see Form 8606 for more information).

You can even reconvert your traditional IRA back to a Roth in 2009 (if you meet the eligibility requirements) beginning on the 31st day following the recharacterization.

4.Continue to contribute

Despite the recent downturn, for many people IRAs and employer retirement plans remain important vehicles for retirement savings. Make sure you’re taking full advantage of any company matching contributions you’re entitled to. And if you’re age 50 or older, keep in mind that you may also be able to make catch-up contributions (up to $1,000 for IRAs and $5,500 for 401(k) plans in 2009).