Planning Errors to Avoid

We cannot avoid getting older, but we can avoid making mistakes with regards to our retirement planning.  For many of us, our retirement benefits may represent our largest asset.  For the rest of us, they are important enough to manage responsibly.

The rules governing our retirement benefits are complicated.  They revolve around both income tax and estate planning.  It is imperative that we at least recognize, and hopefully avoid, the following common errors when planning for our retirement.

Failing to convert to a Roth IRA

Provided you have non-retirement funds to help pay the tax on the conversion, converting to a Roth IRA is the same as making a substantial additional contribution to your IRA.  By way of example, assume you have $100 in your IRA and $30 in other assets.  If you convert your IRA to a Roth and utilize the $30 to pay the income tax on the conversion, you will have $100 in your Roth IRA.  Over the next X years, the asset will grow to $200, which either you or your beneficiaries will be able to withdraw income tax-free.

On the other hand, over that same period of time, if you had not converted the $100 IRA, it will still have grown to the same $200.  However, when you begin to withdraw the $200, you will now have to pay $60 in tax, leaving you $140.  You would have to have a 0% tax rate on your investment income and gains in order for your original $30 taxable account to grow to the same $60.

In addition, the Roth IRA offers the following:

  • No required distributions during lifetime, including the requirement that traditional IRAs have when one reaches 70 ½.
  • Internal Revenue Code section regarding income in respect of a descendant only covers the Federal but not the state income tax.  By converting to a Roth, all of the income tax is removed from the estate for estate tax purposes, while at the same time preserving the stretch out of the IRA distributions.
  • The Roth is a much more valuable asset than a traditional IRA to fund an Exemption Trust, or for that matter, a generation skipping transfer exempt disposition.
  • Under a traditional IRA, assets left in trust are generally subject to compressed income tax brackets.  This is not true for a Roth IRA.
    Generally, in order to convert to a Roth IRA, the IRA’s owner’s modified adjusted gross income cannot exceed $100,000.  However, beginning in 2010, this income cap will no longer apply, enabling more IRA owners to convert to Roths.

Leaving retirement benefits outright to children or grandchildren versus in a discretionary trust

The use of a trust for disposition purposes other than the outright gift offers several opportunities.  They are as follows:

  • Assets in trust are better protected against the beneficiaries’ potential creditors, including divorce, and will not be included in the beneficiaries’ estates.
  • The same reasons apply for leaving other assets in trust that apply to retirement benefits, thus often making it desirable to leave retirement benefits to children or grandchildren in trust rather than outright.  However, please note the stretch out is limited to the life expectancy of the oldest beneficiary of the trust.  In other words, no accumulated IRA benefits can ever go to anyone older than the designated beneficiary.
  • To the extent distributions are required to be distributed from the trust, the protection of the trust is lost.  Thus, one should consider making the trust discretionary, thereby giving the beneficiary the desired degree of control over the trust at a specified age or ages.

Not participating in a retirement plan

As we know, qualified retirement plans allow for tax free compounding of both the income and the gains over long periods of time.  As an example, at an 8% annual return, an employee contributing $15,500 to a 401(k) plan per year will have almost $5,000,000 after 40 years.  This is without any matching contributions, other employer contributions, future increases in the permissible contributions or any catch up contributions after age 50.

A misconception that many harbor is that by contributing to a retirement plan, one is converting capital gains to ordinary income, or for that matter, giving up the opportunity to take advantage of the current 15% tax rate on qualified dividends and capital gains.  However, consider that the effective tax rate on income and gains in an IRA is 0%.  As an example, assume you contribute $5,000 to an IRA and over some period of time, the $5,000 grows to $50,000.  If you are in a 30% tax bracket and you withdraw the $50,000, you will have $35,000 remaining after income taxes.  Now, let’s suppose instead you had paid $1,500 of tax at the beginning and had invested the remaining $3,500 in your taxable account.  The $3,500 taxable account growing to the same $35,000 would require a 0% tax rate on your investment income and gains.

Withdrawing benefits too soon.

Retirement plan participants must generally begin taking benefits at age 70 ½.  However, the benefits may be stretched out over a longer period of time during the IRA owner’s lifetime and after the IRA owner’s death.  This can be accomplished by first using other assets and thus preserving the income tax benefits of the retirement plans.

Failure to leave retirement benefits to your spouse.

There are income and estate tax benefits to leaving a qualified retirement plan to one’s spouse.  They are as follows:

  • The benefits will qualify for the estate tax marital deduction.
  • The surviving spouse may rollover the plan into their own IRA, thus giving them the ability to name new beneficiaries and even convert to a Roth IRA, thereby obtaining a longer income tax stretch out.

Failing to coordinate the designation of the beneficiary with the estate plan.

It is not uncommon for clients to have wills and trusts containing very detailed provisions for the disposition of their assets.  However, the retirement benefits will not pass via the Will or Trust, but instead will pass in accordance with the beneficiary designation.  It is important for retirement plan owners to coordinate their beneficiary designations with the rest of their estate planning.

Coordinating with an Exemption Trust.

With the increasing allowable exemption, many participants do not have enough non-retirement assets to fully fund an Exemption Trust.

Clients must now choose between the income tax benefits of leaving a retirement plan to the spouse and the potential estate tax benefits of fully funding an Exemption Trust.  Under the decoupling of estate taxes, this now becomes a factor as well.

It is possible to leave a portion of the retirement plan to the Exemption Trust or to a trust for the benefit of the children or grandchildren in order to fully utilize the exempt amount.  It is also conceivable to leave the retirement benefits to the spouse, who in turn could disclaim them to the extent necessary to fill up the Exemption Trust.

Not considering a spousal rollover.

As we discussed earlier, there are many benefits to naming the spouse as a beneficiary, i.e. rolling the benefits over into the spouse’s IRA, naming new beneficiaries, and possibly converting to a Roth IRA.

However, once in a while the spouse is not the named beneficiary.  Under numerous Private Letter Rulings issued by the IRS, they are now allowing a spousal rollover even if the spouse was not the named beneficiary.  As an example, retirement benefits may pass down to the spouse under the default provisions of a qualified plan or IRA.  In other cases, the IRA may go to the spouse as a result of a disclaimer, or by intestacy, by reason of the elective share, as community property, or through an estate or a trust in which no one other than a spouse can cause the retirement benefits to be payable to anyone other than the spouse.

If there are no contingent beneficiaries, the benefits will be distributed in accordance with the default provisions of the plan.  If there are no default provisions, then the benefits will go to the participants or the IRA owner’s estate.

A beneficiary may be able to disclaim even after receiving distributions from the IRA.

So, as you can see, there are numerous opportunities for error when dealing with your retirement plan.  Therefore it is important to consult with your advisory team before embarking upon a strategy regarding the distribution and/or set up of your retirement plan.