2010 Roth Conversion

The IRS is having a sale!

Starting in 2010, and in every year after that, anyone willing to pay the income tax cost may convert all or part of their traditional pre-tax IRA’s to a Roth IRA. You will no longer be precluded from doing this if your modified Adjusted Gross Income exceeds $100,000 as is currently the case. And to kick off this new opportunity, they’re having a one-time sale on Roth-ification. A grand opening sale, if you will.

Here’s the deal. Let’s say you have a $500,000 traditional IRA, and you’d like to convert $200,000 of it to a Roth IRA. If you do that in 2009 or 2011 or later, the normal rules apply; normally, you would add that $200,000 to your taxable income in the year of the conversion and pay tax on it at your tax bracket for that year. More likely, with such a large amount of additional income you would end up crossing tax brackets and paying tax at some blended rate.

But in 2010, you can take advantage of the IRS’s one-time sale. Instead of adding $200,000 to your 2010 income, you have the option of splitting it in half and adding half to your 2011 income and half to your 2012 income.

What a deal! There’s two potential benefits to be gained here. First, there’s delay. You get to delay tax payment, which is always worth something. You can set aside the tax dollars you’ll owe, put them in a money market fund, and collect the interest for a while. The IRS is in effect giving you an interest-free loan for a year or two.

But wait. There’s more. Second, by spreading the taxable income—$200,000 in our example—over two years, you might reduce the portion of it that’s kicked up into a higher tax bracket and thereby actually reduce your overall tax bill. It’s Christmas in July! (Or April, actually.)

What about state tax? That depends on how your state figures its income tax. Many states, like New York and Georgia for instance, start their tax calculations with your federal Adjusted Gross Income and then fiddle around from there. In these states you’ll end up getting a similar state tax break, because your $200,000 will be split between your 2011 and 2012 federal Adjusted Gross Income. Unless your state legislature decides this particular situation ought to be handled differently.

So if you’ve concluded that Roth-ification of all or part of your IRA is a good idea for you, then doing it in 2010 might indeed be a very good idea.

Act now (actually next year). This offer won’t be repeated. Operators are standing by.

Income: A Four Letter Word

The word “income” should be outlawed. Or if not outlawed, at least treated with same disdain and awkward silence that might greet an ethnic slur or the word “groovy.”

“Income” means so many different things—some precise, some vague and ill-defined—that its use can’t help but engender miscommunication. You mean one thing when you say “income,” I take it as something completely different, and—presto—miscommunication.

Or worse, even within the quiet confines of your own mind, using an ill-defined concept of “income” can lead to the capital crime of sloppy thinking.

Consider all the different meanings of income. Imagine you have a $5,000,000 pot of assets to retire on. Pretty nice thought, eh? You could live quite comfortably off that. Let’s say you decide to use the 4% Plan as described in January 13’s post (which I don’t particularly care for, but at least the arithmetic’s easy). So you pull out $200,000 to spend. What is your income?
• If that $5,000,000 is in a traditional IRA, and you take a $200,000 distribution, your tax accountant would say you have $200,000 of income. She’s thinking taxes and gross income.
• If you tell your accountant you have made $100,000 of non-deductible contributions to the IRA, she might say you have $196,000 of income. She's still thinking taxes, but now she’s thinking taxable income.
• If instead that $5,000,000 is in a trust Grandma left you, and the trust’s investments yielded, say, $100,000 of interest and dividends, your trustee would say you’ve gotten $100,000 of income and $100,000 of principal. He’s thinking traditional accounting income.
• If the trustee was a bit more modern, and applied his newfangled powers to redefine trust income, he might instead say that the entire $200,000 is income. He’s thinking modern trust accounting income.
• If you’ve decided to spend $200,000 because that’s the largest annual amount you think the pot will sustain for your whole lifetime, you might think that $200,000 is your income. You’re thinking of sustainable spending as income.
• If the $5,000,000 is in a managed investment account, which grew $400,000 in value during the year (not 2008 obviously), your investment advisor might say you had $400,000 of income, irrespective of how much you have chosen to spend. He’s thinking of investment performance as income.
• If, to get your allowance converted to cash, you had to sell $200,000 of appreciated stocks originally costing $50,000, your accountant might say you’ve got $150,000 of income. Again, being tax-oriented, she’s thinking of realized capital gain as income.
• If you took the whole $5,000,000 and bought an annuity paying you $300,000 per year for life, your insurance agent might say you’ve got $300,000 of income. She’s thinking of the annual annuity amount as income.

Eight different meanings of income, all valid within the appropriate context. But what really counts? Ask your grocer or your mortgage lender or your cable company. They just want to be paid in cash. They don’t care whether it’s income in any sense of the word. Really, income just doesn’t matter.

Hidden Tax Brackets

Yesterday’s post described the difficulty of figuring your tax bracket. It mentioned the concept of hidden tax brackets—places where the Tax Code causes you to lose a tax goody because of additional income, resulting in an effective marginal tax rate that’s way higher than what the published tables would have you believe. I thought it would be informative to provide an example.

Informative, yes. Useful, no. Because the intricacies of how these hidden brackets work make it difficult to predict them or plan around them. With that disclaimer, read on.

Example. George is single. He earns $55,000 in 2009 working for the New York Yankees, where he’s covered by a pension plan. George contributes $5,000 to a traditional individual retirement account. And that $5,000 is deductible, as explained in February 14’s post. George’s federal income tax works out to $6,350, after taking into account his IRA deduction, personal exemption and standard deduction. And he’s solidly ensconced in the 25% federal tax bracket.

Lucky George! The Yankees pay him an unexpected year-end bonus of $10,000! George guesses he’ll owe $2,500 federal tax on his year-end bonus because he’s in the 25% bracket. Wrong as usual, George! George is gob-smacked by a nasty hidden tax bracket. The extra $10,000 of income causes him to lose his $5,000 IRA deduction (again, see February 14’s post). Which in turn causes him to pay tax on $15,000 of income rather than $10,000. At his nominal 25% tax bracket, that’s $3,750 of tax. So his actual hidden tax bracket on the $10,000 bonus is 37.5%.

That’s a pretty high tax rate for a poor schlep like George, who’s not even the CEO of a failing bank.

A Word or Two About Tax Rates

Yesterday’s post and a number of prior posts somewhat facilely refer to your tax bracket—both current and future. Just what do I mean by tax bracket? It's time to enter that heart of darkness.

When you are trying to decide between two retirement planning strategies—how much to save, how much to spend, to Roth or not to Roth, which savings bucket to spend first, in which savings bucket to house your stocks, etc.—it often becomes necessary to guess at, and compare, your marginal tax brackets. “Marginal” means the tax bracket affecting your top dollar of income, rather than the average tax rate on all of your income. They’re not the same because we have a progressive tax system.

(A brief aside: “Progressive” means the tax rate gets higher as your income increases, as with the federal income tax. “Regressive” means the rate gets lower as your income increases, as with the Social Security tax [6.2% on the first $106,800 of compensation, 0% on the rest]. But these words are really loaded. “Progressive” sounds so modern, advanced and forward-thinking. “Regressive” sounds like you’re a troglodyte. But no value judgments are intended. The words just describe how the rates vary with the thing that's taxed, income in this case.)

Example. Mary is single and earns $150,000 as a TV news producer. She uses the standard deduction, and claims just herself as a personal exemption. Her 2009 federal income tax totals $33,102, so her overall average tax rate is 22%. But her marginal tax bracket increases with each tranche of income. The first slice of $9,350 of income is taxed at 0% (representing her personal exemption and standard deduction). The next $8,350 is taxed at 10%; then $25,600 at 15%; $48,300 at 25%; and the balance ($58,400) at 28%. Mary’s marginal tax bracket is 28%. So any moves she makes—to reduce or increase her taxed income—either saves or increases her tax by 28%. Sort of. Read on.

Often things are not so simple. Here are some of the complications you’ll run into as you try to figure your marginal tax rate.
• Crossing brackets. A big move might cause you to shift—up or down—from one bracket to the next. So some of your income is at one marginal tax bracket and some at a different one. For example, converting a large traditional IRA to a Roth IRA can easily cause you to straddle two brackets.
• Alternative Minimum Tax. If you have large deductions that are classified as “tax preferences” (such as state and local taxes) then you might be paying Alternative Minimum Taxes, in which case your marginal tax bracket becomes 26% or 28% regardless of what the regular tax rate tables say.
• State income tax. If your state has an income tax, your marginal state tax rate should be added to your marginal federal tax rate to figure your effective tax bracket. In our example, Mary lives in Minnesota, and figures her marginal state tax rate is 7.85%, making her total marginal tax bracket 35.85%.
• Effect of state tax on federal income tax. If Mary itemizes her deductions, then her state tax reduces her federal tax. So her effective marginal tax bracket would then be 33.65%. Unless she’s paying Alternative Minimum Tax. Oy.
• Hidden tax brackets. The federal tax code is just full of hidden tax brackets. Various tax deductions , credits and other such goodies are available only to those with lower income, and then get phased out for those with higher income. If you are within these phase-out ranges—which vary from one goodie to the next—then you are actually subject to a higher hidden tax bracket, as you lose the benefit of a deduction or credit. Gotcha!
• Capital gains. Some income—notably long-term capital gain—is subject to favorable tax treatment, resulting in a lower tax bracket for that type of income.

The message here is that it’s massively complex just figuring what tax bracket you’re in today, even after you’ve completed your tax return. And so what about projecting your bracket 20 years into the future? Forget about precision. Just take your best shot at an educated guess.

The horror; the horror!

How Age and Tax Rate Affect the Roth Decision

In a few recent posts, I have talked about the long-term benefit of Roth-ifying your retirement funds. But is it a good idea for everyone? Certainly not. It’s hard to assess all the factors and uncertainties that go into the decision. But probably the two most critical factors are Time and Tax Rate: How many years until your retirement? How large will your future income tax rate be compared to your current tax rate?

How do these factors impact the Roth decision? Here’s a little thought experiment. Picture Riley. He’s got $10,000 in a traditional IRA and $10,000 in an ordinary taxable investment account. Should he spend some of the dollars in his taxable account to convert the $10,000 IRA into a $10,000 Roth IRA? That depends on how many years Riley has until he retires and his future tax rate. The chart below shows the benefit (or detriment) of the Roth conversion, as measured by the increase (or decrease) in Riley’s future annual after-tax retirement spending generated by his $20,000.

Riley is currently—during his working years—in the 30% tax bracket. The projections below indicate that he might still enjoy some advantage from Roth-ifying his IRA, although a shrinking one, if he expects to be in a lower tax bracket during his retirement years.

Here are the assumptions that went into the figures in the chart.
• Riley’s current tax rate is 30%, so it costs $3,000 to convert his IRA to a Roth.
• Riley is in the 30% tax bracket during his working years.
• Riley’s IRA (traditional or Roth) earns 6% per year during his working years.
• Riley’s taxable account earns 6% during his working years, but keeps only 4.8% after tax.
• Riley spends his two accounts by amortizing them over a 25-year retirement period.
• Riley’s IRA (traditional or Roth) earns 5% per year during his retirement years (when his investments get more conservative).
• Riley’s taxable account earns a fraction of that 5% after tax. To estimate that percentage, I used the following formula:
5% - (2/3) x Tax Rate x 5%
See February 3’s post for the reasons behind the 2/3 fudge factor.
• Riley's assumed number of remaining working years are shown in the top row of the chart below.
• Riley's assumed tax rate during his retirement years are shown in the left-hand column of the chart below.

Tax-Free Conversion of Non-Deductible IRA Contributions to Roth IRA

In yesterday’s post, I described how you figure the tax cost of converting a traditional IRA to a Roth IRA when you’ve got some non-deductible contributions in the traditional IRA. I used an example of an $80,000 traditional IRA with $10,000 of non-deductible contributions.

Wouldn’t it be great if you could just convert the $10,000 of non-deductible contributions to a Roth IRA, and pay no tax for the privilege of doing so? Well, maybe you can. Here’s a little trick that might work for you. Read on.

If your employer maintains a tax-favored retirement plan, such as a 401(k) plan or a 403(b) plan, and that plan accepts rollovers from IRAs, then before you do your Roth conversion, you roll over the taxable portion of your traditional IRA to your employer’s plan, $70,000 in our example. In fact, you’re not even allowed to rollover your $10,000 of non-deductible IRA contributions to an employer plan. What does that leave you with? A $10,000 traditional IRA, all of which is considered your own non-deductible contributions. You can convert the whole thing to a Roth IRA without paying any income tax for the privilege of doing so! What a country!

Here’s a couple of caveats about the foregoing trick:
• It only works if you qualify for a Roth IRA conversion, i.e., $100,000 or less Adjusted Gross Income in 2009. Or wait until 2010, when the AGI limit goes away.
• It only works if your employer’s plan accepts rollovers from IRAs. Some do, some don't.
• You end up with most of your IRA money in your employer’s plan, subject to its investment and distribution restrictions, as described in February 11’s post and February 18’s post.
• While your retirement money is in your employer’s plan, you won’t be able to Roth-ificate it until you are able to roll it over back into an IRA.

But if you can get over these hurdles, you end up moving your non-deductible IRA contributions into a better savings bucket. Take that, IRS!

Roth Conversion of Non-Deductible IRAs

In a number of posts, I have plugged the tax benefits of Roth IRAs. And in February 15’s post, I extolled the virtues of a non-deductible IRA when a deduction is unavailable. Today I amalgamate them. What if you want to convert a non-deductible IRA to a Roth IRA?

First, of course, you have to determine if you’re allowed to. February 10’s post pointed out that in 2009, you can do this only if your Adjusted Gross Income is $100,000 or less. But in 2010 and thereafter, that requirement disappears. Poof! It’s gone! And of course you generally have to pay income tax on the amount converted.

But if you’ve made non-deductible contributions to your traditional IRA, you don’t have to pay income tax on that portion. You paid tax going in, so you don’t have to pay it again. No double tax. Here’s an example. Let’s say your only IRA is worth $80,000 and over the years your aggregate non-deductible contributions have totaled $10,000. In tax jargon, $10,000 is your tax basis in the IRA. (You can find this number on your most recently filed Form 8606.) If you convert the entire IRA to a Roth IRA, you’ll have to pay tax on $70,000 (= $80,000 - $10,000).

But what if you convert only a portion of your IRA to a Roth IRA, e.g., because you can’t afford to pay tax on the whole thing? Then you recover a pro-rata portion of your tax basis. For example, if you convert $20,000 of your $80,000 IRA to a Roth IRA, that’s 25% of the total. So you recover $2,500 of your $10,000 tax basis, and pay tax on $17,500 (=$20,000 - $2,500). You then have $7,500 of basis left in your traditional IRA to recover tax-free in later years.

What if you’ve got more than one traditional IRA? In figuring the portion that’s tax-free, the IRS makes you aggregate all your traditional IRAs (but not your employer plans or Roth IRAs) and all your non-deductible contributions. So it doesn’t help to try to isolate your non-deductible contributions in one small IRA. The IRS is on to your little tricks!

But tomorrow I’ll describe a little trick that can work. Meet you back here about the same time tomorrow.

Figuring Substantially Equal Periodic Payments

Yesterday I described a way to avoid the 10% penalty tax on distributions from an IRA before age 59-1/2 by taking “substantially equal periodic payments.” Today’s post describes how to figure your distributions to meet this exception. Basically, the IRS has approved three methods for calculating “substantially equal” distributions.

Required Minimum Distribution method. Under this method, you determine your annual distributions by dividing your account balance by your remaining life expectancy. To get your life expectancy, you have the option of using (i) your single life expectancy, or (ii) the joint life expectancy of you and your beneficiary, or (iii) a table created by the IRS called the Uniform Lifetime Table. These three tables can be found in the appendix to IRS Publication 590, here:
http://www.irs.gov/pub/irs-pdf/p590.pdf

Once you select one of the three tables, you must stick with it. Each year you redetermine the appropriate life expectancy by going back to the selected table and getting a new divisor based on your attained age or ages in that year. The Required Minimum Distribution method results in a relatively low initial distribution, which then tends to grow over the years.

Life expectancy amortization method. Under this method, you determine an annual distribution by amortizing the IRA’s current value over a life expectancy. This method results in a fixed annual distribution which doesn’t change from year to year. You can do the amortization calculation using a financial calculator. In doing the calculation, you may get your life expectancy from one of the three tables described above; and you may choose any interest rate that does not exceed 120% of a rate published monthly by the IRS (called the federal mid-term rate) for either of the two months preceding the month your distributions begin. The IRS-published rates can be found on their website here:
http://www.irs.gov/app/picklist/list/federalRates.html

Mortality table method. Under this method, you determine an annual distribution by dividing your IRA balance by an annuity factor to be derived from an actuarial mortality table published by the IRS. Like the Life Expectancy Amortization method, this method results in a fixed amount which does not change from year to year. The services of an actuary are needed, making this method inconvenient.

The IRS has approved other methods for determining substantially equal periodic payments from an IRA, but only in private letter rulings, on which you may not rely (as time goes by). So if you act on the advice given in the ruling, you do so at your own risk.

In yesterday’s post, I mentioned that once you start on these distributions, you may not deviate from them without incurring substantial penalties. But here’s an exception: If you have been calculating your periodic distributions under either the Life Expectancy Amortization method or the Mortality Table method (both of which result in a fixed distribution), you are allowed to make a one-time switch to the Required Minimum Distribution method (but not back again) without incurring a penalty recapture tax.

Now that you know how to take IRA distributions before age 59-1/2 without penalty, let me ask you this: Why are you doing this?

Substantially Equal Periodic Payments Exception to the 10% Penalty

Yesterday’s post was sort of a catalogue of exceptions to the 10% penalty tax on distributions from tax-favored retirement plans before age 59-1/2. Only one of those exceptions is within your control: Substantially equal periodic payments. Sometimes jargon-loving financial planners call this the “72(t) exception.”

Today’s post provides an overview of the exception; tomorrow I will go into how you actually calculate distributions that qualify. So here goes the overview.

You may take distributions from a tax-favored retirement plan at any time, without incurring the 10% penalty tax, if the distributions are structured as a series of distributions and the series consists of substantially equal periodic payments. These are rather strict requirements. And you will find that this technique for avoiding a penalty tax will not result in a large immediate distribution, so it will not be suitable if you’re looking to gain immediate access to a large chunk of your IRA. Rather, it can work well—if somewhat inflexibly—if you’re under 59-1/2 and you’re looking to spread your distributions over your lifetime.

Triggering event. If the distributions come from a traditional or Roth Individual Retirement Account, they do not have to be triggered by any particular event. You may start them at any time and any age. However, if they come out of an employer plan, to qualify they must begin after you have separated from service with the employer. Since most employer plans do not offer participants the option to take distributions in flexible ways, you are unlikely to be applying this exception to employer plan distributions. More likely, if you utilize this distribution method, it will be from an IRA.

Frequency of distributions. To qualify, the series of distributions must be periodic, no less frequently than annually. A series of monthly or quarterly distributions may also qualify.

Term of distributions. To qualify, the series must be calculated to occur over one of the following terms:
• Your life expectancy (more on this tomorrow)
• The joint life expectancy of you and your beneficiary
• Your actual lifetime (i.e., in the form of a life annuity)
• The actual lifetime of you and your beneficiary (i.e., in the form of a joint and survivor annuity).

Separate IRAs. In private letter rulings, the IRS has been liberal in allowing someone with two IRAs to calculate substantially equal periodic payments separately for one of the IRAs, while leaving the other IRA untouched; or alternatively, aggregating the IRAs for purposes of calculating the distributions.

Modification of periodic payments. Now, here’s the bad news. Once you start taking substantially equal periodic payments from an IRA, you should continue doing so at least until age 59-1/2, or, if later, five years from the initial distribution. If you modify your series of distributions before age 59-1/2 or five years—including ceasing your distributions—the IRS will recapture the 10% penalty tax you would have owed on your prior pre-age 59-1/2 distributions, plus interest on the penalty. Yow!! That hurts!

Exceptions to recapture tax. There are three exceptions to this recapture tax.
• No penalty tax recapture if the modification occurs after the later of age 59-1/2 or five years after you began the series of distributions; then you are free from the strictures of having to follow the method you began with.
• No penalty tax recapture will apply if distributions are modified on account of death or disability. (But those are rather unpleasant ways to avoid a tax.)
• I’ll talk about the third exception tomorrow, as it relates to the method you use for calculating these distributions.

I gotta go water my plants…..

Exceptions to the 10% Penalty

They say you can never be too rich, too thin, or too young. Well, the Tax Code thinks there is such a thing as too young. Distributions from tax-favored retirement plans before age 59-1/2 are hit with an extra 10% penalty tax in addition to whatever regular income tax you will have to pay. Ouch. (That, of course, assumes you can get a distribution—see yesterday’s post).

When you’re young, there are lots of good reasons to delay distributions. But if you want or need to get at some of your tax-favored dollars, there are many exceptions to the 10% penalty. There are so many exceptions, it’s become the Swiss cheese of tax penalties. Here is a summary.

• Dotage. No penalty if you have already reached age 59-1/2.
• Death. No penalty on distributions to your beneficiary after your death, even if the beneficiary is under age 59-1/2 and even if you were under 59-1/2 when you died.
• Disability. No penalty on distributions made after you are disabled.
• Defer. No penalty on a distribution that is moved to another tax-favored retirement plan in a tax-free rollover.
• Double-tax. No penalty on the portion of the distribution that is not subject to income tax, e.g., because it represents a return of your own after-tax contributions, as described in February 15’s post. (There’s a special rule for Roth IRAs, but that’s a subject for another post.)
• Done. No penalty if you terminate employment with your employer after reaching age 55, and distributions from the employer’s plan begin after your termination of employment. This exception does not apply to a traditional IRA or a Roth IRA.
• Doled. No penalty if the distribution is part of a series of substantially equal periodic payments from the tax-favored retirement plan. This exception allows you to begin distributions at any age, facilitating early retirement if that is your goal, and facilitating emergency access to some of your retirement funds. This is a big one. It’s the only exception that is within your control. And it will be the subject of a future post.
• Divorce. No penalty on distributions to an Alternate Payee (e.g., your former spouse or a minor child) under a Qualified Domestic Relations Order. This exception applies to employer plans, but not to IRAs. If you don’t know what Alternate Payee and Qualified Domestic Relations Order mean, consider yourself lucky. It’s all about marital strife.
• Dorms. No penalty on traditional or Roth Individual Retirement Account distributions (but not employer plan distributions) up to the amount of your higher education expenses for you, your spouse, your children and your grandchildren.
• Domicile. No penalty on distributions of up to $10,000 from a traditional or Roth IRA (but not from an employer plan) used to pay for a first home for you, your spouse, your child or your grandchild.
• Disease. No penalty on distributions up to the amount of your and your dependents’ deductible medical expenses (i.e., to the extent they exceed 7.5% of your Adjusted Gross Income). Better not to qualify for this one.
• Dismissed. No penalty on distributions from traditional or Roth IRAs (but not from employer plans) up to the amount of your health insurance premiums after you have been unemployed for at least 12 weeks.
• Dividends. No penalty on dividends on employer stock paid out to Employee Stock Ownership Plan participants.
• Distributed shares. The Net Unrealized Appreciation (NUA) on employer securities distributed from an employer plan may be temporarily excluded from income tax at the time of distribution if certain requirements are met. If you qualify for that exclusion, then the NUA is also not subject to the 10% penalty tax. The whole NUA thing is a worthy subject for a future post.
• Deferrals. No penalty if your employer’s 401(k) plan distributes back some of your elective deferral in order to meet certain tests.
• Death wish. Some employer plans (but not IRAs) purchase life insurance for the benefit of its participants, and the value of that insurance protection is currently taxed to the participant. Nonetheless, the value of that insurance protection is not subject to the 10% penalty tax.
• Duty. No penalty if you are a reservist called to active duty in the armed forces.
• Distant past. If you terminated employment before March 1, 1986, then distributions from your employer’s plan (but not from traditional or Roth IRAs) that are being made in accordance with an election signed before March 1, 1986, are not subject to the 10% penalty.
• Debt. No penalty on distributions to the IRS to satisfy a federal tax lien. Big whoop.

Restricted Access to Retirement Funds

In a number of prior posts, I’ve extolled the long-term benefits of tax-favored savings buckets—IRA’s, Roth IRA’s, 401(k) plans, 403(b) plans and the like. But you have to take the bad with the good. Today I will talk about restrictions on access to your funds, which you should consider in weighing the pros against the cons.

At the outset, let me emphasize that I’m only talking about employer plans, such as 401(k) plans. The financial institution holding your IRA or Roth IRA will not prevent you from accessing those accounts. There may be a tax penalty imposed (and that’s a subject for a later post), or even an early withdrawal penalty (for example, in a certificate of deposit), but you can at least get at your assets if you need to. With employer plans, however, you can only get at your account at certain times. Here’s a summary.

Plan Document. Your employer’s plan document controls. It says when you can and can’t get at your account. What, you ask, is a plan document? That’s the 60-page, fine-print, legalese opus that nobody has ever actually read. But the plan’s distribution provisions are supposed to be summarized in a shorter, more readable “Summary Plan Description.” That’s the 20-page document which you got when you were first hired 20 years ago, put in a drawer for 10 years, and then threw out.

401(k) Restrictions. By law, 401(k) plans are not allowed to provide for a distribution to you unless you have reached some triggering event. The common allowable triggering events are (i) termination of your employment, (ii) financial hardship, and (iii) reaching age 59-1/2. But it’s important to understand that while these are permissible triggering events, your employer is not required to include them in its plan. So don’t go pounding your fist and insisting you’ve incurred a financial hardship if your employer’s plan doesn’t include that as a triggering event.

Latest Commencement Date. It is very common for 401(k) plans to provide for a distribution at your option shortly after you terminate employment. Very common, but not mandatory. The plan could require you to wait to get your distribution, as late as age 65. That kind of restriction is more common in pension plans, but it could be included in a 401(k) plan. In my entire career, I have never encountered that kind of restriction in a 401(k) plan, although it’s theoretically possible.

No Employer Discretion. Employer plans must not allow your company to exercise discretion in distributing or withholding benefit payments. So your employer can’t—legally anyway—delay distribution (if the plan provides for it) just because he doesn’t like you; nor can he accelerate distribution just because he does.

Method of Distribution. Your employer’s plan document governs not only when you can gain access to your account, but also how your account might be distributed. It’s typical—but not required—for a 401(k) plan to offer a lump sum. The plan might also offer an annuity, or a joint and survivor annuity for the lives of you and your spouse, or even installments over a stated period of years.

Spouse’s Rights. Federal law gives your spouse certain rights in your 401(k) account. Most notably, you must name your spouse as beneficiary in the event of your death before you’ve depleted the account. Also, if you opt for an annuity from a 401(k) plan, it must be in the form of a joint and survivor annuity with your spouse. Your spouse may waive these rights if certain formalities are met.

No Elimination of Distribution Options. Once a plan has given you a distribution option, your employer generally can’t take it away by amending the plan, at least with respect to your existing account balance. There are, however, a bunch of exceptions to this general rule.

Mandatory Distributions. On the other side of the coin, neither you nor the plan may defer distributions forever. There’s a set of rules, called the Required Minimum Distribution rules, which generally requires that you begin distributions no later than age 70-1/2 (or, in the case of an employer plan, retirement if later); and you must deplete the account at a certain minimum prescribed rate. I think I’ll provide more details on Required Minimum Distributions in a future post.

Loans. Some 401(k) plans allow you to borrow from your account. That’s not really a distribution because you have to pay it back. But it’s a limited form of access that may prove useful in a pinch. Plan loans are not a great idea, and that’s something I’ll discuss in a later post.

So these are the restrictions you’ll need to weigh against the tax benefits of shifting your savings into a tax-favored plan. In tomorrow’s post, I’ll talk about a different tax detriment—the 10% penalty tax on distributions before age 59-1/2.

My, How the Little Things Add Up

In a number of prior posts I’ve discussed some ideas for making your retirement savings go further. For the most part, each idea is a modestly good idea, but taken together, they can add up to a great idea. Huge! And that’s today’s task—to put it all together with an example. The results are amazing and heartening.

Consider Wally Cleaver. He’s grown up now. In fact, he’s age 40, with a family and everything. To date, Wally has saved $50,000 in a taxable investment account. Wally has analyzed his many savings options. He thinks of them as creating many different futures—Wally Worlds, if you will. Wally projects how much each additional good idea, layered on top of the others, will add to his annual after-tax retirement spending. All of his projections are shown in real, inflation-adjusted dollars, to keep them meaningful. And all in after-tax dollars, as well, because you can't spend money that goes to the government. The assumptions that went into Wally’s projections are shown in the chart below.

Wally World One. $6,320 per year.
Wally does nothing special and continues to invest his existing savings in an ordinary taxable investment account. He projects that his $50,000 of savings will eventually, at age 65, buy him a retirement of $6,320 per year. A nice start.

Wally World Two. $7,268 per year.
Wally decides to do the hard thing—to forego some spending this year and add $7,500 to his investment account. (In fact, he postpones a planned cross-country trip with his wife and kids to a Disney-esque amusement park.) Giving up some luxuries hurts, but it adds $948 to his annual retirement spending. That’s after-tax and expressed in today’s dollars. Foregoing the pleasures of consumption is the hard part. It gets easier from here.

Wally World Three. $7,950 per year.
Instead of adding $7,500 to his taxable investment account, Wally makes a $10,000 pre-tax elective deferral to his employer’s 401(k) plan. It costs him the same $7,500 as in Wally World Two because he is in the 25% tax bracket. Just by contributing his savings to the right bucket, Wally has increased his future after-tax retirement spending by another $652 per year. Way to go, Wally!

Wally World Four. $8,398 per year.
Wally increases his 401(k) deferral to the maximum $16,500. But he doesn’t decrease his spending by more than the $7,500 of Wally World Two. Rather, as described in February 8’s post, he spends $4,875 from his taxable savings account (shrinking it to $45,125). Because of the tax deduction, it only costs him $4,875 to increase his 401(k) deferral by $6,500. And doing this adds $448 to his retirement spending. Here’s something worth noting: The last two steps combined added more to Wally’s projected retirement spending than did his painful and heroic effort to save $7,500. And they didn’t require any further spending reductions! Oh, happy day! But wait; there’s more!

Wally World Five. $8,722 per year.
Wally has read January 15’s post and decides to make the $16,500 deferral on a Roth basis. The loss of a deduction costs him $4,125 of additional taxes (further reducing his investment account to $41,000). But it has a long-run tax benefit, which increases his projected after-tax retirement spending by an additional $324. Hey. Why not?

Wally World Six. $8,919 per year.
After reading February 15’s post, Wally decides to take another $5,000 out of his investment account (reducing it to $36,000), and use it to open a $5,000 IRA. He has read February 14’s post and has concluded that the contribution won’t be deductible to him, but he finds it to be a worthwhile step nonetheless. In fact, he projects it will add another $197 to his annual retirement spending. And, again, without breaking a sweat.

Wally World Seven. $9,217 per year.
Wally decides to expend some effort to lower his investment costs for his (now three) savings buckets, as described in yesterday’s post. He finds he is able to shave his expenses by a modest 0.1% (10 basis points, in investment world jargon). Wally projects that this modest savings will increase his after-tax retirement spending by another $298 per year. Not a huge amount, but he’ll take it.

Wally World Eight. $9,630 per year.
Wally has read February 12’s post, and decides to do some future spigot planning. When he gets to retirement, instead of spending down his three savings buckets proportionately (as was assumed in prior Worlds), he plans to spend them down in the order that will optimize his annual after-tax spending. He projects that doing this will increase his after-tax spending by another $413. It’s money for nothin’!

Wally World Nine. $10,636 per year.
Wally decides to go further and engage in asset location planning (after reading February 13’s post). He projects that by cleverly allocating his stocks and bonds among his three savings buckets he can increase his retirement spending by another $1,006 per year compared to investing his three savings buckets in the same stock/bond proportion. Cool!

Wally World Ten. $10,967 per year.
What! Yet another world? Yes. Wally has read February 10’s post, and, seeing that he has adjusted gross income of less than $100,000, he realizes he can convert his new $5,000 traditional IRA to a Roth IRA. (And in Wally’s unusual situation, he pays no income tax to do so. The value of his IRA is equal to his after-tax contributions, and he only has to pay income tax on the difference, which is zero.) He projects that this step will increase his retirement spending by another $331. Free money!

Now just look at the aggregate results. Struggling to save $7,500 added $948 per year to Wally’s future retirement security. But just being clever about how he arranges his savings, adds even more: another $3,698. That’s a four-fold increase! Who knew?!

Investment Expenses

A little bit of cost control can pay off big time in the long run.

There are lots of administrative costs to investing, and if you can find ways to shave them just a little bit—without sacrificing the quality of advice that often comes with them—you can painlessly improve your future retirement security.

Here’s a quick example. Patty starts saving $10,000 per year at age 40 in some kind of tax-favored retirement plan. The annual administrative expense built into the plan is 0.4% of her assets. Using some reasonable assumptions, Patty figures as a result of her saving, she can expect retirement spending of $28,325 per year, beginning at age 65. Her cousin Cathy is identical to Patty, same age, savings, etc. Except that Cathy has lived most everywhere, and is a bit smarter than Patty. (In fact, she’s a bit of a Little Miss Smarty Pants.) Anyway, she manages to cut her administrative expenses by one-tenth of a percentage point (aka, 10 basis points, in financial world jargon) to 0.3%. Cathy projects annual spending of $29,067, which represents a 2.6% increase over Patty’s.

Admittedly, a 2.6% increase is not huge. Enhancing your retirement spending by a small amount like that is not a great idea. But it’s a modestly good idea. And when melded with all the other modestly good ideas available to you, it adds up. Anyway, it’s better than a headache.

What kind of administrative expenses are you incurring that might be eroding your savings? There’s lots of them: investment advisor fees, asset custodian fees, account maintenance fees, brokerage commissions, accounting expenses. If your account is inside an employer retirement plan, there are other fees as well: trustee fees, recordkeeping fees, accounting fees, legal fees. The list goes on. Some of these fees may be picked up by your employer, and others may be charged to your account.

Some of these fees may be disclosed, and some hidden. Often all you will ever see on your statement is the net return (or loss, of late) for the quarter, with no explicit statement of what size fee got you down to that net. Some services may be bundled, making it difficult to break out how much you’re paying for what service.

Sometimes there are fees layered upon fees. For example, your 401(k) plan may be invested in mutual funds. There may be some fees charged by the plan, and other fees charged by the mutual fund.

The more you can learn about the fees that erode your account, the better able you will be to find ways to shave them, to intelligently assess which fees are appropriate for the value added, and which can be shrunk without damage to your overall wellbeing.

That’s the theory anyway.

Non-Deductible IRA Contribution

In yesterday’s post, I discussed when a traditional IRA contribution is non-deductible. So what happens if you make a contribution, but you don’t qualify for a deduction? Good question. Let’s look at the consequences, and assess the pros and cons.

First, the amount of your non-deductible contribution will—eventually—come back to you tax-free, unlike investment earnings within the IRA or deductible contributions. That’s fair. After all, if your $5,000 contribution isn’t deducted today, but it’s taxed to you in the future, that would amount to an unfair double tax on the same dollars.

What gets tricky is determining exactly when the $5,000 comes back tax free. It doesn’t happen all at once. Rather, a pro-rata portion of each distribution is treated as tax-free. Here’s a f’rinstance. Say you make a $5,000 non-deductible contribution and that’s your only one. Years later, when you begin taking distributions, the IRA has grown with investment earnings and other additions to $200,000. Let’s say you then take a $10,000 distribution. Since your non-deductible contributions ($5,000) amounts to 2.5% of the IRA’s value, 2.5% of the $10,000 distribution is tax-free. That’s $250 tax-free and $9,750 taxable. You still have $4,750 to recover tax-free with future years’ distributions.

Here’s a detail to keep in mind. Even though the $250 is tax-free it still counts toward meeting your Required Minimum Distribution obligation if you had already reached age 70-1/2.

This whole pro-rata thing sounds complicated. You might ask yourself how in the world you’re going to keep track of these non-deductible contributions when you might not be planning on distributions for another 30 years. (And you can’t even remember where you keep the beach umbrella from one summer to the next!) Well, it turns out the administrative part of the whole thing is not too bad. The IRS makes you file a form when you make a non-deductible IRA contribution (Form 8606). And that form serves the useful functions of keeping track of all your past non-deductible contributions, figuring out the how much of a distribution is tax-free, and carrying over the remainder to the following year. So you only have to find your most recent Form 8606. You, Turbo-Tax or your accountant can certainly handle that.

Is a non-deductible IRA contribution worth it? That depends on many factors, primarily your years to retirement, your investment plan, and your tax bracket. Here’s an example. Margie is age 40 and plans to retire at age 65. She has $5,000 to add to her savings, and her choice is between a taxable investment account and a non-deductible IRA. Using some reasonable assumptions, she projects that the $5,000 will net her, after tax, annual retirement spending of $638.09 if it is invested in a taxable account, and $693.78 if it is invested in a non-deductible IRA. That’s a 9% increase. But if she were instead age 50, the same assumptions would lead her to project a 2% increase; and if she were age 60, a 1% decrease in after-tax spending. So, like so many things, the answer is: "It depends."

Deductible vs. Non-Deductible IRA Contribution

A contribution to an IRA is a good thing. A deductible contribution to an IRA is even better. So how do you know if you’re eligible to make a deductible contribution? Today’s post briefly describes the two-fold path to deductibility.

As pointed out in February 4’s post, all you need to be allowed to contribute to an IRA is some earned income—generally compensation or self-employment income; sweat-of-the-brow type income as distinct from sitting-home-and-clipping-coupons type income. Actually, if either you or your spouse has earned income (and you file jointly), then you both can contribute. But being allowed to contribute is not the same as being allowed to deduct.

There are two paths to deductibility. You don’t need to travel down both those paths. Either one will suffice. Let’s call them the No-Plan Path and the Low-Income Path.

No-Plan Path
The first path to a tax deduction is available if neither you nor your spouse is covered by a tax-favored retirement plan at work for the year of your IRA contribution. There’s a simple way of knowing if you are covered by a plan: Your employer is supposed to check a box on your annual W-2 form if you’re covered. (It’s the box labeled “Retirement Plan” in Box 13 on the 2008 form.) Simple enough: Is the box checked? If it’s not checked by any of your or your spouse’s employers, then you get a deduction for your IRA contributions.

One other rule: If you are married filing jointly, and your spouse is covered by a plan but you are not, then you meet the No-Plan Path to deductibility (but your spouse does not) if as a couple you have modest adjusted gross income: Less than $159,000 in 2008 or $166,000 in 2009.

What determines whether or not your employer checks the box? Those rules can get complicated in specific circumstances, but generally they go like this: If your employer contributes anything during the year to a defined contribution plan (that’s a plan where you have an individual account, like a profit sharing plan or a 401(k) plan), then you’re covered. Your own elective deferrals to a 401(k) plan count as employer contributions for this test. Or if your employer is obligated to contribute for the year, but doesn’t get around to doing it until early the next year, you’re covered. In a defined benefit plan (you know, a traditional pension plan), if you are accruing a benefit by virtue of your work for the employer, then you’re considered covered.

Low-Income Path
Let’s say you or your spouse is covered by a plan. All is not lost! The Low-Income Path to a deduction might be open to you.

If your adjusted gross income (AGI) is not too large, then you can deduct your IRA contribution even if you’re covered by a plan. Whoopee! Break out the Champagne and Oreos! Here are the AGI limits for IRA deductibility for 2008 and 2009. They grow each year with cost-of-living increases. And there is a small range above these amounts (of $10,000 - $20,000) where the deductible limit is phased out.

Single:
2008: $53,000
2009: $55,000
Married filing jointly:
2008: $85,000
2009: $89,000
Married filing separately:
2008: $0
2009: $0

If you think all of this is way too complicated then it needs to be, that’s because it is.

Asset Location Planning

Yesterday I introduced the practice of spigot planning. Today I introduce you to asset location planning. What!? Who ordered that?

First, what is it? Asset location planning is the black art of cleverly matching the different asset classes in which your savings are invested to your different savings buckets.

Example. Let’s say you’ve got two savings buckets, an ordinary taxable investment account worth $400,000 and a traditional pre-tax IRA worth $600,000; $1,000,000 in total. Let’s say your investment plan calls for 65% stocks ($650,000) and 35% bonds ($350,000). You can split the two asset classes between your savings buckets in three basic ways (actually, an infinite variety of ways, but three fundamentally different approaches). Which of these asset location plans is the best?


Your asset location plan matters. It matters because returns on stocks are taxed differently from returns on bonds, as I summarized in February 3’s post. So one of those two asset classes is better suited to take advantage of the IRA’s tax exemption. But which one? Stocks or bonds?

Some (most, I would say) favor allocating bonds first to the IRA—the tax-favored bucket—under the theory that all the tax preferences the tax man bestows on stocks are wasted inside an IRA, where everything comes out as high-taxed ordinary income.

Others favor allocating stocks first to the IRA, under the theory that stocks are expected to grow better than bonds over the long run, and can therefore take better advantage of the IRA’s tax exemption. Certainly, inside an IRA you don’t have to worry about the tax cost of selling stocks and incurring a capital gain (you’re inside a tax shelter of sorts), which should make you a smarter investor. (For the four of you who still have gains left after last year.)

My own favorite approach is sort of a hybrid of the two: Favor stocks in the IRA when you’re younger and you have a greater number of years of tax deferral ahead of you, which can better benefit from the greater expected returns of stocks. Then switch strategies when you’re older, and favor bonds in the IRA, when the benefit of lower tax rates on stock returns becomes the overwhelming factor. Here’s an article describing the process:
http://www.cfapubs.org/doi/abs/10.2469/cp.v2005.n5.3512

So when do you make the switch; what’s the crossover point? That very much depends on factors unique to you. In my studies, I have found the late 50’s or early 60’s to be about right. There’s no way to come up with one age that’s right for everybody. And the crossover age is likely later for Roth IRAs than it is for traditional IRAs.

Man, it’s complicated! But clever asset location planning, like clever spigot planning, can add a bit to your long-term retirement spending. So, hey, why not?

Spigot Planning

If you’re retired, chances are you should be engaged in spigot planning. Say, what!? What is spigot planning?

Chances are you have built up retirement savings in different types of savings buckets. Perhaps you have assets housed in ordinary taxable accounts, in traditional (pre-tax) tax-favored retirement accounts, and in Roth retirement accounts. Spigot planning is the art of determining which buckets to tap to meet your annual spending goal, i.e., which spigot to turn on or off. Through clever spigot planning, you can possibly increase your long-term standard of living.

Here’s one way to approach the task. Let me set the stage. You’re retired. Say you’ve got three savings buckets: a taxable investment account, a traditional IRA, and a Roth IRA. You’ve gone through the process described in Saturday’s post, and you’ve adopted a long-term spending plan of some kind. Let’s say your plan calls for you to spend 6% of your assets this year. Start by pretending you will tap each of your buckets in proportion to their value. Then look at alternatives to see if one of them improves your long-term lot. Should you delay taking Roth distributions, and spend more of your taxable assets? Or vice versa?

Of course there are many factors to consider. And one of the most important is the tax consequences. In general, it is beneficial to delay distributions from Roth and traditional tax-favored retirement accounts for as long as the law (and your resources) allow. But going too far down that road might bunch up your taxable income in later years and put some of those distributions into a too-high tax bracket. It’s certainly not easy weighing that long-term cost against the long-term benefit of tax deferral.

Here’s a way you might be able to get the best of both worlds. Let’s say you plan to open up the taxable spigot full force, and take all of your spending this year from your taxable account. That’s good, in that it maximizes the tax deferral benefit of your two tax-favored retirement accounts. But it’s bad, in that it will put you in an extra-low tax bracket this year, at the cost of putting you in an extra-high bracket in later years. What to do, what to do? Eureka! I’ve got it! Use some of this year’s low tax bracket to convert some of your traditional IRA to a Roth IRA—just enough to get you to the top of your extra-low tax bracket. Then you can tap some of that newly bulked-up Roth IRA in a later year—tax-free—to avoid kicking yourself into a higher bracket. Voila! You retain (actually improve) the benefit of tax deferral and avoid creating a future high tax bracket.

When playing with spigot planning, be sure not to make the mistake of spending too much. After all, one of the primary goals of your spending plan is to equalize spending by the Present You and the Future You; more accurately, to equalize after-tax spending. So when you turn down the traditional IRA spigot, and yurn up the taxable account spigot, you’re building in a bigger tax bite into future years’ spending, which needs to be taken into account.

And one last thing:
Happy 200th birthday, Charles Darwin!

The Dark Side of Tax-Favored Savings Plans

In a few recent posts, I have extolled the benefits of saving inside the shelter of tax-favored retirement plans, and discussed ways to move more of your savings from a taxable investment account into a tax-favored one. But all is not sweetness and light! There are some downsides to weigh against the benefits before you go full bore. Here is a summary. (Alert readers should please let me know, by comment or email, if I have left anything out.)

Restricted access. When you contribute to an employer plan (such as a 401(k) plan), you can’t get access to your account any time you want it. The terms of the plan describe the limited times when you can get at your savings—typically termination of employment; sometimes financial hardship. This consideration does not apply to IRAs, which are freely available to you anytime you want.

10% penalty. If you take funds out of an IRA or 401(k) or other tax-favored retirement plan before you reach age 59-1/2, the amount distributed is subjected to a 10% tax penalty unless an exception applies. (Who came up with that age?) In a future post, I will briefly describe the exceptions to this penalty.

Income tax. Distributions from traditional pre-tax retirement accounts are generally subject to income tax. This is fair, of course, since you didn’t pay tax on those dollars going in. Nonetheless, it’s often hard to remember that when you’re actually faced with the burden of paying the tax.

Negative tax rate arbitrage. If you’re lucky enough to be taking a large enough distribution, there’s the possibility of paying a greater rate of tax coming out than you saved going in. This could be the result of events unique to you, or due to a legislated tax rate increase. It might well be the case that the benefits of compounding your investment earnings at a pre-tax rate of return, as discussed in January 30’s post, exceed the detriment of a higher tax rate on distribution. But it still won’t feel good to pay that tax. (Side note: Many people benefit from retiring to no-income-tax states like Florida. They saved state income tax on contributions in the state they worked in, e.g., New York, but then pay no income tax upon distribution because they then reside in a state without an income tax. All that, and palm trees, too!)

Roth income tax. Distributions from a Roth account are supposed to be totally tax-free. But if you take a distribution before age 59-1/2 and at least five years from when you started contributing, the earnings portion of your distribution will generally be subjected to tax.

Investment control. When you contribute savings to an employer plan, like a 401(k) plan or 403(b) plan, your investment flexibility is constrained by the options offered by the plan. Your employer’s plan might limit the investments offered or the frequency with which you may make investment changes.

Investment no-nos. Some types of investments are inappropriate for any tax-favored retirement account. With retirement accounts, certain types of investments are prohibited (e.g., investments resulting from self-dealing); some are penalized (e.g., works of art); some generate income tax (e.g., leveraged investments); and some are just too awkward to house within a retirement account (e.g., real estate).

Spouse’s rights. When you contribute to an employer plan, such as a 401(k) plan, federal law gives your spouse certain rights to be named death beneficiary of those accounts, perhaps restricting how you would have liked to leave your assets upon your death. Not a problem for most people, but perhaps for some.

Most people, I suspect, can live with these restrictions. But they should be taken into account when considering how much of your savings is housed within a tax-favored retirement plan.

Roth Opportunities

In yesterday’s post and in January 15’s post I discussed how Roth retirement savings can be a valuable option for people who are contributing the maximum allowable amount to their tax-favored retirement plans, or who want to shift more savings from a taxable investment bucket to a tax-favored retirement plan. “Okay,” you say, “sounds right to me. I’m doing it.” Not so fast, Kowalski. Unfortunately, the feds have erected barriers to Roth-ification. Here’s a brief rundown of those barriers.

(Here’s a fun fact to know and tell. Roth retirement accounts are named after the late Senator William V. Roth, Jr. of Delaware, who championed their creation. “Roth IRA” is the first known instance of an individual’s name actually appearing in the Internal Revenue Code. And thus the late Senator Roth has achieved immortality. But as Woody Allen said, I’d rather achieve immortality by not dying.)

Roth opportunities, like detergent, come in three sizes: small, medium and large. And the barriers differ for the three.

Small. You can make your annual Individual Retirement Account contribution to a Roth IRA instead of a traditional pre-tax IRA.
• The maximum contribution is $5,000 (plus cost-of-living increases beginning 2010).
• Plus an additional $1,000 if you will have reached age 50 by the end of the year (plus cost of living adjustment beginning 2010).
• Also may not exceed your earned income (e.g., salary or self-employment income, but not interest or dividends).
• Annual Roth IRA contributions are not allowed if your Adjusted Gross Income for the year (2009) exceeds the following limits. There’s a small range ($10,000 - $15,000) of Adjusted Gross Income above these limits where a Roth IRA contribution is reduced rather than prohibited:
o Married, filing jointly: $166,000
o Single: $105,000
o Married, filing separately: $0

Medium. You can make your elective deferral to your employer’s 401(k) plan or 403(b) plan on a Roth basis instead of a traditional pre-tax basis.
• The maximum contribution is $16,500 (plus cost of living adjustment beginning 2010).
• Plus an additional $5,500 if you will have reached age 50 by the end of the year (plus cost of living adjustment beginning 2010).
• Unlike Roth IRA contributions, with Roth 401(k) contributions there is no cap on your Adjusted Gross Income.
• But there is a potential barrier: This opportunity only applies if your employer’s plan offers it.

Large. You can convert all or part of an existing traditional IRA to a Roth IRA, regardless of its size.
• There is no limit on the amount in the IRA that can be converted.
• You must pay income tax on the amount converted.
• In 2009, this opportunity is restricted to those with Adjusted Gross Income of $100,000 or less (and is not available if you are married, but filing separately).
• “Adjusted Gross Income” is specially defined to exclude income realized from the Roth conversion itself and from required minimum distributions for the year.
• BIG NEWS: The Adjusted Gross Income limitation disappears in 2010, and this opportunity will be available to all with traditional IRAs!

Roth-ificate Your Savings Buckets

Remember Ward Cleaver from yesterday’s post? What he did was to shift money from an ordinary taxable investment account into a tax-favored retirement account. He did that by increasing his tax-deductible savings up to the maximum amount available to him. Today’s post discusses another way to shift assets from a taxable savings bucket to a tax-favored savings bucket. Roth-ificate your retirement account. If you’re allowed to.

If you have assets in a taxable investment account, using some of those assets to pay the income tax cost of converting your tax-favored savings to Roth savings is very much like shifting assets from a taxable savings bucket to a tax-favored one. Just like what Ward did in yesterday’s post.

That last statement is so counter-intuitive as to be, frankly, incredible. Am I saying that paying extra income tax is like adding more to your retirement plan? Yes I am. I alluded to this already in January 15’s post. In today’s post I’ll provide a more concrete example to show how it works.

Consider Ward from yesterday’s post. He’s planning to defer $22,000 into his employer’s 401(k) plan, and he has $66,000 in a taxable savings account. (He had $75,000, but yesterday he figured it would shrink by $9,000 to increase his planned 401(k) contribution to $22,000.) It’s early in the year, and he hasn’t contributed any of the $22,000 yet. Before he does, he’s considering making the contribution on a Roth basis, which his 401(k) plan allows. Ward figures that at his 25% income tax bracket, it will cost him $5,500 more income tax to do this (= 25% x $22,000). Which will leave him $60,500 in his taxable account. Ward figures this $5,500 expenditure is financially equivalent to turning his $22,000 contribution to a $29,333 contribution (= $22,000/(1 – 25%)). So he decides to Roth-ificate his 401(k) contribution. They don’t call him Clever Cleaver for nothing!

To see how paying taxes is like adding to tax-favored saving (incredible!), consider the following: Yesterday, we figured it would cost Ward $9,000 from his taxable account, after paying income tax, to increase his traditional pre-tax 401(k) contribution by $12,000. Had he been allowed to increase it to $29,333 (a $19,333 increase over his $10,000 planned contribution), by the same reasoning his taxable account would have been reduced by $14,500, to $60,500. So his taxable account is the same whether he Roth-ificates his $22,000 contribution, or hypothetically increases a pre-tax contribution to $29,333. But what kind of annual retirement benefit do these two different contributions get him? To see that, look at the chart on the bottom of this post. They’re the same! Ward can effectively shift more savings from a taxable environment into the shelter of a tax-favored environment!

This example explains why it's simply wrong to base your Roth-ification decision solely on a comparison between today's income tax bracket and your projected future tax bracket. In fact, there was just a short-sighted statement to that effect in an article in yesterday's New York Times. In a future post, we'll explore how this effect can easily justify paying a higher tax going in than you save going out!

Roth-ification only works this well if you pay the income tax cost with dollars that are outside your retirement account, i.e., either out of your current salary or from an existing taxable investment account. And it only works, of course, if you are allowed to Roth-ificate your retirement savings. More on that tomorrow.

Shifting Savings Buckets

Let’s say you’re working and saving a prudent amount toward retirement. Good for you. Let’s say you’ve read Wednesday’s post about the maximum amount you can contribute to a tax-favored retirement plan. Let’s say the amount you’re allowed to contribute is more than the amount you’re adding to savings this year. If you’ve got a meaningful amount sitting inside an ordinary taxable investment account, you should consider shifting some of that to a tax-favored savings bucket to take advantage of its superior earning power (as discussed in January 28’s post)

Here’s a f’rinstance. Consider Ward Cleaver. He’s figured that he should be saving $10,000 this year, out of his $100,000 salary, which he’s doing through his employer’s 401(k) plan. Ward’s allowable maximum deferral this year (2009) is $22,000 (Ward is age 50). He has an ordinary taxable investment account with $75,000 in it. So Ward increases his deferral into the 401(k) plan by another $12,000 of his salary. To make up for his reduced take-home pay, he takes some funds out of his savings account. Actually, he withdraws less than $12,000. Because of the tax deduction, if Ward is in the 25% tax bracket, his take-home pay is reduced by only $9,000 as a result of the additional $12,000 deferral, so he only has to withdraw $9,000 from his investment account. Voila! Ward has taken advantage of the $22,000 maximum allowable tax-favored saving without reducing his spending by more than the desired $10,000 amount. Clever Cleaver!

But isn’t it imprudent for Ward to be spending down his savings? No, not necessarily. He’s not spending down his savings. What he’s really doing is indirectly shifting a piece of it from his taxable savings bucket to his tax-favored savings bucket.

The main things Ward has to consider are the restrictions he’s bought into with that shift. Is the superior earnings power of the 401(k) bucket worth the additional restrictions? Assets inside his taxable savings bucket are totally flexible. They may be invested and spent when and how Ward sees fit. But there are three main restrictions Ward’s buying into with the 401(k) plan: (i) He’s limited to investments offered by the plan. (ii) He can only gain access to the assets when the plan allows—perhaps not until after he leaves his company. (iii) And if he wants to spend the money before he’s 59-1/2, he may have to pay a 10% tax penalty for the privilege of doing so.

I think I need to devote a couple of future posts to a discussion of these restrictions. I’ll get back to you.

Ward weighed the pros and cons and opted for the superior earning power of the 401(k) plan over the flexibility of the taxable investment account. If he was saving that money toward his son Wally’s college education expenses over the next few years, he might not have done the same thing.

Overview of the Retirement Spending Process

Let’s say you’re just about to retire. They’ve thrown you the party, given you the watch, and you’re out the door. You’ve got, say, $1,000,000 saved up. Now what?

(If you’re still in your working years, please don’t tune out. You need to have an idea of what the process will be once you get to retirement. That will then allow you to set a savings target for yourself.)

Now you’ve got to determine—and meet—your standard of living out of your accumulated savings. You’ve got to give yourself an allowance. You’re passed the planning stage; you can no longer determine how much to save out of your salary, because you’ve cut that lifeline. Your only degree of freedom is to bow to reality, and determine how much of a lifestyle to treat yourself to based solely on your available resources. You’re like a teenager who has to get by on the allowance Mom and Dad give you, but you’re also Mom and Dad determining what that allowance is. How do you determine that allowance?

Here’s an overview of the seven main steps in the process of determining your allowance.
Step One. Think about, and make a rough guess at, your personal poverty level, as discussed in January 17’s post. It will help to have a rough sense of this as you go through the remaining steps.
Step Two. Adopt a spending plan, i.e., the methodology you will go through every year to convert your wealth into an annual allowance. For example, in January 13’s post I described one I don’t particularly care for. I will describe others in future posts.
Step Three. Adopt an investment plan, i.e., a suitable allocation of your retirement assets among major asset classes (you know, stocks, bonds, cash). Your investment plan may very well involve a projected change in asset allocation as your projected days on earth shrinks over time. Lots more on this subject in future posts.
Step Four. Adopt appropriate assumptions for all those unknowns. You know, investment returns, inflation, your life expectancy, and the like.
Step Five. Now run those assumptions through your spending plan and investment plan, and out pops your allowance!
Step Six. Now figure out how to get by on your allowance.
Step Seven. Every year, repeat Steps Four, Five and Six.

That’s just an overview. There’s a lot of thought and decision-making that has to go into these steps. In fact, I get tired just thinking about it. I gotta go lie down. More to come in future posts. Lots more.

The Illusion of Probability

Did you spot the fallacy in yesterday’s post?

Here it is: It is misleading of me—and frankly of the whole financial profession—to assign probabilities to levels of confidence. How do you know that it’s 50% probable that you’ll be able to spend this amount or that? Nobody knows the future. And nobody even knows how to assign probabilities to the future. Nonetheless, I will continue to do so, because it serves a useful purpose.

I think I better explain myself.

When you flip a coin, you don’t know what the outcome will be—heads or tails. But at least you know that it’s 50% likely to be heads. You have some certainty about your uncertainty. But with financial matters, we don’t even have that. We can pretend to assign probabilities to various outcomes, e.g., “the stock market is 50% likely to return 9% or more over the long-term.” We might glean these false probabilities from the market’s historical performance. Or we might glean them from sophisticated modeling employing Monte Carlo simulations (which are, at bottom, based on historical performance). But the fact is that the financial markets simply don’t follow the same neat laws of probability as coin flips do.

In his eye-opening book, The (Mis)behavior of Markets, the eminent mathematician (and some-time economist) Benoit Mandelbrot totally debunks the illusion that market prices bear any resemblance to coin flips. Rather than following the same neat laws of probability, markets follow their own logic. Millions of people buying and selling, each motivated by their own needs, opinions, and prejudices, create a turbulence that can’t be explained by the same rules that govern coins and dice. See 2008 for an example.

(By the way, Mandelbrot has earned his credibility. He is one of the founders of chaos theory, and the discoverer of the “Mandelbrot set.” Should you happen to get a case of the visual munchies, gaze at a picture of the Mandelbrot set for a while. You can see an animation of it in Wikipedia here. Scroll down to the heading labeled "Zoom Animation.")

So if we can’t legitimately assign probabilities to financial outcomes, why did I do that in yesterday’s post? And in January 14’s post? What kind of double-talk is this? I think assigning fake probabilities serves a useful purpose. It provides a basis for comparison. We can all agree that “50% confident” is better than “25% confident.” But just don’t fall for the illusion of precision. I can’t legitimately say that “50% confident” is twice as confident as “25% confident.” The numbers are just not that meaningful.

Your Number

Everyone wants to know, “What’s my Number?”

How much do you need to accumulate in order to retire securely, to cut your lifeline to the main source of your income? A couple of years ago, Lee Eisenberg wrote an excellent book called The Number. In it he asks you to think about the tough issues you have to wrestle with before you can even think about arriving at an answer. One of the main purposes of this column is to take the next step, to go beyond the broad issues raised in the book and to (gradually) give you the tools to arrive at your Number.

The first thing you have to realize is that the savings you need to accumulate—your Number—will really buy you two distinct things: the dollars to meet your standard of living, and security that there’s enough remaining to last your and your spouse’s lifetimes. For shorthand, let’s call them “Consumption” and “Confidence.” Every penny you add to the pot can buy you more Consumption or more Confidence, but not both. A glib financial planner might ask, “What would you rather do? Eat better or sleep better?” (Financial planners learn that question in Chapter 1 of the Junior Woodchuck Guide to Financial Planning.)

A quick diversion. There’s actually a third thing that goes hand in glove with Confidence, and that’s an inheritance for your children or favorite charities. The less you spend on Consumption and instead allocate to Confidence, the more you increase the likelihood and size of your kids’ inheritance. So to be more accurate, the dichotomy is not between Consumption and Confidence, but between Consumption and Confidence/Kids. I think most of us are struggling to earn a decent retirement, and are not particularly motivated to grow their kids’ inheritance. Nonetheless, that becomes an inevitable by-product of increasing your Confidence. Think of it as their unintentional inheritance.

What makes it so hard to come up with your Number is your need to figure out where you sit on the Consumption-Confidence matrix. It’s relatively easy to get a handle on Consumption. You sort of know how much you’re spending—the cost of your lifestyle. But Confidence is another dimension altogether. What does it mean to say you’re 50% confident? 75% confident? 99% confident? 100% confident? (No, forget 100% confident. There’s no such thing.)

And are you really so self-aware that you can focus on alternative hypothetical standards of living? I want to be 99+% sure of a $50,000/year standard of living; 75% confident of a $60,000/year standard of living; and 50% confident of a $70,000/year standard of living. If you’re a genius of self-awareness, you can come up with more and more ever-finer Consumption-Confidence goals. Each one will (eventually, with enough tools and work) translate into a savings goal. And then your target—your Number—is the largest of the goals you’ve been able to think of.

Can you spot the built-in fallacy in today’s post? For the answer, see tomorrow’s post.

Limitations on Tax-Favored Retirement Savings

After reading the last couple of posts, I expect you may be convinced, as I am, that a tax-favored retirement plan is the best place to accumulate your retirement savings target. “I’m going to do all my saving inside a tax-favored retirement plan,” you say. Not so fast, Froggy. Congress has imposed annual limits on how much you can add to these types of plans. Here’s a quick and dirty guide to these limits for 2009.

Individual Retirement Accounts (traditional IRA or Roth IRA)
• $5,000 (plus cost of living adjustment beginning 2010)
• Plus additional $1,000 if you will have reached age 50 by December 31, 2009 (plus cost of living adjustment beginning 2010)
• Also limited to your earned income (e.g., salary or self-employment income, but not interest or dividends)
• Aggregate contributions to traditional and Roth IRAs are subject to above limits
• Roth IRA contribution not allowed (or limited) if you have adjusted gross income over:
o $105,000 if single
o $166,000 if married filing jointly
• Contribution to traditional IRA may or may not be deductible (the subject of a future post)

401(k) plans and 403(b) plans and 457 plans
• Elective deferral limits:
o $16,500 (plus cost of living adjustment beginning 2010)
o Plus additional $5,500 if you will have reached age 50 by December 31, 2009 (plus cost of living adjustment beginning 2010)
o Limits apply in the aggregate to elective deferrals to all employer plans you participate in
• Other employer contributions (e.g., matching contribution and/or profit sharing contributions):
o $49,000 (plus cost of living adjustment beginning 2010)
o Also limited to 25% of your compensation from the employer
o Your employer may also fund a traditional defined benefit pension plan for you

Simplified Employee Pension Plans (SEPs)
• $49,000 (plus cost of living adjustment beginning 2010)
• Also limited to 25% of your compensation from the employer

SIMPLE IRA Plans
• Elective deferral limits:
o $11,500 (plus cost of living adjustment beginning 2010)
o Plus additional $2,500 if you will have reached age 50 by December 31, 2009 (plus cost of living adjustment beginning 2010)
• Other employer contribution:
o Dollar-for-dollar matching contribution for elective deferrals of up to 3% of compensation; or
o Non-elective employer contribution of 2% of compensation

Pre-Tax vs. After-Tax Returns

In January 30’s post I showed how the most valuable feature of tax-favored retirement plans is their tax exemption, compared to investing inside ordinary taxable investment accounts. How do you assess that value as you weigh the pros and cons of contributing to a tax-favored retirement plans? The two most important factors influencing that value are: (i) time (how long before you must distribute dollars from the plan?), and (ii) return differential (what is the difference between your pre-tax rate of return and your after-tax rate of return?). In today’s post I want to give some thought to the second factor.

In the example in January 28’s post, Ralph and Ed were in the 30% tax bracket during their working years. I asked you to assume that their investments earned 7%, but that Ed’s investment returns, being outside the shelter of a retirement plan, were shaved down to 5.3%. Where did that come from?

Wouldn’t it be better to assume that if Ed is in the 30% tax bracket, his investment income would be shaved by 2.1 percentage points (= 30% x 7%), down to 4.9%? No, Kemosabe, it would not. Why not? I’m glad you asked.

Shaving Ed’s return by his tax rate would be accurate enough if all of Ed’s investments were in the form of taxable bonds and other interest-bearing investments. But how likely is that? It’s more likely to be invested in a mixture of asset classes, with more complicated tax treatment. Consider all these complications:
• To the extent invested in municipal bonds, the appropriate differential is determined by the difference in interest rates between taxable and municipal bonds, as dictated by the financial markets and not Ed’s tax bracket at all.
• To the extent invested in stocks, a big component of Ed’s expected return is appreciation in value, which is not taxed at all until there’s a sale of the stock.
• When there’s a sale of appreciated stock, that appreciation is turned into capital gain, and Ed will have to pay tax on that gain. But the Feds give us a break and impose a lower tax rate than Ed’s 30% if the gain is long-term (i.e., the stock was held more than a year). Currently the federal rate is 15% or lower. That huge break may not hold for very long, but it’s a safe bet that long-term capital gain will continue to receive some sort of favorable treatment.
• And capital gain is very lumpy. It’s realized in chunks as Ed chooses to sell appreciated stock, unlike interest and dividends, which are taxed smoothly as they accrue. With capital gain, you can easily end up with a big tax bill in a money-losing year simply because that’s the year you choose to sell and reap prior years' appreciation.
• Under current tax law, built-in appreciation that has not been realized (by a sale of the stock) disappears at death and doesn’t get taxed at all. Well, actually the appreciation doesn’t disappear—just the taxation of it. (That particular rule is scheduled to change in 2010, but I have a feeling Congress and Obama will opt to retain the existing rule when it acts to reinstate the federal estate tax.)
• Currently, dividends are taxed at a preferential rate, like long-term capital gain, which is another complicating factor. Although it does not seem likely that will continue beyond 2010.

So if you invest a portion of your taxable account in anything other than taxable bonds, it is likely that your after-tax investment return will be somewhat greater than the number you would get by simply reducing your pre-tax rate of return by your tax rate. There will be some remaining differential, however, and that will be a big factor in determining the benefit you can expect from housing your savings in a tax-favored retirement account.

Projections, Predictions, Assumptions

Yesterday’s post talked about the need to do a new projection every year as a way of constantly adjusting your planning to reality. Makes sense. But . . . what’s a projection? Here’s the transcript of an actual recorded conversation between Kwai Chang Caine and Master Po.

Caine: “What’s a projection, Master Po?”
Po: “It’s an educated guess about the future, Grasshopper”

“And do I get this guess from a Magic Eightball? Or from the wind?”
“No, Grasshopper, it’s an educated guess. No fingers in the wind. You start with the facts—the things that are real. To that you add assumptions about the future—how long you will live, what your investments will earn, how much your salary will be—such things as that.”

“So these assumptions, they are my predictions for the future?”
“No! No predictions! We are Shaolin priests, not charlatan fortune tellers!”

“Thank you for correcting me, Master. I am humbled by your wisdom. And where do these assumptions come from?”
“You must glean them from the world as you see it. You can take them from history. Or from indicators if you like. Or from reputable experts. Whatever source is rational and readily at hand.”

“Can I take them from different sources in different years?”
“Bad idea, Grasshopper. That is a prescription for fooling yourself. And a Shaolin priest, above all else, never fools himself. Try to avoid switching sources. Be consistent in the source for each of your assumptions”

“So this annual prediction . . . no, projection . . . it is my educated guess as to the most probable outcome for the future?”
“Close, Grasshopper. Not the most probable. But rather, the expected outcome. The probable center of all possible outcomes.”

“I think I understand, Master. But I must ask one more question if I may.”
“Knock yourself out, Grasshopper.”

“You said I could find reasonable assumptions from history if I choose, such as average returns on stocks or bonds. But Master Kan has taught me that history is no predictor of the future. So how is that a reasonable basis for making a projection? Or projecting an expected outcome?”
“That’s a tough one. We Shaolin masters think long term. And we believe that certain historical long-term tendencies are likely to reassert themselves in the long-term future.”

“That still sounds like double-talk to me. No disrespect intended, Master.”
“Shaolin masters do not engage in double-talk, Grasshopper. Now go out and preach the ways of peace. And beat up some bad guys with your stick.”

Your Annual Date with Reality

Get real. Really. At least annually, get real.

Whether you’re in your working years or your retirement years, the main challenge of retirement planning is figuring out an appropriate amount to save (in your working years) or to spend (in your retirement years). Actually, the main challenge is then sticking to your budget. But the main planning challenge is figuring out this amount. The amount you come up with is bottomed on projections about the future, which will most assuredly not come to pass. They’re just guesses after all. Reality and your projections diverge a little bit more every day.

These divergences come from all over the place. They come from outside your personal life, such as the financial markets (was it a better than projected year for stocks, or worse?); and from events unique to you—an unexpected bonus, a surprise leak in your roof.

So the method you’re using to come up with your saving or spending amount had better have a built-in mechanism for periodically adjusting to cold reality. If you don’t, one of two things will happen. If things go worse than you projected, you will gradually pauperize yourself. If things go better than projected, you will gradually build up an inheritance for your children (the worthless good-for-nothings!) at the expense of the more comfortable lifestyle you could have treated yourself to.

How often should you recalculate? At least annually. You could do it more frequently, like monthly, but you’d drive yourself crazy. Your saving/spending amount would bounce up and down with the same sort of volatility as you see in your 401(k) statement. You’d be seasick in no time. Or you could do it every five years, but then your adjustments would be vertiginous. Annually seems about right. Pick a month, and then set aside some time for your annual review. I don’t like December for this task—too much other stuff going on. January or February seem about right. A good time to be inside; not much else happening then (unless you celebrate President’s Day bigtime); early enough in the year to adjust your elective deferral to your 401(k) plan.

The benefit of annual adjustments is that they will be small in relation to the size of actual events. The younger you are when it happens, the smoother the adjustment. That’s because you have a whole lifetime to make up for (or revel in) the large unexpected loss (or gain).

Here’s a f’rinstance. Remember Ernie from January 21’s post. He had $75,000 in his 401(k) plan, and projected an annual savings goal of $8,426 over the next 25 years. Let’s say instead of earning 6% as projected, his 401(k) account lost 33% of its value, dropping to $50,000 (sound like 2008?). When Ernie refigures his annual savings goal the following year, all other things being equal, it will work out to $10,776 per year for the next 24 years. That’s a $2,350 increase in required saving to make up for a $25,000 loss. It will pain Ernie to reduce his current spending by that amount, but it won’t devastate him.

If you’re in retirement, your adjustment might be more dramatic. That’s a subject for another post.